Understanding earnings quality - MIT Sloan School of Management

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power such as percentage of insiders on board, and debt variables such as the ratio of book value of debt to the market value of equity) are associated with restatements. Non-audit fees, which are presumed to affect auditor independence and hence may compromise auditor quality, are not associated with restatements on average (Agrawal and Chadha, 2005). Kinney, Palmrose, and Scholz (2004) also find no association between fees for financial information systems design and implementation or internal audit services and restatements, but they find some association between fees for unspecified non-audit services and restatements. When using a sample of U.K. firms, Ferguson, Seow, and Young (2004) find a positive association between nonaudit fees and restatements. Consequences of restatements Managers/Directors: Managers at restatement firms experience significantly higher turnover (Desai, Hogan and Wilkins, 2006; Hennes et al., 2008) and director turnover (Srinivasan, 2005) than control firms. Desai et al. (2006) also find that it is more difficult for these displaced managers to find subsequent employment than displaced managers of control firms. Srinivasan (2005) finds that director turnover rate is higher for more severe restatements and for audit committee directors. Firm value: Palmrose, Richardson, and Scholz (2004) document an average market-adjusted return of -9.2 percent over a two-day restatement announcement window; the average is -20 percent for restatements associated with fraud. 33 Lev, Ryan, and Wu (2008) document that the restatements that 33 Desai, Krishnamurthy, and Venkataraman (2006) find that short sellers accumulate positions in restatement firms before restatement announcements and unwind these positions after stock prices decline due to the restatement. Their finding suggests that short sellers are able to identify firms that will likely restate in advance of the restatement announcement. It does not, however, explain their assumptions regarding market efficiency. One possibility is that the short sellers believe the stock is overpriced due to the valuation implications of the misstated earnings, they expect the restatement to reveal the mispricing and the price to correct. Another possibility is that the short-sellers anticipate that markets will react negatively to restatements on average, regardless of the implications of the restatement for valuation. More research is needed to interpret the implications of this evidence for earnings quality. 69
significantly change the historical pattern of earnings (e.g., shortening histories of earnings growth) have more negative stock market consequences. Gleason, Jenkins, and Johnson (2008) find that restatement announcements cause stock price declines for non-restatement firms in the same industry. Hribar and Jenkins (2004) document a significant increase in a firm’s cost of equity capital, measured based on the residual income model, in the month following a restatement. Kravet and Shevlin (2009) document a significant increase in the pricing of information risk after restatement announcements. Litigation: Palmrose and Scholz (2004) find that 38 percent of restatements are associated with litigation, including litigation actions against the company, officers, directors, and auditors. They document that the likelihood of litigation increases with the impact of restatements on earnings (magnitude) and the fraudulent nature of restatements. Restatements of core earnings (i.e., recurring earnings from primary operations) and restatements that involve a greater number of accounts tend to result in a higher likelihood of lawsuits and larger payments by defendants. Lev et al. (2008) find that restatements that curtail histories of earnings growth or positive earnings have a higher likelihood of class action lawsuits than other restatements. Conclusions based on studies of restatements Restatements measure both intentional and unintentional errors; they are not a good proxy for intentional earnings management. In support of this conclusion, the compensation variables, that would provide incentives for intentional earnings management, and the monitors that would constrain such behavior, are not consistently associated with restatements. Support for this conclusion also comes from a related study by Kinney and McDaniel (1989), which finds that firms that correct previously announced quarterly earnings are smaller, are less profitable, have higher 70
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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
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Proxies for asymmetric timeliness b
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sample. Hence, sample specific char
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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
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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
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Page 57 and 58: earnings quality. The studies speci
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Page 61 and 62: they assert proxy for lower indepen
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Page 67 and 68: eadjustments in valuations associat
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Page 89 and 90: 5.2 Financial reporting practices a
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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
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Page 103 and 104: management related to incentives pr
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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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