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JurnalAkuntansidanEkonomi50(2010)344401

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JournalofAkuntansidanEkonomi
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Memahamikualitaslaba:Sebuahtinjauandariproxy,penentudankonsekuensimereka$
patriciaDechowsebuah,WeiliGeb,CatherineSchrandc,n
UniversityofCalifornia,Berkeley,CA94720,AmerikaSerikatbUniversityofWashington,Seattle,WA98195,Amerika
SerikatcUniversityofPennsylvania,Philadelphia,PA19104,AmerikaSerikat
artikelInfo
Tersediaonline4November2010
JELklasifikasi:G31M40M41
Katakunci:kualitasLabamanajemenlabaUlasanSurvey
01654101/$melihathaldepan&2010ElsevierAllrightsreserved.doi:10,1016/j.jacceco.2010.09.001
abstrak
Penelititelahdigunakanberbagailangkahsebagaiindikasi''kualitaslaba''termasukketekunan,akrual,kelancaran,ketepatan
waktu,menghindarikerugian,responinvestor,danindikatoreksternalsepertipenyajiankembalidanpenegakanSECrilis.Untuk
setiapukuran,kitamembahaspenyebabvariasidalamukuransertakonsekuensi.Kamimencapaitidakadakesimpulantunggal
padaapakualitaslabainikarena''kualitas''bergantungpadakontekskeputusan.Kamijugamenunjukkanbahwa''kualitas''laba
adalahfungsidarikinerjafundamentalperusahaan.Kontribusikinerjafundamentalperusahaanterhadapkualitaslabadisarankan
sebagaisalahsatudaerahuntukpekerjaandimasadepan.
&2010ElsevierAllrightsreserved.
1.Pendahuluan
PernyataanKonsepAkuntansiKeuanganNo.1(SFACNo.1)menyatakanbahwa''Pelaporankeuanganharusmenyediakan
informasi tentang kinerja keuangan suatu perusahaan selama satu periode. '' Bahasa Pinjaman dari SFAC No 1, kita
mendefinisikankualitaslabasebagaiberikut:
kualitaslabayanglebihtinggimemberikaninformasilebihlanjuttentangfiturkinerjakeuanganperusahaanyangrelevandengan
keputusantertentuyangdibuatolehpembuatkeputusantertentu.
Adatigafituryangperludiperhatikantentangdefinisikitatentangkualitaslaba.Pertama,kualitaslabaadalahtergantungpada
keputusanrelevansiinformasi.Jadi,dibawahdefinisi,istilah''kualitaslaba''sajatidakberarti;kualitaslabadidefinisikanhanya
dalamkonteksmodelkeputusantertentu.Kedua,kualitassejumlahlabayangdilaporkantergantungpadaapakahituadalah
informatiftentangkinerjakeuanganperusahaan,banyakaspekyangtidakteramati.Ketiga,kualitaslabasecarabersamasama
ditentukanolehrelevansikinerjakeuanganyangmendasarikeputusantersebutdanolehkemampuansistemakuntansiuntuk
mengukur kinerja. Definisi kualitas laba menunjukkan bahwa kualitas dapat dievaluasi sehubungan dengan keputusan itu
tergantungpadarepresentasiinformatif
$BerkatAnwerAhmed,DanGivoly,KrishnanGopal,IlanGuttman,MichelleHanlon(editor),ChristianLeuz,SarahMcVay,
ShivaRajgopal,TerryShevlin,NemitShroff,DougSkinner,RichardSloan,AnnTarca,danRodrigoVerdiuntukmembantu
komentar.KerangkauntukulasaninididasarkanpadadiskusiSchranduntukkualitaslabapadaCAREConferenceApril2006
yangdisponsoriolehPusatPenelitianAkuntansidiUniversitasNotreDame.KamiberterimakasihkepadaSeungminCheeuntuk
bantuanpenelitiannya.
nSesuaipenulis.Tel.:+12158986798;fax:12155732054.
AlamatEmail:schrand@wharton.upenn.edu(C.Schrand).
P.Dechowetal./JurnalAkuntansidanEkonomi50(2010)344401345
kinerjakeuangan.Initidakmembatasikualitasmenyiratkankegunaankeputusandalamkontekspenilaianekuitasdecisions.1
Konsisten dengan definisi ini luas kualitas laba, kamimeninjaulebihdari300studikarakteristikatauatributdarilaba,
umumnyadefined.2Kamitidakmengharuskanpenelitimenyatakanbahwalabaukurandalampenelitianiniadalah''proxy''
untukkualitaslaba,meskipunbanyakdilakukan.Untuksetiapkertas,kamimengidentifikasi''proxy''untukkualitaslaba,jika
diindikasikan,ataupenghasilanukuran,lebihumum,yangmerupakanfokusdarianalysis.3Kamimengevaluasikeseluruhan
buktitentangsetiapproxyyangdiidentifikasidalamuntukmemahamikemampuannyauntukmenangkapkonstruklatenkualitas
laba.ProsesinimengikutipendekatanyangCronbachdanMeehl(1955)menyarankanuntukmenilaivaliditaskonstruklaten
denganmengambil3.601pandanganit.4
Kamimengaturproxykualitaslabamenjaditigakategori:sifatlaba,investortanggapterhadaplaba,danindikatoreksternal
salahsajilaba.Kategori1,sifatdaripendapatan,termasukpersistensilabadanakrual;labakelancaran;ketepatanwaktuasimetris
danpengakuankerugiantepatwaktu;dansasaranpemukulan,dimanajarakdaripendapatandaritarget(misalnya,keuntungan
kecil)dipandangsebagaiindikasimanajemenlaba,danmanajemenlabadiasumsikanmengikiskualitaslaba.Kategori2,investor
tanggapterhadaplaba,termasukkertasyangmenggunakankoefisienresponlaba(ERC)atauR2darimodellabakembalisebagai
proxyuntukkualitaslabadanyangberhubunganERCuntukmembangunyanglainsepertikualitasauditor.Kategori3,indikator
eksternalsalahsajilaba,termasukAkuntansidanPersPenegakanAuditing(AAERs),penyajiankembali,dankontrolkekurangan
prosedurinternalyangdilaporkandibawahSarbanesOxleyAct,yangsemuanyadipandangsebagaiindikatordarikesalahanatau
manajemenlaba.
Tabel1memberikangarisbesarreview.Bagian2adalahkomentarpadakeadaanumumliteraturyangluasini.Kitamulai
dengan menyediakan kerangka kerja untuk berpikir tentang laba yang dilaporkan, mengakui bahwa perusahaan laba yang
dilaporkanbergantungpadakinerjakeuanganperusahaandanbagaimanamengukurkinerjasistemakuntansi.Kerangkakerjaini
menyediakandasaruntukmenjelaskanduapengamatankamiyangluaspadaliteraturkualitaslaba(EQ).
Pengamatanumumpertamakamiadalahbahwameskipunkualitaslabaperusahaanbergantungpadakinerjakeuangankedua
perusahaandanpadasistemakuntansiyangmengukuritu,kamimemilikirelatifsedikitbuktitentangbagaimanamendasar
kinerjamempengaruhikualitaslaba.LiteraturseringtidakcukupmembedakandampakdarikinerjafundamentalpadaEQdari
dampaksistempengukuran.Kitabisamengutiphanyabeberapamakalahuntukmendukungpengamatanini,yang
menggarisbawahititikkitabahwakitaperlupenelitianlebihlanjuttentangtopikini.Selainitu,sementarakitamengidentifikasi
beberapapotensisumberdistorsiyangmempengaruhikemampuansistemakuntansiuntukmenangkapkinerjafundamentallaba
yangdilaporkan,penelitiankamiumumnyaberfokuspadadistorsiyangterkaitdengankesalahanimplementasidanmanajemen
laba.Pengamatanumumkeduakamitentangkeadaanliteraturdilihatsecarakeseluruhanadalahbahwatidakadaukurankualitas
labayanglebihungguluntuksemuamodelkeputusan.MetodekamimenganalisabuktiberikutCronbachdanMeehlpendekatan
membentukdasaruntukkesimpulanini.Kamimengklasifikasikansetiapkertaskesalahsatudariduakelompoksesuaidengan
apakahitumemberikanbuktipadadeterminanataukonsekuensidariproxykualitaslabamengkaji.Faktorpenentukertas
mengusulkanatautesteoritentangfiturdarisuatuperusahaan(misalnya,kontrakkompensasi)ataudarisistempengukuran
akuntansi(misalnya,pilihanakrual)yangmenyebabkanhasillaba;proxykualitaslabaadalahvariabeldependendalamanalisis.
Konsekuensikertasmengusulkanatautesteoritentangdampakkualitaslabapadahasil(misalnya,biayamodal);proxykualitas
labaadalahvariabelindependendalamanalisis.Kamikemudianmeninjaumakalahdalamsetiapkategoripenentuatau
konsekuensi,tetapidiberbagaiproxykualitaslaba.Jikakualitaslabayangsatukonstrukdanproxyhanyadiukurdengan
berbagaitingkatakurasi,makakitaakanmengharapkanuntukmengamativaliditaskonvergendiproxyEQuntukpenentuyang
samadanmenemukanbahwasemuaproxyEQakanmemilikikonsekuensiyangsama.Menyandingkankertasterhadapsurat
suratlainyangmenelitideterminansamaataukonsekuensiyangsamamenarikperhatianbuktidicampurdalamliteratur.Jika
penentutertentutidakterkaitdengansemuaproxy,ataujikaberbagaiproxytidakmemilikikonsekuensiyangsama,makaproxy
mengukurkonstrukyangberbeda.
Kamimenekankankeunikanproxykarenaduaalasan.Pertama,dariwaktukewaktuistilah''kualitaslaba''telahberkembang
sedemikian rupa sehingga beberapa peneliti menggunakannya seolaholah maknanya jelas dan tidak ambigu. Istilah ini
digunakansejak1934olehGrahamdanDodddalamAnalisisKeamanan,ketikamerekamenggambarkanWallStreetmodel
penilaianekuitassebagailabapersaham
1 Sejumlah makalah survei kualitas laba dan / atau manajemen laba mendahului ulasan ini: Healy dan Wahlen (1999);
DechowdanSkinner(2000);McNichols(2000);Fieldsetal.(2001);Imhoff(2003);Penman(2003);Nelsonetal.(2003);
SchipperdanVincent(2003);DechowdanSchrand(2004);Francisetal.(2006);Lo(2008).Ulasaninibiasanyamemberikan
definisidarikualitaslabadalamkontekspenilaianekuitasdanhanyamembahasliteraturyangberkaitandengandefinisiitu.
2Kamimencariempatjurnaldimulaidenganedisipertama(dalamkurung)melalui2008:PenelitianKontemporerAkuntansi
(1984),JurnalAkuntansidanEkonomi(1980),JurnalPenelitianAkuntansi(1964),danUlasanStudiAkuntansi(1996).Kami
mencariAkuntansiUlasandaritahun1970hingga2008.Kamimenambahkanartikeldarijurnallaindankertaskerjasejauhyang
kitasadarmereka,tapikamitidakmelakukanreviewsistematisuntukmenemukanmereka.
3Untukkenyamananseluruhreview,kitamenggunakanistilah''proxy''atau''ukuran''bergantianuntukmenggambarkan
berbagaiatributlabayangdipelajari.Bahkan,luasnyaulasaninidimotivasisebagianolehfaktabahwabanyakkertas,terutama
penelitian yang lebih tua, memberikan bukti pada ukuran pendapatan yang bermanfaat untuk mengevaluasi kegunaan
keputusannya,tetapimerekatidakmenggunakanistilah''kualitaslaba.''Kamimengidentifikasisampaitigaproxy/langkahper
kertas.
4MenggunakanterminologiCronbachdanMeehl(1955),kitabelajartentangmembangundenganmengelaborasijaringan
nomologicaldimanaituterjadi.Jaringannomologicaladalahsisteminterlockinghukumyangmungkinberhubungan(a)sifat
diamatiataujumlahsatusamalain,(b)konstruksiteoritisuntukdiamati,atau(c)konstruksiteoritisyangberbedasatusamalain,
yangditetapkanundangundangdimanakonstrukterjadi.
P.Dechowetal./JurnalAkuntansidanEkonomi50(2010)344401346
Tabel1Daftarisi.
1.Pendahuluan1.2.Commentarypadakeadaanliteratur2.
3.BuktidariproxyindividuuntukPropertikualitaslabalabaLabapersistensi3.1.1akrualabnormaldanpemodelanproses
akrual3.1.2Labakelancaran3.1.3Asymmetricketepatanwaktudankehilanganwaktupengakuan3.1.4Sasaran
mengalahkan3.1.5
tanggapInvestoruntuklababuktilangsungpadaERCsebagaiproxyuntukEQ3.2.1buktitidaklangsungpadaERCsebagai
proxyuntukEQberdasarkanfaktorfaktorpenentu3.2.2hubunganantaraERCdannoninformasipenghasilan3.2.3peringatan
akhirtentangERCsebagaiproxyuntukEQ3.2.4
indikatorEksternalPerusahaantundukSECpenegakan(AAERs)3.3.1labasajipenyajiankembali3.3.2kelemahanpengendalian
internal3.3.3
4.lintasnegarastudi4.
5.penentuFirmkarakteristikkualitaslaba5,1praktikpelaporankeuangan5.2TataKeloladanmengontrol5,3Auditor5.4
Capitalinsentifpasarinsentifketikaperusahaanmeningkatkanmodal5.5.1insentifyangdiberikanolehtargetpendapatan
berbasis5.5.2faktoreksternal5.6
6.konsekuensidarikualitaslaba6.
7.Kesimpulan7.
'.koefisienkualitas'kali''deskripsimerekadarikoefisienkualitasmenyiratkandefinisimerekakualitas:koefisienmencerminkan
kebijakandividen,sertakarakteristikspesifikperusahaanseperti''ukuran,reputasi,posisikeuangandanprospek,''dansifat
operasiperusahaan,sertafaktorfaktorekonomimakrotermasuk''marahdaripasarumum''(GrahamdanDodd,1934,p.351).
O'Glovekembalimemperkenalkanistilahdalamlaporankeuangananalisisbukuteksberorientasipraktisinya,KualitasLaba,
diterbitkan pada tahun 1987 (O'Glove, 1987). Lev (1989) mempopulerkan '' kualitas '' sebagai karakteristik deskriptif dari
pendapatanuntukpenelitiakademisketikaiamenyatakanbahwasalahsatupenjelasanuntukR2Srendahlaba/mengembalikan
modeladalahbahwa:''Tidakadaupayaseriussedangdilakukanuntukmempertanyakankualitasmelaporkanangkalabasebelum
berhubungan mereka dengan hasil '' (hlm. 175, penekanan ditambahkan). Studi lama setelah Lev (1989) dengan hatihati
ditentukanhubunganantarakarakteristikkualitasdanmodelkeputusanpenilaianekuitas.Seiringwaktu,bagaimanapun,laba
atributyangditemukanuntukmenunjukkankualitasdalamsatumodelkeputusandiperlakukansecaraumumsebagaiukuran
kualitasdilain.5Studiyangdilakukanmemperlakukanmetriklabasebagaiproxypenggantilaporankualitaslababahwahasil
merekakuatuntukmenggunakanlangkahlangkahalternatif.Namundalambeberapakasus,hasiltidakharuskuat,danjadikita
mempertanyakanapaketahananmenyiratkan.
AlasankeduakamiuntukmenekankantitikbahwaproxyEQbukanlahpenggantilebihoptimis.Perbedaandiantaramereka
merupakanpeluangpenelitian.Penelitiankamiharusmemanfaatkanfiturunikdariproxylabauntukmemberikanbuktiyang
lebih menarik yang mengidentifikasi faktorfaktor penentu dan konsekuensi dari kualitas untuk pertanyaan penelitian yang
diberikan.
Bagian3memberikananalisisrincidarimasingmasingproxykualitaslaba.Kamimenjelaskanbagaimanaproxyumumnya
diukurdangarisbesarkesimpulanvariabelspesifikkitatentangfiturunikdarivariabelsebagaiproxyuntukkualitaslaba.Studi
yangmendukungkesimpulaninidijelaskandisetiapsubbagian.Sementarakitamempersempit300+temuanindividudari
kertas kamimeninjau untuksatu setyang lebihkecil darikesimpulan variabelspesifik, kamimenekankan lagibahwa kita
mencapaitidakadakesimpulantentangukurantunggalterbaikdarikualitaslaba.
Bagian4memberikananalisisrincidaristudiyangmenelitivariasilintasnegaradalamkualitaslaba.Kamisecaraterpisah
membahasstudiinikarenafiturunikdaridata.Diskusimenyorotiapayangbisakitapelajarihanyadaristudilintasnegara,bukan
daristudiyangmenggunakandatatingkatperusahaandalamsatunegara,danmengidentifikasitemuanyangbertentangandengan
yangdidasarkanpadaanalisisdariperusahaanperusahaanAS.
5evolusiiniistilahseperti''kualitaslaba''kekondisisaatinidariambiguitastidakunik.Schelling(1978)menjelaskan
fenomena:'' Setiap profesi akademik dapat mempelajari perkembangan bahasanya sendiri. Beberapaistilahmenangkapdan
beberapatidak.Sebuahistilahburuburumemilihyangmembantumemenuhikebutuhanakandiinisiasikebahasasebelumorang
menyadariapaistilahyangtidakpantasitu.Orangorangyangmenyadaribahwaistilahadalahsatumiskinmenggunakannyapula
terburuburuuntukmenyimpanpemikiranyanglebihbaik,dandalamkemalasankolektifkitamembiarkanterminologiyang
tidakpantasdalambahasakitasecaradefault.Syaratyangpernahmemilikimaknayangakuratmenjadipopuler,menjadiceroboh
digunakan,danberhentiberkomunikasidenganakurasi.''
P.Dechowetal./JurnalAkuntansidanEkonomi50(2010)344401347
Bagian5dan6berisireviewdaribanyakmakalahyangsamadibahasdiBagian3dan4,tetapiyangdiselenggarakanoleh
penentu hipotesis dari ukuran pendapatan (Bagian 5) atau dengan dihipotesiskan konsekuensi (Bagian 6). Sementara pada
awalnya ini mungkin tampak seperti redundansi yang tidak perlu, membahas suratsurat untuk kedua kalinya, tapi
diselenggarakan dengan cara yang berbeda, merupakan elemen penting dari tinjauan ini. Sebagaimana dicatat sebelumnya,
meninjauliteraturyangdiselenggarakanolehpenentudankonsekuensimenarikperhatianbukticampurandiproxyEQ.Kitabisa
denganmudahmengidentifikasikasusdimanaproxyEQtidakmenunjukkanvaliditaskonvergen,yangmerekaharusjikamereka
mengukur konstruk yang sama. Misalnya, kepemilikan manajerial berhubungan dengan kualitas laba yang lebih rendah
menggunakan ketepatan waktu asimetris sebagai proxy tetapi dengan kualitas laba yang lebih tinggi menggunakan akrual
diskresionerataukuasanyatanggapinvestor.InkonsistensidalamhasildiproxyEQinijauhlebihjelasdalamdiskusidiBagian5
dan6daripadaBagian3dan4.
