Understanding earnings quality - MIT Sloan School of Management

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enforcement firms have high discretionary accruals). The conclusions below are based on the review of the literature represented in Figures 1 through 4. 2.1 Overall conclusions A somewhat unsatisfying feature of this survey for readers is that we do not suggest that there is a single best proxy for earnings quality that is appropriate for all decision contexts. In fact, an overriding message of the survey is that earnings quality is context-specific, and thus our assessment of the ability of each measure to capture decision usefulness is also context specific. The commonly used proxies for EQ, however, vary with respect to the degree to which they measure decision-usefulness across different types of decisions, and hence there is no overall best measure. Our review of the proxies provides evidence on which types of useful information each EQ proxy captures. All of the proxies for earnings quality that involve earnings (i.e., properties such as persistence as well as the ERCs) have at their core the reported accrual-based earnings number. Reported accrual-based earnings are a function of “fundamental” earnings (X), which are unobservable, as well as the accounting system that imperfectly measures X: Reported Earnings = Function of (X) + error induced by accounting system (e) Fundamental earnings (X) represents the output of the firm’s production function or business model and can be thought of as the expected cash flows generated during the period that could be annuitized to obtain the fundamental value of the firm, alternatively referred to as perpetual earnings. Throughout the review, we use the term “fundamental earnings process” to represent X. The quality 5
of fundamental earnings will be a function of the operating cycle, macro business condition, investment opportunity set, managerial skill, and other features of the firm. The “error” term represents the ability of the accounting system to measure the firm’s fundamental earnings process. There may be a feedback loop: the accounting measurement system could influence management’s behavior that in turn changes “fundamental” earnings and its quality. For example, not requiring the expensing of stock options could result in greater stock option usage than otherwise would occur, which could affect risk taking behavior, which will in turn affect the fundamental earnings process. Since all of the EQ proxies involve reported earnings, they all are affected by both the fundamental earnings process as well as the ability of the accounting system to measure the process. There are multiple reasons that the accounting measurement system captures the fundamental process with error. The standard setters are working with a different measurement system in mind (e.g., focusing on fair valuing assets and liabilities and measuring earnings as the change in wealth). Management make poor forecasts that affect accrual estimation (e.g., forecasting the level of returns incorrectly) or that affect real decisions (e.g., overinvesting in inventory or PPE, requiring a subsequent write down). Items that should be expensed are ignored (e.g., expected environment liabilities, bad investments). Firms structure transactions to get around undesirable accounting implications (leasing, securitizations, stock options). As accountants, one important area of research should evaluate the ability of the accounting system to measure different types of earnings processes. That is, we should focus on the “e” term. Another important area of research should examine when reported earnings, in total, are of higher quality. Both types of research are important for understanding earnings quality. Our point is that the current research does not adequately recognize the distinction between the fundamental earnings process and the measurement of the process, which limits the conclusions 6
Page 1 and 2: *Title Page/Author Identifier Page/
Page 3 and 4: Street equity valuation model as ea
Page 5: earnings quality proxy is the indep
Page 9 and 10: contributions of the fundamental co
Page 11 and 12: 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
Page 19 and 20: unintentional misstatements, which
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
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earnings quality. The studies speci
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to conservatism, which is defined a
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they assert proxy for lower indepen
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paper, however, finds that firms ar
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Debt covenants: Dechow et al. (1996
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eadjustments in valuations associat
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ange of misstatements and they are
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significantly change the historical
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the firm’s public accountants mus
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whether disclosure of material weak
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with “shareholder” corporate go
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accruals) that stems from the confl
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observable variables such as natura
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and do not appear to be made to boo
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firms identified in the AAERs than
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past service costs). Zmijewski and
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5.2 Financial reporting practices a
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5.2.2 Other financial reporting pra
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The notion that accounting method c
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quality and the quality of M&A deci
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In countries with high ownership co
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for the AAER firm executives than f
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Dechow and Sloan (1991), who study
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management related to incentives pr
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nonaudit fees) and discretionary ac
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errors when litigation risk is high
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to suffer from omitted correlated v
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capital accruals as a proxy. Perry
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how the incentives provided by the
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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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