Understanding earnings quality - MIT Sloan School of Management

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5.3.1 The Board of directors and earnings quality Several papers document that more independent boards, measured by a greater proportion of outsiders for example, and higher audit committee quality, measured by independence and meeting frequency for example, are associated with less earnings management, measured by discretionary accruals, the likelihood of the firm avoiding an earnings decline and negative earnings surprises, accounting manipulations, and internal control quality (e.g., Beasley, 1996; Klein, 2002; Vafeas, 2005; Farber, 2005; Abbott, Parker, and Peters, 2004). Krishnan (2005) documents a positive association between audit committee quality and quality of internal control procedures. García Lara, García Osma, and Penalva (2009) find a positive association between commonly used governance proxies for effective monitoring and asymmetric timeliness. Larcker et al. (2007) start with 39 governance variables and use principal component analysis to extract governance factors. They find mixed and weak evidence of associations between the fourteen governance factors and earnings quality measured by discretionary accruals and restatements. Larcker and Richardson (2004) find that strong governance mitigates the negative relation between audit fees and accruals. The studies consistently suggest a positive association between audit committee quality and earnings management (with the exception of Larcker et al., 2007). This result is not surprising because the audit committee’s primary responsibility is to oversee the financial reporting process. Thus inferences from studies that predict an association between audit committee quality and accruals quality have the greatest internal validity ceteris paribus. The theory that underlies tests of an association between BOD quality and earnings management, however, is weaker. Directors are usually involved with decisions at a high level such as setting overall strategy (Adams, Hermalin, and Weisbach, 2008). Hence, while it may be reasonable to argue a correlation between BOD 93
quality and the quality of M&A decisions, the argument that cross-sectional variation in many BOD characteristics can explain cross-sectional variation in earnings management is less compelling. Tests based on an overall governance score as a proxy for internal controls that might constrain earnings management must assume that variation in the score is correlated with the quality of mechanisms that specifically affect earnings management opportunities or incentives. Tests that assume that the monitoring role of governance affects dimensions of earnings quality other than earnings management, such as conservatism, face even greater challenges (e.g., Garcia Lara et al., 2009). Many internal control mechanisms are substitutes or complements. For example, Krishnan (2005) emphasizes the complementarity of two internal control mechanisms (i.e., audit committees and internal control procedures). Larcker et al. (2007) more thoroughly address the problem and argue that this causes econometric problems (e.g., inconsistent coefficient estimates) when using only a limited set of corporate governance measures. 5.3.2 Internal control procedures Using internal control disclosures under SOX, Doyle et al. (2007b) find that firms with material weaknesses in internal control procedures over financial reporting have lower accruals quality (measured based on Dechow and Dichev, 2002), higher discretionary accruals, lower earnings persistence, and a higher likelihood of restatements than other firms. Ashbaugh-Skaife et al. (2008) further find that firms that have remediated their internal control weaknesses tend to have improved accruals quality. 54 The predicted association between internal controls and accruals and 54 Both Doyle et al. and Ashbaugh-Skaife et al. attempt to control for the self-selection bias associated with a manager’s choice of internal controls. The selection bias associated with using internal control deficiency reports under SOX as a proxy for poor quality is a separate issue and is discussed in Section 2.4.3. 94
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*Title Page/Author Identifier Page/
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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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1993). 12 The studies find conflict
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Xie (2001) uses the Jones model (di
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sophisticated investors do understa
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measurement. Nwaeze, Yang, and Yin
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and better reflects revenue manipul
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Page 89 and 90: 5.2 Financial reporting practices a
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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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