Understanding earnings quality - MIT Sloan School of Management

5.1.5 Summary of firm characteristics as a determinant of earnings quality
Our review yields the following insights. First, fundamental firm characteristics are
associated with accounting method choice. Any studies that predict accounting choices as an
indication of earnings quality must control for these fundamental differences before inferring
opportunism. Second, the evidence that weak performance provides incentives for earnings
management is fairly well-established. The extent to which opportunities constrain the behavior,
however, is a less actively researched topic (see DeAngelo et al., 1994). Third, while the evidence
suggests a relation between size and earnings management, it is impossible to generalize any sort of
implications for a relation between size and earnings quality on any dimension, given that firm size
could proxy for various underlying constructs (e.g., political visibility, information environment
etc.).
Finally, equity investors appear to unwind firm’s incentives arising from debt contracts to
manage earnings (Aboody et al., 1999). The evidence, however, on investors’ ability to unwind
incentives and to incorporate an expectation of rational earnings management into their pricing is
limited, even for debt-related incentives, which are among the strongest documented incentives for
earnings management and potentially the most transparent to investors. Other than Aboody et al.
(1999) and Shivakumar (2000), we do not have studies in our database that condition equity market
reactions to earnings on investors’ ability to unwind earnings management that represents a value-
maximizing activity that is the outcome of efficient contracting.
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