Understanding earnings quality - MIT Sloan School of Management

More documents

Recommendations

Info

(Moehrle, 2002). Firms also make real decisions such as repurchasing stock (Hribar, Jenkins, and Johnson, 2006) or selling fixed assets or marketable securities (Herrmann, Inoue, and Thomas, 2003) or repurchasing shares (Bens, Nagar, Skinner, and Wong, 2003). Ayers, Jiang, and Yeung (2006), following the basic approach of Dechow, Richardson, and Tuna (2003), assess the relation between discretionary accruals and meeting or beating analyst forecasts and reporting small earnings increases. They find some evidence consistent with an association between earnings management through the use of accruals and these targets. In the second type of analysis, the study focuses on firms’ equity market incentives to meet or beat a target. Matsumoto (2002) finds that firms with greater incentives, primarily given their ownership structure, are more likely to just meet or beat a target. 21 Beatty, Ke, and Petroni (2002) find that public banks are more likely to use discretionary bank-specific accruals to report small profit increases. Cheng and Warfield (2005) find that managers with high equity incentives are more likely to just meet or beat a target, and McVay, Nagar, and Tang (2006) find insider trading subsequent to just meeting or beating. Abarbanell and Lehavy (2003) indirectly link earnings management activities to equity market incentives assuming that analyst stock recommendations – not meeting or beating a forecast – proxy for incentives. In the third type of analysis, the study focuses on opportunities to meet or beat a target. Frankel, Johnson, and Nelson (2002) find a positive (negative) correlation between non-audit (audit) fees as proxies for auditor quality and independence and small earnings increases and the likelihood of meeting or beating analyst forecasts. Brown and Pinello (2007) show that firms are more likely to avoid negative earnings surprises relative to an analyst forecast at interim quarters when they hypothesize the greatest opportunities to manage earnings. Barton and Simko (2002) find that firms 21 She supports this indirect evidence with direct tests that the firms appear to meet or beat via abnormal accruals and by managing the forecast down. 53
with overstated net asset values are constrained in their opportunities to manage earnings and are less likely to meet or beat analyst forecasts. Consequences of small earnings surprises: Three papers suggest that meeting or beating targets has positive market consequences. Two papers document that firms that consistently report earnings increases relative to the prior year or relative to the same quarter of the prior year receive a price premium (e.g., Barth, Elliott, and Finn, 1999; Myers, Myers, and Skinner, 2007). These studies do not provide evidence on whether the strings are achieved by artificial smoothing. Bartov, Givoly, and Hayn (2002) find that meeting or beating analyst forecasts is associated with a higher contemporaneous quarterly return. Bhattacharya et al. (2003) find that greater opacity, which he measures as an increasing function of loss avoidance, is associated with a higher average cost of equity and a lower level of trade, however, the loss avoidance proxy alone is not a significant determinant. The positive market consequences are mitigated if earnings management is suspected. Kasznik and McNichols (2002) find that meeting or beating on an ad hoc basis does not lead to higher valuations, but that meeting or beating regularly does. Gleason and Mills (2008) show that when earnings management is more obvious and detectable, and thus investors are more able to differentiate meeting or beating that represents earnings management from that which represents value-relevant good news, there is a market discount for beating. Patterns in analyst forecasts/stock recommendations as a consequence of meeting or beating targets, however, suggest that analysts do not detect/anticipate earnings management to meet or beat targets (Abarbanell and Lehavy, 2003; Burgstahler and Eames, 2003). A final consequence paper uses a unique measure of “surprise.” Affleck-Graves, Callahan, and Chipalkatti (2002) compute an earnings predictability “score” based on analyst forecast errors 54
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 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: explain the kink. Durtschi and East
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
Page 99 and 100: for the AAER firm executives than f
Page 101 and 102: Dechow and Sloan (1991), who study
Page 103 and 104: management related to incentives pr
Page 105 and 106:
nonaudit fees) and discretionary ac
Page 107 and 108:
errors when litigation risk is high
Page 109 and 110:
to suffer from omitted correlated v
Page 111 and 112:
capital accruals as a proxy. Perry
Page 113 and 114:
how the incentives provided by the
Page 115 and 116:
(Jones, 1991); 2) Department of Jus
Page 117 and 118:
5.6.3 Tax regulations Several studi
Page 119 and 120:
importance of implicit claims, they
Page 121 and 122:
attention (Aboody et al. , 1999). 7
Page 123 and 124:
of internal control procedure defic
Page 125 and 126:
differences, which investors ration
Page 127 and 128:
Bid-ask spread: Evidence on the ass
Page 129 and 130:
low accrual quality stock that are
Page 131 and 132:
6.1.5 Summary To summarize, the evi
Page 133 and 134:
plaintiffs will prevail in sharehol
Page 135 and 136:
income increasing restatement firms
Page 137 and 138:
evisions do not fully account for t
Page 139 and 140:
the fact that some disclosures are
Page 141 and 142:
Therefore, the proxies are not meas
Page 143 and 144:
Amir, E., Harris, T., Venuti, E., 1
Page 145 and 146:
Beasley, M., 1996. An empirical ana
Page 147 and 148:
Burgstahler, D., Kinney, W., Martin
Page 149 and 150:
Considine, J., Mensah, Y., Oakes, L
Page 151 and 152:
Desai, H., Rajgopal, S., Venkatacha
Page 153 and 154:
Farber, D., 2005. Restoring trust a
Page 155 and 156:
Gong, G., Louis, H., Sun, A., 2008.
Page 157 and 158:
Hung, M., 2000. Accounting standard
Page 159 and 160:
Kothari, S., Leone, A., Wasley, C.,
Page 161 and 162:
Malmquist, D., 1990. Efficient cont
Page 163 and 164:
Phillips, F., 1999. Auditor attenti
Page 165 and 166:
Tucker, J., Zarowin, P., 2006. Does
Page 167 and 168:
Figure 1. Summary of the investigat
Page 169 and 170:
Figure 3: Key links between determi
Page 171 and 172:
Table 1. Categories of “Earnings
Page 173 and 174:
Exhibit 1: Summary of earnings qual
Page 175:
Exhibit 2: Summary of widely used m
show all

Understanding earnings quality - MIT Sloan School of Management

Create successful ePaper yourself

Delete template?

Save as template?