Selainjelasmenyajikanbuktiyangmendukungpengamatankamibahwatidakadaukurantunggalterbaikdarikualitaslaba,
Bagian5dan6melayanitujuanpraktis.Cukupmengidentifikasidanmengklasifikasikankertasyangkitameninjauadalahtugas
yangsignifikandanmerupakankontribusipentingdarisurveikami.Klasifikasidarimakalaholehpenentuataukonsekuensi
diperiksaadalahreferensiyangbergunabagiparapenelitiyangmengeksplorasibidangbaru.Wawasankuncitentangkualitas
lababerdasarkanpembahasanreorganisasiadalahbahwabukticampurandiproxymenunjukkanbahwasetiapproxyindividu
mengukurfituryangberbedadarikeputusankegunaanlaba;proxyinitidakmengukurkonstrukdasaryangsama.Bagianinijuga
memberikanbeberapakesimpulantentangfaktorfaktorpenentudankonsekuensiyangdiperiksasertamasalahdesainpenelitian
khususuntukmempelajarimereka.
Bagian 7 menyimpulkan. Selama proses pemeriksaan, kami mengidentifikasi lima kesempatan penelitian tambahan.
Pengamatantambahanyangbukantentangkualitaslabaperse,tetapitentangisuisumetodologisdalamstudiEQatausekitar
pertanyaanterbukauntukpenelitianmasadepan.Kesimpulantermasukproposalini.
2.Commentarypadakeadaanliteratur
Dalamrangkamemberikankomentartentangkeadaanliteratur,kitamulaidenganmenghadirkankerangkakerjauntuk
berpikirtentangkualitaslaba.Untukkenyamananeksposisi,kitamendefinisikanmelaporkanlabasebagaiberikut:
DilaporkanLabafX:
Xadalah''kinerjakeuanganyenterpriseselamaperiodepelaporan,''yangSFACNo.1negarayangpendapatan,fokusutamadari
pelaporankeuangan,harusmewakili.6fungsifmerupakansistemakuntansiyangmengubahteramatiXkelabadiamati.Salah
satuimplikasidaridefinisiiniadalahbahwapenghasilan,dankegunaankeputusanlaba,adalahfungsidarikinerjaitusendiri,dan
bukanhanyapengukuranX,yangmerupakantitikpentingbahwakitaakankembalikenanti.
Kamimeminjamistilah''kinerjakeuangan''langsungdariSFACNo1untukmendefinisikanX,tapikamimenyadaribahwa
makna''kinerja''adalahambigu.Untukmodelsatuperiodedarisuatuperusahaan,''kinerja''diamatidanterdiridariaruskas
yangdihasilkanselamaperiodeditambahperubahannilailikuidasiaktivabersih.Ketikasuatuperusahaanadaselamabeberapa
periodepelaporan,kinerjamerupakantigakomponen:(i)aruskasyangdihasilkanselamaperiodeberjalan;(ii)nilaisekarang
dariaruskasyangakandihasilkanpadaperiodemendatangyangmerupakanhasildaritindakanyangdiambildalamperiode
berjalan;dan(iii)nilaisekarangdariperubahannilailikuidasiaktivabersihyangmerupakanhasildaritindakanyangdiambil
dalamperiodeberjalan.PenmandanSougiannis(1998)menggambarkankonstrukprimitifsepertiX,khususnyadalamkonteks
penilaianekuitas,sebagai''yattributesdalamperusahaan,yangdikatakanuntukmenangkapaktivitaspenciptaannilai''(hlm.
348).
Untukmenjelaskantambahanpadasifatdariapayangkitamaksuddengankinerja,kitaberalihkecontohspesifikdalam
nasihatGrahamdanDoddanalistentangpenggunaaninformasikeuangan:
Palingpentingdarisemua,analisharusmengakuibahwanilaidarijenistertentudatabervariasidenganjenisperusahaanyang
sedangdipelajari.Limatahunrekorpendapatankotorataubersihdarikeretaapiatauperusahaantokorantaibesarmungkin
mampu,jikatidakkonklusif,setidaknyasecaracukupsuarauntukmengukurkeselamatanisuseniordandayatarikdarisaham
biasa.Tapistatistikyangsamayangdiberikanolehsalahsatuperusahaanpenghasilminyakyanglebihkecilmungkinterbukti
lebihmenipudariberguna,karenamerekaadalahterutamahasildariduafaktor,yaitu,hargayangditerimadanproduksi,yang
keduanyamungkinberbedasecararadikaldimasadepandaripadadimasalalu.(p.3334)
Dalamcontohini,hargayangditerimadanproduksiadalahjenisfaktoryangakanmenentukankinerjakeuanganyangtidak
teramatiperusahaan(X).
Duafiturdaridefinisikitatentanglabayangdilaporkanpatutdicatat.Pertama,tidakteramatikomponenXdidefinisikantanpa
mengacupadasuatupemangkukepentingantertentu(misalnya,equityholderataudebtholder).Namun,relevansielementertentu
darikinerjaperusahaan,sepertiproduksiatauharga,dapatbervariasidistakeholdersdanmodelkeputusan.Sebagaicontoh,input
modelkeputusanpentinguntukdebtholderjangkapanjangmungkinnilailikuidasiasetpadaperiodesaatpembayaranpokok
jatuh tempo, sedangkan masukan model keputusan yang relevan untuk debtholder jangka pendek adalah jangka pendek
diharapkanaruskas,dankinerja(X)berbedabedadapatmempengaruhiduahasiltersebut.Sebuahkomitekompensasimungkin
6Kamimenggunakan'kinerjafundamental,'istilah''''kinerjakeuangan,''dan''kinerja''bergantianseluruhreview.
P.Dechowetal./JurnalAkuntansidanEkonomi50(2010)344401348
perawatanhanyatentangunsurunsurkinerjayangberadadibawahkendalimanajemen.MendefinisikanXtanpasehubungan
denganmodelkeputusandisengajadankonsistendenganlamaperdebatandalamliteraturakuntansipadaapapendapatanharus
mewakili.Haruskahperubahanlabaukurannilaiwajar(saatiniatauhargakeluar)darisuatuperusahaan(misalnya,Chambers,
1956;Sterling,1970),atauharuslabaukuran''aruskas'berkelanjutan'(misalnya,PatondanLittleton,1940;Ohlson,2000),
sehinggadapatannuitizeduntukmencerminkannilai?Perdebatankualitaslaba,yangbertentangandengankualitasneraca,adalah
pertanyaanpentinglain,danitumenggarisbawahipesanyangsignifikandarireview:kegunaankeputusaninformasiakuntansi
secarabersamasamaditentukanolehmodelkeputusandandenganakuntansiinformasiyangdigunakansebagaiinputuntuk
model.
FiturpentingkeduadefinisikitatentanglabayangdilaporkanadalahbahwamelaporkanpendapatantidaksamaX;ituadalah
fungsiX.Kamimembedakantigapenjelasanmengapasuatusistempengukuranakuntansi(f)tidakakansempurnamengukur
kinerja:
(1)Beberapamodelkeputusan:Sebuahsistemakuntansiyangmenghasilkanmelaporkanjumlahlabatunggaltidakdapat
menghasilkanrepresentasiXyangadalahjugarelevandalamsemuamodelkeputusan.DiUSGAAP:''Tujuandiarahkan
kepentinganumumdaribanyakpenggunapadakemampuanperusahaanuntukmenghasilkanaruskasyangmenguntungkantetapi
diutarakanmenggunakankeputusaninvestasidankreditsebagaireferensiuntukmemberimerekafokus''(SFACNo.1).Pada
akhirnya,pembuatstandarmembuattradeoffdalammenetapkanstandardiseluruhkebutuhanpenggunadiantisipasi',danpada
akhirnyatidakadapembuatkeputusanindividumendapatrepresentasidarikinerjaperusahaanyangsempurnarelevanuntuknya
decision.7(2)VariasiX:Perusahaanmemilihdiantaraseperangkatterbatasprinsippengukuranyangtelahditentukan(misalnya,
standarakuntansi)untukmengukurX.TidakadastandartunggalsempurnaakanmengukurXuntukdiberikanfirm.8Perhatikan,
misalnya,hargapokokpenjualan(COGS),yangmerupakanukurandilaporkankinerjaproduksipersediaantidakteramatisuatu
perusahaanselamaperiodetersebut.GAAPmendefinisikanbiayauntukdimasukkandalamCOGSdanwaktupengakuanbiaya.
Namun,yangdihasilkan''standar''ukuranHPPtidakakanmenjadiukuranyangsamabaikdarikeputusankinerjayangrelevan
diseluruhXs(misalnya,rantairiteldibandingkanperusahaanpenghasilminyak,menggunakanGrahamdanDoddmisalnya),dan
itutidakakanmenjadirepresentasisempurnadarisetiapX.(3)Pelaksanaan:sebuahsistemakuntansiyangmengukurkonstruk
yangtidakteramati(X)inherenmelibatkanestimasi
danpenilaian,dandengandemikianmemilikipotensiuntukkesalahanyangtidakdisengajadanbiasdisengaja(yaitu,manajemen
laba).
Definisilabayangdilaporkansebagaif(X)menyediakanlandasanuntukmembahasduapengamatanumumkitatentang
keadaanliteraturtentangkualitaslabayangdijelaskansecarasingkatpadahalaman3daripendahuluan.Pengamatanumum
pertamakamiadalahbahwakamitelahmembuatkemajuanbesardalammenelitiisuisuimplementasiyangmempengaruhi
pengukuranX(#3diatas)relatifterhadappenelitianpadaduapenjelasanlainuntukefekfpadalabayangdilaporkandan,
khususnya, relatif terhadap penelitian pada efek dari X sendiri pada laba yang dilaporkan. Sebagian besar penelitian kami
mengidentifikasiuntukulasanini,dalamhalvolumetipisdarimakalahyangditerbitkan,adalahtentangfaktorfaktorpenentudan
konsekuensidariakrualyangabnormalberasaldarimodelakrual,dengangagasanbahwaakrualtidaknormal,apakahmereka
mewakilikesalahanataubiasmengikiskegunaankeputusan.Setkeduaproxyseringditelitiuntukkualitaslabaadalahindikator
eksternalsepertiAAERsdanPeninjauankembali,yangjugamemberikanbuktikhusustentangpelaksanaan.
Pengamatan kami bahwa kami telah membuat kemajuan yang cukup meneliti isuisu implementasi tidak berarti bahwa
pekerjaanlebihlanjuttidakdiperlukan.Sebagaicontoh,studiakrualtidaknormalbisamajukearahyanglebihbaikmembedakan
dampakdaripengukuranXpadapendapatandaridampakkinerjaitusendiri.Modelyangumumdigunakanuntukmengukur
akrualtidaknormalupayauntukmengendalikanakrualyangterkaitdengankinerjaperusahaan,menyebutmerekanormal,non
discretionary,atauakrualbawaan(lihatExhibit2).Tetapivariabelyangdigunakanuntukmodelakrualnormalsendiridiukur
denganmelaporkanlababerbasisakrualterkaitdengankinerja(misalnya,pertumbuhanpendapatanpenjualandilaporkan).Jadi,
sementaramodelakrualdapatmembedakanakrualyangnormaldarikomponenyangmewakilikebijaksanaan,akrual''normal''
ataubawaantidakselalumengukurkinerjateramati.Bahkanstudiyangmengukurapakahtotalakruallebihunggularuskastidak
mengisolasiefekdarisistempengukuranpadakegunaankeputusandaripengaruhXitusendirikarenaaruskastidakmewakili
kinerjasepertiyangkitatelahmendefinisikanit.9
Penelitiakanperlumelampauipemeriksaanakrualyangabnormalberasaldarimodelakrualuntukmendapatkanwawasan
pengukurandaripadaefekimplementasisistemakuntansi.ContohpenelitianjenisiniadalahLevdanSougiannis(1996),yang
memanfaatkandanbiayaR&Ddanmengevaluasidampakdariinvestortanggapterhadaplaba;Landsmanetal.(2008),yang
mencobauntukmerekamasetdankewajibanoffbalancesheetyangterkaitdengansecuritizationsdan
7MasalahbeberapapenggunalaporankeuanganjugadibahasdalamKotharietal.(2010).8Selainitu,mungkinadaumpan
balik:sistempengukuranakuntansidapatmempengaruhiperilakumanajemenyangpadagilirannyaperubahan''mendasar''
pendapatandankualitas.Misalnya,tidakmembutuhkanmembebankanopsisahamdapatmengakibatkanpenggunaanopsisaham
yanglebihbesardaripadayangakanterjadi,yangdapatmempengaruhipengambilanrisikoperilaku,yangpadagilirannyaakan
mempengaruhiproseslabafundamental.LihatjugaEwertdanWagenhofer(2010).
9SebagaimanadicatatolehDeFond(2010),namun,mengembangkanmodelkualitasakrualyangmemisahkanfdariXadalah
masalahyangtidakakan''diselesaikan''persekarenaXadalahteramati.Sementarakitamengidentifikasikekuranganinidari
model akrual, kami menggarisbawahi bahwa akrual model telah berkembang ke arah kami sarankan dengan maksud
membedakankinerjafundamentaldaripengukuran(misalnya,DechowdanDichev,2002;.Francisetal,2005).
P.Dechowetal./JurnalAkuntansidanEkonomi50(2010)344401349
memeriksaresponinvestor;Ge(2007),yangmengkapitalisasisewaoperasidanmengkajidampakpadapersistensilaba;dan
DuttadanReichelstein(2005),yangmenyediakanpekerjaanteoritiskebijakankapitalisasioptimal.
Sementarastuditentangisuisuimplementasisangatterwakilidalamliteratur,penelitiantentangdampakkinerjakeuangan
mendasarpadakualitaslabaterbatas.Kinerjafundamentalcenderungbervariasidipenampangdanmemilikisifatyangmelekat
sendiri,sepertiketekunan.Dengandemikian,kualitasataukeputusankegunaanlabayangdilaporkanadalahfungsidarikualitas
atau keputusan kegunaan kinerja itu sendiri. Sebagai akuntan, kami telah memfokuskan pada pengukuran proses (f), dan
khususnyapadaisuisuimplementasi.Lebihbanyakpenelitiantentangdampakkinerjalabayangdilaporkanadalahpentinguntuk
pemahamankitatentangkualitaslaba.ContohstudidalamgenreiniadalahBiddledanSeow(1991)danAhmed(1994),yang
keduanya memeriksa ERC sebagai fungsi dari karakteristik perusahaan yang mendasar. Kesulitan yang signifikan dengan
penelitianini,tentusaja,adalahuntukmengembangkanproxyuntukXyangdiamatidanbukanfungsidarisistemakuntansi.
Pengamatanumumkeduakamitentangkeadaanliteraturadalahbahwasifatdarilabayangseringdigunakansebagaiproxy
untukEQtidaktindakanpenggantikegunaankeputusan(ataunegara)labaperusahaan.Berbagaiproperti,sepertiketekunandan
kelancaran,adalahsifatmelaporkanjumlahpendapatanyangsama.Dengandemikian,semuadarimerekadipengaruhibaikoleh
kinerjafundamentalperusahaan(X)danolehkemampuansistemakuntansiuntukmengukurkinerja,tetapiberbagaisifattidak
samadipengaruhiolehduafactors.10Korelasiiniantarasifatlabamenunjukkantitikini.Tabel2menunjukkanbahwakorelasi
antarasifatpendapatanumumnyapositifdansignifikansecarastatistiktetapitidakekonomissignificant.11 Korelasi antara
pengakuankerugiantepatwaktudanketekunan,misalnya,kurangdari2%.Selainitu,kelancaranberkorelasinegatifdengan
sifatsifatlainnya.
Korelasirendahdanbahkannegatifharusdatangtidakmengejutkan.Sebagaimanadicatat,sedangkanproxymewakilisifat
sifat yang sama dilaporkan jumlah pendapatan, proxy mengukur kualitas atribut yang berbeda dari laba. Titik menyajikan
korelasiadalahuntukmenekankanbahwatesempirisharusmengeksploitasivariasidilangkahlangkahuntukmembuatprediksi
tentangfiturspesifiklabayangmembuatmerekakeputusanyangberguna.Hipotesisdiujitentangfaktorfaktorpenentudan
konsekuensidarikegunaankeputusanberasaldarimodelkeputusanyangmenyiratkankarakteristikpenghasilantertentuyang
akanmeningkatkanhasilkeputusan.Kebanyakanteoritidakakanmemprediksihubungandengansemuapropertipendapatan,
atausetidaknyatidakakanmemprediksihubunganyangsamakuatdengansemua.Predictionsaboutthespecificpropertyof
earningsthatwillbeaffectedbyadeterminantvariableorpredictionsabouttheconsequenceofaspecificpropertywillallow
betteridentificationofthetestsoftheunderlyingtheory.Studiesthatinsteadtreattheearningspropertiesassubstitutesgenerally
cannotrejectthehypothesisthatthedeterminantorconsequenceiscorrelatedwiththeeffectoffirmperformance(X)onthe
earningsproperty,ratherthanwiththemeasurementoftheprocess.Suchstudiesreportthattheirresultsarerobusttoalternative
measuresofearningsquality,althoughtheytypicallydonotaddresswhethertheorywouldpredictthattheyshouldbe.
