Understanding earnings quality - MIT Sloan School of Management

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the definition of fraud in SAS No. 99. In some cases, however, the SEC alleges that managers were negligent (i.e., “reckless in not knowing” of the misstatement). Because the AAER sample includes cases of egregious and intentional misstatements (i.e., earnings management), it is likely to have a lower Type I error rate than samples identified using other methods such as abnormal accruals models. One issue of concern, however, is the potential for selection bias related to how the SEC identifies the misstating firms. Given a constrained budget, the SEC may not pursue cases that involve ambiguity and that it does not expect to win. The SEC states that it will scrutinize firms that restate earnings because the firm has already admitted to making a mistake. The SEC also states that it is concerned with market impact because their role is to protect investors. Therefore, they scrutinize firms with large market capitalizations as well as IPO firms and firms raising public debt or equity. Determinants of AAERs Managerial compensation: Dechow et al. (1996) and Beneish (1999) do not find an association between the existence of an earnings-based bonus plan and the likelihood of accounting manipulations. Johnson, Ryan, and Tian (2009) find that AAER managers face stronger incentives from unrestricted stocks than those of control firms, however, Erickson, Hanlon, and Maydew (2006) and Armstrong, Jagolinzer, and Larcker (2009) do not find a positive association between stock-based incentive compensation and the likelihood of accounting fraud. Dechow et al. (1996) do not find abnormally higher stock sale activities for the officers and directors of the AAER firms during the manipulation years, but two subsequent studies find that insiders of fraud firms tend to engage in more stock sales during the manipulation period (Summers and Sweeney, 1998; Beneish, 1999). 63
Debt covenants: Dechow et al. (1996) find that manipulation firms have higher leverage ratios and are more likely to violate debt covenants during and after the manipulation period than control firms. Beneish (1999), however, does not find statistically significant differences between manipulation firms and control firms in either leverage ratios or default risk. 29 Capital market incentives: Dechow et al. (1996) find that manipulation firms have higher ex ante external financing demands and higher ex post external financing activities than non-manipulation firms. Beneish (1999) again provides conflicting evidence, but Dechow et al. (2009) confirm the result using a more comprehensive sample of AAER firms. Board of directors and CEOs: AAER firms tend to have a smaller percentage of outside members on the board of directors, are more likely to have a CEO who also serves as chairman of the board or founder of the company and are less likely to have an outside blockholder than control firms (e.g., Dechow et al, 1996; Beasley, 1996; Farber, 2005). In addition, Feng, Ge, Luo, and Shevlin (2009) provide evidence suggesting that CFOs become involved mainly under CEO pressure rather than for their own immediate financial benefits. Audit committees and auditors: Dechow et al. (1996) find that AAER firms are less likely to have an audit committee, but Beasley (1996) does not find a significant association. Farber (2005) shows that fraud firms tend to have fewer audit committee meetings and fewer financial experts on the audit committee. 30 He does not, however, find an effect of audit committee independence on accounting fraud. Neither Dechow et al. (1996) nor Beneish (1999) finds a significant difference between the auditor quality of misstatement firms and control firms, using Big 4 status as an 29 Dechow et al. (1996) and Beneish (1999) find conflicting results in several cases. A possible explanation is the difference between the samples. Beneish’s sample includes 10 “fraud” firms identified from a search of the financial press that were not the subject of AAERs (yet, he argues). Dechow et al.’s sample consists of just over 90 AAER firms, all of which overstate earnings. 30 McDaniel, Martin, and Maines (2002) in an experimental setting find that financial experts help audit committees focus on monitoring more important financial reporting issues. 64
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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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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
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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 and 54: explain the kink. Durtschi and East
Page 55 and 56: with overstated net asset values ar
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: paper, however, finds that firms ar
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
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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
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Page 85 and 86: firms identified in the AAERs than
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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
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
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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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