Poor Earnings Quality Research Articles

Does Ownership Structure and Financial Health Affect Firm’s Earnings Quality? Evidence from Emerging Economy

Earnings quality is a demanding attribute of firm and is valued by investors in resource allocation decisions. High earnings quality firms create value for stakeholders and poor earnings quality causes value deterioration. This study takes into account earnings quality attributes of Pakistani corporate sector and investigates impact of ownership structure and financial health on firms’ earnings quality. Earnings quality has been measured by four attributes of accrual quality, earnings persistence, earnings predictability, earnings smoothness. A sample of 325 non-financial PSX listed Firms have been selected and classified into four unique categories on the basis of financial health (healthy and distressed) and ownership (family and non-family). The classification aims to determine level of earnings quality for each category. Results find significant effect of book financial position and ownership structure on earnings quality of firms. Findings reveal Earnings quality for non distressed family (NDF) firms was highest followed by non distressed non family firms (NDNF), while earnings quality for distressed family (DF) firms was poor and poorer for distressed non family (DNF) firms when firms were classified into these four categories. These results provide important implications for investors, analysts, regulators and standard setters.

Debt maturity structure, credit ratings and audit fees: new evidence

PurposeThis research aims to revisit Gul and Goodwin (2010), which focuses on exploring the relationship between debt maturity structure, credit ratings and audit fees. Furthermore, the authors investigate whether this association varies based on firm size, firm life cycle and financial reporting quality.Design/methodology/approachTo investigate the research question, the authors use an extended sample period, 2004–2017, in comparison to the sample period, 2003–2006, used in Gul and Goodwin (2010). The authors use ordinary least squares regression as a baseline methodology along with two-stage least-squares regression and change analysis to control for endogeneity concerns.FindingsAccording to Gul and Goodwin (2010), auditors charge lower audit fees for firms with higher short-maturity debt and better credit ratings, indicating a lower likelihood of financial misreporting. Further, Gul and Goodwin (2010) find that lower credit rated firms benefit more from short-term debt. Primarily, the findings are consistent with Gul and Goodwin (2010) and provide further evidence that the beneficial effects of short-maturity debt for firms with poor ratings are evident for small firms, firms in the growth stage of their life cycle and firms with poor earnings quality.Practical implicationsThe findings imply that practitioners in the audit profession and investors should take a more nuanced and comprehensive approach to varied firm and financial factors, taking into consideration the intricate relationships between many elements impacting a firm’s financial health. As a result, audit professionals may give more accurate appraisals of a firm’s financial condition, and investors can make better investment decisions.Originality/valueThe authors reconfirm the findings of Gul and Goodwin (2010) using an extended sample. The findings are novel, which evidence that the lower audit fees for rated firms with short-maturity debt are moderated by firm size, life cycle and financial reporting quality.

Do the Levels of Environmental Sustainability Disclosure and Indebtness Affect the Quality of Earnings?

Previous research has found that, when firms engage in environmental sustainability practices, they tend to give a consistent signal to external stakeholders by acting in a more responsible, transparent, and ethical manner, and these firms tend to exhibit high earnings quality. However, other studies have found that those activities may mask a poor earnings quality. On the other hand, firms with high debt levels face constraints in raising funds. In this study, we expect these firms, when involved in environmental reporting practices, to reveal an increase in their earnings quality in order to improve their ability to capture financing. Thus, we analyze whether the level of environmental disclosure and a firm’s debt increase earnings quality. To analyze the former association, we develop an environmental sustainability reporting index (ESReporting), based on GRI standards, using the content analysis for Portuguese firms from 2016 to 2020. We use earnings persistence as a proxy for earnings quality because it is a fundamental characteristic to determine firm value. Regarding debt, we include a financial indicator to analyze its effect on earnings persistence. To test the hypotheses, we estimate a multiple linear regression, applying panel data. Our results suggest that ESReporting and debt tend to positively affect earnings persistence. In addition, our evidence suggests that ESReporting produces a higher positive impact then debt. These results show that ESReporting and debt may be used as regulating mechanisms of earnings management. Besides, this article brings some insights to the improvement of earnings quality resulting from a higher commitment to environmental disclosure and contributing to monitoring managers’ activities.

