Understanding earnings quality - MIT Sloan School of Management

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
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