Understanding earnings quality - MIT Sloan School of Management

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Determinants of asymmetric timeliness and timely loss recognition: 20 The first determinant we discuss is accounting standards. Loss recognition is more timely in common law than code law countries (Ball, Kothari, and Robin, 2000, BKR). Using the Basu (1997) reverse regression, BKR find that the R 2 of the regression is higher and the β1 coefficient is lower in common law countries, which suggests greater asymmetric timeliness recognition. Within bad news observations, loss recognition is more timely in common law countries. Loss recognition is more timely for firms that use IAS (Barth, Landsman, and Lang, 2008). Using logit analysis, Barth et al. (2008) compare IAS adopters to non-adopters. The model includes a dummy explanatory variable for large negative reported earnings and control variables for other determinants of the choice to follow IAS. The coefficient on the indicator variable is positive. Barth et al. (2008) also estimate a logit regression within the sample of IAS adopters with the dependent variable equal to one if the observation is post IAS adoption and equal to zero pre-adoption. The coefficient estimate on the indicator variable is positive, so IAS adoption is associated with a greater frequency of reported losses within the same sample of firms across time. Loss recognition is more timely when equity market incentives demand it. This conclusion is based on four studies. Ball and Shivakumar (2005), using the Basu (1997) tendency-to-reverse measure, find that loss recognition is more timely in U.K. public companies than U.K. private companies. Ball, Robin, and Sadka (2008), using the R 2 and β1 coefficient estimate from the Basu (1997) reverse regression (as in BKR), find that loss recognition is more timely for firms in countries with greater prominence of debt markets relative to equity markets. Ball, Robin, and Wu (2003), also using the BKR metrics, find that East Asian countries, which share a common law origin but are asserted to have lower equity capital markets incentives, do not have more timely loss recognition 20 Many of the studies of the determinants of asymmetric timeliness are cross-country studies, which also are discussed in Section 4. 49
than code law countries. The differences in timely loss recognition within countries (or regions) with the same standards or legal origin suggest that timely loss recognition has an endogenous component related to firms’ reporting incentives. It is not driven purely by a country’s accounting system. Pae, Thornton, and Welker (2005), also using the BKR metrics, find that firm-level price- to-book ratios are a determinant of timely loss recognition and that the negative association is correlated with the accrual component of earnings, which again supports the conclusion that equity incentives, and not just mechanical application of accounting principles, are associated with observed timely loss recognition. Loss recognition is more timely when enforcement, either internal or external, is stronger. Francis and Wang (2008) find that the positive association between common law countries as a proxy for greater investor protection and timely loss recognition is higher only for firms with Big- four auditors. García Lara, García Osma, and Penalva (2009) find a positive association between commonly used governance proxies for effective monitoring and timely loss recognition. Chung and Wynn (2008) find that D&O liability insurance coverage for Canadian firms is negatively associated with timely loss recognition. One paper provides negative evidence: within a sample of U.S. firms, Ruddock, Taylor, and Taylor (2006) find no relation between non-audit services, which could impede independence and reduce auditor monitoring, and timely loss recognition. All four studies use the Basu (1997) reverse regression to measure timely loss recognition; Chung and Wynn (2008) and García Lara, García Osma, and Penalva (2009) additionally check the robustness of the results to the use of the Basu (1997) tendency-to-reverse measure. 50
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Page 5 and 6: earnings quality proxy is the indep
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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
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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
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Page 43 and 44: All of the accruals models can be e
Page 45 and 46: Second, investors seem to recognize
Page 47 and 48: fact improve predictability relativ
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Page 53 and 54: explain the kink. Durtschi and East
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Page 57 and 58: earnings quality. The studies speci
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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
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Page 71 and 72: significantly change the historical
Page 73 and 74: the firm’s public accountants mus
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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
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Page 97 and 98: In countries with high ownership co
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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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