Understanding earnings quality - MIT Sloan School of Management

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Section 302 are associated with negative stock price reactions. In addition, Beneish et al. (2008) find that Section 302 disclosures are associated with a decrease in analyst forecast revisions and an increase in cost of equity capital. However, disclosures of internal control weaknesses under Section 404 are not associated with a negative stock price reaction, a decrease in analyst forecast revisions, or an increase in cost of equity capital (Ogneva, Subramanyam and Raghunandan, 2007; Beneish et al. 2008). Only one study by Ashbaugh-Skaife, Collins, Kinney, and LaFond (2009) documents a significant increase of the cost of equity capital following Section 404 disclosures, arguing that Ogneva et al.’s findings suffer from look-ahead bias in the classification of internal control quality. 37 Conclusions based on studies of internal control procedures The determinants and consequences of internal control deficiencies disclosed under SOX Section 302 exhibit predictable patterns that suggest that such deficiencies measure the propensity for misstatements. The use of this variable to proxy for variation in EQ, however, is subject to a concern that disclosures of material weaknesses are correlated with manager and auditor incentives to discover and disclose internal control weaknesses (Ashbaugh-Skaife et al., 2007; Hogan and Wilkins, 2008). The mixed findings on the consequences of internal control disclosures based on Section 404 reports cast doubt on whether the Section 404 disclosures are a source of information about financial reporting quality to investors. There are several explanations for the difference in the consequences of Section 302 and Section 404 reports. First, the threshold for Section 404 material weaknesses may be lower than that for Section 302. Second, the Section 404 sample currently is limited to accelerated filers that have a richer information environment. Third, there is ambiguity regarding 37 A related study by Chang, Chen, Liao, and Mishra (2006) finds that firms that have CEOs and CFOs certify their financial statements under SOX experience a decline in bid-ask spreads. 73
whether disclosure of material weaknesses is mandatory under Section 302, and as a result, less severe material weaknesses are not disclosed (Doyle et al., 2007b). Fourth, the Section 404 disclosures are made in the annual report, while the Section 302 disclosures can be made on dates without confounding announcements in the event window. There is a wide range of different types of internal control weaknesses (e.g., weaknesses resulting in restatements versus not, weaknesses resulting in accounting errors versus earnings management, weaknesses driven by various determinants such as organizational changes). Thus firms with internal control weakness disclosures are also a sample that researchers could use to examine the complete path from a determinant to “earnings quality” to a consequence. 4. Cross country studies This section discusses the papers in our database that examine determinants and consequences of cross-country variation in earnings quality. Section 4.1 discusses studies on determinants of country-level earnings informativeness to equity markets, using proxies such as ERCs. Section 4.2 discusses studies that examine determinants of country-level earnings management as a specific element of earnings quality. Section 4.3 discusses studies on consequences of country-level earnings quality. 4.1 Earnings informativeness proxies for earnings quality Four papers in our database examine variations in country-level value-relevance measures. Alford, Jones, Leftwich, and Zmijewski (1993) document cross-country variation in long-window ERCs and earnings-based hedge portfolio returns for 17 countries. They do not test hypotheses about predictable differences in ERCs across countries. Rather, they provide the reader with a 74
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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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unintentional misstatements, which
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Empirical studies have examined mul
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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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