Measures Of Earnings Quality Research Articles

Optimal versus suboptimal choices of accounting expertise on audit committees and earnings quality

By employing a Heckman two-stage selection model, we identify whether employing a financial expert with or without accounting expertise on the audit committee is optimal and how earnings quality varies across these optimal and suboptimal choices. Using four earnings quality measures (informativeness, timely loss recognition, earnings persistence, and accruals quality), we find no differences in earnings quality between firms optimally choosing an expert with or without accounting expertise, consistent with Demsetz and Lehn (J Polit Econ 93:1155–1177, 1985) and others who argue that when firms optimize their choice (i.e., accounting expertise), there should be no difference across the characteristic (i.e., earnings quality) being examined. We do find, however, earnings quality is significantly higher for firms that optimally choose an accounting expert relative to firms that choose (with/without accounting expertise) suboptimally. Finally, firms suboptimally choosing an accounting expert exhibit no improvement, or even lower earnings quality, than firms that optimally choose no accounting expert. Our results provide important evidence of the impact accounting expertise has on earnings quality when considering the firm’s choice.

Earnings quality measures and excess returns: A case study of Tehran Stock Exchange

A B S T R A C T This paper presents an empirical investigation to study the relationship between earning quality measure and excess returns on selected firms trading on Tehran Stock Exchange. The purpose of this study is to find the relative advantage of income figures reported in formal financial statements. The study uses hedge return, six accounting ratios and three market ratios and performs the study over the period of 2001-2011 using 56 firms whose shares were traded on Tehran Stock Exchange. The proposed study uses regression analysis as well as structural equation modeling. The results of this study indicate that market based figures are more influencing than accounting based ratios on hedge return. In other words, hedge return for persistency index was more predictable than smoothness and abnormal accruals. However, on the contrary to what we expected, hedge return for accruals was not more than other accounting based figures.

The Earnings Quality of High Growth Firms Before and after the Sarbanes-Oxley Act

Here we examine whether earnings quality improved after the Sarbanes-Oxley Act of 2002 (SOX) in the context of high growth and lower growth firms. Our examination is based on the notions that high growth creates unique management and reporting challenges that can contribute to lower earnings quality and that the period of increased attention to accounting and reporting issues initiated by SOX has been particularly relevant for high growth firms. Our earnings quality measures include modified Jones performance-matched discretionary accruals and absolute value book tax differences. Our results indicate that earnings quality for high growth firms improved in the period after SOX relative to lower growth firms. We also find that the relation between accounting returns and market returns weakened in the period after SOX. However, we find that the returns relations are significantly lower only for lower growth firms. We interpret these results as indicative of dual and potentially conflicting effects from improvements in financial reporting.

Internal control system, earnings quality, and the dynamics of financial reporting

Using an earnings management model in which managers manipulate information when the firm’s control system fails, I introduce a measure of earnings quality, based on the notion of integral precision, that has solid theoretical foundations. A trade‐off between the frequency and the magnitude of overstatements is shown: overstatements are larger when misreporting is less likely. Overall, the model generates a distribution of earnings announcements similar to its empirical analogue and provides a structural method to identify the likelihood and magnitude of misreporting by exploiting information from the moments of the distribution of reported earnings.

The supplemental role of operating cash flows in explaining share returns

PurposeIn response to recent concerns on earnings quality and a firm's fundamental performance, the purpose of this paper is to re‐examine salient questions under accrual accounting: how earnings quality affects the role of earnings and operating cash flows in a firm's valuation.Design/methodology/approachUsing a large sample ranging from 1989 to 2008, the authors contrast the effects of three representative accrual‐based earnings quality measures on the association between earnings, operating cash flows and a firm's abnormal stock returns.FindingsIn the univariate analysis it was found that earnings explain returns similarly to operating cash flows. With control of earnings quality, the results indicate that earnings' role in explaining contemporaneous abnormal returns remains unchanged when earnings quality is better. Conversely, operating cash flows explain more contemporaneous abnormal returns when earnings quality is better. The findings could suggest that the market reacts to operating cash flows conditionally on earnings quality. Intriguingly, the results also indicate that the market perceives better earnings quality captures superior performance of operating cash flows rather than that of earnings. These findings are further fortified by additional analyses revealing that the earnings quality measure with control of operating cash flows affects the supplemental role of operating cash flows most.Originality/valueThe paper's findings provide insights on how the market processes firm value signals embedded in earnings quality, which have direct implications for regulators, standard setters, academics and practitioners.

