Understanding earnings quality - MIT Sloan School of Management

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3.1.4 Benchmarking This section covers studies that use small positive differences between reported earnings and any benchmark as a measure of earnings quality. A significant component of this literature is related to the “kink” in the distribution of reported earnings around zero: a statistically small number of firms with small losses and a statistically large number of firms with small profits (Hayn, 1995; Burgstahler and Dichev, 1997). A common but controversial interpretation of this pattern is that firms with unmanaged earnings just less than the heuristic target of zero intentionally manage earnings just enough to report a small profit. Thus, small profits (or avoiding small losses) are a de facto indication of earnings management. Likewise, small earnings increases are a proxy for earnings management based on the finding in Burgstahler and Dichev (1997) of a statistically unusual number of firms with small decreases in earnings, and meeting or beating an analyst forecast is a proxy for earnings management based on the finding in Dechow, Richardson, and Tuna (2001) of a “kink” in earnings around consensus analyst forecasts. The consequences studies frequently use small positive surprises (or avoidance of negative surprises) as a proxy for managed earnings, and the authors make predictions about the consequences of the assumed diminished quality. In the determinants studies, the most common research question is whether the assumption that is made in the consequences studies – that small positive surprises are more likely to represent managed earnings – is justified. Determinants of small positive profits: Several studies suggest that small profits are not evidence of earnings management. Dechow, Richardson, and Tuna (2003), in a large-sample study, find no relation between realizations of small profits and increases in discretionary accruals. Beaver, McNichols, and Nelson (2007) suggest that asymmetric taxes, rather than opportunistic choices, can 51
explain the kink. Durtschi and Easton (2005) suggest that the kink is due to statistical and sample bias issues. Several types of results, however, suggest a relation between small profits and other recognized proxies for earnings management. First, there is a correlation between small profits and discretionary accruals in industry-specific and/or account-specific studies. Beaver, McNichols, and Nelson (2003) find a positive correlation between earnings management of loss reserves and small profit realizations at P&C insurers. Phillips, Pincus, and Rego (2003) find an association between deferred tax expense and avoiding losses. In both studies, the results are subject to the caveat that neither the accruals metric nor small profits represent earnings management, but the two variables are correlated, perhaps as explained in Beaver et al. (2007). Firms that were able to use more aggressive revenue recognition techniques, which might provide greater opportunities for earnings management, are more likely to report small profits and are less likely to report small losses (Altamuro, Beatty, and Weber, 2005). Second, the kink is strongest in the fourth quarter when studies assert that the incentives for earnings management are predicted to be higher (Kerstein and Rai, 2007; Jacob and Jorgensen, 2007). Third, low audit effort measured by hours worked, which might mitigate opportunities for earnings management, is associated with small positive profits (Caramanis and Lennox, 2008). Determinants of meeting or beating targets: The literature on the determinants of meeting or beating analyst forecasts and reporting small earnings increases includes three types of analyses. In the first type, the study focuses on the mechanisms/tools that firms use to produce earnings that just meet or beat a target. Firms make accounting choices such as managing tax expense (Dhaliwal, Gleason, and Mills, 2004); managing the classification of items within the income statement (McVay, 2006); and managing the creation and reversal of restructuring charge accruals/cushions 52
Page 1 and 2: *Title Page/Author Identifier Page/
Page 3 and 4: Street equity valuation model as ea
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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
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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 51: than code law countries. The differ
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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
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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 77 and 78: with “shareholder” corporate go
Page 79 and 80: accruals) that stems from the confl
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Page 89 and 90: 5.2 Financial reporting practices a
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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
Page 99 and 100: for the AAER firm executives than f
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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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