Understanding earnings quality - MIT Sloan School of Management

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measured by stock returns. Four firm characteristics deserve a separate discussion: 1) Performance and losses; 2) Growth and investment; 3) Debt; and 4) Size. 5.1.1 Firm performance The most commonly studied firm characteristic that affects EQ proxies is performance. The studies hypothesize that weak financial performance provides incentives for earnings management. 41 Petroni (1992) documents downwardly biased discretionary reserves for claim losses for financially weak P&C insurers. DeFond and Park (1997) document income smoothing in which firms manage earnings upward (downward) when unmanaged performance is poor (good) and when expected performance is strong (weak). 42 Balsam, Haw, and Lilien (1995) suggest that firms use discretion to time the adoption of income increasing accounting methods when the firm’s change in ROA is lowest. Keating and Zimmerman (1999) suggest that poorly performing firms use the discretion allowed in accounting standard adoption to their advantage. Financially weak firms also disclose more internal control weaknesses (Doyle, Ge, and McVay, 2007a) and are more likely to correct previously reported earnings, which is interpreted as ex post evidence of earnings management (Kinney and McDaniel, 1989). Francis, Hanna, and Vincent (1996) find no evidence that write-offs, after controlling for the likelihood that assets are impaired, are associated with poor performance. The only study in our database that finds negative evidence is done by DeAngelo, DeAngelo, and Skinner (1994). For a sample of firms with persistent losses, they find that the accruals reflect the underlying economics 41 Lee, Li, and Yue (2006) create a stylized model in which firms with higher performance overstate earnings more. The model predictions result from assumptions about the cost of earnings management and about how earnings performance and earnings growth affect the proportion of true economic earnings in total reported earnings. Their empirical evidence is mixed. 42 Elgers, Pfeiffer, and Porter (2003), however, suggest that the results in DeFond and Park (1997) are sensitive to the method used to “back out” abnormal accruals. 81
and do not appear to be made to boost earnings. They acknowledge, however, that their sample is a unique sample of troubled firms, not just firms with weak performance. 5.1.2 Firm growth and investment There is some debate as discussed in Section 3 over whether growth, the unobservable construct, or accruals as a measure of growth, affects earnings persistence. The bottom line is that high growth firms have less sustainable earnings (Nissim and Penman, 2000). This finding is not surprising. Earnings summarize performance of the firm’s earnings process during the reporting period. If the fundamental process changes (i.e., grows), so will earnings, and properties of earnings like persistence and smoothness will be adversely affected. Studies like Penman and Zhang (2002) provide more contextual evidence about how the accounting system affects the degree to which growth matters. In addition to the impact of growth on the fundamental element of earnings properties, growth also is associated with greater measurement error and more manipulation opportunities (Richardson et al., 2005). We are not aware of papers that specifically analyze the role of growth as a determinant of timely loss recognition or benchmarking. Researchers have, however, examined growth as a determinant of the external indicators of quality. AAER firms have high market to book ratios and high accruals during manipulation years (see Dechow et al., 2009). Doyle et al., (2007a) and Ashbaugh-Skaife et al. (2007) find that young growth firms disclose more internal control weaknesses. Lee et al. (2006), however, do not find evidence supporting the association between restated amounts and growth. 82
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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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methodology. Studies could make uni
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The discussion of earnings persiste
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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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