Effects of International Institutional Factors on Earnings Quality of Banks

We examine the relation between legal, extra-legal and political institutional factors and earnings quality of banks across countries. We predict that earnings quality is higher in countries with legal, extra-legal and political systems that reduce the consumption of private control benefits by insiders and afford outside investors greater protection. Using a sample of banks from 35 countries during the pre-crisis period from 1993 to 2006, we find that all five measures of earnings quality studied are higher in countries with stronger legal, extra-legal and political institutional structures. We also find that banks in countries with stronger institutions are less likely to report losses, have lower loan loss provisions, and higher balance sheet strength during the 2007-2009 crisis period. Our findings highlight the implications of country level institutional factors for financial reporting quality and are relevant to bank regulators who are considering additional regulations on bank financial reporting.

Engliish

The aim of the paper is to investigate the relationship between audit committee characteristics and earnings management. Samples in the study included 50 industrial companies listed on the Amman Stock Exchange ASE. Two models were used to measure earnings quality: one which depends on earnings continuity as an indication of quality, and one which depends on the decrease of discretionary accruals of quality, using pooled data regression for the two tests (Ordinary Least Squares OLS and Binary Logit). The study found that there was an influence of some standard characteristics of the audit committee on earnings quality.

Institutional Monitoring and Earnings Quality in Malaysia

This study examines the relationship between institutional ownership in Malaysia and the quality of reported earnings. Given the typically significant stake and unique position of influence, participation from active institutional investors is said to provide an effective monitoring role in the companies in which they invested. Using the accrual quality model to measure earnings quality, this study provides evidence that concentrated shareholdings, in the hands of institutional investors, afford greater incentives to closely monitor firms’ activities. The results confirm the active monitoring hypothesis, which suggests that institutional investors are likely to actively monitor their investments due to the large amount of wealth they invested. Furthermore, the government's commitment to the establishment of the Minority Shareholder Watchdog Group (MSWG) to encourage shareholder activism appears to have a positive effect on the financial reporting quality in Malaysia.

Extracting Sustainable Earnings from Profit Margins

Revenues and expenses are fundamentally proportional to one another, but are likely to be disproportionally affected by transitory items or economic shocks. We build on this observation and propose a new measure of sustainable earnings based on deviations from normal profit margins. While some other sustainable earnings metrics attempt to identify transitory components on a line-by-line basis, our measure, referred to as the intensity of core earnings (ICE), uses ratio analysis to extract the transitory portion of earnings from all line items. We find that the ICE, as measured here, is positively associated with earnings persistence, better earnings predictability, and stronger market reaction to unexpected earnings. We also find that our measure is positively associated with post-earnings announcement excess stock returns. Comparing our measure with an accrual-based measure of earnings quality, we find that, in general, the two metrics provide distinct incremental information relative to one another and in some instances our measure is better than an accrual-based measure in assessing earnings quality.

An Extended Dechow and Dichev (2002) Model with Cash Flow Forecasts

We propose a modification to the Dechow and Dichev (2002) model (DD hereafter) by replacing realized next-period cash flows with forecasted future cash flows. We first theorize the relation between the modified- and original DD model and that between abnormal accruals from the modified DD model and future stock returns. Our empirical evidence shows that the accruals quality from the modified DD model is associated with established measures of earnings quality. Further, we find that the residuals from the modified DD model, especially under information asymmetry, are predictive of future size-adjusted returns, matching the performance from Jones-type models. Overall, our modified DD model without the foresight requirement is as effective as the original DD model in measuring earnings quality. More importantly, expanding the usefulness of the DD model, our model can estimate the current-year information on earnings management and allow investors to predict stock returns.

The Effects of Management Demography on Auditor Choice and Earnings Quality: Evidence from China

Recent management literature shows that demographic characteristics of top management and corporate performance are related. Bamber et al. (2010) conclude that managers' voluntary disclosure styles are related to demographic characteristics. Also, Francis et al. (2008) demonstrate a negative relation between CEO reputation and earnings quality. We conjecture that, management demography affects auditor choice and earnings quality. Using a sample of 3,881 firm-year observations between 2001 and 2005 in China and controlling for board governance characteristics, we find that a chairperson with better reputation (i.e., holding titles) prefers well-known auditors on the national basis, regional basis and in the industry group. Furthermore, chairpersons with titles and longer tenure report earnings of higher quality. Our results are robust using different measures of auditor choice and earnings quality.

