Understanding earnings quality - MIT Sloan School of Management

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indication of audit firm quality, but Farber (2005) finds that fraud firms are less likely to have Big-4 audit firms using a more recent sample. Geiger, Lennox, and North (2008) do not find empirical evidence that auditor independence is associated with fraud, while Joe and Vandervelde (2007), in an experimental setting, suggest that it is. Consequences of AAERs Manager turnover: Feroz et al. (1991) find that 42 of 58 AAER firms between 1982 and 1989 (72.4 percent) have management turnover (i.e., firing or resignation) after the public disclosure of the misstatement. Beneish (1999) documents that only 35.9 percent of misstatement firms have CEO turnover subsequent to the discovery of accounting misstatements (during the year of discovery and four years following the discovery) for AAER firms between 1987 and 1993. Karpoff, Lee, and Martin (2008) find that 93 percent of the individuals identified by the SEC as the responsible party leave the company by the end of the enforcement period, and these culpable individuals suffer serious legal penalties (e.g., criminal charges) and monetary losses. Firm value: Feroz et al. (1991) and Dechow et al. (1996) find a stock return of -9 to -10 percent on the first announcement day of the accounting misstatements (see also Miller, 2006a). Dechow et al. (1996) document a significant increase in bid-ask spreads and a significant decline in analyst following after the discovery of accounting misstatements. Karpoff, Lee, and Martin (2008b) find that the enforcement firms on average lose a total of 38 percent of their market values measured over all announcement dates related to the enforcement action. They suggest that two thirds of the decline represents lost reputation, which they define as “the decrease in the present value of future cash flows as investors, customers, and suppliers are expected to change the terms of trade with which they do business with the firm.” The remaining one-third represents legal penalties, and 65
eadjustments in valuations associated with the “restated” financial information. Farber (2005) finds that only firms that improve their corporate governance (e.g., by increasing the percentage of outside members on the board) experience improved stock market performance in the three-year post- detection period after controlling for changes in operating performance. Auditors: Feroz et al. (1991) find that large auditors of the AAER firms are less likely to be censured by the SEC and suffer lighter penalties than small auditors. They suggest two explanations: large auditors are associated with less extreme cases and/or large auditors can afford more resources to negotiate with the SEC to lower penalties. Bonner, Palmrose, and Young (1998) document that auditors face litigation in 38 percent of AAER firms in their sample. The litigation risk for auditors is higher when the type of fraud occurs frequently across companies (i.e., common frauds) or when the fraud is caused by fictitious transactions. Conclusions based on studies of AAERs AAER firms would seem to be a powerful place for researchers to investigate incentives to manipulate earnings, but the evidence on the determinants of AAERs, and in particular on the role of governance in monitoring manipulations, is mixed and weak. One explanation is large type II errors. That is, firms that manage earnings for similar reasons are not identified by the SEC or firms manage earnings just within the boundaries of GAAP and avoid SEC selection. This problem inhibits proper matching. Other explanations include (i) small sample sizes that lack power, (ii) differences in sample composition over time; or (iii) endogeneity of contracting variables (e.g., Armstrong et al., 2009). There is consistent and compelling evidence that investors react negatively to discovery of a misstatement, but it is less clear how to interpret this result. Keeping in mind that most samples of 66
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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,
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While we identify these contradicti
Page 15 and 16: Proxies for asymmetric timeliness b
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Page 21 and 22: Empirical studies have examined mul
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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
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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 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
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Page 61 and 62: they assert proxy for lower indepen
Page 63 and 64: paper, however, finds that firms ar
Page 65: Debt covenants: Dechow et al. (1996
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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
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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
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Page 109 and 110: to suffer from omitted correlated v
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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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