Understanding earnings quality - MIT Sloan School of Management

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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. 71
the firm’s public accountants must attest to this assessment. 35 Prior to these reports, companies (with the exception of the banking industry) were required to disclose significant internal control deficiencies in 8-Ks only when disclosing a change in auditors (Ge and McVay, 2005; Krishnan, 2005; Altamuro and Beatty, 2009). Earlier research consisted primarily of case studies or analysis of survey data. For example, Willingham and Wright (1985) survey audit firm partners and do not find an association between auditors’ assessment of internal control effectiveness and financial statement errors detected by auditors. 36 A couple of studies have shown a positive association between internal control quality and various earnings quality measures such as discretionary accruals and earnings persistence (e.g., Doyle et al., 2007b; Ashbaugh-Skaife et al., 2008). These studies provide some justification for using the internal control deficiencies reported under SOX as an indication of earnings quality. Determinants of internal control procedures: Krishnan (2005) finds that independent audit committees and audit committees with financial expertise are significantly less likely to be associated with the incidence of internal control problems. Ashbaugh-Skaife et al. (2007) and Doyle et al. (2007a) find that firms with higher control risk associated with organizational complexity and significant organizational changes are more likely to have internal control deficiencies. The weakness firms also appear to be more constrained in their resources to invest in internal control systems (i.e., firm size, financial strength). Consequences of internal control procedures: Hammersley, Myers, and Shakespeare (2008) and Beneish, Billings, and Hodder (2008) find that disclosures of internal control weaknesses under 35 Internal control disclosures under Section 404 are available in machine readable form from Audit Analytics. The early papers collected the reports from Compliance Week. 36 Kinney (2000) also notes that lack of access to data was a barrier to research on internal control procedures. Some very early work analyzed the design and tests of internal control system (e.g., Cushing, 1974; Kinney, 1975). 72
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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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unintentional misstatements, which
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Page 35 and 36: Xie (2001) uses the Jones model (di
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Page 53 and 54: explain the kink. Durtschi and East
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Page 61 and 62: they assert proxy for lower indepen
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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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