Understanding earnings quality - MIT Sloan School of Management

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3.1.1.6 Determinants and consequences and interpretation of discretionary accruals proxies If “normal” accruals are the predicted value from a regression model of accruals associated with the firm’s fundamental earnings process, then abnormal accruals represent estimation errors, which can be intentional or unintentional. Almost one hundred papers in our database use abnormal accruals as a measure of earnings quality and test predicted determinants or consequences. These studies test the joint hypothesis that the residual from an accruals model reflects earnings management and that the predicted determinant induces earnings management or that earnings management has a predicted consequence. For ease of exposition and to reduce the amount of repetition in this survey, we discuss the results of such tests in the relevant determinant or consequence section. In this section, however, we emphasize several general findings. First, while abnormal accruals are less persistent than normal accruals, they do have positive persistence. Xie (2001) finds that discretionary accruals have a significantly positive persistence coefficient of 0.57. In addition, Subramanyam (1996) uses the modified Jones model to measure abnormal accruals and finds incremental information content in abnormal accruals, which he interprets as evidence that abnormal accruals are not opportunistic but that they communicate private information about equity value. Also using the modified Jones model to measure abnormal accruals, Chaney, Jeter, and Lewis (1996) suggest that discretionary accruals smooth earnings and they interpret their finding as evidence that discretionary accruals are not opportunistic but that they communicate information about the firm's long-term (permanent) earnings to equity markets. Subramanyam (1996) and Chaney et al. (1996) assume that investors are able to isolate the abnormal accrual component. If investors are naïve and fixate on earnings, then a positive stock price reaction could be documented even if the accrual component is not value relevant. 43
Second, investors seem to recognize the distinction between abnormal accruals and normal accruals, but they do not fully incorporate the implications into price. DeFond and Park (2001), find that abnormal accruals suppress the magnitude of market reactions to earnings surprises, suggesting that investors do not find them as reliable as normal accrual components. However, even though investors realize that abnormal accruals are less reliable, they still overreact to the information (i.e., the abnormal accrual component is negatively associated with future stock returns). Xie (2001) finds that the accrual anomaly hedge returns are stronger for hedge portfolios based on abnormal accruals measured using the Jones model. Third, research that examines the complete path from a determinant of abnormal accruals through to the consequences for future period earnings comes to a different conclusion than most studies that independently study the links. Bowen, Rajgopal, and Venkatachalam (2008) find an association between lax governance and abnormal accruals, 16 where governance quality is measured by an overall governance score and by the “usual suspects” of individual governance characteristics. Bowen et al. (2008) also find, however, that the accounting discretion associated with lax governance is positively related to future performance (ROA), which they interpret as evidence that abnormal accruals reflect future performance expectations, not opportunism. 3.1.2 Smooth earnings Earnings smoothness or its inverse, variability, is a firm-specific time-series construct. 17 While the concepts statements do not state that “smoothness” is a desirable property of earnings or an objective of the accruals process, SFAC No. 1 does recognize that accrual earnings help mitigate problems associated with a “mismatch” of cash receipts and payments when reporting accounting 16 Bowen et al. (2008) use an aggregate index of accounting discretion. The use of abnormal accruals is one component of the index, along with a measure of accrual-based smoothing and the tendency to avoid negative earnings surprises. 17 Early discussions and analyses of smoothing include Beidleman (1973) and Ronen and Sadan (1975). 44
Page 1 and 2: *Title Page/Author Identifier Page/
Page 3 and 4: Street equity valuation model as ea
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Page 13 and 14: While we identify these contradicti
Page 15 and 16: Proxies for asymmetric timeliness b
Page 17 and 18: sample. Hence, sample specific char
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Page 21 and 22: Empirical studies have examined mul
Page 23 and 24: there are (in theory) predictable a
Page 25 and 26: is primarily driven by the firm’s
Page 27 and 28: methodology. Studies could make uni
Page 29 and 30: The discussion of earnings persiste
Page 31 and 32: and documents that β2 < β1, which
Page 33 and 34: 1993). 12 The studies find conflict
Page 35 and 36: Xie (2001) uses the Jones model (di
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Page 39 and 40: measurement. Nwaeze, Yang, and Yin
Page 41 and 42: and better reflects revenue manipul
Page 43: All of the accruals models can be e
Page 47 and 48: fact improve predictability relativ
Page 49 and 50: lower book values of assets (higher
Page 51 and 52: than code law countries. The differ
Page 53 and 54: explain the kink. Durtschi and East
Page 55 and 56: with overstated net asset values ar
Page 57 and 58: earnings quality. The studies speci
Page 59 and 60: to conservatism, which is defined a
Page 61 and 62: they assert proxy for lower indepen
Page 63 and 64: paper, however, finds that firms ar
Page 65 and 66: Debt covenants: Dechow et al. (1996
Page 67 and 68: eadjustments in valuations associat
Page 69 and 70: ange of misstatements and they are
Page 71 and 72: significantly change the historical
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Page 77 and 78: with “shareholder” corporate go
Page 79 and 80: accruals) that stems from the confl
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Page 85 and 86: firms identified in the AAERs than
Page 87 and 88: past service costs). Zmijewski and
Page 89 and 90: 5.2 Financial reporting practices a
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Page 93 and 94: The notion that accounting method c
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quality and the quality of M&A deci
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In countries with high ownership co
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for the AAER firm executives than f
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Dechow and Sloan (1991), who study
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management related to incentives pr
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nonaudit fees) and discretionary ac
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errors when litigation risk is high
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to suffer from omitted correlated v
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capital accruals as a proxy. Perry
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how the incentives provided by the
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(Jones, 1991); 2) Department of Jus
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5.6.3 Tax regulations Several studi
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importance of implicit claims, they
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attention (Aboody et al. , 1999). 7
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of internal control procedure defic
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differences, which investors ration
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Bid-ask spread: Evidence on the ass
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low accrual quality stock that are
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6.1.5 Summary To summarize, the evi
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plaintiffs will prevail in sharehol
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income increasing restatement firms
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evisions do not fully account for t
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the fact that some disclosures are
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Therefore, the proxies are not meas
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Amir, E., Harris, T., Venuti, E., 1
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Beasley, M., 1996. An empirical ana
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Burgstahler, D., Kinney, W., Martin
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Considine, J., Mensah, Y., Oakes, L
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Desai, H., Rajgopal, S., Venkatacha
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Farber, D., 2005. Restoring trust a
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Gong, G., Louis, H., Sun, A., 2008.
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Hung, M., 2000. Accounting standard
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Kothari, S., Leone, A., Wasley, C.,
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Malmquist, D., 1990. Efficient cont
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Phillips, F., 1999. Auditor attenti
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Tucker, J., Zarowin, P., 2006. Does
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Figure 1. Summary of the investigat
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Figure 3: Key links between determi
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Table 1. Categories of “Earnings
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Exhibit 1: Summary of earnings qual
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Exhibit 2: Summary of widely used m
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