Wedocumentcasesofmixedevidencethroughouttheliteraturepotentiallyrelatedtousingtheproxiesassubstitutes.An
exampleisthemixedevidenceoninternalcontrolsasadeterminantofaccrualquality(seeSection5.3).Apredictedassociation
betweeninternalcontrolproceduresandaccrualqualityisfairlydirect,andtheevidenceofanassociationisstrong.Thepredicted
associationbetweenothercontrolmechanisms,suchasamoreindependentboardofdirectors,andaccrualqualityismore
tenuous.Outsidedirectorsatsomefirmsmaynotplayanyroleintheaccountingreportingprocess,ingeneral,andintheaccrual
process,inparticular.Notsurprisingly,theevidenceonboardcompositionasadeterminantofaccrualqualityismixed.12Thus,
based on the finding that accrual quality is related to internal control procedures, it appears that accrual quality captures
meaningfulvariationintheeffectsofimplementationoftheaccountingsystem(f)tofundamentalperformance(X),whichisthe
thirdexplanationaboveforwhyanaccountingmeasurementsystem(f)wouldnotperfectlymeasureperformance.However,
basedonthefindingthataccrualqualityisnotsystematicallyrelatedtoboardcharacteristics,itdoesnotappeartobeagood
proxyfortheeffectsoffundamentalperformanceonquality,orforthefirsttwoexplanationsforhowtheaccountingsystem
mightaffectquality.Useoftheproxiesassubstitutes,andtheresultingmixedevidenceinsomecases,limitsourabilitytomake
morevariablespecificstatementsaboutwhetheraparticularearningsmeasureisagoodproxyforearningsquality.Furthertests
oftheoriesthatpredictarelationofadeterminantsorconsequencetoaspecificearningsqualityproxy,butnotothers,wouldbe
useful.
Weshouldpointout,however,thatourexaminationofthedeterminantsandconsequencesoftheproxiesshowedconsistent
results across proxies, particularly related to abnormal accruals. For example, high accrual firms also tend to have high
''discretionary''accruals,havelesspersistentearnings,bemoresubjecttoSECenforcementaction,havemorerestatements,have
poorerinternalcontrols,havelessinvestorresponsivenesstoearnings(wheninvestorsareawareoftheextremeaccruals),and
appeartobeatbenchmarksmoreoften.Thereismoreambiguityintherelationbetweenaccruals
10EwertandWagenhofer(2010)provideathoughtfulanalysistoquantifythisstatement.Theymodelafirm'saccounting
choicesoverasingleearningsprocessanddeterminetherationalexpectationsequilibriumreportedearningsintwoperiods.They
thencomputecommonlyusedproxiesforthequalityofthemodeledearningschoiceincludingsmoothness,persistence,and
valuerelevance,andtheyevaluatetheseproxiesrelativetoaconstructintheirmodelthatrepresentstheunobservablereduction
inthevarianceofthefirm'sterminalvalue.
11Forillustrativepurposes,wemeasureeachvariableusingacommonmodelspecification,andwesignthevariablesuch
thatitisincreasinginearnings''quality''asthetermistypicallyusedintheliterature.Forexample,weusetheadditiveinverseof
theDechow/Dichevabnormalaccrualsmeasurebecauselargerabsoluteerrorsaretypicallyassumedtorepresentlowerquality.
12Constructvalidityofinternalcontrolproceduresisaseparateissue.SOXreportsprovideameansofidentifyinginternal
controlprocedureweaknesses.Identifyingmeasuresof''good''and''bad''governance,however,ismoredifficult(Armstronget
al.,2010a).
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401350
Table2Spearmancorrelationsbetweenearningsqualityproxies(Sampleperiod:19872007).
ThistablereportstheSpearmancorrelationcoefficientsbetweencommonlyusedspecificationsoftheearningsmeasures,as
definedinExhibit1.Persistenceismeasuredastheestimatedbinthefirmlevelregression:Earnings
t+1
=a+bEarnings
t
+e
t
.Totalaccrualsisdefinedasthedifference
betweenearningsandcashflowsfromoperations.9Accruals9istheabsolutevalueofTotalaccruals.Estimationerrorsisdefined
asthefirmlevelmeanabsolutevalueoftheresidualfromAWC=a+b
1
+e
t
.s(residual)isthefirmlevelstandarddeviationoftheresidualfrom
theaboveregression.s(EARN)/s(CFO)isthefirmlevelstandarddeviationofearningsdividedbythestandarddeviationofcash
flowfromoperations.Corr(AACC,ACFO)isthefirmlevelcorrelationbetweenchangeintotalaccrualsandchangeincashflow
fromoperations.Timelylossrecognition(TLR)isdefinedas(b
0
CFO
t1
+b
2
CFO
t
+b
3
CFO
t+1
+b
1
)/b
0
fromthefirmlevelregression:Earnings
t+1
=a
1
+a
2
D
t
+b
0
Ret
t
+b
1
D
t
Ret
t
+e
t
whereD
t
=1ifRet
t
o0.ERCisdefinedastheestimatedb
fromthefirmlevelregressionofannualreturnsonearnings:Ret
t
=a+bEarnings
t
+e
t
. The sample consists of 3,733 firms (47,187 firmyears) with
eightormoreconsecutiveannualobservations.Significancelevelsareshowninitalics.Eachearningsattributeiswinsorizedat
1%and99%.Timelylossrecognitionistrimmedatthevalueof5and5,resultingin2,487firms.Totalaccruals,9Accruals9,
Estimationerrors,ands(residual)representtheadditiveinverseofthesevariablessuchthatallvariablesareincreasingintheir
hypothesizedquality.
AccrualsSmoothnessTLRERCs
Totalaccruals
s(residual)s(Earn)/s
(CFO)
Corr(AACC,ACFO)CoefficientR2
Persistence0.0820.1280.1280.1290.1510.2540.0140.1910.079
o0.0001o0.0001o0.0001o0.0001o0.0001o0.00010.485o0.0001o0.0001Totalaccruals0.7000.0800.0790.2140.275
0.0030.1280.032o0.0001o0.0001o0.0001o0.0001o0.00010.880o0.00010.052|Accruals|0.3080.3030.2410.264
0.00070.1740.030o0.0001o0.0001o0.0001o0.00010.742o0.00010.069Estimationerrors0.9930.2990.2500.026
0.2140.048o0.0001o0.0001o0.00010.202o0.00010.004s(residual)0.2970.2490.0290.2170.053o0.0001o0.00010.149
o0.00010.001s(EARN)/s(CFO)0.7090.0590.3390.152
o0.00010.004o0.0001o0.0001Corr(AACC,
ACFO)0.0720.3210.125
o0.0001o0.0001o0.0001
Timelylossrecognition
(TLR)
|Accruals|Estimation
errors
0.2000.172o0.0001o0.0001ERCcoefficient0.551
o0.0001
andotherearningsqualityproxiessuchastimelylossrecognition,smoothness,andtargetbeating.Disentanglingtheroleof
fundamental performance from the role of the measurement system is a challenge in interpreting the convergence (and
divergence),andweencouragefurtherresearchtoclarifytheroleeachplaysinthedocumentedfindings.
3.Evidenceontheindividualproxiesforearningsquality
Uptothispoint,wehavedrawnonlybroadconclusionsabouttheliteraturetakenasawhole.Wenowprovideadiscussionof
the specific proxies for earnings quality. We discuss three categories of EQ proxiesproperties of earnings, investor
responsivenesstoearnings(ie,ERCs),andexternalindicatorsofearningsmisstatements.Wediscusstheuseofeachproxyfor
earningsqualityandsummarizetheevidencefromstudiesthatexamineitsdeterminantsorconsequences.Exhibit1listseachof
theearningsqualityproxiesandreportsthemostcommonspecification(s)ofthevariable.Theexactspecificationofthemeasures
canvarybystudy.Exhibit1alsosummarizesthetheoryfortheuseofeachmeasureasaproxyforqualityandprovidesan
abbreviatedsummaryofitsstrengthsandweaknesses.Thediscussionsofspecificpapersthatsupportthesesummaryconclusions
followinSections3.13.3.Thereisnocommonthemetotheorganizationofthesections.Eachsectionisorganizedaccordingto
theissuesthatareimportanttothespecificproxy.
3.1.Propertiesofearnings
Thepropertiesofearningsthatweexamineincludeearningspersistence(Section3.1.1),abnormalaccrualsderivedfrom
modeling the accrual process (Section 3.1.2), earnings smoothness (Section 3.1.3), asymmetric timeliness and timely loss
recognition(Section3.1.4),andtargetbeating(Section3.1.5).The''targetbeating''studiesusemeasuresofearningsrelativeto
anytarget(orbenchmark)asaproxyforearningsquality.
3.1.1.Earningspersistence
Althoughourdefinitionofearningsqualityisdecisionusefulnessingeneral,muchoftheresearchonpersistencefocuseson
theusefulnessofearningstoequityinvestorsforvaluation.Therearetwobroadstreamstothisresearch.Thefirststreamis
motivatedbyanassumptionthatmorepersistentearningswillyieldbetterinputstoequityvaluationmodels,andhenceamore
persistentearningsnumberisofhigherqualitythanalesspersistentearningsnumber.Thegoal
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401351
Exhibit1SummaryofearningsqualityproxiesExhibit1liststheearningsmeasuresidentifiedinthereviewascommonlyused
proxiesfororindicatorsofearningsqualityandthemostcommonspecification(s)ofthevariable.Theexactspecificationofthe
measurescanvarybystudy.Foreachmeasure,wesummarizethetheoryforitsuseasanindicatorofqualityandweprovidean
abbreviatedsummaryofitsstrengthsandweaknesses.Thediscussionsofspecificpapersthatsupportthesesummaryconclusions
areinSection3.
EmpiricalproxyTheoryStrengthsandweaknesses
PersistenceEarnings
t+1
=a+bEarnings
t
+e
t
bmeasurespersistence
Firmswithmorepersistentearningshaveamore''sustainable''earnings/cashflowstreamthatwillmakeitamoreusefulinput
intoDCFbasedequityvaluations
Pros:FitswellwithaGrahamandDoddviewofearningsasasummarymetricofexpectedcashflowsusefulforequity
valuation.Cons:Persistencedependsbothonthefirm'sfundamentalperformanceaswellastheaccountingmeasurementsystem.
Disentanglingtheroleofeachisproblematic.Persistencemaybeachievedintheshortrunbyengaginginearningsmanagement
MagnitudeofaccrualsAccruals=Earnings
t
CF
t
Extremeaccrualsarelowqualitybecausetheyrepresentalesspersistentcomponentofearnings
Pros:Themeasuregetsdirectlyattheroleofan
accrualsAccruals=A(noncashworkingcapital)basedaccountingsystemrelativetoacashflowbasedsystemAccruals=A(net
operatingassets)Specificaccrualcomponents
Cons:Fundamentalperformanceislikelytodifferforfirmswithextremeaccrualsversuslessextremeaccruals.Thusthelower
persistenceoftheaccrualcomponentcouldbedrivenbybothfundamentalperformanceandthemeasurementrules
ResidualsfromaccrualmodelsErrortermfromregressingaccrualsontheireconomicdrivers(seeExhibit2)
Residualsfromaccrualmodelsrepresentmanagementdiscretionorestimationerrors,bothofwhichreducedecisionusefulness
Pros:Themeasureattemptstoisolatethemanagedorerrorcomponentofaccruals.Theuseofthesemodelshasbecomethe
acceptedmethodologyinaccountingtocapturediscretionCons:Testsofthedeterminants/consequencesofearningsmanagement
arejointtestsofthetheoryandtheabnormalaccrualmetricasaproxyforearningsmanagementCorrelatedomittedvariables
associatedwithfundamentals,especiallyperformance,areofconcerngiventhedependenceofnormalaccrualsonfundamentals
andtheendogeneityofthehypothesizeddeterminants/consequenceswiththefundamentals
Smoothnesss(Earnings)/s(Cashflows)
Alowerratioindicatesmoresmoothingoftheearningsstreamrelativetocashflows
Smoothingtransitorycashflowscanimproveearningspersistenceandearningsinformativeness.However,managersattempting
tosmoothpermanentchangesincashflowswillleadtoalesstimelyandlessinformativeearningsnumber
Pros:IncomesmoothingappearstobeacommoncorporatepracticeinmanycountriesaroundtheworldCons:Itisdifficultto
disentanglesmoothnessofreportedearningsthatreflectssmoothnessofthe(i)fundamentalearningsprocess;(ii)accounting
rules;and(iii)intentionalearningsmanipulation
Timelylossrecognition(TLR)Earnings
t+1
=a
0
+a
1
+e
twhereD
t
D
t
+b
0
Ret
t
+b
1
D
t
Ret
t
ThereisademandforTLRtocombat
Pros:Aimsatdisentanglingthemeasurementoftheprocess=1
ifRet
t
o0.Ahigherb
1
implies
management'snaturaloptimism.TLR
fromtheprocessitselfbyassumingthatreturns
appropriatelymoretimelyrecognitionoftheincurred
representshighqualityearnings
reflectfundamentalinformationlossesinearnings.
Cons:TheneteffectofTLRonearningsqualityisunknownbecauseTLRresultsinlowerpersistenceduringbadnewsperiods
thanduringgoodnewsperiods(Basu,1997).BothpersistenceandTLRaffectthedecisionusefulnessofearnings.TLRisa
returnbasedmetric;seecommentsonERCs
BenchmarksKinksinearningsdistribution
Changesinearningsdistribution
Kinksinforecasterrordistribution
Stringofpositiveearningsincreases
Pros:Themeasureiseasytocalculate,theconceptisintuitivelyappealing,andsurveyevidencesuggestsearningsmanagement
aroundtargetsCons:Inadditiontostatisticalvalidityissues,evidencethatkinksrepresentopportunisticearningsmanagementis
mixed,withcrediblealternativeexplanationsincludingnonaccountingissues.Itisdifficulttodistinguishfirmsthatareatkinks
bychanceversusthosethathavemanipulatedtheirwayintothebenchmarkbins
ERCsRet
t
Unusualclusteringinearningsdistributionsindicatesearningsmanagementaroundtargets.Observationsatorslightlyabove
targetshavelowqualityearnings
=a+b(EarningsSurprise
t
)+e
tMoreinformativecomponentsofearningswillhaveahigherb.
Investorsrespondtoinformationthathasvalueimplications.Ahighercorrelationwithvalueimpliesthat
Pros:Themeasuredirectlylinksearningstodecisionusefulness,whichisquality,albeitspecificallyinthecontextofequity
valuationdecisions
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401352
Exhibit1(continued)
EmpiricalproxyTheoryStrengthsandweaknesses
MorevaluerelevantearningswillhaveahigherR2
earningsbetterreflectfundamentalperformance
Cons:Assumesmarketefficiency.Inaddition,inferencesareimpairedbycorrelatedomittedvariablesthataffectinvestor
reaction(includingendogenouslydeterminedavailabilityofotherinformation),measurementerrorofunexpectedearnings,and
crosssectionalvariationinreturngeneratingprocesses
ExternalindicatorsofearningsmisstatementsAAERsidentifiedbySECRestatements
SOXreportsofinternalcontroldeficiencies
Firmshaderrors(AAERsand
Pros:Unambiguouslyreflectaccountingmeasurementrestatementfirms)orarelikelyto
problems(lowTypeIerrorrate).Theresearcherdoesnothavehavehaderrors(internalcontrol
touseamodeltoidentifylowqualityfirmsdeficiencies)intheirfinancial
Cons:ForAAERs:smallsamplesizes,selectionissues,andreportingsystems,whichimplies
matchingproblemsduetoTypeIIerrorrate.Forrestatementslowquality
andSOXfirms:problemswithdistinguishingintentionalfromunintentionalerrorsorambiguitiesinaccountingrulesthatleadto
errors
of the studies is to identify financial characteristics associated with persistent earnings. These studies are limited in their
contributiontoevaluatingpersistenceasaproxyforearningsqualitybecauseofthemaintainedassumptionthatmorepersistent
earningsaremoredecisionusefulforequityvaluation.Therefore,asecondstreamofresearchattemptstoaddressthebroader
issueofwhetherearningsisdecisionusefulinthatitimprovesequityvaluationoutcomes.Thislineofresearchisdiscussedin
Section3.1.1.3.Animportantissueinthisliteratureisthebenchmarkusedtoevaluatetheequitymarketoutcomes.
Relatedtothefirststreamofresearch,asimplemodelspecificationestimatesearningspersistenceas:
Earnings
t1
14abEarnings
t
e
t
1a
Earningsaretypicallyscaledbyassets,althoughsomeresearchersexaminemargins(scalebysales)orscalebythenumberof
shares.Ahigherbimpliesamorepersistentearningsstream.Intuitively,thelogicbehindearningspersistencebeingaquality
metricisasfollows:IffirmAhasamorepersistentearningsstreamthanfirmB,inperpetuity,then(i)infirmA,currentearnings
isamoreusefulsummarymeasureoffutureperformance;and(ii)annuitizingcurrentearningsinfirmAwillgivesmaller
valuationerrorsthanannuitizingcurrentearningsinfirmB.Thushigherearningspersistenceisofhigherqualitywhenthe
earningsisalsovaluerelevant.
Acommonextensionistodecomposetotalearningsintocomponentsanddeterminewhethersuchadecompositionhelpsin
predictingearningspersistence.AninstrumentalpaperinthisareaofresearchisSloan(1996)whodecomposestotalearnings
intothecashflowcomponentandtotalaccruals:
Earnings
t1
14ab
1
CF
t
b
2
Accruals
t
e
t
1b
anddocumentsthatb
2
ob
1
,whichimpliesthatthecashflow(CF)componentofearningsismorepersistentthantheaccrual
component.Theliteraturehasevolvedtofurtherexaminethepersistenceofthecomponentsoftotalaccrualsandcashflows.A
furtherextensionistodeterminewhetherotherfinancialstatementelementsorvariablesbeyondthefinancialstatements(eg,
disclosuresfromthefootnotes)areincrementalovercurrentearningsinpredictingfutureearnings:
Earnings
t1
14ad
1
Earnings
t
d
2
Financialstatementscomponentsd
3
Otherinformation
t
e
t
1c
Thisevolutionfromtheanalysisofthepersistenceoftotalearningstothepersistenceofcashflowsversusaccrualstothe
persistenceofcomponentsofcashflowsandaccrualsoccurredinboththeliteraturesthatstudiedthedeterminantsofpersistence
andtheconsequencesofitaswillbediscussedbelow.
Beforeweexaminetheliteratureonaccrualsasadeterminantofpersistence,however,wenoteoneareaoftheliteratureon
persistencethatrequiresmoreextensivestudyinordertomakeareasonableevaluationofpersistenceasameasureofquality.
