Understanding earnings quality - MIT Sloan School of Management

debt, are more slowly growing, and face more serious uncertainties. They interpret their evidence as
suggesting that accounting errors are the outcome of a weak accounting system (i.e., weak internal
control procedures) rather than opportunistic earnings management. The mixed results about the
determinants of restatements, however, could be due to selection bias associated with detection of
the accounting irregularity and the firm’s decision to report it.
Restatements reflect errors that cause investors to revise their beliefs about information
precision associated with the firm’s earnings (e.g., Hribar and Jenkins, 2004; Kravet and Shevlin,
2009). We found no studies that provide similar evidence about the effects of AAERs on investor
beliefs.
The restatement samples might be useful to examine the complete path from a predicted
determinant (i.e., weak internal control procedures) to a particular type of earnings quality and then
to a predicted consequence because of the variation in the types of errors reflected in the
restatements. For example, one could address whether the market consequences of a misstatement
are different if an internal control weakness rather than an agency problem causes it.
3.3.3 Internal control procedures quality as a proxy for earnings quality 34
Under Section 302 of the Sarbanes Oxley Act of 2002 (SOX), which became effective on
August 29, 2002, management is required to certify in its 10-Qs and 10-Ks their conclusions about
the effectiveness of the firms’ internal control procedures. Section 404 of SOX, which became
effective on November 15, 2004 for accelerated filers, requires companies to include management’s
assessment of the effectiveness of the internal control structure and procedures in its annual report;
34 Studies that examine whether internal control procedures are a determinant of another earnings quality proxy (e.g.,
discretionary accruals or persistence) are discussed in Section 5.2.3.
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