Understanding earnings quality - MIT Sloan School of Management

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smoothness is dominated by the cross-sectional variation in the discretionary component, which makes the “abnormal smoothness” measure a reasonable proxy for earnings management. Within the U.S., studies of the consequences of smoothness, artificial or otherwise, are limited. Tucker and Zarowin (2006) find that smoothness improves earnings informativeness. The analysis splits firms into a high smoothing group, defined as firms that have a stronger negative correlation between discretionary accruals and unmanaged earnings (total earnings – discretionary accruals), and a low smoothing group. Their measure of earnings informativeness is the extent to which changes in current stock returns are reflected in future earnings, following Collins, Kothari, Shanken, and Sloan (CKSS, 1994). The high smoothing group has a stronger CKSS relation. This result holds after various controls for the smoothness of the fundamental earnings process. Their conclusion is that the net smoothing effect of accrual accounting, which they predict would lead to greater informativeness if accruals smooth noise but to reduced informativeness if managers artificially smooth earnings relative to the fundamental process, is to improve informativeness and not to garble earnings. 3.1.3 Asymmetric timeliness and timely loss recognition We include in this section any studies that measure separately the timeliness of loss recognition and profit recognition. A more timely recognition of losses is often associated with a “conservative” accounting system (Basu, 1997; Pope and Walker, 1999). More recent studies distinguish conditional conservatism, which is more timely recognition of bad news than of good news in earnings, from unconditional conservatism, which describes an ex ante policy that results in 47
lower book values of assets (higher book values of liabilities) in the early periods of an asset or liability life. 18 The most frequently used measure of timely loss recognition is the reverse earnings-returns regression from Basu (1997). Earningst+1=α0 + α1Dt + β0Rett+β1Dt Rett + εt where D = 1 if Ret < 0, and a higher β1 implies more timely loss recognition. The specification is reported in Exhibit 1. Basu (1997) provides a second measure that is not based on returns. ΔΝΙτ =α0 +α1NEGDUM+α2ΔΝΙτ_1+α3(NEGDUM*ΔΝΙτ_1) + ετ where ΔNIt is the change in income from year t-1 to t, scaled by beginning book value of total assets, and NEGDUM is an indicator variable equal to one if ΔNIt-1 is negative. If bad news is recognized on a more timely basis than good news, negative earnings changes will be less persistent and will tend to reverse more than positive earnings changes. This translates into a prediction that α3 < 0, and Basu (1997) finds support for this prediction. This tendency-to-reverse measure is used in some papers when equity returns are not available (e.g., Ball and Shivakumar, 2005), and it is used in other papers to check the robustness of the results. 19 Our review of the asymmetric timeliness literature focuses on studies of the determinants and consequences of asymmetric timeliness, specifically when it is a suggested measure of quality. Ryan (2006) provides a recent and thorough review of the literature on conservatism, more generally including measurement issues. 18 Basu (1997) uses the term conditional to describe his measure of conservatism, but he does not specifically call it “conditional conservatism.” 19 The use of this measure to check the robustness of the results based on the Basu (1997) reverse regression measure has increased since the publication of Dietrich, Muller, and Riedl (2007), which suggests that the reverse regression measure is biased. Ryan (2006) questions the magnitude of the bias, but also provides some possible solutions. 48
Page 1 and 2: *Title Page/Author Identifier Page/
Page 3 and 4: Street equity valuation model as ea
Page 5 and 6: earnings quality proxy is the indep
Page 7 and 8: of fundamental earnings will be a f
Page 9 and 10: contributions of the fundamental co
Page 11 and 12: accruals, in total or individually,
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
Page 19 and 20: unintentional misstatements, which
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
Page 37 and 38: sophisticated investors do understa
Page 39 and 40: measurement. Nwaeze, Yang, and Yin
Page 41 and 42: and better reflects revenue manipul
Page 43 and 44: All of the accruals models can be e
Page 45 and 46: Second, investors seem to recognize
Page 47: fact improve predictability relativ
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
Page 73 and 74: the firm’s public accountants mus
Page 75 and 76: whether disclosure of material weak
Page 77 and 78: with “shareholder” corporate go
Page 79 and 80: accruals) that stems from the confl
Page 81 and 82: observable variables such as natura
Page 83 and 84: and do not appear to be made to boo
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
Page 91 and 92: 5.2.2 Other financial reporting pra
Page 93 and 94: The notion that accounting method c
Page 95 and 96: quality and the quality of M&A deci
Page 97 and 98: 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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