Wehavelimitedevidenceontheextenttowhichthepersistenceofafirm'sfundamentalperformanceaffectsthepersistenceof
reported earnings. Our definition of reported earnings emphasizes that the earnings properties are determined both by
fundamentalperformanceandbytheaccountingsystem.ThisisconsistentwiththenotionsexpressedintheGrahamandDodd
definitionofquality,whichacknowledgesthatpersistenceislikelytobedriventoalargeextentbythebusinessinwhichthefirm
operates.Webelievethatitwouldbeinterestingtodistinguishtherelativecontributionsoffundamentalperformance(X)versus
themeasurementrule(f)onthepersistenceofreportedearnings.Anexampleofastudythattakesaverydirectapproachto
evaluatingtheroleoffundamentalperformanceonpersistenceisLev(1983),whoassociatespersistencewithproducttype,
industrycompetition,capitalintensity,andfirmsize.13Other
13EarlystudiesthatanalyzedthestatisticalprocessthatunderliesearningsincludeFoster(1977);WattsandLeftwich(1977);
Albrecht et al. (1977); Beaver (1970); and Griffin (1977). Baginski et al. (1999) emphasize that timeseries modeling
assumptions can create significant differences in parameter estimates, and lead to different economic conclusions about
persistence.TheyarguethattherelationsdocumentedinLev(1983)areweakwhen
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401353
examplesincludestudiesthatinvestigatewhetherearningsaremoresustainableforfirmsthatfollowadifferentiationstrategy
associatedwithhighermarginsandlowerturnoverversusacostleadershipstrategyassociatedwithlowermarginsandhigher
turnover(eg,NissimandPenman,2001;FairfieldandYohn,2001;Soliman,2008).Overall,theresultssuggestthatcreating
barrierstoentrybyhavingatechnologythatallowsthefirmtosellitsproductatlowercostismoresustainablethancreatinga
uniqueproductthatissoldathighmargins.Thebenefitsofcostleadershiparelikelytodependontheindustrythefirmoperates
in,growth,competition,andtheproportionofcoststhatarefixed.Futureresearchcanattempttobetteridentifyandisolatethose
circumstancesandtheirimplicationsforearningspersistence.
3.1.1.1. Determinants of earnings persistence. Accruals as a component of earnings are the most studied determinant of
persistence.Oneconfusingaspectofthisareaofresearch,particularlyforPh.D.studentsastheyenterthefield,isthatthe
definitionof''accruals''haschangedovertime.Inearlyresearchdonepriortomandatoryreportingofthestatementofcashflows,
accrualswerefrequentlydefinedasnoncashworkingcapitalanddepreciation.Thesenumberswerebackedoutofthestatement
ofworkingcapitalorthebalancesheet.Sloan(1996),Jones(1991),andHealy(1985)usethistypeofdefinitionofaccruals.
Sincetheintroductionofthestatementofcashflows,accrualsaremoreoftendefinedasthedifferencebetweenearningsandcash
flowswherecashflowsareobtainedfromthestatementofcashflows.Themotivationfortheuseofthismeasurestemsfrom
researchbyHribarandCollins(2002),whosuggestthatthisdefinitionmitigateserrorinducedbymergersandacquisitions.
Thedefinitionofaccrualsisstillevolving.Realizingthatallbalancesheetaccounts(exceptcash)aretheresultoftheaccrual
accountingsystem,Richardsonetal.(2005)provideamorecomprehensivemeasureofaccruals(intuitively,thechangeinnet
operatingassetsotherthancash)withthechangeinthecashbalancereflecting''cashearnings.''Thisdefinitionismoreconsistent
withresearchthatassumescleansurplus(oftennecessaryforresearchfocusingonvaluation)sinceitisnecessarytoreconcilethe
changeinequityfromthebalancesheetwithearningsanddividends(seeOhlson,2010).Mergersandacquisitionandothernon
cashtransactionsresultinawedgebetweennumbersreportedinthestatementofcashflowsandchangesinconsecutivebalance
sheetaccounts.Thesedifferencescouldberelevantforforecastingfuturecashflowsorfutureearnings.Forexample,increasesin
inventorythataretheresultofanacquisitionwillnotbereflectedinchangesininventoryreportedinthestatementofcashflows.
However,suchincreases,whichcouldberelevantforpredictingfuturewriteoffs,wouldbereflectedinthechangeininventory
fromconsecutivebalancesheets.Futureresearchcouldthereforeconsiderthecircumstanceswhenitisbettertocalculateaccruals
fromthebalancesheetversusaccrualsfromthestatementofcashflows.
Armedwiththiscaveataboutthedefinitionofaccruals,andkeepinginmindthemaintainedassumptionofthestudiesthat
morepersistentearningsaremoredecisionusefulinputstoequityvaluationmodels,westartwithadiscussionoftheassociation
betweenaccrualsandpersistence.
OneexplanationforthelowerpersistenceoftheaccrualscomponentasdocumentedbySloan(1996)isthatitistheresultof
measurementproblemswiththeaccountingsystem(f),eitherbecauseofhowitreflectsfundamentalperformanceorbecauseof
thediscretionallowedintheaccountingsystem.However,otherresearchhasarguedinsteadthatthelowerpersistenceofaccruals
isrelatedtotheeffectoffundamentalperformance(X)onpersistenceandinparticulargrowthinfundamentalperformance.For
example,Fairfieldetal.(2003a)arguethattherearediminishingmarginaleconomicreturnstoincreasedinvestment,suggesting
thatasindustriesexpanditismoredifficulttomaintainthesamesalespriceongoods,sopricesdrop,whichthenaffectsprofit
margins.14Fairfieldetal.showthatthechangeinPPEhassimilarimplicationsforearningspersistenceasworkingcapital
accruals,andtheyinterpretthisfindingasevidencethatgrowthexplainsthelowerpersistenceofaccruals.
ThisinferenceisbasedontheassumptionthatgrowthinPPEproxiesforfundamentalexpansionandthatitisnotitselfan
accrual.ButthechangeinPPEonthebalancesheetisaproductoftheaccrualaccountingsystem,anditrepresentsboth
fundamentalexpansion(X)andmeasurementoffundamentalexpansion(f).Thustheirresultsdonotunequivocallysupportthe
diminishingreturnsstory.Thereareseveralalternativeexplanationsforthedeclineinfuturereturnonassets:(a)adeclinein
salesprices(assuggestedbythediminishingreturnsstory),(b)anincreaseincoststhatthencausesadeclineinmargins,or(c)a
declineinefficiency(turnoverratios)thatthenaffectsmargins.Anexamplewillhelpclarifytheissue.Ifafirmgrowsitsasset
baseanddepreciatesittooslowlyorovercapitalizesassets(eg,Worldcom),thenfuture''returnonassets''measuredusingthe
accountingsystemcoulddeclinerelativetocurrentratesofreturnduetothegrowthin''assets''ratherthanadeclineintheprice
forwhichgoodsaresold.
ThefactthatwerequireameasureoftheunobservableXinordertooperationalizeempiricaltestsofthesourceofpersistence
incashflowsandaccruals,andthatmostmeasureswilluseoutputsfromtheaccountingsystem,isaproblemthatisdifficultto
resolve.Whengrowthismeasuredasthechangeinnetoperatingassets,thereisnodifferencebetween''accruals''andgrowth.
Otherproxiesfor''growth''suchastheincreaseinPPEorsalesrevenue,aswellasmarkettobook
(footnotecontinued)persistencemetricsfromlowerordertimeseriesmodelsareusedbutexistwhenthemeasureofpersistence
isbasedonadifferenced,higherordermodel.
14Richardsonetal.(2006),however,pointoutthatwhileFairfieldetal.(2003a)measuregrowthatthefirmlevel,theStigler
(1963,p.54)referencetotheroleofdiminishingreturnsismadeattheindustrylevel.Therefore,Fairfieldetal.'sargument
requiresfirmlevelgrowthtoinfluenceindustryleveloutputeitherbecausethefirmisalargeproportionoftheindustryor
becausethereisstrongcorrelationofgrowthwithintheindustry.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401354
ratios,arealsomeasuredviatheoutputsoftheaccrualaccountingsystem.Thus,theyarenotmeasuresofXindependentofthe
measurementsystem.Webelievethatthoughtfullydesignedteststhatanalyzeproxiesforgrowthinfundamentalperformance
(X)withdifferentmeasurementimplicationsinearningswillhelpmakeprogressinthisareaofresearch.
Forexample,Richardsonetal.(2006)arguethatifaccrualsreflectrealinvestmentgrowth,thenthegrowthwillleadtohigher
sales,whereasifaccrualsincreasewithnochangeinsales,thenthisfindingwouldsuggestthattheaccrualincreaseisdueto
declinesinefficiencyeitherbecauseofaccountingdistortionsorthelessefficientuseofcapital.Thediminishingmarginal
returnsexplanationforaccrualspredictsarelationbetweenaccrualincreasesandsalesgrowthbutdoesnotpredictarelation
betweenaccrualincreasesanddeclinesinefficiency.Theydecomposethechangeinnetoperatingassets(totalaccruals)intoa
growthcomponent,measuredbysalesgrowth,andanefficiencycomponent,measuredbythenetoperatingassetturnoverratio,
andaninteractioneffect.Theyshowthatfirmswithhighaccrualshaveanincreaseinsales(consistentwiththediminishing
returnsstory)andadecreaseinefficiency(consistentwiththemeasurementerrorstory).Theyinterprettheirfindingsasevidence
thatthelowerpersistenceofearningsinhighaccrualfirmscannotbepurelyduetohigh(fundamental)growthfirmsfacing
diminishingeconomicmarginsfortheirproducts.Inaddition,theyshowthatextremeaccrualfirmsaremorelikelytobesubject
toSECenforcementreleases,furthersuggestingthatmeasurementproblemsareacontributingfactortothelowerearnings
persistence.NissimandPenman(2001)alsoprovidesinsightsinthisarea.Theydecomposereturnonassetsintoanoperating
leveragecomponentandafinancialleveragecomponent.Theysuggestthatanincreaseinoperatingleverageislikelytodepress
currentearningsbutleadtofutureimprovementsinearnings.Anincreaseinfinancialleverage,however,tendstohavean
incrementallynegativeeffectonfutureearnings(scaledbyequity).
Zhang(2007)isanotherexampleofresearchthatattemptstodifferentiatetheeffectsofgrowthinXfromtheaccrualsthat
measureit.Heinvestigateswhetherthelowearningspersistenceofextremeaccrualsfirmsreflectsgrowthusinggrowthproxies
otherthanthosemeasuredbytheaccountingsystem(eg,employeegrowth).15Hisfocus,however,isonthemispricingaspectof
theaccrualanomaly.Hedoesnotincludearegressionwithcashflows,accrualsandemployeegrowthasindependentvariables
andfutureearningsasthedependentvariableandthenshowthataccrualshaveacoefficientequaltothatofcashflowsafter
controllingforgrowth.Therefore,histestsdonotdirectlyaddresswhether''growth''explainsthelowerpersistenceoftheaccrual
componentofearnings.
Itisimportanttohighlighttheinterpretationofthelowerpersistenceoftheaccrualcomponentrelativetothecashcom
ponentofearnings,sinceitisanissuethatwewillreturntoinlatersectionsofthepaper.Thelowerpersistenceoftheaccrual
component does not imply that accruals are not useful. The result simply tells us that when earnings are composed pre
dominantlyofaccruals,theywillbelesspersistentthanwhenearningsarecomposedpredominantlyofcashflows.Interpreting
thisresultasevidencethataccrualsdonotimproveearningsquality,however,doesnotallowaccrualstobedecisionuseful
exceptthroughtheirimpactonpersistence.Toclarify,researchershaveshownthatearningsproducesmallerforecasterrorsthan
cashflowsinvaluationmodels,thatearningsaremorestronglyassociatedwithstockreturnsthanarecashflows,thatearnings
aremorepersistentthancashflows,andthatearningsarelessvolatilethancashflows(seeSection3.1.1.3).Suchresultssuggest
thataccrualscanimprovethedecisionusefulnessearningsdespitethefactthattheyhavelowerpersistence.Thusthelower
persistenceoftheaccrualcomponentofearningsshouldbeputincontext.Accrualadjustmentsareuseful,eventhoughfactors
suchasmeasurementerror,managerialdiscretion,andgrowthaffecttheirrelationtopersistence.
Havingdecomposedearningsintototalaccrualsandcashflows,anothernaturaldirectionfortheliteraturetotakeisto
examinethespecifictypesofaccrualsthataremoreorlesspersistent.16Richardsonetal.(2005)decomposethefinancial
statementsintoshortandlongtermoperatingassetsandliabilitiesandfinancialassetsandliabilities.Theyshowthatshortterm
accrualcomponentsarelesspersistentthanlongtermcomponentsandthatfinancialaccrualsaremorepersistentthanoperating
accruals.Theyinterpretthisevidenceasconsistentwithreliabilityandmeasurementerrorconcernsbeinggreaterforoperating
assetsand,inparticular,greaterforshorttermoperatingassetsthanforfinancialassets.
Otherstudieshavefocusedondecomposingworkingcapitalaccrualsintoreceivablesandinventory.Twoexamplesofstudies
inthisareaareLevandThiagarajan(LT)(1993)andAbarbanellandBushee(AB)(1997).Bothstudiesexamineavarietyof
accruals;wefocusourdiscussiononlyontheresultsforinventoryandaccountsreceivable.Withrespecttoaccountsreceivable
accruals,thestudiesfindconflictingevidence.LevandThiagarajan(1993)findanegativerelationbetweenabnormalaccounts
receivable(ie,receivableschangeslesssaleschanges)andcontemporaneousreturns,andtheyinterpretthisresultasevidence
that disproportionate receivables changes indicate difficulties in selling the firm's products, related credit extensions, and
premature revenue recognition.17 Abarbanell and Bushee (1997), however, find an unexpectedly positive relation between
abnormalreceivablesandoneyearaheadearningschanges,whichtheyinterpretasevidencethatreceivablesgrowthindicates
salesgrowthandnotreliabilityorcustomercollectionproblems.Thepointofdiscussingthisexampleisthatwelearnlittleabout
earningsqualityfromitbecauseoftheconflictingresults,yetwecouldnotfindresearchthatattemptstoreconciletheevidence.
Withrespecttoinventoryaccruals,LTandABfindthatfirmswithindicatorsofpoorqualityinventoryaccrualshavepositive
futurechangesinEPS(AbarbanellandBushee,1997)andcontemporaneousreturns(LevandThiagarajan,1993).
15Zhang(2007)providesausefuldiscussionoftheissueweraisedpreviouslyaboutthefactthatresearchers'measuresof
''growth''aregenerallybasedonvariableslikesalesgrowth,whicharethemselvesproductsoftheaccountingsystem.16See
MelumadandNissim(2008)foradetailedanalysisofspecificaccruallineitems.17LTalsofindnorelationbetweenthe
abnormalcomponentoftheprovisionfordoubtfulreceivablesandcontemporaneousreturns,whichtheydescribeassurprising.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401355
Moreover,ThomasandZhang(2002)documentthatthechangeininventoryisthestrongestdriverofaccrualanomalyhedge
returns.18However,theydonotdirectlyinvestigatewhetherchangesininventoryhadalowercoefficientthanotheraccrual
componentsinthepersistenceregression(1bor1c).RecentworkbyAllenetal.(2009)suggeststhatinventoryaccrualsresultin
lesspersistentearningsbecauseofmeasurementerrorrelatedtothewritedownsofinventory.Thissuggeststhatmeasurement
errorplaysaroleinthelowerpersistenceoftheinventorycomponent.
Researchershavealsospecificallyanalyzedtheroleofwritedownsandotheraccrualtypeadjustmentsthatresultinspecial
items.Thegeneralfindingisthatspecialitemsareaccrualadjustmentsthatreducethepersistenceofearningsandalsoexplain
thelowerpersistenceoftheaccrualcomponent(Fairfieldetal.,1996;NissimandPenman,2001;DechowandGe,2006;Allenet
al.,2009).Againthisresultshouldbeputincontext.Specialitemsmaynotbehelpfulforpredictingfutureearnings,sincethey
arebytheirnaturetransitory.However,theycouldbeveryrelevantforevaluatingmanagement'sperformanceandpriordecision
making.19
Therearealsostudiesthathaveinvestigatedtheroleofotherinformationinpredictingearningspersistence.Forexample,Li
(2008)documentsthatfirmsthathavemorereadablefinancialreportshavemorepersistentearnings.Herecognizescausalityas
anunansweredquestion,andacknowledgesthattheexplanationfortherelationisbeyondthescopeofhispaper.Thecausalityis
aninterestingquestion.Isitthatafirmwithamorestablebusinessmodel,thatasaconsequencehasmorepersistentearnings,
haslessdetailtodiscussintheirfinancialreports?Orisitthatalessreadablefinancialreportisindicativeofmanagementthatis
engaginginearningsmanagementthroughcomplextransactionsorotheraccountingshenanigansthattheythenneedtoexplain
(in a complicated way to hide the earnings management) that subsequently leads to earnings reversals and less persistent
earnings?
Likewise, researchers have investigated the role of earnings persistence in management guidance. The results generally
suggestthatmanagersoffirmswithmorevolatileearningsarelesslikelytoprovideguidance(see,forexample,Verrecchia,
1990;Waymire,1985),althoughintheempiricalanalysis,thecausalityisnotalwayseasytodetermine.Thustheroleofother
informationandthecausalitylinkstopersistenceappeartobeinterestingareasforfutureresearch.
3.1.1.2.Consequencesofpersistence.Thevastmajorityofpapersonconsequencesofpersistenceexamineequitymarketcon
sequences.Onlyafewpapersdiscussconsequencesthatwerefertocollectivelyasotherthanequitymarketconsequences.20
Equitymarketconsequences:Researchershypothesizetwodistinctequitymarketconsequencesofpersistence.Thefirst
predictionisthatmorepersistentearningswillyieldahigherequitymarketvaluationand,therefore,thatincreasesinestimatesof
persistencewillyieldpositive(contemporaneous)equitymarketreturns.EarlyresearchbyKormendiandLipe(1987),Collins
andKothari(1989),andEastonandZmijewski(1989)provideevidencethatmorepersistentearningshaveastrongerstockprice
response.
The second prediction concerning equity market consequences relaxes the assumption of market efficiency and takes a
financialanalysisperspective.Specifically,theresearcherattemptstousevariablestohelppredictearningspersistenceandthen
investigateswhetherinvestorsareawareofthedifferentialimpactofthevariablesonearningspersistence. The review by
Richardsonetal.(2010)focusesonexaminingaccountingbasedanomaliesandtheirunderlyingcauses,sowedonotgointo
detailinthisreview.Forourpurposes,akeyresultisthatofSloan(1996),whoshowsthatinvestorsarenotfullyawareofthe
differingpersistencelevelsoftheaccrualandcashflowcomponentsofearnings.Sloan(1996)documentsthatahedgetrading
strategythatislonginlowaccrualfirmsandshortinhighaccrualfirmsearnsapproximatelya12%returnperyear.Subsequent
studieshaveprovidedseveralexplanationsforthehedgereturns(theaccrualanomaly)including(i)investormisunderstandingof
abnormal accruals (Xie, 2001); (ii) investor misunderstanding of errors in accruals or reliability (Richardson et al., 2005;
HirshleiferandTeoh,2003);(iii)investormisunderstandingofthegrowthreflectedinaccruals(Desaietal.,2004;Fairfieldetal.,
2003a;Zhang,2007);and(iv)mismeasurementofexpectedreturnsorotherresearchdesignissues(Khan,2008;Kraftetal.,
2006).
