Understanding earnings quality - MIT Sloan School of Management

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Francis, Schipper, and Vincent (2002) find a significant positive cross-sectional association between abnormal returns to analyst announcements (aggregated over all announcements prior to the earnings announcement) and the market response to subsequent quarter earnings. Evidence on the association between mean abnormal returns and ERCs, however, is mixed. They interpret the totality of their evidence as providing little support for the view that competing information from analysts erodes the informativeness of earnings. Collins and DeAngelo (1990) find that the market is more responsive to earnings during a proxy contest. This finding rejects one proposed hypothesis which is that earnings during this period are less precise because they are likely to be opportunistically managed. Rather, they interpret their finding as evidence that a proxy contest is a period of heightened uncertainty and that the earnings number is especially useful for valuation. In summary, firms appear to supplement poor fundamental earnings informativeness with additional information (Lougee and Marquardt, 2004; Chen, DeFond, and Park, 2002). However, management forecasts are associated with historically stronger earnings informativeness (higher ERCs), so the relation between disclosure and ERCs is not generalizable. Consequences of ERCs Figure 2 indicates that the only examined consequence of ERCs as a proxy for earnings quality is voluntary disclosure. Two papers find that firms voluntarily disclose non-earnings information when earnings are less informative. Chen, DeFond, and Park (2002) find that when earnings informativeness is low or uncertain, firms have a greater propensity to voluntarily disclose balance sheet information in earnings announcements. Lougee and Marquardt (2004) document that firms with low historical ERCs are more likely to voluntarily disclose pro forma earnings. One 61
paper, however, finds that firms are more likely to issue management forecasts of earnings when earnings are more informative (Lennox and Park, 2006). Their explanation for the result is that managers’ propensity to forecast is increasing in the manager’s confidence about forecast accuracy, given reputation concerns. 3.3 External indicators of financial reporting quality (FRQ) The external indicators of financial reporting quality that we review are: 1) SEC Accounting and Auditing Enforcement Releases (AAERs), 2) Restatements, and 3) Internal controls. We term these external measures of financial reporting quality because the researcher does not measure a characteristic of earnings to determine its quality, but rather obtains evidence from an outside source (the SEC, or the management team themselves in the case of restatements, or the auditor in the case of internal control disclosures). Two important distinctions of these variables as proxies for EQ is that they often provide information about the quality of the financial statements as a whole, not just earnings, and that they each involve potentially significant selection issues, as discussed below. 3.3.1 AAERs as a proxy for earnings management The SEC issues accounting and auditing enforcement releases (AAERs) after it completes an investigation and takes action against a firm, manager, or the auditor of the firm. Samples of AAERs used in accounting research typically consist of cases where the SEC alleges that the firm has misstated or overstated earnings. Samples usually exclude cases against auditors and pure disclosure cases. Almost half of the AAER firms have overstated revenue, but overstatements of inventory and other assets are also common (Dechow, Ge, Larson, and Sloan 2009). In most AAER cases, the SEC typically accuses managers of intentionally misstating financial statements, which is 62
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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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contributions of the fundamental co
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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
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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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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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