Accounting Standards, Earnings Management, and Earnings Quality

This paper examines how the characteristics of accounting systems and management incentives interact and collectively determine financial reporting quality. We develop a rational expectations equilibrium model that features a steady-state firm with investments, financial and non-financial information, and earnings management opportunities. We measure earnings quality by the information content of earnings in equilibrium. The analysis confirms some intuitive results, such as that earnings quality increases in accounting precision. However, we also find counter-intuitive results, such as that an accounting standard that makes unbiased accounting earnings more informative can reduce earnings quality. These results are mainly driven by an interaction between managers’ smoothing incentives and smoothing provided by the accounting standard. Finally, we study value relevance measures and show that they trace the changes in earnings quality accurately for the variation of some and not of other characteristics of the accounting system.

Quality of reported earnings by Chinese firms: The influence of ownership structure

This paper examines the influence of ownership structure on earnings quality of firms listed on the Chinese Stock Exchanges. We empirically test four contemporary earnings quality measures, including volatility of earnings, variability of earnings over cash flows, correlations between accruals and cash flows, and level of discretionary accruals, for 1438 firms listed on Shenzhen Stock Exchange and Shanghai Stock Exchange. We find that although state-owned firms are bigger in size and appear more profitable based on reported earnings; privately-owned firms, foreign-owned firms and society-owned firms outperform the state-controlled firms in earnings quality; and foreign-owned firms have the highest earnings quality among all types of ownership groups. We find that there is not much difference in earnings quality between collectively-owned firms and state-owned firms and employee-owned firms exercise least discretion in earnings management. The findings in particular will have direct policy implications for the China Securities Regulatory Committee (CSRC).

The Effect on Financial Reporting Quality of an Exemption from the SEC Reporting Requirements for Foreign Private Issuers

We test for differences in financial reporting quality between companies that are required to file periodically with the SEC and those that are exempted from filing reports with the SEC under Rule 12g3-2(b). We examine three earnings quality measures: conservatism, abnormal accruals, and the predictability of earnings. Our results, for all three measures, show different financial reporting quality for companies that file with the SEC than for companies exempt from the filing requirements. This paper provides empirical evidence of a link between filing with the SEC and financial reporting quality for foreign firms.

Earnings Quality: Evidence from the Field

The final working paper version: http://ssrn.com/abstract=2103384. Presentation slides: http://ssrn.com/abstract=2347428. We provide insights into earnings quality from a survey of 169 CFOs of public companies and in-depth interviews of 12 CFOs and two standard setters. CFOs believe that (i) above all, high-quality earnings are sustainable and repeatable; specific characteristics include consistent reporting choices, backing by actual cash flows, and absence of one-time items and long-term estimates; (ii) about 50% of earnings quality is driven by non-discretionary factors such as industry and macro-economic conditions; (iii) in any given period, about 20% of firms manage earnings to misrepresent economic performance, and for such firms 10% of EPS is typically managed; (iv) earnings manipulation is hard to unravel from the outside but peer comparisons and lack of correspondence between earnings and cash flows provide helpful red flags. In addition, CFOs disagree with current standard setting on a number of issues including the sheer number of promulgated rules, the top-down approach to rule-making, the neglect of the matching principle, and the emphasis on fair value accounting. They indicate that a rules-based culture makes the audit function centralized and mechanical, and hinders the development of audit professionals. A summary impression from our work is that CFOs view earnings quality as more of a single and unconditional characteristic, in contrast to current research where measures of earnings quality are strongly conditional on the decision setting. This CFO view is related to their idea of “one number” – a single earnings metric that shapes both their interactions with external stakeholders and internal decision-making.

