Understanding earnings quality - MIT Sloan School of Management

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5.1.3 Firm debt 43 Watts and Zimmerman (1986) suggest the debt covenant hypothesis: Firms closer to violating debt covenants will make income-increasing accounting choices to avoid covenant violations. Early research used debt-equity ratios or other indirect proxies for the existence of debt covenants (e.g., Bowen, Noreen, and Lacey, 1981; Zmijewski and Hagerman, 1981; Daley and Vigeland, 1983; Johnson and Ramanan, 1988). 44 These papers provide consistent cross-sectional evidence that more highly-levered firms choose income-increasing accounting methods. 45 In addition, Balsam, Haw, and Lilien (1995) suggest that firms time the adoption of income-increasing accounting methods when leverage is highest. LaBelle (1990) finds that greater leverage and lower interest coverage are associated with accounting method changes in Canada. Specifically in the oil and gas industry, Johnson and Ramanan (1988) and Malmquist (1990) identify operating characteristics associated with the choice of successful efforts vs. full cost accounting, and find that leverage-related variables are incrementally important determinants of the choice. Three papers examine choices other than accounting methods. Bartov (1993) finds that firms time asset sales to use the gains to reduce earnings volatility and to avoid debt covenant violation. The smoothing and debt covenant explanations for the real earnings management are incremental to each other. Kinney and McDaniel (1989) find that more highly levered firms are more likely to correct previously reported earnings, which implies that they had misreported, and Efendi et al. (2007) find that firms with lower interest coverage ratios (higher ratio of interest to income) are more likely to restate. In addition, Dechow et al. (1996) find higher leverage ratios for manipulation 43 We include debt as a firm characteristic, although debt may also be viewed in its role as a monitor, much like the monitors discussed in Section 3.3. 44 Daley and Vigeland (1983) also find that the firms that choose income increasing voluntary accounting methods have higher ratios of dividends to retained earnings, which is another proxy for the extent to which debt covenants are likely to be binding. 45 See Christie (1990) for a rigorous statistical meta-analysis of existing studies of theories of accounting method choice. He finds that size and leverage are consistently related to accounting choice. 83
firms identified in the AAERs than control firms, but Beneish (1999) does not find this relation for his sample of manipulation firms. The aforementioned papers interpret the correlation between leverage and earnings management as evidence that debt covenants provide incentives for firms to manage earnings, but they do not examine debt covenants specifically. 46 Subsequent research tested the debt covenant hypothesis using data on specific debt covenants. Sweeney (1994) provides evidence that firms make income-increasing accounting choices as they move closer to violating debt covenants. DeFond and Jiambalvo (1994) find that working capital accruals and a measure of abnormal accruals are both higher in the year prior to the year that a firm reports a covenant violation in its annual report. In the year of violation, the accruals are high after controlling for management changes and audit qualifications. Using a comprehensive sample of detailed debt covenants, Dichev and Skinner (2002) show that an unusually large (small) number of loan quarters have financial measures at or just above (below) covenant thresholds, consistent with the debt covenant hypothesis. In contrast, DeAngelo et al. (1994), discussed previously, find relatively little difference between accruals for firms with and without binding covenants. While the conclusion is that firms closer to covenants, measured directly or indirectly, are more likely to manage earnings, the implications of the conclusion for our assessment of earnings quality are ambiguous. On the one hand, the fact that earnings are managed opportunistically generally implies that the earnings are less reliable. On the other hand, the mechanisms used to manage earnings under the debt covenant hypothesis are typically accounting method choices that 46 Zimmer (1986) shows that accounting choice is related to leverage even in the absence of debt covenants using a sample of Australian firms. Specifically, he finds that higher leverage is associated with interest capitalization (incomeincreasing), but the significance is eliminated when he controls for whether firms use project-specific financing. He interprets this as evidence that leverage does not capture covenants but rather that it is correlated with type of financing used by companies. 84
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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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and documents that β2 < β1, which
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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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