Earnings quality and financial flexibility: A moderating role of corporate governance

The aim of this study is primarily to demonstrate how earnings quality is an influential determinant of financial flexibility. Secondly, how earnings quality affects financial flexibility. And finally, to provide evidence of the role of corporate governance between earnings quality and financial flexibility composing overall corporate governance index (CG-INDEX). This study considered unbalanced panel data from the year 2007 to 2020 from the database CSMAR yielding 14,088 firm-year observations. This study used liquidity as the proxy of financial flexibility, and also used a comprehensive index of corporate governance constructed by adopting the principal component analysis and STATA has been used for analyzing data. The study used System GMM regression for analysis and controls endogeneity by applying lag financial flexibility as an instrumental variable. The empirical results reveal that poor earnings quality significantly negatively influences the level of corporate financial flexibility. The results also demonstrate that corporate governance can significantly positively moderate the relationship between earnings quality and financial flexibility. This suggests that when the earnings quality is poor, firms are less likely to be financially flexible in holding liquidity. More specifically, firms with poor earnings quality will reduce their financial flexibility of firms; hence, firms need to provide high-quality earnings in order to be more financially flexible. Earnings quality is an important factor, which led the author to examine how earnings quality influences financial flexibility. Under the views of agency theory and positive accounting theory, poor earnings quality is a source of amplified shareholder’s concern of increased informational asymmetry, which may adversely affect the firm’s financial flexibility. Conversely, higher earnings quality reduces the information asymmetry which leads to higher financial flexibility. This study provides a way how to achieve financial flexibility with the assistance of corporate governance which is essential to combat financial crises and smooth business operations successfully.

Public sector bank dominated financing and earning quality: Indian evidence

PurposeGood earnings quality (EQ) provides reasonable assurance as to the reliability of future cash-flow generation capability of the borrowing firms and thereby mitigates the credit risk of the banks. Against the backdrop of the stressed-assets problem in public-sector banks in India, adversely impacting the public finance system, this paper aims to explore the role of EQ of the borrowers in obtaining bank credit and the ways to mitigate the problem.Design/methodology/approachUsing a sample of listed 3,486 non-financial and non-government firms, the authors apply Jones (1991) model to estimate their EQ. Then, the authors conduct Hausman’s (1970) test and find the existence of a two-way relation between bank finance and EQ. The authors adopt a two-stage least-square regression model to test the nature of the association between the two after controlling for firm and industry-level characteristics.FindingsThe empirical results suggest that there exists a two-way negative association between EQ and bank finance implying that the Indian firms tend to report abnormal accruals to enhance tangibility for enjoying higher credit limits and easier access to bank finance. Also, the poor EQ is associated with earnings volatility, adversely impacting the credit quality. The findings are consistent.Practical implicationsThe study highlights the role of EQ in mitigating credit risk and addressing adverse selection problems in granting credit by practicing bankers.Originality/valueThe findings of the study enrich the literature on EQ, capital structure, agency theory and public finance in several ways and have significant ethical and policy implications in bank-finance-led economies.

Women on audit committees and the relationship between related party transactions and earnings management

AbstractOur results indicate a negative relationship between related‐party transactions (RPT) and earnings management, but a significantly positive relationship between discretionary accruals and the presence of a woman chairing the audit committee. While we observe a positive relationship between RPT volume and earnings quality, we fail to find any relationship between other audit committee characteristics and the latter. One significant result in the article is the positive relation between promoter presence on the audit committee and poor earnings quality. This article documents, for the first time, such a relationship from the perspective of an audit committee, at least in the Indian context.

Earnings Management and Different Tax Book To Explain Earnings Persistency

The study aims to test the direct and indirect effects of earnings management on earnings persistence through different tax books. Opportunistic earnings management results can reduce persistence of accruals. A decrease in accrual persistence will reduce earnings persistence. Different book tax variable was added as an alternative explanation. Earnings management can increase the book tax different reported by the company. A high tax different book can also reduce earnings persistence. A high tax different book is a signal of poor earnings quality. The population of this study is companies listed on the Indonesia Stock Exchange. The sample of this research is manufacturing companies listed on the Indonesia Stock Exchange in 2012-2018. Data analysis methods used in this study were descriptive statistics and path analysis. The path analysis results prove that there is an indirect effect of earnings management on earnings persistence through different tax books. The results of the study prove that there is no direct influence of earnings management on earnings persistence.Keywords: Book Tax Different; Earnings Management; Earnings Persistency.