Studiesfurtherdisaggregateaccrualsandexaminehowspecificaccrualsrelatetoearningspersistenceandtheimplicationsfor
investors.Oneareathathasbeenextensivelyexaminedistheimplicationsofwriteoffs(ie,largenegativespecialitems)for
earningspersistence.Bartovetal.(1998)summarizethefindingsfromtheliteratureonwriteoffsthrough1998.Theearly
researchdocumentednegativestockmarketreactionstotheannouncementofspecialitems,butthenegativereactionsweresmall
(around1%),andannouncementperiodreturnswerepositiveifthewriteoffwasassociatedwitharestructuringoranoperational
change.Bartovetal.(1998)questionthesmallstockpriceresponseattheannouncementdateandexamineasampleof317
writeoffsin1984and1985.Theyfindannualizednegativeabnormalreturnsof 21%overatwoyearperiodfollowingthe
announcementsofthewriteoff,robusttovariousriskadjustments.DechowandGe(2006),however,findthatfirmswithlarge
negativeaccrualsdrivenbyspecialitemshavepositivefuturereturns,whichsuggeststhatinvestorstendtooverweightspecial
itemaccruals.Thecontrastingresultscouldstemfromthewaythatspecialitems
18LaFond(2005)alsodocumentsthatinventoryaccrualsexplainhedgereturnsin13outof17countries.19Researchershave
alsofocusedonthecashflowcomponentandidentifiedthedriversofitshigherpersistence(relativetotheaccrualcomponent).
Dechowetal.(2008)showthatretainedcashflowshaveimplicationsforpersistencesimilartothoseofaccruals.Cashflows
relatedtothepaymentorissuancesofequityarethemajordeterminantofthehigherpersistenceofthecashflowcomponentof
earningsrelativetoaccruals.
20Francisetal.(2005a)findthatfirmswithmorepersistentearningshavealowercostofdebtandequitycapital.Franciset
al.(2005a)examinetheconsequencesofotherEQproxiesaswell,anditispartofalargerliteraturethatrequiresmoreextensive
discussionduetosomemethodologicalissues.Therefore,weleaveadetaileddiscussionofthisstudytoSection6,wherewe
covertheliteratureontheimpactofearningsqualityonthecostofcapital.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401356
affectfutureearnings.Ifmanagerstakebigbathsthatsetthemupforhealthyreboundsthatarenotpredictedbyinvestors,then
futurereturnscouldbepositive(seealsoMcVay,2006).Incontrast,ifafirmcontinuestotakefuturewritedownsandwriteoffs
andthespecialitemisthefirstofaseriessuchthatmorebadnewscouldfollow,thenfuturereturnscouldcontinuetodeclineif
thenewsisunanticipatedbyinvestors.Insummary,thereasonforthewriteoff,achoicevariable,isanimportantfactorin
understandingwhethertheeffectofthewriteoffonpersistenceimprovesorhindersdecisionusefulness.Afurthergroupof
studiesoftheconsequencesofaccrualsexaminesindustryspecificlossaccruals.BeaverandEngel(1996)findthatthenormal
componentofbanks'allowancesforloanlossreservesisnegativelypricedandtheabnormalcomponentisincrementally
positivelypriced.Theyinterpretthepositivecoefficientonabnormalaccrualsasfollows:''ypositiveeffectsonsecuritypricescan
occurbecausediscretionarybehavioraltersthemarket'sassessmentoftheexpectednetbenefitsofdiscretionarybehavioror
conveysmanagement'sbeliefsaboutthefutureearningspowerofthebank.''BeaverandMcNichols(2001)findthatinvestors
correctlypricethelossreserveaccrualeventhoughtheyincorrectlypriceotheraccrualsinamannerconsistentwithSloan
(1996).TheirfindingsuggeststhattheextensivedisclosuresaboutlossreserveaccrualsofP&Cinsurershelpinvestorsto
estimatethepersistenceandvaluationimplicationsofthiscomponent.Thisresultisconsistentwiththefindingsdiscussedabove
thattheaccrualanomalyislesslikelytooccurwheninvestorsaremoreinformed,suggestingthatthepersistenceassociatedwith
thisparticularaccrualisdecisionuseful.
Anotherelementoftheresearchoninvestorresponsivenesstoearningspersistencefocusesonspecificactivitiesandthe
implicationsoftheiraccountingtreatmentforfutureearnings.Forexample,investorsappeartoviewexpensedR&Dexpenditures
asassets,buttheydonotperfectlypricethefullimplicationsoftheR&Dinvestment(LevandSougiannis,1996).Inaddition,
investorsdonotappeartobefullyawarethatacutinR&Dwilltemporarilyboostcurrentearningsattheexpenseoffuture
earnings (Penman and Zhang, 2002). Ge (2007) finds that information in footnote disclosures on the growth in leases is
incrementallyusefuloveraccrualsforpredictingthepersistenceofearnings.However,investorsdonotfullyincorporatethese
implicationsaboutearningspersistenceintoprices.Inasimilarvein,Lee(2010)findsthatinformationreportedinmanagement's
discussionandanalysisonfuturepurchaseobligationsisusefulforpredictingfuturesalesandearningsbutthatthisinformation
isnotfullyincorporatedintoprices.Interestingly,hispaperhelpsidentifyhighaccrualfirmsthatwillcontinuetoreportsuperior
performance.
Research that examines the treatment of specific transactions/activities helps us better understand the implications of
accountingrulesforvaluation.Thistypeofresearchprovidesafruitfulwayforresearcherstodistinguishtheroleoffundamental
performance(X)fromthemeasurementsystem(f)usedtoreportatransaction/activity.
Finally,researchershaveexaminedwhetherequitymarketconsequencesofthepersistenceoftheaccrualcomponentof
earningsvarywithaninvestor'sinformationprocessingabilityorwiththeavailabilityofotherinformation.Themotivationfor
thisresearchistounderstandifinvestorswhoaremoreinformedabouttheaccrualcomponentanditsimplicationsforthe
persistence ofearnings priceearnings correctly. Generally, thetakeaway fromthis lineof researchis thatmore informed
investorsbetterprocesstheinformationinthefinancialstatements,whichresultsinlessmispricing.Heterogeneityininvestor
informednessmayberelatedtoacharacteristicoftheinvestor,eitherduetoexogenousinformationendowmentsorduetothe
investor'sendogenousinformationacquisitionactivities.Heterogeneitymayalsoberelatedtoacharacteristicofthefirm,either
duetoanexogenousfeatureofthefinancialreportingsystemthataffectsitsabilitytoprovidevaluerelevantinformationordue
to the firm's endogenous information production decisions, including its decisions to manage earnings or make voluntary
disclosures.
Someexamplesofsuchstudiesincludethefollowing:LouisandRobinson(2005)whofindthatstocksplitannouncements
addcredibilitytoaccruals;Levi(2008)whofindsthattheaccrualanomalyexistsonlyforfirmsthatdelaythereleaseofaccrual
informationtotheir10Qanddonotincludecashflowandbalancesheetinformationinpressreleases;andCollinsetal.(2003)
whofindthatfirmswithahighlevelofinstitutionalinvestorsandaminimumthresholdlevelofactiveinstitutionaltradershave
stock pricesthat moreaccurately reflectthe persistenceof accruals. Anotherexample isRichardson (2003), whofinds no
evidence that shortsellers are clustered in highaccrual firms. However, his sample period is 19901998, and the accrual
anomalydidnotbecomewidelyknownuntilafterthepublicationofSloan(1996).Therefore,shortsellersmaynothavebeen
tradingontheaccrualanomalypriorto1996.Consistentwiththisinterpretation,Greenetal.(2010)findthatreturnstothe
accrualanomalyhavedeclinedovertime,particularlyafterthepublicationofSloan(1996).Insummary,ifresearchersusethe
behaviorofinformedinvestorsasabenchmarkforevaluatingthedecisionusefulnessofearningspersistence,thereisevidence
supportingtheassumptionthatpersistenceisadecisionusefulcharacteristicofearnings.
Otherthanequitymarketconsequences:Theevidenceonwhethergreaterpersistenceisofhigherqualityforotherdecision
usersislimited.Thisisperhapsnotsurprisinggiventhemaintainedassumptionthatpersistenceisausefulattributeforinvestors
becauseitmakesearningsamoreusefulinputintoequityvaluationmodels.Motivatingpersistenceasadecisionusefulproperty
ofearningsinotherdecisioncontextsrequiresadecisionspecificexplanation.
Twopapersexaminecompensationdecisionsasafunctionofearningspersistence.Baberetal.(1998)findthatearnings
persistence increases the positive relation between unexpected earnings and the annual change in various components of
compensation.Inotherwords,compensationismoresensitivetoearningswhenearningsaremorepersistent.Thus,conditional
on the compensation contract containing a variable cash component, more persistent earnings are more decision useful to
compensationcommitteesinestablishingtotalcompensation.Nwaezeetal.(2006)findthatfirmswithlesspersistentearnings
havelowerweightplacedonearningsrelativetocashflowsincompensation.Thisresultimpliesthatcompensationcommittee's
decisions are affected by earnings persistence, and thus persistence is decision useful information. Both papers attempt to
distinguishpersistencedrivenbyfirmfundamentalperformancefrompersistence
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401357
associatedwithaccountingmeasurement.Nwaezeetal.(2006)measureearningspersistencerelativetocashflowpersistence.
Baber et al. (1998) include stock returns in the model. However, not all papers find that compensation committees adjust
compensationbasedonthereliabilityofearningscomponents.Forexample,GaverandGaver(1998)findthatmanagersare
compensatedforgains,whilelossesareignored.Insummary,whilecompensationcommitteesappeartorecognizethatearnings
persistenceisausefulattributeforrewardingexecutives,thecontextappearstobeimportant.
Evidence on consequences other than compensation is limited. Bradshaw et al. (2001) document that sellside analysts'
forecastsdonotfullyincorporatethepredictableearningsdeclinesassociatedwithhighaccrualfirms.Inaddition,highaccrual
firmsarenotmorelikelytogetqualifiedauditopinionsortohaveauditorchanges.Bradshawetal.confirmthatthehighaccrual
firmsindeedhavesubsequentearningsdeclines.Thus,theyinterprettheirfindingsasevidencethatanalystsandauditorsdonot
appeartobeawareofqualityissuesforhighaccrualfirms.BhojrajandSwaminathan(2007)findthat,likeequityinvestors,bond
investorsmispricehighandlowaccrualfirms. These results suggest that stakeholders other than equity investors can also
misunderstandearningspersistence.Weviewthisevidence(togetherwithequitymarketmispricing)assuggestingthatrule
makingisimportant.Howaccountingrulesaredesignedandtheirsubsequentimpactonearningspersistence(asaproxyfor
quality)haveconsequencesformanydecisionusers.
3.1.1.3.Linkingearningspersistencetoequityvaluation.Uptothispointwehavefocusedonearningspersistencestudiesthatare
motivatedbythemaintainedassumptionthatamorepersistentearningsnumberisindicativeofhigherearningsquality.In
particular,whenearningsaremorepersistentandsustainable,itisassumedtobetterindicatefuturecashflows,andsobeamore
usefulinputforvaluation.However,aquagmireforresearchersisthatpredictingnextperiod'searningsisnotequivalentto
predictingthestreamoffuturecashflows.Ultimately,forearningstobeofhighquality,wewouldwantittoreflectthisfuture
cashflowstream,ratherthanjustnextperiod'searnings.Whatifcurrentcashflowswereactuallyabetterindicatorofthefuture
cashflowstreamthancurrentearnings?Sucharesultwouldreducethevalidityofearningspersistenceasaqualityproxy.
Thereforeitisimportanttoknowwhetherearningsareactuallymorevaluerelevantthancashflowsbecausethisinturnsupports
researchexaminingearningspersistenceasadesirablequalityattribute.
Thedifficultresearchdesignissueishowtomeasurethe''true''valueofthefirmbasedontheexpectedfuturecashflow
streamsinceitisnotobservable.Theuseofactualfuturecashflowsisproblematicduetoproblemswithsurvivalbiases.Theuse
ofshorttermcashflowsisproblematicbecausethesemaybeapooranduntimelyindicatorofexpectedfuturecashflows,
particularlyingrowthfirms.Theuseoffutureearnings(aggregatedoverseveralyears)isalsoproblematicforthesamereasons.
Finally,theuseofmarketvaluesandstockreturnsisproblematicbecauseitassumesmarketefficiency.Ifinvestorsfixateon
earnings,thenearningscouldbefoundtobesuperiorevenwhentheyarenotabetterindicatoroffuturecashflows.Theuseof
future market values is also problematic because of survival biases. Therefore, all approaches have shortcomings, so it is
interestingtodeterminewhetherresultsareconsistentorinconsistentacrossdifferentproxiesoffundamentalvalue.Wediscuss
thedifferentapproachesbelow.
PenmanandSougiannis(1998)compareearningstocashflowsassummaryinputsintovariousvaluationmodels.They
concludethatovervarioustimehorizons,inmodelswithandwithoutaterminalvalueassumption,modelsthatapplysimple
forecastingassumptionstoearningsprovideabetterforecastofcurrentmarketvaluethanmodelsbasedoncashflowordividend
forecasts.21Thusunconditionally,accrualsappeartoimprovetheabilityofearningstoreflectvaluerelativetocashflows.They
documentfirmcharacteristicsthataffectthedecisionusefulnessofthemodels.Oneimportantconclusionoftheiranalysisisthat
themorethatthevaluationisweightedtowardstheterminalvalueassumptions,thelargerareforecasterrorsusinganyvaluation
approach.Considerhighgrowthfirmsthatarenotpayingdividends,havenegativecashflows(duetoinvestments),andhavelow
earnings(duetoexpensingofinvestmentssuchasR&D).Inthesefirmsmostofthevaluationwillbedrivenbyassumptions
concerningtheterminalvalue.Asaconsequence,thevaluationwillbesubjecttoconsiderablemeasurementerrorbecauseneither
cashflownorearningsbasedinputsareverygoodatreflectingfuturecashflows.Insuchfirmsearningspersistenceisalsolikely
tobelow.
Anotherapproachthatresearchershaveusedistoexaminetherelationbetweencontemporaneousstockreturnsandvarious
fundamental attributes such as earnings before and after depreciation (Ball and Brown, 1968) or earnings and cash flows
(Dechow,1994).Stockbasedmeasuresgenerallyfindthataccrualshelpimprovetheabilityofearningstoreflectvalueexcept
whenearningsincludelargewritedownsorspecialitems.Thus,usingmarketvaluesasthebenchmarkyieldsconsistentresults.
Earningsappeartobeamoreusefulmeasurethancashflowsatreflectingvalue.
Otherresearchershaveevaluatedtherelativeabilitiesofearningsandcashflowstoreflectexpectedfuturecashflowsusing
nonmarketbasedmeasures.However,notsurprisingly,giventhedifferentmeasuresusedtoevaluateearnings,andthemyriadof
approachesusedtoperformtheanalysis,resultsaremixed.Forexample,someresearchersusefuturecashflows(measuredfor
t+1oruptot+4),whileothershaveusedfutureearnings(aggregatedoversomeperiodoftime).Thedefinitionofcashflows
variesbasedonwhenthestudywaswritten(whetherthestatementofcashflowswasinexistence).Thedefinitionofearningscan
alsovary(earningsbeforedepreciationandtaxescouldbecomparedtobottomlineearnings).Barthetal.(2001)findthatcash
flowsaresuperiortoearningsatpredictingfuturecashflows,while
21Notethatundercleansurplusaccounting,aslongasthesamesetofforecastingassumptionsareapplied,aDCFmodeland
aresidualincomemodelwillyieldequivalentvaluations(eg,Penman,1998;PenmanandSougiannis,1998;Lundholmand
O'Keefe,2001).ThedifferentvaluationresultsobtainedinPenmanandSougiannisstemfromtheirresearchobjectivebeingto
determinewhichmeasuresaremoreusefulsummaryinputsinsimplevaluationmodels.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401358
Bowenetal.(1986)findthatcashflowsdonotappeartobesuperiortoearnings.Incontrast,Greenbergetal.(1986)findthatthe
predictiveabilityofaggregateearningsissuperiortothatofcashflows,whileFinger(1994)findsthatearningsandcashflows
havesimilarpredictiveabilityforlongerhorizons,butcashflowsareslightlysuperiortoearningsforshorthorizons.However,
cashflowpredictionmodelsthatdisaggregatetheworkingcapitalandotheraccrualcomponentsofearningsresultinlowercash
flow forecast errors and improve predictability (Dechow et al., 1998; Barth et al., 2001). Therefore, the results are quite
contextualanddependentonresearchdesignandvariabledefinitions.
Insummary,theobjectiveofthissectionistoexamineresearchthatprovidesinsightsintowhetherearningspersistenceisa
reasonableproxyforearningsquality.Theissueofconcernisthatcurrentearningscouldbeagoodindicatorofnextperiod's
earnings,whichiswhatthepersistenceparametersmeasure,butthatunderstandingnextperiod'searningsisnotdecisionuseful
becauseitdoesnotadequatelyreflectthefuturestreamofcashflowsthatthefirmwillgenerate.Inaddition,currentcashflows
maybetterpredicttheexpectedfuturecashflowstreameventhoughtheymaynotpredictnextperiod'searningsaswellasdo
currentearnings.Therefore,validationofearningsusefulnessinpredictingexpectedfuturecashflowshelpsusbetterunderstand
benefitsandcostsofusingpersistenceasaqualityproxy.Theresultsfromtheliteraturearealittlemoremixedthanonemight
expect.Asnotedabove,whileearningsingeneralappeartobeareasonableproxyforexpectedfuturecashflows,therelation
dependsonthetypeofaccrualsincludedinearnings.
3.1.2.Abnormalaccrualsandmodelingtheaccrualprocess
Adistinctandsignificantareaofresearchdistinguishes''abnormal''from''normal''accrualsbydirectlymodelingtheaccrual
process.22Thenormalaccrualsaremeanttocaptureadjustmentsthatreflectfundamentalperformance,whiletheabnormal
accrualsaremeanttocapturedistortionsinducedbyapplicationoftheaccountingrulesorearningsmanagement(ie,duetoan
imperfect measurement system).23 These measures attempt to directly capture problems with the accounting measurement
systemandsoareparticularlyrelevanttoaccountingresearchers.Thegeneralinterpretationisthatifthe''normal''componentof
accrualsismodeledproperly,thentheabnormalcomponentrepresentsadistortionthatisoflowerquality.
