Understanding earnings quality - MIT Sloan School of Management

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ownership, strong investor rights, and strong legal enforcement. The Leuz et al. (2003) artificial smoothness measures are commonly used in cross-country studies as a proxy for earnings management. The first proxy, measured at the country-level, is the median of the firm-level standard deviation of operating earnings divided by the firm-level standard deviation of cash flow from operations. The second proxy is the contemporaneous correlation between changes in accounting accruals and changes in operating cash flows. Both measures emphasize that smoothness represents earnings management when it is measured relative to inherent or fundamental smoothness of the firm’s operations. Operating cash flow smoothness is used to control for inherent smoothness. Lang, Raedy, and Wilson (2006) compare the extent of earnings management between a sample of non-U.S. firms that are cross-listed in the U.S. and a sample of U.S. firms. They document that the cross-listed non-U.S. firms exhibit more evidence of smoothness, a greater tendency to report small profits, and less timely recognition of losses, and lower ERCs than U.S. firms and that this difference is greater for firms from countries with poor investor protection. 40 Lang, Raedy, and Wilson (2006) do not use the Leuz et al. (2003) measure of artificial smoothness; they develop their own measure of artificial smoothness that similarly attempts to control for smoothness of the fundamental earnings process. They measure smoothness as the volatility of earnings scaled by total assets, where “volatility” is the variance of the residuals from a regression of annual scaled changes in net income on control variables for fundamental firm characteristics. Their analysis also uses a matched sample design with matching based on past sales growth and industry, which is an effort to control for fundamental variability. Three later studies extend Leuz et al. by providing evidence on how the interactions between different institutional factors influence the extent of earnings management. Haw et al. (2004) document that earnings management (measured by the unsigned magnitude of discretionary 40 They use ERCs as one of their earnings management proxies. 77
accruals) that stems from the conflicts between controlling shareholders and minority shareholders is lower in countries with high protection of minority shareholders’ rights and strong legal enforcement. Francis and Wang (2008) find that earnings quality (measured by the magnitude of discretionary accruals, the likelihood of reporting a loss, and timely loss recognition) is positively related to country-level investor protection, but only for firms with Big-four auditors. They suggest that investor protection affects earnings quality through the incentives of Big-four auditors (i.e., litigation risk and reputation risk). Finally, Burgstahler, Hail, and Leuz (2006) document interactions between the effects of institutions on earnings management and the effects provided by public equity markets interact. Using a sample of private and public firms from 13 European Union countries, they find that private companies manage earnings more, consistent with less pressure for earnings quality. Stronger legal institutions curb earnings management. The Burgstahler et al. (2006) earnings management measures are similar to those used in Leuz et al. (2003). 4.3 Consequences of country-level earnings quality The three papers in our database that examine consequences of earnings quality at the country level focus on the earnings management element of earnings quality. Bhattacharya, Daouk, and Welker (2003) find that high country-level earnings quality measured by earnings aggressiveness (i.e., accruals), loss avoidance, and earnings smoothness (measured following Leuz et al., 2003), are associated with higher country-level of cost of equity capital and lower trading volume. Their hypothesis assumes that these features of earnings are associated with greater opacity. Pincus, Rajgopal, and Venkatachalam (2007) find that the accrual anomaly, while a global phenomenon, is concentrated in four countries, Australia, Canada, the United Kingdom, and the U.S., all of which are common law countries. The accrual anomaly is positively associated with the 78
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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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there are (in theory) predictable a
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is primarily driven by the firm’s
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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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