Do related party transactions affect earnings quality? Evidence from East Asia

Purpose The purpose of this paper is to examine the effect of related party transactions (RPTs) and types of RPTs (complex, simple and loan) on earnings quality in four East Asian countries: Hong Kong, Malaysia, Singapore and Thailand. Design/methodology/approach RPTs and types of RPTs are measured using two approaches, magnitude and abnormal (magnitude change). Earnings quality is measured using proxies for accrual earnings management and identified as discretionary accruals (DAC) and performance matched discretional accruals (PMDAC). Findings The results suggest that firms in these countries experience poor earnings quality when they are engaged in RPT. The effect of RPT-simple on earnings quality is more severe than RPT-complex. However, the presence of higher investor protection and stricter enforcement of regulations in countries like Singapore and Hong Kong reduce the negative impact of RPTs on earnings quality. Research limitations/implications The results support the argument that the presence of controlling shareholders in East Asia is likely to lead to engagement with RPTs, which will increase the likelihood of firms’ earnings manipulation via DAC. This study has two limitations. It only focuses on Hong Kong, Malaysia, Singapore and Thailand, and the results may not be generalizable to other countries. Second, this study only measures the magnitude and abnormal RPTs based on the disclosures available in annual reports. Originality/value This paper contributes to the literature by examining the effect of RPTs and types of RPTs on earnings quality in four selected East Asian countries.

Human Resource Accounting and Quality of Financial Reporting of Quoted Oil and Gas Companies in Nigeria

Financial reporting is a veritable tool that provides information to all stakeholder’s for the purpose of decision making. The preparation and presentation of the report is done by the human asset. Building public confidence for capital market participants, transparency, and trust are very germane in any capital market. Poor earnings quality, opportunistic earnings and biased financial report portents great fears in the mind of investors and analysts alike in making rational investment decisions. The study investigated the effect of human resource accounting on quality of financial reporting (using earnings quality, accounting conservatism, earnings smoothness and persistence as proxies) of quoted oil and gas companies in Nigeria. The study adopted ex-post facto research design. The population of the study was 12 oil and gas companies in Nigeria. Purposive sampling technique was used and considered 12 oil and gas which had secondary data information that covered a period of 10 years from 2004 -2018. The null hypothesis (H0): Human Resource Accounting does not have significant effect on financial reporting quality in oil and gas companies in Nigeria The empirical findings of financial reporting quality revealed that the human asset provided the basis for these improvement in oil and gas companies with the results F(8.133)=65.13 (P – value=0.000); Adjusted R2=0.315 and F(5.102)=217.6 (P – Value=0.000); Adjusted R2=0.323. The study concluded that human resource accounting has significant effect on financial reporting quality of quoted oil and gas companies in Nigeria. The study recommended that the regulatory bodies should find ways of rewarding companies that comply with the regulatory guiding standards and comply with information disclosure for earnings quality assessment and sanction erring companies that conceal relevant and purposeful information from the stakeholders.

Earnings Quality and Book-to-Market in the Cross Section of Expected Returns

The purpose of this paper is to examine whether earnings quality contributes to the book-to- market’s predictive power in the cross section of stock returns. Earnings quality is embedded in the value-growth effect given that retained earnings is a key part of the book value of equity. Earnings quality reflects the effects of managerial discretion on reported earnings, which has been shown to be associated with both risk and behavioral biases in asset pricing. Our results affirm the existence of a value premium and show that the value premium is more pronounced within poor earnings quality stocks. Moreover, we find that poor earnings quality contributes to the value premium mainly through the pricing of growth stocks. Our results suggest that the quality of reported earnings has an incremental role in shaping expected returns of value versus growth stocks.

