Understanding earnings quality - MIT Sloan School of Management

with “shareholder” corporate governance model) countries. Ball, Kothari, and Robin (2000) find
that earnings are less timely in recognizing economic losses in code law countries than in common
law countries, consistent with their prediction that institutions and practices in code law countries
have developed over time such that the demand for decision-useful information is lower. 39 Ball,
Robin, and Wu (2003) examine a sample of firms in East Asian countries. They assert that the
accounting standards in these countries are of high quality (i.e., as they are more similar to U.K. or
U.S. GAAP or IAS than they are to standards in code law countries), but that these countries have
institutions with incentive structures more similar to those that evolve under the code law. They
show that earnings quality (measured by timely loss recognition) is lower in these countries and thus
conclude that the institutional and governance environment of code-law countries diminishes
managers’ and auditors’ incentives to provide high quality accounting information. Guenther and
Young (2000) similarly suggest that earnings quality is demand driven and institutional factors such
as legal system and tax conformity affect earnings quality. They operationalize earnings quality as
the association between cross-sectional average return on assets in a country and its real economic
growth measured by the percentage change in a country's real GDP. They document that this
association is high in the U.K., U.S. and Japan, and low in France and Germany.
4.2 Earnings management as an element of earnings quality
A common hypothesis in cross-country studies is that variation in investor protection affects
the aggregate level of observed earnings management in a country. Leuz, Nanda, and Wysocki
(2003), who measure earnings management by accruals-based measures, smoothness, and small loss
avoidance, find less earnings management for countries with developed stock markets, dispersed
39 Ball et al. (2000) also find that U.K. earnings are less timely than U.S. earnings in incorporating economic losses.
Pope and Walker (1999), however, suggest that this result is sensitive to the consideration of extraordinary items. They
find that earnings after extraordinary items in the U.K. are more timely than U.S. earnings.
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