Understanding earnings quality - MIT Sloan School of Management

driven by special items have positive future returns, which suggests that investors overweight these
accruals.
Several studies also examine the consequences related to industry-specific loss accruals.
Beaver and Engel (1996) find that the normal component of banks’ allowances for loan loss reserves
is negatively priced and the abnormal component is incrementally positively priced. They interpret
the positive coefficient on abnormal accruals as follows: “…positive effects on security prices can
occur because discretionary behavior alters the market's assessment of the expected net benefits of
discretionary behavior or conveys management's beliefs about the future earnings power of the
bank.” McNichols and Beaver (2001) find that investors correctly price the loss reserve accrual even
though they incorrectly price other accruals in a manner consistent with Sloan (1996). Their finding
suggests that the extensive disclosures about loss reserve accruals of P&C insurers help investors to
estimate the persistence and valuation implications of this component.
Finally, Francis et al. (FLOS, 2005) find that firms with more persistent earnings have a
lower cost of debt and equity capital. FLOS use multiple earnings proxies and so for ease of
exposition and to reduce repetition, we provide an extensive review of the literature that predicts the
cost of capital as a consequence of earnings quality in Section 6.
Other than-equity-market consequences: Two papers examine compensation decisions as a function
of earnings persistence. Baber, Kang, and Kumar (1998) find that earnings persistence increases the
positive relation between unexpected earnings and the annual change in various components of
compensation. Nwaeze, Yang, and Yin (2006) find that firms with less persistent earnings have
lower weight placed on earnings relative to cash flows in compensation. Both papers attempt to
distinguish persistence driven by firm fundamentals from persistence associated with accounting
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