Earnings Quality on the Street

To understand how practitioners operationalize evaluations of earnings quality, we obtain a proprietary dataset of 1,029 reports on aggressive reporting practices over 2003-2015 for 348 unique firms published by a research firm (RF) that sells such data to institutional clients. From these reports, we identify 121 measures of poor earnings quality under four major categories: (i) sales quality; (ii) margin quality; (iii) cash flow quality; and (iv) others. As a first-cut to short-list stocks for detailed fundamental analysis, the RF appears to screen for larger, growing firms with lower barriers to arbitrage. The firms flagged by the RF also have higher M-score, F-score, and total and abnormal accruals. The average two (251) days abnormal return after the stock is first flagged by the RF is -1.30 (-18.5) percent, and such return is incremental to the return attributable to mispricing of accruals. Modified Jones and Dechow-Dichev models of abnormal accruals do not appear to capture RF identified signals well suggesting that such models are too coarse to pick up nuanced fundamental analysis conducted by the RF. In out of sample analyses, we find that the RF signals are associated with future restatements, AAERs, and GAAP-related lawsuits after controlling for other earnings quality indicators. We develop an improved earnings quality indicator (RFSCORE) for firms in the retail, durable manufacturing, and business services sectors using the RF’s signals which are based on granular, context- and industry-specific fundamental analysis. To the Street, our paper suggests that fundamental analysis, beyond just the magnitude of accruals, can predict future stock returns. To academics, our research demonstrates that granular, context-specific analysis of public data can supplement and improve the workhorse models used to identify poor earnings quality.

Earnings quality and corporate payout policy linkages: An Indian context

We investigate the role of accounting quality as an antecedent of dividend payout decision of firms, for both dividend levels and dividend event, in an emerging market context. Using the data for Indian firms through the years 2006–2016, we evaluate the impact of discretionary accruals on payout decision employing Tobit and Logit regression models amid set of idiosyncratic controls. We report that better earnings quality, on average, is associated with large dividend payments for Indian firms. Moreover, the likelihood of dividend payment reduces with poor earnings quality and more so when earnings manipulation is done to increase earnings. Nonetheless, we show that higher earnings quality reduces dividends during the crisis period and also for group-affiliated firms. However, the same doesn’t hold true for dividend likelihood. The relationship is robust to the idiosyncratic controls and the causality test confirms that results are not susceptible to endogeneity issue. Overall, we conclude that better earnings quality takes care of free cash flow problems and alleviates the agency and information asymmetry related costs, thereby stimulating payout policy.

Jim Cramer’s Mad Money Charitable Trust Performance and Factor Attribution

This article analyzes the complete historical performance of Jim Cramer’s Action Alerts PLUS portfolio from 2001 through 2017, which includes many of the stock recommendations made on Cramer’s TV show, Mad Money . Both since inception of the portfolio and since the start of Mad Money in 2005 (when the portfolio was converted into a charitable trust), Cramer’s portfolio has underperformed the S&P 500 total return index both on an overall returns basis and in Sharpe ratio. Being the first to analyze Cramer’s post-crisis return history, these findings contrast with previous studies, which analyzed Cramer’s outperformance in short windows before the 2008 financial crisis. Using factor analysis, we find that Cramer’s portfolio returns are primarily driven by underleveraged exposure to market returns and, in some specifications, tilting toward small-cap stocks, growth stocks, and stocks with poor earnings quality.

Earnings Quality and Information Asymmetry: Evidence from Trading Costs

The adverse consequences of poor earnings quality have been the subject of significant debate among academics, practitioners and regulators. However, the empirical evidence on pricing implications of earnings quality is sparse and controversial. We examine one potential consequence of poor earnings quality - its impact on information asymmetry. We document that poor earnings quality increases the adverse selection risk as manifested in trading costs and lowers liquidity in financial markets. Both innate and discretionary components of earnings quality contribute significantly to information asymmetry. Further, poor earnings quality exacerbates information asymmetry around earnings announcements, especially for firms where earnings represent the principal source of information for market participants, suggesting that poor quality earnings offers a greater information advantage to informed traders. An important implication is that earnings quality can affect cost of capital via its impact on trading cost. Additionally, from a policy perspective, we show that earnings quality can lead to significant variation in information asymmetry even for firms within a uniform reporting regime.

Earnings Quality and Information Asymmetry: Evidence from Trading Costs

Information asymmetry in financial markets relates to the idea that one party to a transaction has better information than the other. Since financial reporting involves the transmission of value relevant enterprise information, we investigate whether the quality of reported earnings can contribute to differentially informed financial market participants. Higher information asymmetry is costly as it increases the adverse selection risk for market participants and lowers liquidity. For a large sample of NYSE and NASDAQ firms, we show that (i) poor earnings quality is significantly and incrementally associated with higher information asymmetry, (ii) earnings quality disproportionately affects information asymmetry for firms with poor information environments, (iii) both innate and discretionary components of earnings quality increase information asymmetry, and (iv) poor earnings quality exacerbates the information asymmetry around earnings announcements. Our results suggest that the standard setters’ efforts to develop accounting standards that improve earnings quality should contribute to a better information environment for market participants and increase stock liquidity.

