Understanding earnings quality - MIT Sloan School of Management

More documents

Recommendations

Info

Hung (2001) index of accrual accounting intensity and negatively associated with share ownership concentration. Somewhat weaker evidence suggests that the occurrence of the accrual anomaly is negatively related to investor rights. Pincus et al. (2007) interpret the results, taken together, as suggestive that earnings management is associated with the accrual anomaly. Biddle and Hilary (2006) document that smoothness using the Leuz et al. (2003) measure is associated with lower investment efficiency as measured by investment cash flow sensitivity metrics (see also Verdi, 2006). 4.4 Summary The cross-country studies allow inferences about the impact of certain control mechanisms that are not possible using a sample of U.S. firms because of a lack of variation in the control mechanism within the U.S. This branch of studies generally concludes that earnings quality (including earnings management) is influenced by investor protection, bank versus market-oriented economy, code versus common law tradition, accounting standards, and managers’ and auditors’ incentives. There is not much conflicting evidence. The cross-country variation is generally asserted to proxy for very broad theoretical constructs such as differences in the demand for information or the ability of accounting rules to reflect fundamental value. The cross-country studies are not designed to provide inferences about specific internal control mechanisms. The cross-country studies commonly use return-based earnings quality measures such as ERCs and timely loss recognition. There are many differences across countries that can affect these returns-based metrics other than the institutional factors envisioned as determinants by the researchers. The studies clearly recognize the potential for alternative explanations for the results, and most studies either use empirical methods to control for un-modeled sources of cross-country variation or model expected sources of variation such as industry concentration. However, even 79
observable variables such as natural resource endowments and the level of economic development are not frequently modeled, and less consideration is given to unobservable cultural differences such as trust in governance mechanisms (Zingales, Sapienza, and Guiso, 2008). Somewhat surprisingly, little effort is devoted to controlling for variation in the return component of the returns-based proxies for earnings quality, despite evidence of variation in the relation between economic and market development (Frost, Gordon, and Hayes, 2006). 5. The determinants of earnings quality In this section, we juxtapose the studies according to the determinant of earnings quality that is examined (see Table 1). There are six categories of determinants: 1) Firm characteristics, 2) Financial reporting practices, 3) Governance and controls, 4) Auditors, 5) Equity market incentives, and 6) External factors. 5.1 Firm characteristics as determinants of earnings quality Several studies use multiple proxies for firm fundamentals, including simply industry membership, and provide broad evidence that firm operating characteristics are associated with the various proxies for earnings quality. Hagerman and Zmijewski (1979) provide preliminary evidence on the association between size, risk, capital intensity, and industry concentration and a firm’s choice of accounting principles. LIFO adoption, in particular, is a common choice to examine (e.g., Jung, 1989; Lindahl, 1989). Lev (1983) relates (theoretically and empirically) multiple proxies for the economic fundamentals of a firm’s operating environment to properties of its earnings (i.e., persistence and volatility). Dechow (1994) relates multiple characteristics of a firm’s operating environment to the ability of accruals to capture underlying firm performance, where this ability is 80
Page 1 and 2:
*Title Page/Author Identifier Page/
Page 3 and 4:
Street equity valuation model as ea
Page 5 and 6:
earnings quality proxy is the indep
Page 7 and 8:
of fundamental earnings will be a f
Page 9 and 10:
contributions of the fundamental co
Page 11 and 12:
accruals, in total or individually,
Page 13 and 14:
While we identify these contradicti
Page 15 and 16:
