Understanding earnings quality - MIT Sloan School of Management

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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. 67
ange of misstatements and they are primarily earnings restatements. Third, many restatements are caused by internal errors in applying accounting rules rather than intentional misreporting, and the proportion of such restatements in the database has increased in recent years (Plumlee and Yohn, 2008; Hennes, Leone, and Miller, 2008). Fourth, the selection problem in the restatement sample differs from that in the AAER sample, although it is not clear which is a bigger concern. Different selection criteria across the multiple sources that identify restatements might suggest that the selection problem simply creates noise in the analysis rather than bias, but knowing that the SEC selects the AAER cases may make it easier to control for the potential bias. Determinants of restatements Managerial compensation: Burns and Kedia (2006) find that the sensitivity of the CEO's option portfolio to stock price is significantly positively associated with the likelihood of restatements, but the sensitivity of other components of CEO compensation, (i.e., equity, restricted stock, long-term incentive payouts, and salary plus bonus) is not related. Efendi et al. (2007) find that the likelihood of restatements increases when the CEO has considerable holdings of in-the-money stock options. 32 However, Armstrong et al. (2009) do not find any significant association between CEO equity incentives and restatements after controlling for the compensation contracting environment. Board of directors and auditors: Restatement firms tend to have CEOs who serve as chairman of the board or have founder status, and have board or audit committee directors with financial expertise (Agrawal and Chadha, 2005; Efendi et al., 2007). Independence of the board or audit committee is not a determinant of the likelihood of restatement (Agrawal and Chadha, (2005). Larcker, Richardson, and Tuna (2007) find that only two out of fourteen dimensions of governance (insider 32 Efendi et al. (2007) also find that restatements are more likely when firms are constrained by an interest-coverage debt covenant and when they raise external financing. This paper is the only one in our database that examines debt contracting and equity market incentives as determinants of restatements. 68
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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
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Proxies for asymmetric timeliness b
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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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