Do Short Sellers Target Firms with Poor Earnings Quality? Evidence from Earnings Restatements

We study the behavior of short sellers around earnings restatements. We find that short sellers accumulate positions in restating firms several months in advance of the restatement and subsequently unwind these positions after the drop in share price induced by the restatement. The increase in short interest is larger for firms with high levels of accruals prior to restatement, and the association between short interest and accruals is robust to controlling for other factors that affect the shorting decision. We document that heavily shorted firms experience poor subsequent performance and a higher rate of delisting. Overall, these results suggest that the motive for short selling is, at least in part, related to suspect financial reporting and that short sellers pay attention to the same type of information that is being conveyed by accruals.

Cash holdings and earnings quality: evidence from the Main and Alternative UK markets

In this paper we investigate the importance of earnings quality as a determinant of cash holdings by companies, exploring among other factors the nature of earnings (positive or negative) and the level of financial disclosure, proxied by the market where firms are listed (Main or AIM-Alternative Investment Markets in the United Kingdom). Based on a sample covering the period of 1998–2015, we provide evidence that as earnings quality decreases, firms tend to hold more cash except when firms are facing losses in both Main and AIM markets. In addition, we document that information conveyed by earnings quality is a more important determinant of cash reserve levels for Main Market than for AIM firms (where the level of financial disclosure and oversight is lower). Overall, our evidence suggests that cash balances are positively influenced by the presence of greater information asymmetries arising from poor earnings quality but also from the existence of lower levels of regulatory oversight and the occurrence of losses, both of which reduce the importance of earnings quality as a determinant of cash levels. Our results also imply that companies with higher levels of earnings opaqueness seem to benefit from having higher cash holdings so as to avoid dependence from costly external funding.

Earnings Quality Effect on Corporate Excess Cash Holdings and Their Marginal Value

ABSTRACTBy using panel data from Korea’s listed firms, we find that firms with poor earnings quality are more likely to accumulate excess cash holdings, perhaps in an attempt to buffer themselves from information asymmetry problems. We also find that firms with poor earnings quality are more likely to discount the marginal value of their excess cash holdings because their shareholders appear to question the reason for such cash policy changes from the agency theory perspective. Overall, our results suggest that information asymmetry and agency problems are likely to co-exist in firms with poor earnings quality.

Does Idiosyncratic Return Volatility Capture Information or Noise?

This paper examines the cross-sectional association between earnings quality and firm-specific return volatility for a sample of UK firms listed in the London Stock Exchange. Identifying the determinants of idiosyncratic volatility has been a topical issue since the Campbell et al. (2001) study which documents a noticeable increase in average firm-level volatility across time. Using panel data, we find that poor information environments resulting from poor earnings quality are associated with higher firm-specific return volatility. This finding is consistent with the noise-based approach of firm-specific return volatility. In addition, we provide empirical evidence that such association becomes stronger after combining accruals quality and the dispersion in analysts' forecasts to describe a poor information environment. These findings are likely to contribute to the debate on whether firm-specific return volatility captures more firm-specific information being impounded in stock prices or essentially reflects noise.

Does idiosyncratic return volatility capture information or noise

This paper examines the cross-sectional association between earnings quality and firm-specific return volatility for a sample of UK firms listed in the London Stock Exchange. Identifying the determinants of idiosyncratic volatility has been a topical issue since the Campbell et al. (2001) study which documents a noticeable increase in average firm-level volatility across time. Using panel data, we find that poor information environments resulting from poor earnings quality are associated with higher firm-specific return volatility. This finding is consistent with the noise-based approach of firm-specific return volatility. In addition, we provide empirical evidence that such association becomes stronger after combining accruals quality and the dispersion in analysts' forecasts to describe a poor information environment. These findings are likely to contribute to the debate on whether firm-specific return volatility captures more firm-specific information being impounded in stock prices or essentially reflects noise.