Proxies for asymmetric timeliness b
Page 17 and 18:
sample. Hence, sample specific char
Page 19 and 20:
unintentional misstatements, which
Page 21 and 22:
Empirical studies have examined mul
Page 23 and 24:
there are (in theory) predictable a
Page 25 and 26:
is primarily driven by the firm’s
Page 27 and 28:
methodology. Studies could make uni
Page 29 and 30: The discussion of earnings persiste
Page 31 and 32: and documents that β2 < β1, which
Page 33 and 34: 1993). 12 The studies find conflict
Page 35 and 36: Xie (2001) uses the Jones model (di
Page 37 and 38: sophisticated investors do understa
Page 39 and 40: measurement. Nwaeze, Yang, and Yin
Page 41 and 42: and better reflects revenue manipul
Page 43 and 44: All of the accruals models can be e
Page 45 and 46: Second, investors seem to recognize
Page 47 and 48: fact improve predictability relativ
Page 49 and 50: lower book values of assets (higher
Page 51 and 52: than code law countries. The differ
Page 53 and 54: explain the kink. Durtschi and East
Page 55 and 56: with overstated net asset values ar
Page 57 and 58: earnings quality. The studies speci
Page 59 and 60: to conservatism, which is defined a
Page 61 and 62: they assert proxy for lower indepen
Page 63 and 64: paper, however, finds that firms ar
Page 65 and 66: Debt covenants: Dechow et al. (1996
Page 67 and 68: eadjustments in valuations associat
Page 69 and 70: ange of misstatements and they are
Page 71 and 72: significantly change the historical
Page 73 and 74: the firm’s public accountants mus
Page 75 and 76: whether disclosure of material weak
Page 77 and 78: with “shareholder” corporate go
Page 79: accruals) that stems from the confl
Page 83 and 84: and do not appear to be made to boo
Page 85 and 86: firms identified in the AAERs than
Page 87 and 88: past service costs). Zmijewski and
Page 89 and 90: 5.2 Financial reporting practices a
Page 91 and 92: 5.2.2 Other financial reporting pra
Page 93 and 94: The notion that accounting method c
Page 95 and 96: quality and the quality of M&A deci
Page 97 and 98: In countries with high ownership co
Page 99 and 100: for the AAER firm executives than f
Page 101 and 102: Dechow and Sloan (1991), who study
Page 103 and 104: management related to incentives pr
Page 105 and 106: nonaudit fees) and discretionary ac
Page 107 and 108: errors when litigation risk is high
Page 109 and 110: to suffer from omitted correlated v
Page 111 and 112: capital accruals as a proxy. Perry
Page 113 and 114: how the incentives provided by the
Page 115 and 116: (Jones, 1991); 2) Department of Jus
Page 117 and 118: 5.6.3 Tax regulations Several studi
Page 119 and 120: importance of implicit claims, they
Page 121 and 122: attention (Aboody et al. , 1999). 7
Page 123 and 124: of internal control procedure defic
Page 125 and 126: differences, which investors ration
Page 127 and 128: Bid-ask spread: Evidence on the ass
Page 129 and 130: low accrual quality stock that are
Page 131 and 132:
6.1.5 Summary To summarize, the evi
Page 133 and 134:
plaintiffs will prevail in sharehol
Page 135 and 136:
income increasing restatement firms
Page 137 and 138:
evisions do not fully account for t
Page 139 and 140:
the fact that some disclosures are
Page 141 and 142:
Therefore, the proxies are not meas
Page 143 and 144:
Amir, E., Harris, T., Venuti, E., 1
Page 145 and 146:
Beasley, M., 1996. An empirical ana
Page 147 and 148:
Burgstahler, D., Kinney, W., Martin
Page 149 and 150:
Considine, J., Mensah, Y., Oakes, L
Page 151 and 152:
Desai, H., Rajgopal, S., Venkatacha
Page 153 and 154:
Farber, D., 2005. Restoring trust a
Page 155 and 156:
Gong, G., Louis, H., Sun, A., 2008.
Page 157 and 158:
Hung, M., 2000. Accounting standard
Page 159 and 160:
Kothari, S., Leone, A., Wasley, C.,
Page 161 and 162:
Malmquist, D., 1990. Efficient cont
Page 163 and 164:
Phillips, F., 1999. Auditor attenti
Page 165 and 166:
Tucker, J., Zarowin, P., 2006. Does
Page 167 and 168:
Figure 1. Summary of the investigat
Page 169 and 170:
Figure 3: Key links between determi
Page 171 and 172:
Table 1. Categories of “Earnings
Page 173 and 174:
Exhibit 1: Summary of earnings qual
Page 175:
Exhibit 2: Summary of widely used m
show all

Understanding earnings quality - MIT Sloan School of Management

Create successful ePaper yourself

Delete template?

Save as template?