Understanding earnings quality - MIT Sloan School of Management

More documents

Recommendations

Info

(2008) hypothesize that International Accounting Standards (IAS) increases earnings quality in part because the standards are principles-based, and they find evidence that use of (IAS) is associated with less earnings management, more timely loss recognition, and greater value relevance. 51 They are careful to acknowledge that these ex post characteristics of earnings also are a function of differences in institutions, which affect the demand for information, enforcement, and fundamental firm characteristics of the IAS adopters. While they attempt to control for these differences, the results are still subject to their caveat. 5.2.4 Summary There is relatively sparse evidence on the ability of accounting methods to capture firm fundamentals, either across different methods or across different fundamentals. We were at first surprised by the small number of papers in this category, but research design issues seem to be the explanation. If firms follow different methods, it is because they have chosen to, which creates an endogeneity problem. When accounting methods are mandatory (i.e., exogenous), there is no cross- sectional variation to examine. An alternative is to study firms in different mandatory reporting regimes (i.e., different countries or different time periods), which creates an omitted correlated variables problem. After the mid-1970s, the limited set of papers we found use either simulations or examine specific methods, which improves internal validity but at the expense of generalizability. In summary, the results on the implications of accounting methods for earnings quality are method specific. 51 The degree of earnings management is measured based on earnings variability, earnings variability relative to cash flow variability (Leuz, Nanda, and Wysocki, 2003), the correlation between accruals and cash flows, and meeting earnings targets. Timely loss recognition is measured by the frequency of large losses, and value relevance is measured as the contemporaneous association between stock prices and earnings and equity book value. 91
The notion that accounting method choice is opportunistically used for earnings management purposes, thus reducing the overall quality of earnings, does not get much support. It is not the case that cash flow methods dominate accrual-based methods that involve estimation (Dharan, 1987) or that more “aggressive” income recognition methods are viewed as opportunistic (Loudder and Behn, 1995; Altamuro et al., 2005). Moreover, investors appear to efficiently adjust their valuation decisions to reflect information that is not reported (Lev and Sougiannis, 1996). Investors also appear to adjust their valuations when they anticipate earnings management (Aboody et al., 1999). 5.3 Governance and controls as determinants of earnings quality Using the terminology of Jensen and Meckling (1976), internal controls include monitoring mechanisms, optimally chosen by the principal in the principal-agent relationship, as well as bonding mechanisms, optimally chosen by the agent at some cost. The mechanisms we discuss in this section include: 1) The Board of directors (BOD); 2) Internal control procedures, 52 3) Managerial share ownership; 4) Managerial compensation; and 5) Managerial change. The studies associated with the BOD and internal control procedures view internal controls as monitors of the financial reporting system that constrain a manager’s opportunity or ability to manage earnings, while the studies of managerial share ownership and managerial compensation are predicted to affect earnings quality because they provide incentives for earnings management. 53 In both cases, internal controls affect earnings management, and discretionary accruals and accounting misstatements are popular measures of earnings quality. 52 We emphasize the distinction between “internal controls” as the term is used by Jensen and Meckling (1976), which includes what researchers commonly refer to as corporate governance mechanisms, from internal control “procedures.” We will use the term internal control procedures for the tasks performed to monitor the financial reporting system. 53 See Ng and Steockenius (1979), Lambert (1984), Verrecchia (1986), Dye (1988) and Liang (2004). 92
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 and 80: accruals) that stems from the confl
Page 81 and 82: observable variables such as natura
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: 5.2.2 Other financial reporting pra
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

You also want an ePaper? Increase the reach of your titles

Delete template?

Save as template?