Belowwediscussvariousmodelsofaccruals(Section3.1.2.1).Animportantpointtorememberwhenreviewingthesemodels
isthatthemeasuresofabnormalaccrualsobtainedfromthemodelstendtobepositivelycorrelatedwiththelevelofaccruals.In
otherwords,afirmwithextremeaccrualsalsohasextremeabnormalaccruals.Thisobservationisimportantforinterpreting
resultsintheliterature.Thecorrelationraisesconcernsaboutwhetherabnormalaccrualsreflectaccountingdistortionsorwhether
theyinsteadaretheresultofpoorlyspecifiedaccrualsmodelsandincludeacomponentthatmeasuresfundamentalperformance.
Wefirstsummarizetheaccrualsmodelsthatgenerateameasureofabnormalaccruals(Section3.1.2.1).Next,inSection
3.1.2.2wediscusstheliteratureonthedeterminantsandconsequencesofabnormalaccrualsandpersistence.Wedonotdiscuss
theextensiveliteraturethatdocumentsthedeterminantsofabnormalaccrualsandtheconsequencestofirmsandmanagersthat
produceabnormalaccrualsinSection3.1.2.2.Toreducetheamountofrepetitionwediscussthedeterminantsofabnormal
accrualsinSection5andtheconsequencesinSection6.Section3.1.2.2discussesonlythestudiesthatspecificallylinkabnormal
accrualstopersistence.
3.1.2.1.Accrualsmodels.Exhibit2summarizesthemostwidelyusedaccrualsmodels.Thefocusofourdiscussionisonthe
potentialofthemodeltoidentifyabnormalaccrualsthatrepresentadistortion.MisclassificationerrorscanincludeTypeIerrors,
whichclassifyaccrualsasabnormalwhentheyarearepresentationoffundamentalperformance(ie,afalsepositive),andTypeII
errors,whichclassifyaccrualsasnormalwhentheyarenot.Weevaluateeachmodelintermsofitsabilitytoseparatelyidentify
thenormalandabnormalcomponentsofaccrualsandmitigateTypeIandTypeIIerrors.
Jones(1991)definestheaccrualprocess(workingcapitalaccrualsanddepreciation)asafunctionofsalesgrowthandPPE.
WhilesalesgrowthandinvestmentinPPEarereasonableandintuitivedriversoffirmvalue,andtheestimationoftheJones
modelconfirmsacorrelationbetweenthesefundamentalfirmattributesandaccruals,theexplanatorypoweroftheJonesmodel
islow,explainingonlyabout10%ofthevariationinaccruals.Oneinterpretationofthelowexplanatorypoweristhatmanagers
haveconsiderablediscretionovertheaccrualprocess,whichtheyusetomaskfundamentalperformance.Consistentwiththe
assumptionthattheresidualrepresentsgreaterdiscretion,Xie(2001)documentsthattheresidualsfromtheJonesmodelhave
lowerpredictiveabilityforyearaheadearningsthanthenondiscretionary(ie,''normal'')accruals.However,theresidualsare
highly(80%)positivelycorrelatedwithtotalaccruals(Dechowetal.,2003),andtheyarepositivelycorrelatedwithearnings
performanceandnegativelycorrelatedwithcashflowperformance(Dechowetal.,1995).Thesepatternsaresuggestiveofahigh
TypeIerrorrate.Inaddition,Dechowetal.(forthcoming)showthatdiscretionaryaccrualsaregenerallylesspowerfulthantotal
accrualsatdetectingearningsmanagementinSECenforcementreleases,whichindicatesthatuseoftheJonesmodelresidualsas
aproxyforpoorqualityaccrualsduetoearningsmanagementissubjecttoTypeIIerrors.Dechowetal.(1995)modifytheJones
modeltoadjustforgrowthincreditsalesinanattempttoreduceTypeIIerrors.Creditsalesarefrequentlymanipulated;thusthis
modificationincreasesthepoweroftheJonesmodeltoyieldaresidual
22Abnormalaccrualshavebeenthefocusofmuchempiricalresearchinaccounting.Almostonehundredpapersinour
databaseuse''abnormal''accrualsgeneratedfromanaccrualsmodelasameasureofearningsquality.Abnormalaccrualshave
beenusedasaproxyforearningsqualitytotestpredictionsinalmostallofthedeterminantsandconsequencescategories.
23Weuse''discretionaryaccruals''interchangeablywithabnormalaccruals,eventhoughitisasomewhatloadedtermthat
seemsmoreassociatedwithanactivechoiceratherthananoutcomeofthemeasurementsystemorerror.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401359
Exhibit2SummaryofwidelyusedmodelsofaccrualsThistablesummarizescommonlyusedmodelstoestimatenormallevels
ofaccruals.Residualsfromthemodelsareusedasameasureof''abnormal''accruals.
AccrualmodelTheoryNotes
Jones(1991)modelAcc
t
=a+b
1
ARev
t
+b
2
+e
t
AccrualsareafunctionofrevenuegrowthanddepreciationisafunctionofPPE.Allvariablesarescaledbytotalassets
Correlationorerrorwithfirmperformancecanbiastests.R2around12%.Residualiscorrelatedwithaccruals,earningsandcash
flowModifiedJonesmodel(Dechowetal.,1995)Acc
t
PPE
t
=a+b
1
(ARev
t
ARec
t
)+b
2
+e
t
AdjustsJonesmodeltoexcludegrowthincreditsalesinyearsidentifiedasmanipulationyears
Providessomeimprovementinpowerincertainsettings(whenrevenueismanipulated)Performancematched(Kotharietal.,
2005)DisAcc
t
PPE
t
Matchedfirm'sDisAcc
t
MatchesfirmyearobservationwithanotherfromthesameindustryandyearwiththeclosestROA.Discretionaryaccrualsare
fromtheJonesmodel(orModifiedJonesmodel)
Canreducepoweroftest.Applyonlywhenperformanceisanissue
DechowandDichev(2002)approachAWC=a+b
1
+b
2
+b
3
+e
t
Accrualsaremodeledasafunctionofpast,
s(e
t
)orabsolutee
tpresent,andfuturecashflowsgiventheirpurposetoalterthetimingof
cashflowrecognitioninearnings
proxiesforaccrualqualityasanunsignedmeasureofextentofaccrual''errors.''Focusesonshorttermaccrualsdoesnotaddress
errorsinlongtermaccrualsDiscretionaryestimationerrors(Francisetal.,2005a)TCA
t
CFO
t1
CFO
t
CFO
t+1
=a+b
1
+e
ts(e
t
CFO
t1
+b
2
CFO
t
+b
3
CFO
t+1
+b
4
ARev
t
+b
5
PPE
t)=a+l
1
s(CFO)
t
s(Rev)
t
Decomposesthestandarddeviationofthe
Innateestimationerrorsarethepredictedresidualfromtheaccrualsmodelintoan
componentfroms(e)
t+l
4
innatecomponentthatreflectsthefirm'soperatingenvironmentandadiscretionarycomponent(n
t+l
2
+l
3
regression
24ThemodifiedJonesmodelhasmanyvariantsandadaptations.DeFondandJiambalvo(1994)estimatetheregressionby
industryratherthanbyfirmtolessenfirmyearrequirements.Chambers(1999)suggestsaddinglaggedaccrualstothemodelto
capturepredictablereversals.Dechowetal.(2003)estimatethenormalrelationbetweencreditsalesandtotalsalestocontrolfor
nondiscretionarycreditsales.Theyalsoaddfuturesalesgrowthtocaptureaccrualsmadeinanticipationoffuturegrowth.Their
adjustmentsincreasetheR2fromaround9%to20%.Guayetal.(1996)provideacomparisonofvariousmodels.
25Forexample,assumeROAis20%forfirmsAandB,withfirmAusingdiscretionaryaccrualstoboostitsROAby2%to
report20%.FirmBisnotmanipulatingearnings;ithasachieved20%ROAbecauseithashighernondiscretionaryaccrualsthan
firmA.MatchingfirmBtofirmAwouldsuggestthatfirmA'slevelofnondiscretionaryaccrualsshouldbethesameasfirmB's,
butthismatchisincorrectsincethecorrectmatchshouldbeafirmwithROAof18%.
Size
tlog(OperCycle)
t
+l
5
NegEarn
t
+n
t
)thatreflectsmanagerialchoice
thatisuncorrelatedwithexpected(ie,normal)revenueaccrualsandbetterreflectsrevenuemanipulation.However,themodified
JonesmodelstillsuffersfromTypeIerrors,perhapsevenmorethantheoriginalJonesmodel.24
Holthausenetal.(1995)andKotharietal.(2005)suggestwaystocombatconcernsaboutthecorrelationsbetweenperformance
andtheresidualsfromtheJonesmodelandmodifiedJonesmodel.Theybothsuggestcontrollingforthenormallevelofaccruals
conditionalonROA.Kotharietal.(2005)identifyafirmfromthesameindustrywiththeclosestlevelofROAtothatofthe
samplefirmanddeductthecontrolfirm'sdiscretionaryaccruals(ie,residuals)fromthoseofthesamplefirmtogenerate
''performancematched''residuals.Becausethemodelsofnormalaccrualsthatgeneratetheresidualsexplainonly1012%ofthe
variationinaccruals,thisapproachislikelytoaddnoisetothemeasureofdiscretionaryaccruals,anditisbestappliedwhen
correlatedperformanceisanimportantconcern.Inaddition,theperformancematchingcanextracttoomuchdiscretionwhen
earningsarebeingmanaged,resultinginlowpowertests.25Takingadifferentperspective,DechowandDichev(2002)viewthe
matchingfunctionofaccrualstocashflowsasbeingofprimaryimportanceandthusmodelaccrualsasafunctionofcurrent,
past,andfuturecashflowsbecauseaccrualsanticipatefuturecashcollections/paymentsandreversewhencashpreviously
recognizedinaccrualsisreceived/paid.Theyfocusonshorttermworkingcapitalaccrualsanddonotattempttomodellongterm
accrualsandtheirrelationtocashflows.TheR2sfromtheirspecificationarehigherthanthoseofthemodifiedJonesmodel:47%
atthefirmlevel,34%attheindustrylevel,and29%atthepooledlevel.Thestandarddeviationoftheresidualsfromthemodelis
theirproxyforearningsquality.Theyshowthatfirmswithlargerstandarddeviationshavelesspersistentearnings,longer
operatingcycles,largeraccruals,andmorevolatilecashflows,accrualsandearnings;thesefirmsaresmallerandaremorelikely
toreportaloss.Theirfindingssuggestthatthesefirmcharacteristicsareindicativeofagreaterlikelihoodofestimationerrorin
accrualsandthusloweraccrualquality.NotethattheDechowandDichevmodelisunsigned.Usinganunsigned
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401360
measurecanreducethepoweroftestswhentheresearcherpredictsaccountingdistortionsinaparticulardirection(eg,managers
boostingearnings).Inaddition,theirmodelcannotbeusedtoidentifydistortionsinducedbylongtermaccruals.Thisisan
importantlimitationofthemodelbecauseimpairmentsofPPEandgoodwillarelikelytoreflectearningsmanagementor
accountingdistortionsthatcanbeparticularlyimportantforevaluatingthequalityofearnings.Francisetal.(FLOS)(2005a)
modifyandextendtheDechowandDichevmodelintwoways.First,assuggestedbyMcNichols(2002),theyaddgrowthin
revenueinanattempttoreflectperformance,andtheyaddPPE,whichexpandsthemodeltoabroadermeasureofaccrualsthat
includesdepreciation.However,FLOSdonotinvestigatewhethertheseadjustmentshelporhinderTypeIorTypeII
misclassificationerrors.ThesecondwaytheyextendtheDechow/Dichevmodelistodecomposethestandarddeviationofthe
residualintofirmlevelmeasuresofinnateestimationerrorsanddiscretionaryestimationerrors.Thisallowstheauthorstomake
statementsabout''managerialchoices''(ie,intentionalerrors)avoidedbyDechowandDichev.Specifically,FLOS(2005)
estimatetheiraccrualspredictionmodelbyindustryyearandcalculatethethroughyeartstandarddeviation(fiveyears).Theof
theresidualsforstandarddeviationofeachfirmjinyearttheresidualss(e
j
)
t
[s(e
j
)
t
]basedonthevalueofe
jisameasureinyear'st4ofaccrualquality(AQ);higherstandarddeviationsarelowerquality.TodecomposeAQintoan
innatecomponentandadiscretionarycomponent,FLOSmodelAQasafunctionoffirmcharacteristicsidentifiedinDechowand
Dichev(2002)
sej

t
14l
0,j
l
1,j
Size
j,t
l
2,j
sCFO
j,t
l
3,j
sSales
j,t
l
4,j
OperCycle
j,t
l
5,j
NegEarn
j,t
n
j,t
Thepredictedandthevalueofresidual(n
j,t
)s(ej
)
t
representsthequalityoftheaccrualsystemtocapturethefirm'sfundamentalperformance,
representsestimationerrorsandcorrections,discretionaryaccrualquality.Notethattheinnatecharacteristicscouldalsoreflect
whichreducesthepowerofn
j,t
to reflect intention (ie, a Type I error). Alternatively it
couldinducebias(inanunknowndirection)intotheproxyfordiscretion(TypeIIerror).Furtherresearchisneededtoevaluate
theimportanceoftheseconcerns.
Finally,weemphasizethatalloftheaccrualsmodelscanbeestimatedatthefirmlevel,whichallowsvariationacrossfirmsin
thedeterminantsofnormalaccruals.Firmlevelestimation,however,assumestimeinvariantparameterestimatesandtypically
imposessamplesurvivorshipbiases.Themodelsarethereforemostfrequentlyestimatedattheindustrylevel.Thisspecification
assumesconstantcoefficientestimateswithintheindustry.Thus,somefirmsmayhavelargeresidualsbecauseofvariation
inducedbyindustryclassificationratherthanbecauseofearningsmanagementorerrors.Measurementerrorintheresidualwill
berelatedtoindustrycharacteristics,whichcanbeaconcerninsomecontexts.Forexample,themodelmayhaveapoorerfitin
growthindustries,andgrowthmaybecorrelatedwiththehypothesizeddeterminantorconsequenceofaccrualquality.
Severalstudiesdevelopmodelsofspecificaccruals,oftenforsamplesoffirmsthatarehomogeneousinawaythatallowsthe
researchertodevelopabettermodelofthenormalcomponentofanaccrualwhichthengeneratesalessnoisyestimateofthe
abnormalcomponent(ie,modelresidual),resultinginmorepowerfultests.ConsidertheconflictingevidenceinMillerand
Skinner(1998)andSchrandandWong(2003).Bothstudiesmodeltheeconomicdeterminantsofthevaluationallowancefor
deferred tax assets (DTAs) required under SFAS 109. Miller and Skinner (1998) do not find much evidence of earnings
managementusingtheresidualfromtheirmodelestimatedforfirmswithlargeDTAs.SchrandandWong(2003),however,are
abletofindevidenceofearningsmanagementusingamodeloftheDTAallowancespecificallydesignedforbanks.Ofcourse,
thebenefitsofmodelingspecificaccruals,especiallywithinspecificindustries,comeattheexpenseofgeneralizability.
3.1.2.2.Studiesofabnormalaccrualsandpersistence.Studiesofabnormalaccrualsandpersistenceyieldthreegeneralfindings.
First,abnormalaccrualshavepositivepersistence,albeitlowerthanthatofnondiscretionaryaccruals.Xie(2001)findsthat
discretionaryaccrualshaveasignificantlypositivepersistencecoefficientusingtheJonesmodeltodecomposeaccrualsintoa
normalandabnormalcomponent.Hefindsthatthepersistenceparametersoncashflows,normalaccruals,anddiscretionary
accrualsare0.73,0.7,and0.57,respectively.26DechowandDichev(2002)arguethatlargeaccrualadjustmentsarelikelyto
containmoreforecastsandinvolvemoreestimation.Therefore,earningsinfirmswithextremeaccrualsarelikelytocontainmore
estimation error that will need to be corrected/reversed in future periods. These error corrections are likely to reduce the
persistenceofearnings.Holdingthemagnitudeofaccrualsconstant,theyshowthatfirmswithgreatermeasurementerrors(via
theiraccrualqualityproxy)havelowerearningspersistence.Therefore,theresultsinbothDechowandDichev(2002)andXie
(2001)suggestthatreliabilityconcernsplayaroleinexplainingwhyextremeaccrualfirmshavelesspersistentearnings.
Twostudiesexaminetherelationbetween''accrualerrors''andpersistencebutdonotuse''abnormal''accrualsderivedfroma
model.Doyleetal.(2007a)examineviolationsundertheSarbanesOxleyActtoidentify''abnormalaccruals''withtheideathat
suchviolationsareindicatorsofmeasurementerrorandproblemswithaccruals.Theyfindthatfirmsthatdiscloseatleastone
materialweaknessduringthe20022005periodhavelesspersistentearnings.Richardsonetal.(2005)
26Returnbasedstudiesproviderelatedevidence.Subramanyam(1996)usesthemodifiedJonesmodeltomeasureabnormal
accrualsandfindsincrementalinformationcontentinabnormalaccruals,whichheinterpretsasevidencethatabnormalaccruals
arenotopportunisticbutthattheycommunicateprivateinformationaboutequityvalue.AlsousingthemodifiedJonesmodelto
measureabnormalaccruals,Chaneyetal.(1998)suggestthatdiscretionaryaccrualssmoothearnings,andtheyinterprettheir
findingasevidencethatdiscretionaryaccrualsarenotopportunisticbutthattheycommunicateinformationaboutthefirm'slong
term(permanent)earningstoequitymarkets.Subramanyam(1996)andChaneyetal.(1998)assumethatinvestorsareableto
isolatetheabnormalaccrualcomponent.Ifinvestorsarenaveandfixateonearnings,thenapositivestockpricereactioncould
bedocumentedeveniftheaccrualcomponentisnotvaluerelevant.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401361
arguethatoperatingassetsandliabilitiesarelessreliablymeasuredthanfinancialassetsandliabilities.Consistentwiththeir
predictions,theyfindthatworkingcapital(operating)accrualshavethelowestreliability,accrualsrelatedtofinancialassetsand
liabilitieshavethehighestreliability,andlongtermoperatingaccrualsareinthemiddle.Broadlyspeaking,theyfindapositive
relationbetweentheirexantereliabilityrankingsandreturnonassets.Takentogether,theresultsfromthesestudiessuggestthat
measurementandreliabilityconcernsplayanimportantroleinwhyextremeaccrualfirmshavelesspersistentearnings.
