Understanding earnings quality - MIT Sloan School of Management

expenditures in the pharmaceutical industry provides earnings streams that are more closely
associated with fundamental values than immediate expensing or full capitalization. Moses (1987)
attempts a direct assessment of the impact of methods on earnings quality proxies in a large sample.
He suggests that firms change accounting methods to achieve smoother earnings. His analysis
includes all methods changes; they are primarily associated with inventory and pension accounting.
Income-increasing changes are more likely than income-deceasing changes, and the propensity for
changing is positively associated with firm size, existence of a bonus plan, and incentives for
meeting earnings targets.
Five studies examine choices of specific accounting methods. Loudder and Behn (1995) and
Altamuro, Beatty and Weber (2005) suggest that R&D capitalization and pre-SAB 101 revenue
recognition practices, both of which are generally income increasing, result in more informative
earnings as measured by ERCs. Lev and Sougiannis (1996) use a clever research approach to
understand the implications of method choice for earnings quality. They use real firm data to
“simulate” earnings outcomes if R&D were (pseudo) capitalized and show that the capitalized
amounts are associated with information used by equity markets to value high-R&D firms (i.e.,
value-relevance). Aboody, Barth, and Kasznik (1999) find that asset revaluations in the UK are
positively related to future operating income and cash flows and investors respond positively to
revaluations. Sivakumar and Waymire (2003) exploit a change in fixed asset accounting rules in the
early 1900s and find evidence of increased asymmetric timeliness using the Basu metric
(conservatism), but no evidence of smoothing, where smoothing techniques could incorporate
artificial accounting accruals or real cost management.
89