Direct and Mediated Associations among Earnings Quality, Information Asymmetry, and the Cost of Equity

ABSTRACTUsing path analysis, we investigate the direct and indirect links between three measures of earnings quality and the cost of equity. Our investigation is motivated by analytical models that specify both a direct link and an indirect link that is mediated by information asymmetry, but do not suggest which link would be more important empirically. We measure information asymmetry as both the adverse selection component of the bid-ask spread and the probability of informed trading (PIN). For a large sample of Value Line firms during 1993–2005, we find statistically reliable evidence of both a direct path from earnings quality to the cost of equity, and an indirect path that is mediated by information asymmetry, with the weight of the evidence favoring the direct path as the more important.

Changes in Managers’ Forecasting Behavior and the Market’s Assessment of Forecast Credibility during Periods of Financial Misreporting

The capital market benefits of high quality financial reporting create incentives for managers to signal the quality of their voluntary disclosure practices. Prior research focuses on the relations between observable measures of earnings quality and observable measures of voluntary disclosure quality. We examine the characteristics of management earnings forecasts during periods in which managers possess private (i.e., unobservable to the market) knowledge that they are engaging in financial misreporting (i.e., committing accounting fraud). Using a sample of Securities and Exchange Commission enforcement actions, we hypothesize and find that managers issue more bad news forecasts in periods of fraud relative to pre-fraud periods and control firms, consistent with the increased use of voluntary disclosure to manage expectations downward while violating constraints on earnings management. The fraud period forecasts are, when compared to fraudulent earnings observed by the market, less ex post biased and more accurate than pre-fraud period forecasts and thus give the appearance of higher quality voluntary disclosures. However, the fraud period forecasts are not less ex post biased or more accurate when accounting restatements later reveal true actual earnings. A consequence of the perceived increase in quality is greater bad news fraud-period forecast impact on prices relative to pre-fraud periods. Further, the enhanced price reactions do not deteriorate after the fraud is made public, suggesting that the public revelation does not taint investors’ assessment of the credibility of bad news management forecasts.

Perks and the informativeness of stock prices in the Chinese market

While the literature shows that perks can affect firm values positively or negatively, we argue that firms with higher perks are more likely to be associated with a lower quality of financial reporting, which, in turn, can affect the informativeness of stock prices. Based on hand-collected data on perks from Chinese listed firms, we find that firms with lower perks are associated with higher informativeness of stock prices (or lower R-square). Moreover, the positive association between perks and R-square is shown to be weaker for firms with higher financial reporting quality through audit and earnings quality measures.

Corporate Assets Turnover as the Proxy for Earnings-Quality on the Polish Stock Market

Earnings manipulations are often revealed with significant lag. This usually entails dramatic share price’ slide. Therefore investors should avoid/buy stocks with low/high earnings-quality. However, given the shortcomings of auditing, using this strategy requires application of the other (then the auditors’ opinion) tools of earnings management’ detection. We tested the usefulness of one of the “red flags” (i.e. assets turnover) as the earnings-quality measure. Often earnings overstatement manifests itself in assets growth surpassing revenues growth. If assets turnover has the relationship with earnings-quality, than strategy of buying/avoiding stocks with increasing/decreasing assets turnover should generate above-average long-term returns. We compared profitability of strategies based on assets turnover’ change on the Polish stock market in 2000-2010 years. The strategy of investing in 20% stocks with the highest/lowest assets turnover’ change generated above-average/below-average returns. The average annual nominal return of the highest earnings-quality stocks in 2000-2010 period was 2'89% compared to 4,8% in the lowest earnings-quality stocks and compared to the average annual return of the market as a whole of 6%.

The Effects of Ownership Structure and Monitoring Mechanisms on Earnings Quality and Cost of Equity

This paper examines the relationship between ownership structure (cash flow/voting rights and type of ultimate controlling party), monitoring mechanisms (audit committee and substantial shareholding), various measures of earnings quality and the cost of equity as a form of market assessment of information risk. There is no evidence that ownership structure affects earnings quality and the cost of equity. However, the significant association between substantial shareholding and both earnings quality and cost of equity suggests that substantial shareholding plays a monitoring role. Substantial shareholding has also a role in increasing information flow to the public i.e in reducing information risk and thus is priced by the market. In contrast, the market seems to be indifferent with the rule based mechanism of audit committee. The results suggest that companies just about satisfy the minimum requirement for audit committee whose monitoring role is not evident. This has an important implication on the relative emphasis given by regulators on market and rule based mechanisms.