Second,investorsappeartorecognizethedistinctionbetweenabnormalaccrualsandnormalaccruals,buttheydonotfully
incorporatetheimplicationsintoprice.DeFondandPark(2001)findthatabnormalaccrualssuppressthemagnitudeofmarket
reactionstoearningssurprises,suggestingthatinvestorsdonotfindthemasreliableasnormalaccrualcomponents.However,
eventhoughinvestorsrealizethatabnormalaccrualsarelessreliable,theystilloverreacttotheinformation(ie,theabnormal
accrualcomponentisnegativelyassociatedwithfuturestockreturns).Xie(2001)findsthattheaccrualanomalyhedgereturnsare
strongerforhedgeportfoliosbasedonabnormalaccrualsmeasuredusingtheJonesmodel.
Third,researchthatexaminesthecompletepathfromadeterminantofabnormalaccrualstotheconsequencesforfuture
periodearningshavecometoadifferentconclusionthanmanystudiesthatindependentlystudythelinks.Consistentwithother
studies, Bowen et al. (2008) find an association between lax governance and abnormal accruals.27 Governance quality is
measuredbyanoverallgovernancescoreandbythe''usualsuspects''ofindividualgovernancecharacteristics.However,Bowen
etal.(2008)alsofindthattheaccountingdiscretionassociatedwithlaxgovernanceispositivelyrelatedtofutureperformance
(ROA),whichtheyinterpretasevidencethatabnormalaccrualsreflectfutureperformanceexpectations,notopportunism.
NotethatthepersistenceresultspresentedabovebyXie(2001)aresuggestiveofthecompletepathresultsdocumentedby
Bowenetal.(2008)relatedtofutureperformance.Alowercoefficientonabnormalaccrualsinaregressionsuchas1(b)or1(c)
doesnotimplythatabnormalaccrualsareofnorelevanceforpredictingfutureearningsorhavenorelevanceforvaluation.They
simplyimplythattheyarelessrelevantthanothercomponentsofearnings.Moreresearchofthistypewouldbeusefulto
distinguishthesourcesofaccrualqualityandhowtheyrelateacrossvariousearningsqualityproxies.
3.1.3.Earningssmoothness
Abasictenetofanaccrualbasedearningssystemisthatearningssmoothrandomfluctuationsinthetimingofcashpayments
andreceipts,makingearningsmoreinformativeaboutperformancethancashflows.Whiletheconceptsstatementsdonotstate
that''smoothness''isnecessarilyadesirablepropertyofearningsoranobjectiveoftheaccrualsprocess,SFACNo.1does
recognize that accrual earnings help mitigate problems associated with a ''mismatch'' of cash receipts and payments when
reportingaccountinginformationforfiniteperiods.Inaddition,SFACNo.1concludesthataccrualearningswillprovide''ya
betterindicationofanenterprise'spresentandcontinuingabilitytogeneratefavorablecashflowsthaninformationlimitedtothe
financialeffectsofcashreceiptsandpayments.''Thus,thestandardsetter'sgoalisarepresentationoffundamentalperformance
thatimprovescashflowpredictability.Smoothnessisanoutcomeofanaccrualbasedsystemassumedtoimprovedecision
usefulness;itisnottheultimategoalofthesystem.
Inassessingsmoothnessasameasureofearningsquality,wefirstdiscusstheconceptualabilityofsmoothnesstoreflect
decisionusefulnessabsentconsiderationofafirm'saccountingchoicesinapplyingthemeasurementsystem.Asnoted,the
standardsettershaveeffectivelymadethechoicetoestablishanaccrualsystemofaccountingratherthanacashbasedsystem.
Anunderlyingassumptionofthestandardsetter'schoiceisthataccrualearningsisabettermeasureoffundamentalperformance
thanisameasurementsystembasedoncashreceiptsandpayments.Theassumptionthataccrualbasedearningswillbeabetter
representationoffundamentalperformancethancashreceiptsandpaymentsseemsintuitiveformanybusinessactivities,butitis
justanassumption.Accrualsthatleadtosmoothnesscanhideordelaythemeasurementofchangesinfundamentalperformance,
whichpresumablywouldbedecisionusefulifrevealed.Thus,evenabsentaccountingchoicebyfirmswithrespecttoaccounting
methods,estimates,orrealactivities,smoothnessisnotadefactoindicationofgreaterdecisionusefulnessorhigherearnings
quality.
Thenextlayertoaddtotheassessmentofsmoothnessasameasureofearningsqualityistheimpactofafirm'saccounting
choices.28Empiricalstudiesaddresstwodistinctquestions.Thefirstquestionis:Whenmanagershaveaccountingchoicesthat
caninfluencesmoothness,dotheymakechoicesthatresultingreaterearningssmoothness?Thestudiesthataddressthisquestion
whicharestudiesofthedeterminantsofsmoothnessaregenerallyneutralaboutwhethertheresultingsmoothnessisdecision
useful.Theyexplorewhetheraccountingchoicesreflectagoalofsmoothness,butnotwhetheragoalofsmoothnesswould
improveearningsquality.Thefocusofthedeterminantsstudiesisonwhichchoicesfirmsmaketoachievesmoothnessandcross
sectionalvariationinthefirmsthatmakethesechoices.29Hence,theevidencefromthesestudiesonearningssmoothnessasa
proxyforearningsqualityisindirectatbest.
27Bowenetal.(2008)useanaggregateindexofaccountingdiscretion.Theuseofabnormalaccrualsisonecomponentofthe
index,alongwithameasureofaccrualbasedsmoothingandthetendencytoavoidnegativeearningssurprises.
28SeeLambert(1984),Demski(1998),andKirschenheiterandMelumad(2002)foranalyticalmodelsofsmoothingbehavior.
29See,forexample,White(1970),DascherandMalcom(1970),BarefieldandComiskey(1971),Barneaetal.(1976),
McNicholsandWilson(1988),Moses(1987),Dharan(1987),Chaneyetal.(1998),Hand(1989),andKanagaretnametal.
(2004).EarlydiscussionsandanalysesofsmoothingincludeBeidleman(1973)andRonenandSadan(1975).Intheearlystudies,
smoothingistreatedasaperiodspecificaccountingchoice,thusthesepapers
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401362
Thesecondquestionthattheliteratureaddresses,whichismorepertinenttoourunderstandingofsmoothnessasanindicationof
quality,iswhetherthesmoothnessofafirm'searningsreflectsvariationininformativenessaboutfundamentalperformance.On
theonehand,smootherearningsmaybemoreinformativeiftheaccrualbasedmeasurementsystemintheabsenceofchoiceand
thefirm'simplementationofanaccrualbasedsystem(bothofwhichinfluencesmoothness)betterreflectfundamental
performancethandoothersystemsorchoices.Ontheotherhand,afirm'saccountingchoicesmaybeopportunisticallymotivated
andmaynotimprovethedecisionusefulnessofearnings.30Thefindingsoftheconsequencesstudies,whichexaminetherelation
betweensmoothnessanddecisionoutcomessuchasequitymarketconsequences,shouldbeusefultoaddressthequestionof
informativenessandthereforetoassesssmoothnessasaproxyforearningsquality.Unfortunately,evidencefromthe
consequencesstudiesprovidesnoclearconclusion.Theproblemisthatcrosssectionalvariationinsmoothnesscanresultfrom
variationinthesmoothnessoffundamentalperformance(X),fromvariationintheabilityofanaccrualbasedaccountingsystem
absentanychoicetocapturefundamentalperformance,orfromvariationinaccountingchoice.Moreover,theaccountingchoice
canbemotivatedeithertoincreasedecisionusefulnessortodistortit.Thus,usingtheconsequencesstudiestounderstand
smoothnessasaproxyforearningsqualityrequiresdifferentiatinginherentorfundamentalsmoothnessfromsmoothnessrelated
toaccountingchoice,anddifferentiatinginformativechoicesfromopportunisticchoices,aseachelementwillhavedifferent
implicationsfordecisionusefulness.Giventhedifficultyofthismeasurementproblem,itisperhapsnotsurprisingthattherearea
fairlylimitednumberofconsequencesstudiesthatprovideevidenceonsmoothnessasameasureofquality.Intheend,whether
smoothnessindicatesgreaterdecisionusefulnessisverymuchanopenquestion.Furtherworkonmeasuringsmoothnessinaway
thatcandistinguishtheartificialcomponentofsmoothnesswillbenecessary.
Themajorityoftheevidenceontheconsequencesofsmoothness,whichmightbeusedtoassessitsuseasaproxyfor
earningsquality,isfromstudiesthatusecrosscountrydataandexaminevariationintheconsequencesofcountrylevelrather
thanfirmlevelmeasuresofsmoothness.Section4discussesthesestudies.Inthecrosscountrystudies,thecommonlyused
measures of earnings smoothness are a variant of the variability of earnings relative to cash flows from operations
(s(EARN)/s(CFO))andthecorrelationbetweenchangesinaccrualsandchangesincashflowsfromoperations(Corr(AACC,
ACFO)).Inbothcases,cashflowsmoothnessisthebenchmark.Thepresumptioninthecrosscountrystudiesisthatthecross
sectionalvariationinopportunisticcomponentofthesemetricsdominatesthevariationinthecomponentofsmoothnessthat
wouldmakeaccrualbasedearningsmoreinformativeaboutfundamentalperformance.Thus,inacrosscountrystudy,these
''abnormalsmoothness''measuresareassumedtobeaproxyforthedegreeofearningsmanagementacrosscountries.Consistent
withthispresumption,asdiscussedmorecompletelyinSection4,thebroadconclusionfromthecrosscountrystudiesisthat
smoothinglowersearningsqualitybasedonevidencethatitisassociatedwithpredicteddeterminantsoflowearningsquality
suchaslowqualitycountryGAAP,lessenforcement,orpoorshareholderrights(eg,Leuzetal.,2003).
In contrast, within US firms, the use of discretionary accruals to smooth earnings is associated with more informative
earnings,althoughthisconclusionisbasedononlytwostudiesandondifferentmeasuresofsmoothnessthanthoseusedinthe
crosscountrystudies.TuckerandZarowin(2006),forexample,concludethatsmoothnessimprovesearningsinformativeness
basedonananalysisthatsplitsfirmsintoahighsmoothinggroup,definedasfirmsthathaveastrongernegativecorrelation
betweendiscretionaryaccrualsandunmanagedearnings(totalearningsdiscretionaryaccruals),andalowsmoothinggroup.The
highsmoothinggrouphasgreaterearningsinformativeness,measuredastheextenttowhichchangesincurrentstockreturnsare
reflected in future earnings, following Collins et al. (1994). This result holds after various controls for the smoothness of
fundamentalperformance.Theirconclusionisthatthenetsmoothingeffectofaccrualaccounting,whichtheypredictwouldlead
togreaterinformativenessifaccrualssmoothnoisebuttoreducedinformativenessifmanagersartificiallysmoothearnings
relativetofundamentalperformance,istoimproveinformativenessandnottogarbleearnings(seealsoSubramanyam,1996).
Whiletheconsequencesstudiesdonotprovideaclearconclusionaboutsmoothnessasaproxyforearningsquality,theydo
leadustooneconclusion:inordertounderstandtheconsequencesofsmoothnessintermsofdecisionusefulness,wewillneed
smoothnessmeasuresthatbetterdistinguishartificialsmoothnessfromthesmoothnessoffundamentalperformance.Similarto
thecommentonaccrualsmodels,furtherdevelopmentofempiricalproxiestodistinguishartificialsmoothnessfrominformative
smoothnesswouldbeuseful.Thedevelopmentofmodelsof''normal''smoothnesslagsthedevelopmentofmodelsofnormal
accruals.Bettermodelscouldhelpustounderstandwhetherthemixedevidenceinthecrosscountrystudiesversusthestudiesof
USfirmsareduetoarealdifferencebetweenUSandnonUSfirmsorduetodifferencesintheabilityoftheempiricalproxies
forsmoothnesstodifferentiateartificialsmoothnessfrominformativesmoothness.
(footnotecontinued)typicallymeasuresmoothingasthenegativecorrelationbetweenaproxyforunmanagedearnings(eg,non
discretionaryaccruals),andthe''discretionaryaccrual''thatisbeingusedtosmoothearnings.Beidleman(1973),forexample,
measuressmoothnessasthedifferencebetweenreportedearningsand''normal''earnings,wherenormalearningsisanaverage
earningslevel,estimatedbasedonhistoricalearningsandaconstantgrowthrate.30Thedebateoverwhethersmoothness
improvesordiminishesdecisionusefulnessisrelatedtothelongrecognizedquestionoverwhetheraccountingchoicesmore
generallyaremotivatedbyopportunismorefficientcontracting(eg,ChristieandZimmerman,1994;Bowenetal.,2008).See
EwertandWagenhofer(2010)foradetaileddiscussionandanalysisofthecomplexeffectofsmoothingincentives,inparticular,
ontheinformativenessofearnings.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401363
3.1.4.Asymmetrictimelinessandtimelylossrecognition
Thissectiondiscussesearningsmeasuresthatseparatelydistinguishthetimelinessoflossrecognitionandprofitrecognition.
ThemostfrequentlyusedmeasureoftimelylossrecognitionisthereverseearningsreturnsregressionfromBasu(1997):
Earnings
t1
14a
0
a
1
D
t
b
0
Ret
t
b
1
D
t
Ret
t
e
t
,
whereD
t
=1ifRet
t
o0.Themodelassumesthatmarketsefficientlyreflectlossesinreturns(Ret)whensuchlossesareincurred.
Ahigherb
1
impliesmoretimelyrecognitionoftheincurredlossesinearnings(seeExhibit1).Basu(1997)providesa
secondmeasureoftimelylossrecognitionthatisnotbasedonreturns
ANI
t
14a
0
a
1
NEGDUM
t1
a
2
ANI
t1
a
3
NEGDUM
t1
ANI
t1
e
t
,
whereANI
t
isthechangeinincomefromyeart1tot,scaledbybeginningbookvalueoftotalassets,andNEGDUM
t1
is
anindicatorvariableequaltooneifANI
t1
isnegative.Ifbadnewsisrecognizedonamoretimelybasisthangoodnews,
negativeearningschangeswillbelesspersistentandwilltendtoreversemorethanpositiveearningschanges.Thistranslatesinto
apredictionthata
3
o0,andBasu(1997)findssupportforthisprediction.Webeginthissectionwithadiscussion
ofmeasurementissuesassociatedwiththeasymmetrictimelinessmeasures(Section3.1.4.1).Wethenturntothemoresalient
discussionofasymmetrictimelinessasaproxyforearningsquality(Section3.1.4.2).Animportantdistinctionoftheevidencein
thissectionisthatourdatabasedoesnotcontainanypapersthatwewouldclassifyasstudiesofthe''consequences''of
asymmetrictimeliness.Asnotedabove,themostcommonmeasureofasymmetrictimelinessisareturnbasedmeasureinwhich
returnsaregenerallyassumedtoprecedetherecognitionoflossesinearnings.Nostudiesusedthereturnbasedmeasureto
captureothercapitalmarketconsequencesinfutureperiods.Whiletherearenoconsequencesstudies,onesubsetofthe
determinantsstudiesprovidesevidenceonwhetherasymmetrictimelinessisdecisionusefultocapitalmarketsbyshowinga
correlationbetweenasymmetrictimelinessandvariablesthatproxyforinvestordemandforasymmetrictimeliness.Assuming
thatthedegreeofasymmetrictimelinessinafirm'searningsiscontrollablebymanagers,atleastinpart,andthatmanagers
rationallyrespondtodemandthroughtheirreportingchoices,thecorrelationbetweendemandandasymmetrictimeliness
suggeststhatasymmetrictimelinessisdecisionuseful.Demandforasymmetrictimelinessisdiscussedalongwiththeother
determinantsinSection3.1.4.2.
3.1.4.1.Measurementissues.Ameasurementconcernwithreturnbasedasymmetrictimelinessmeasuresisthattheyspeaktothe
abilityofreturnstoreflectvaluerelevantinformationinadditiontothequalityofearningsforequityvaluation.Thereturnbased
timelylossrecognitionmeasuresassumemarketefficiency.31Hence,variationinasymmetrictimelinesscouldbeevidenceof
variationinthe''quality''ofthereturngeneratingprocess,ratherthanvariationinearningsquality,acrossregimeswithdifferent
standards,incentives,andenforcement.Thatis,theextenttowhichpricesreflectinformationmaynotholdequallywellacross
firms(orcountries)withinasample,whichcreatesaclassicomittedcorrelatedvariableproblem.
A second measurement issue associated with a returnbased EQ proxy is that returns reflect all information, not just
informationinearnings.Ifaccountingpracticesthatresultinmoretimelylossrecognitioninearningsarecorrelatedwiththe
productionordisseminationofalternativeinformationsources(eg,GiglerandHemmer,2001;Givolyetal.,2007),thenareturn
basedmeasureofasymmetrictimelinesscapturesasymmetrynotonlyinfinancialreportingbutalsoininformationavailability.
Theassumptionthatreturnsprovideanequalrepresentationoftimelylossrecognitionisespeciallyproblematicincrosscountry
studieswherevariationinmarketstructuresandinformationflowaresignificant.Researchersrecognizethisissueandattemptto
controlforcountryleveldifferences,32butitstillposesasignificantchallengetostudiesthatusereturnbasedproxiesfor
quality.
Severalrecentpapersdiscussmeasurementissuesassociatedwiththe''timelyloss''coefficient.Dietrichetal.(2007)suggests
thatthereverseregressionmeasureisbiased.Ryan(2006)questionsthemagnitudeofthebiasbutalsoprovidessomepossible
solutions.33SeealsoGivolyetal.(2007),Beaveretal.(2008),andPatatoukasandThomas(2010).Sincethepublicationof
Dietrichetal.(2007),inparticular,asacriticismofthereverseregressionmeasureofasymmetrictimeliness,theuseofBasu's
alternative''tendencytoreverse''measurehasincreased.Thetendencytoreversemeasurehasbeenusedinsomepaperswhen
equityreturnsarenotavailable(eg,BallandShivakumar,2005),anditisusedinotherpaperstochecktherobustnessofthe
results.
3.1.4.2.Evidenceontimelinessasaproxyforearningsquality.Wefirstsummarizethestudiesthatexamineaccountingstandards
andenforcement,eitherinternalorexternal,asdeterminantsofasymmetrictimeliness.Lossrecognitionismore
31Amarketefficiencyassumptionalsoinvolvesawellknownphilosophicalconundrum:ifmarketpricesreflectinformation,
thenthe''quality''oftheinformationitsdecisionusefulnessisirrelevant,atleasttoequityvaluationdecisions.
