Understanding earnings quality - MIT Sloan School of Management

AAERs consist of overstatement of earnings, there are at least four explanations for a negative
market reaction. First, investors could adjust their forecasts of future cash flow because the forecasts
are based on historical earnings and the AAER reveals that historical earnings are lower than
previously reported. Second, investors could reassess the multiplier (persistence parameter) they
apply to the firm’s fundamental earnings process (growth prospects) as well as change the discount
rate. Third, investors could increase the discount rate if the AAER causes them to revise downward
their expectations about the precision of the firm’s accounting information. Finally, investors might
revise their expectations of future cash flows because they expect the AAER to create additional
costs that the firm would otherwise not have incurred, such as litigation or reputation loss.
The third potential source of negative returns – that investors change their assessment of the
precision of the accounting measurement and reporting system – should be of particular interest to
accountants, but it is difficult to disentangle this explanation from the others. The AAER reactions,
however, have advantages for documenting revaluations due to changes in information risk. Many
of the announcements are a surprise, the event window is fairly short, and the events are not
clustered in calendar time. Karpoff et al. took a useful first step toward differentiating among the
possible explanations for the negative stock market reactions, and we would encourage the use of
this sample to identify the pricing of earnings quality.
3.3.2 Restatements as a proxy for earnings quality
There are four important differences between firms that restate earnings and the AAER
firms. 31 First, restatement samples are significantly larger than samples of AAER firms in any given
year, which adds power to the empirical tests. Second, the restatement sample includes a wider
31
See Dechow et al. (2009) for a detailed discussion of the comparison between different databases related to accounting
misstatements.
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