Understanding earnings quality - MIT Sloan School of Management

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ecognition of more transitory losses in earnings (e.g., Givoly and Hayn 2000). Johnson (1999) however, shows that the association between earnings and stock returns is larger in economic expansions and smaller in economic recessions. This result raises the question of whether it is the “return” component of ERCs or the “earnings” component of ERCs that is changing. If market structures and asset pricing patterns are time-variant, one might observe time variation in ERCs in the presence of stable earnings quality (Hoitash, Krishnan, and Sankaraguruswamy, 2002). 3.2.2 Firm characteristics Governance characteristics: Using both short and long-window ERCs, Francis, Schipper, and Vincent (2005) find that earnings are less informative for firms with dual class shares. Further analysis suggests that markets view the earnings of firms with a dual class structure as less credible primarily because of the separation of voting rights from cash flow rights, although the firms with dual class shares also tend to have greater managerial ownership. Using long-window ERCs, Wang (2006) finds a positive association between founding family ownership and earnings informativeness, measured as the regression coefficient in an annual returns-earnings model. 26 Debt Characteristics: Our database includes Dhaliwal, Lee, and Fargher (1991) and Core and Schrand (1999), which find that leverage is associated with non-linearities in ERCs. Both papers recognize that equity is a call option on the value of the firm and predict the shape of the earnings- returns relation as a function of the firm’s debt structure. These papers present researchers with a measurement issue to consider when using ERCs as a measure of quality. Auditors: Teoh and Wong (1993) report higher ERC coefficients for firms with Big-8 auditors, which they use as a proxy for audit quality. Francis and Ke (2006) find that non-audit fees, which 26 Warfield, Wild, and Wild (1995) document a similar relation between managerial ownership and an identical specification of the ERC, based on the same theoretical arguments. Warfield et al., however, use the term “earnings informativeness” rather than “earnings quality” to motivate the test. 59
they assert proxy for lower independence, are negatively related to ERCs. Hackenbrack and Hogan (2002) find that the average short window (2-day) ERC for the two annual earnings announcements after an auditor change that likely indicates a credibility decrease (e.g., to lower fees, because of a disagreement over fees, or because of a disagreement with the auditors) is lower than the ERC for the two annual pre-change earnings announcements. However, the average ERC is higher for firms that switch for reasons that the authors classify as service related. Manry, Tiras, and Wheatley (2003) report that quarterly returns have a stronger association with contemporaneous earnings levels for firms that have timely auditor reviews of their interim earnings, but they have a stronger relation with lagged earnings for firms that have retrospective auditor reviews. 27 3.2.3 Information environment Concurrent disclosure of non-earnings information generally improves the earnings-returns relation for firms with poor earnings informativeness (e.g., Lougee and Marquardt, 2004). Baber, Chen, and Kang (2006) reach a similar conclusion based on a finding that the market discount that investors apply to earnings that are likely to be upwardly managed declines when balance sheet information is disclosed concurrent with the earnings announcement. 28 Amir and Lev (1996) confine the analysis to an industry in which financial information “informativeness” is likely low – independent cellular companies – and document that non-financial indicators (e.g., POPS, which is a measure of population density) are value-relevant. Amir, Harris, and Venuti (1993), however, characterize their evidence as “mixed” on whether 20-F earnings reconciliations improve earnings informativeness using both long and short-window ERCs. 27 Due to data constraints, sample size limits the power of the tests. There are 328 observations with timely reviews and 84 retrospective reviews. The authors are unable to address selection issues and the authors acknowledge that the results are “mixed” across quarters and specification of the earnings variable in levels or changes. 28 This analysis incorporates the findings of Chen, DeFond, and Park (2002), which models the firm’s decision to voluntarily disclose balance sheet information in earnings announcements. 60
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*Title Page/Author Identifier Page/
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Street equity valuation model as ea
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earnings quality proxy is the indep
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of fundamental earnings will be a f
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Page 13 and 14: While we identify these contradicti
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Page 27 and 28: methodology. Studies could make uni
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Page 35 and 36: Xie (2001) uses the Jones model (di
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Page 51 and 52: than code law countries. The differ
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Page 57 and 58: earnings quality. The studies speci
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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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