Understanding earnings quality - MIT Sloan School of Management

fact improve predictability relative to cash earnings assuming, like the concepts statement, that the
fundamental earnings process is smoother than the cash receipt/payment process.
Most studies, however, explore the relation between incentives for smoothing and specific
accounting choices (or real activity choices) that generate smoother earnings. The focus is on the
mechanisms used to smooth earnings, but the analyses are joint tests of the incentives and of the
mechanism choice (e.g., White, 1970; Barnea, Ronen, and Sadan, 1976; Moses, 1987; Chaney, Jeter,
and Lewis, 1998; Hand, 1989). Studies of accrual choices frequently investigate specific accounts,
or even employ industry-specific small sample case studies (e.g., Dascher and Malcolm, 1970;
McNichols and Wilson, 1988; Kanagaretnam, Lobo, Yang, 2004). Smoothing is treated as a period-
specific accounting choice, thus these papers typically measure smoothing as the negative
correlation between a proxy for unmanaged earnings (e.g., non-discretionary accruals), and the
“discretionary accrual” that is being used to smooth earnings.
Consequences of smoothness:
The majority of the consequences studies examine the implications of smoothness in a cross-
country context. Section 4.2 discusses these studies. The advantage of the cross-country analyses is
the researcher’s ability to create a smoothness proxy that represents artificial smoothing or earnings
management. Smoothness has both a fundamental component, which is predicted to increase
quality, and an artificial component, which is predicted to decrease quality. The predicted
consequences of the two components are different, thus the research necessitates distinguishing non-
discretionary (normal) smoothness from discretionary (abnormal) smoothness. In the cross-country
studies, the notion is that the measurement error in the model of the fundamental component of
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