Abstract
This paper examines how commonly used earnings quality measures fulfill a key objective of financial reporting, i.e., improving decision usefulness for investors. We propose a stock-price-based measure for assessing the quality of earnings quality measures. We predict that firms with higher earnings quality will be less mispriced than other firms. Mispricing is measured by the difference of the mean absolute excess returns of portfolios formed on high and low values of a measure. We examine persistence, predictability, two measures of smoothness, abnormal accruals, accruals quality, earnings response coefficient and value relevance. For a large sample of US non-financial firms over the period 1988–2007, we show that all measures except for smoothness are negatively associated with absolute excess returns, suggesting that smoothness is generally a favorable attribute of earnings. Accruals measures generate the largest spread in absolute excess returns, followed by smoothness and market-based measures. These results lend support to the widespread use of accruals measures as overall measures of earnings quality in the literature.
Highlights
There has been considerable interest in the quality of financial reporting
We argue that measures that are associated with higher hedge returns are more informative about future stock returns and, “better” measures of earnings quality
We use the following controls: Size: natural logarithm of total assets; Operating cycle: natural logarithm of the sum of days accounts receivable and days inventory;9 Intangible intensity: reported R&D expense divided by sales (R&D expense is set equal to zero when missing); Capital intensity: net book value of property, plant and equipment divided by total assets; Growth: percentage change in sales; Leverage: total liabilities divided by equity book value
Summary
There has been considerable interest in the quality of financial reporting. Many studies analyze earnings quality trends over time and their determinants; others measure the effects of specific changes in accounting standards, enforcement systems, or corporate governance requirements within or across countries; further studies use earnings quality to explain variations in economic outcomes, such as the cost of capital. Earnings quality is often considered as a result of good governance, so this paper adds to that strand of literature by considering an aspect of corporate governance and financial reporting Earlier work, such as Francis, LaFond, Olsson, and Schipper (2005) and Core, Guay, and Verdi (2008), has focused mainly on the implications of earnings quality on the cost of capital and discussed whether differences in expected returns are attributable to omitted risk factors, e.g., information risk. By varying the incentives and operating and accounting characteristics, they compare these measures based on their ability to capture the change in the information content of reported earnings They find that value relevance is a good proxy, whereas earnings smoothness and discretionary accruals are unreliable according to their model.
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