Understanding earnings quality - MIT Sloan School of Management

They show that firms with larger standard deviations have less persistent earnings, longer operating
cycles, larger accruals, and more volatile cash flows, accruals and earnings. They are smaller firms
and the firms are more likely to report a loss. They suggest that these firm characteristics are
indicative of a greater likelihood of estimation error in accruals and thus lower accrual quality.
Francis, LaFond, Olsson, and Schipper (2005) modify and extend the Dechow and Dichev
model in two ways. First, as suggested by McNichols (2002), they add growth in revenue and PP&E
to the model of normal accruals. Second, they decompose the regression residual into firm-level
measures of innate estimation errors and discretionary estimation errors, such that the discretionary
error is meant to represent the outcome of “managerial choices” (i.e., intentional errors).
Specifically, FLOS (2005) estimate their accruals prediction model by industry-year and calculate
the standard deviation of the residuals for each firm j in year t [σ(εj)t] based on the value of εj in
year’s t-4 through year t (five years). The standard deviation of the residuals σ(εj)t is a measure of
accrual quality (AQ); higher standard deviations are lower quality. To decompose AQ into an innate
component and a discretionary component, FLOS model AQ as a function of firm characteristics
identified in Dechow and Dichev (2002):
σ(εj)t = λ0,j+λ1,jSizej,t-1+λ2,jσ(CFO)j,t + λ3,jσ(Sales) j,t + λ4,jOperCyclej,t + λ5,jNegEarnj,t + νj,t
The predicted value of σ(εj)t represents the quality of accruals associated with the inherent
ability of an accrual system to capture the firm’s fundamental earnings process, and the residual (νj,t.)
represents discretionary accrual quality. An argument can be made that each of the innate
characteristics could also reflect estimation errors and corrections that would reduce the power of νj,t
(or induce bias) as a proxy for discretion.
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