32Balletal.(2003)emphasizethebenefitsoftheirsample,whichincludesfirmswithinEastAsia,tomitigatetheconcern
thatcrosscountryvariationinERCsreflectsvariationinthereturngeneratingprocessratherthandifferencesinearningsquality.
33Ryan(2006)includesadiscussionofmeasurementissuesassociatedwiththereverseregressionmeasure,butmore
generallyprovidesarecentandthoroughreviewoftheliteratureonconservatism.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401364
timelyincommonlawthancodelawcountries(Balletal.,2000,BKR)andforfirmsthatuseIAS(Barthetal.,2008).34Francis
andWang(2008)findthatthepositiveassociationbetweencommonlawcountries,whichispositivelycorrelatedwithinvestor
protection,andtimelylossrecognitionishigheronlyforfirmswithBigfourauditors.GarcaLaraetal.(2009)findapositive
association betweentimely lossrecognition andgovernance characteristicscommonly associatedwith effectivemonitoring.
ChungandWynn(2008)findthatD&OliabilityinsurancecoverageforCanadianfirmsisnegativelyassociatedwithtimelyloss
recognition.Onepaperprovidesnegativeevidence:withinasampleofUSfirms,Ruddocketal.(2006)findnorelationbetween
nonauditservices,whichcouldimpedeindependenceandreduceauditormonitoring,andtimelylossrecognition.Thesestudies
usetheBasu(1997)reverseregressiontomeasuretimelylossrecognition;ChungandWynn(2008)andGarcaLaraetal.(2009)
additionallychecktherobustnessoftheresultstotheuseoftheBasu(1997)tendencytoreversemeasure.
Whilethefindingsofthesestudiesareimportant,theiruseinassessingasymmetrictimelinessasaproxyforearningsquality
islimited.Thesestudiesareajointtestofthehypothesesaboutwhichmethodsorenforcementmechanismsproduceamore
decisionusefulnumberandoftheassumptionthatasymmetrictimelinessisadecisionusefulfeatureofearnings.Underthe
assumptionthatproducingahighqualityearningsnumberisthegoalofaccountingstandardsetters(orauditors,principals,or
lawmakers),theresultssuggestthattimelylossrecognitionistheoutcomeofaprocessmeanttoproduceadecisionuseful
number.However,thisconclusionaboutasymmetrictimelinessasaproxyforearningsqualityissubjecttothestrongassumption
thatthesepartieshavethegoalofproducingahighqualityearningsnumber.
Thefinalgroupofdeterminantsstudiesismoreusefulforassessingasymmetrictimelinessasaproxyforearningsquality.
Four studies provide evidence that proxies for equity market demand for decision useful earnings are a determinant of
asymmetric timeliness. Ball and Shivakumar (2005), using the Basu (1997) tendencytoreverse measure, find that loss
recognitionismoretimelyinUKpubliccompaniesthaninUKprivatecompanies.Balletal.(2008),usingtheR2andb
1
coefficientestimatefromtheBasu(1997)reverseregression(asinBKR),findthatlossrecognitionismoretimelyforfirmsin
countrieswithgreaterprominenceofdebtmarketsrelativetoequitymarkets.Balletal.(2003),alsousingtheBKRmetrics,find
thatEastAsiancountries,whichshareacommonlaworiginbutareassertedtohavelowerequitycapitalmarketsincentives,do
nothavemoretimelylossrecognitionthancodelawcountries.Thedifferencesintimelylossrecognitionwithincountries(or
regions)withthesamestandardsorlegaloriginsuggestthattimelylossrecognitionhasanendogenouscomponentrelatedto
firms'reportingincentives.Itisnotdrivenpurelybyacountry'saccountingsystem.Paeetal.(2005),alsousingtheBKRmetrics,
findthatfirmlevelpricetobookratiosareadeterminantoftimelylossrecognitionandthatthenegativeassociationiscorrelated
withtheaccrualcomponentofearnings.Takentogether,allfourstudiessuggestthattimelylossrecognitionhasanendogenous
componentrelatedtofirms'reportingincentives,primarilyequityincentives.Thus,assumingthatmanagersarerespondingto
investordemandfordecisionusefulness,thesestudiessuggestthatequitymarketsperceiveasymmetrictimelinessasimproving
earningsquality.35
Weofferafinalcaution.Thefindingsinstudiesofequitymarketdemandasadeterminantofasymmetrictimelinessimply
onlythatequitymarketsperceiveasymmetrictimelinessasimprovingearningsquality.Theycannotspeaktowhetherequity
markets should demand timely loss recognition. That is, they do not provide evidence on whether asymmetric timeliness
improvesdecisionoutcomes.Thislatterquestionisrelatedtotheongoingdebateaboutaccountingconservatism.Amoretimely
recognitionoflossesisoftenassociatedwithaconservativeaccountingsystem(Basu,1997;PopeandWalker,1999).Studies
distinguish conditional conservatism, which is more timely recognition of bad news than of good news in earnings, from
unconditionalconservatism,whichdescribesanexantepolicythatresultsinlowerbookvaluesofassets(higherbookvaluesof
liabilities)intheearlyperiodsofanassetorliabilitylife.36Whetherunconditionalconservatismincreasesordecreasesthe
decisionusefulnessofearningsisacontroversialissue(seeWatts,2003a,2003b;Givolyetal.,2010;Armstrongetal.,2010a).
3.1.5.Targetbeating
Researchershavedocumenteda''kink''inthedistributionofreportedearningsaroundzero:astatisticallysmallnumberof
firmswithsmalllossesandastatisticallylargenumberoffirmswithsmallprofits(Hayn,1995;BurgstahlerandDichev,1997).
Acommon(butcontroversial)interpretationofthispatternisthatfirmswithunmanagedearningsjustlessthantheheuristic
targetof''zero''(ie,firmswithsmalllosses)intentionallymanageearningsenoughtoreportasmallprofit.Basedonthisfinding,
earningsmeasuressuchassmallprofitsandsmalllossavoidancehavebeenidentifiedasanindicationofearningsmanagement,
asonespecificdimensionofearningsquality.Similarly,researchershaveproposedthatsmallearningsincreasescouldindicate
earnings management based on a statistically unusual number of firms with small decreases in earnings documented by
BurgstahlerandDichev(1997)andthatmeetingorbeatingananalystforecast
34Balletal.(2000)alsofindthatUKearningsarelesstimelythanUSearningsinincorporatingeconomiclosses.Popeand
Walker(1999),however,suggestthatthisresultissensitivetotheconsiderationofextraordinaryitems.Theyfindthatearnings
afterextraordinaryitemsintheUKaremoretimelythanUSearnings.
35ArelatedpaperbyGuentherandYoung(2000)suggeststhatearningsqualityisdemanddrivenandthatinstitutional
factors such as the legal system and tax conformity affect earnings quality. They operationalize earnings quality as the
associationbetweencrosssectionalaveragereturnonassetsinacountryanditsrealeconomicgrowthasmeasuredbythe
percentagechangeinacountry'srealGDP.TheydocumentthatthisassociationishighintheUK,USandJapan,andlowin
FranceandGermany.
36Basu(1997)usestheterm''conditional''todescribehismeasureofconservatism,buthedoesnotspecificallycallit
''conditionalconservatism.''
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401365
isanindicationofearningsmanagementbasedonthe''kink''inthedistributionofforecasterrors:reportedearningsless
consensusanalystforecasts(eg,Degeorgeetal.,1999).
ThestudiesthatexaminethedeterminantsoftargetbeatingarediscussedinSection3.1.5.1.Thedeterminantsstudiesprovide
evidenceonwhethertargetbeatingrepresentsearningsmanagementbyexaminingwhethertargetbeatingiscorrelatedwith
variablesthatalsoarecorrelatedwithearningsmanagement,primarilytheincentivesandopportunitiestomanageearnings.The
studiesthatexaminetheconsequencesoftargetbeatingarediscussedinSection3.1.5.2.Theconsequencesstudiesprovide
evidenceonwhethertargetbeatingrepresentsearningsmanagementbyexaminingwhethercapitalmarketresponses(andanalyst
behavior)areconsistentwithearningsthatmeetorbeattargetscontainingamanagedcomponent.
TosummarizethemoredetaileddiscussionsinSections3.1.5.1and3.1.5.2,findingsonwhethersmallprofitsandsmallloss
avoidancerepresentearningsmanagementbasedontheobserveddeterminantsismixed,whichissuggestivethatsmallprofits
andsmalllossavoidancemaynotbeanindicationofearningsmanagement.Thisindirectevidenceissupportedbymoredirect
evidenceincludingDechowetal.(2003),whoshowthatdiscretionaryaccrualsarenodifferentforsmallprofitversussmallloss
firms;Beaveretal.(2007),whosuggestthatthe''kink''inearningsaroundzerocanbeexplainedbyasymmetrictaxes,ratherthan
opportunisticchoices;andDurtschiandEaston(2005,2009),whoshowthatitisexplainedbystatisticalandsamplebiasissues
related to scaling by price. The indirect evidence on whether meeting or beating analyst forecasts represents earnings
management,basedonboththeobserveddeterminantsandtheobservedconsequences,issomewhatmorepersuasive.Moreover,
incontrasttotheliteratureonthekinkaroundzero,nostudiesinourdatabaseprovideevidenceinsupportofanyalternative
explanationtotheearningsmanagementexplanationforthekinkaroundtheconsensusanalystforecast.Inaddition,conflicting
evidence(discussedbelow)onthequarterlypatternsinthekinkaroundzeroandinthekinkaroundtheconsensusanalyst
forecast also suggests that small profits and small loss avoidance and meeting or beating analyst forecast targets are not
measuringthesameconstruct.
Thetotalityoftheevidenceindicatesthattheuseofsmallprofitsasaproxyforearningsmanagementmoregenerallyis
unsubstantiated.Anadditionalimportantcaveattotheuseoftargetbeatingasaproxyforearningsmanagementisthatmeeting
orbeatingatargetisacensoredmeasureofearningsmanagementiffirmsareconstrainedintheirabilitytomanageearnings
(BartonandSimko,2002).
3.1.5.1.Determinantsoftargetbeating.Studiesonwhethersmallprofitsandlossavoidancerepresentearningsmanagement,
motivatedbytheobservedkinkinearningsaroundzero,providemixedevidence.Dechowetal.(2003)inalargesamplestudy
findthatdiscretionaryaccrualsaresimilarinboththesmallprofitgroupandthesmalllossgroup.Iffirmsweremanaging
earningsuptoavoidaloss,discretionaryaccrualsareexpectedtobehigherinthesmallprofitgroup.Studiesofspecificaccruals,
however,findevidenceofanassociation.Beaveretal.(2003)findthatsmallprofitsareassociatedwithearningsmanagement
basedoncorrelationsbetweensmallprofitsanddiscretionarylossreservesatP&Cinsurers,andPhillipsetal.(2003)findthat
deferredtaxexpenseisusefulindetectingearningsmanagementtomeetbenchmarkssuchasavoidinglosses.Smallpositive
profitsalsoareassociatedwithgreaterincentivesforearningsmanagementinthefourthquarter(KersteinandRai,2007;Jacob
and Jorgensen, 2007)and withgreater opportunitiesfor earningsmanagement becauseof lowaudit effort(Caramanis and
Lennox,2008)orbecauseoftheavailabilityofaggressiverevenuerecognitiontechniques(Altamuroetal.,2005).
Evidencethatearningsarelikelymanagedwhenfirmsjustmeetorbeatanexternaltarget(ie,ananalystforecast)ismore
persuasive.Thisliteratureincludesthreetypesofanalyses.Thefirsttypeofanalysisshowsthatthemechanisms/toolsthatfirms
usetoproduceearningsthatjustmeetorbeatatargetareconsistentwithearningsmanagement.Firmsmakeaccountingchoices
suchasmanagingtaxexpense(Dhaliwaletal.,2004),managingtheclassificationofitemswithintheincomestatement(McVay,
2006),andmanagingthecreationandreversalofrestructuringchargeaccruals/cushions(Moehrle,2002).Moregenerally,Ayers
etal.(2006)findsomeevidenceconsistentwithanassociationbetweendiscretionaryaccrualsandmeetingorbeatinganalyst
forecastsandreportingsmallearningsincreases.Firmsalsomakerealdecisionstomeetanalystforecastssuchasrepurchasing
stock(Hribaretal.,2006),sellingfixedassetsormarketablesecurities(Herrmannetal.,2003),orrepurchasingshares(Benset
al.,2003).
Thesecondtypeofanalysisfindsarelationbetweentargetbeatingandfirms'equitymarketincentivestomeetorbeatatarget,
whereequitymarketincentivesderivefromtheownershipstructureofthefirm(Matsumoto,2002;Beattyetal.,2002)or
managers' compensation/stockownership (Chengand Warfield, 2005;McVay etal., 2006). Abarbanelland Lehavy(2003)
indirectlylinkearningsmanagementactivitiestoequitymarketincentives,assumingthatanalyststockrecommendationsrather
thanmeetingorbeatingaforecastmeasureincentives.
Thethirdtypeofanalysisfindsarelationbetweentargetbeatingandfirms'opportunitiestomeetorbeatatarget.Frankelet
al.(2002)documentacorrelationbetweentargetbeatingandlowerauditquality,andBrownandPinello(2007)documentthat
smallnegativeanalystforecasterrorsaremoreprevalentininterim(unaudited)quarters.TheBrownandPinello(2007)finding
ofastrongerkinkinthedistributionofearningsaroundtheconsensusanalystforecastininterimquartersconflictswiththe
previouslydiscussedevidenceofastrongerkinkaroundzerointhefourthquarter(KersteinandRai,2007;JacobandJorgensen,
2007).Thefirststudysuggeststhatbecauseearningsmanagementopportunitiesaregreaterininterimquarters,thequarterly
patterninthekinkaroundtheconsensusanalystforecastimpliesthatsmallnegativeanalystforecasterrorsrepresentearnings
management.Thelattertwostudiessuggestthatbecauseearningsmanagement
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401366
incentivesaregreaterinthefourthquarter,theoppositequarterlypatterninthekinkaroundzeroimpliesthatsmallprofits
representearningsmanagement.
Insummary,unlikesmallprofits,meetingorbeatinganalystforecastsisconsistentlyassociatedwithpredicteddeterminants
ofearningsmanagementbehavior.Ourinterpretationoftheconsistencyoftheevidenceisthatthisvariableisamorereliable
indicatoroftheearningsmanagementdimensionofearningsqualitythanaresmallprofits.Thisconclusion,however,comeswith
threeimportantcaveats.First,ifopportunitiesareconstrainedbecausenetassetvaluesarealreadyoverstated,targetbeatingis
moderated(BartonandSimko,2002).Inotherwords,meetingorbeatingatargetisacensoredmeasureofearningsmanagement.
Second,theanalystforecasttargetcanbemanaged(Matsumoto,2002).Finally,whilesomeevidenceshowsarelationbetween
discretionaryaccrualsandmeetingorbeatinganalystforecasts,firmscanbemanagingearningsupordowntomeetconsensus
forecasts,whichposesachallengetoresearchersattemptingtolinkthetwoactivities.Itwouldbeusefultohavemoreevidence
onwhethersmallforecasterrorssuggestearningsmanagement.
3.1.5.2.Consequencesoftargetbeating.Theconsequencesstudiesgenerallysupporttheconclusionthatmeetingorbeatingan
analystforecastmaybeanindicationofearningsmanagement,butthereissomecontradictoryevidencethatprovidesseveral
importantcaveatstothisgeneralconclusion.Thecontradictoryevidenceisasfollows.Bhojrajetal.(2009)findthatfirmsthat
just beat analyst forecasts by using accruals or by cutting discretionary expenses experience shortterm stock performance
improvement.Assumingthattheaccrualsadjustmentsdiminishquality,andassumingmarketefficiency,theseresultssuggest
thatthemarketdoesnotviewtargetbeatingasevidenceofearningsmanagement.Bartovetal.(2002)documentapremium(a
highercontemporaneousquarterlyreturn)associatedwithmeetingorbeatinganalystforecasts,againsuggestingthatthemarket
doesnotviewtargetbeatingasevidenceofanerosionindecisionusefulness,butrathermayviewitasanoutcomeofefficient
contracting.AbarbanellandLehavy(2003)andBurgstahlerandEames(2003)suggestthatanalystsdonotdetect/anticipate
earningsmanagementtomeetorbeattargets,althoughanalternativeexplanationforthesefindingsisthatthecomplicated
incentivesofanalystscausethemtoignoreearningsmanagement(Libbyetal.,2008).
Indefenseoftargetbeatingasanindicationofearningsmanagement,however,GleasonandMills(2008)showthatwhentarget
beatingisassociatedwithdecreasesintaxexpense,thepositivemarketconsequencesoftargetbeatingarediminished.One
interpretationofthisresult,incontrasttothecontradictoryevidencecitedabove,isthatspecificallybeatingatargetbymanaging
taxexpenserepresentsdiminishedquality,whileothermechanisms(eg,accruals)donotdiminishearningsquality.Another
interpretationofthisresultassumesthattaxexpensedecreasesareamoreobviousanddetectableformofearningsmanagement.
Inthiscase,thefindingsofGleasonandMills(2008)suggestthattargetbeatingisanindicationofearningsmanagement,andthe
presumedcontradictoryresultsinotherstudies(ie,Bhojrajetal.,2009;Bartovetal.,2002;AbarbanellandLehavy,2003;
BurgstahlerandEames,2003)areduetoanerrantassumptionofmarket(oranalyst)efficiency.Inaddition,whilethereissome
contradictoryevidencethatbeatingexternaltargetssuchasanalystforecastsrepresentsearningsmanagementonaverage,studies
providecompellingevidencethatconsistentlymeetingtargetsisimportant.KasznikandMcNichols(2002)findthatmeetingor
beatingearningsexpectationsbasedonanalystforecastsonanadhocbasisdoesnotleadtohighervaluations,butthatmeetingor
beatingregularlydoes.Similarly,stringsofearningsincreasesrelativetotheprioryearorrelativetothesamequarteroftheprior
yearreceiveapricepremium(Barthetal.,1999;Myersetal.,2007).37Assumingthatmarketparticipantsassignahigher
probabilitythatearningsaremanagedwhenforecastsaremetonanadhocbasis,theseresultsimplythatadhoctargetbeatingis
agoodproxyforearningsmanagement.
Finally, only one study addresses the market consequences of small profits or small loss avoidance, which limits the
conclusionswecandrawabouttheuseofthesemeasuresasproxiesforearningsquality.Bhattacharyaetal.(2003b)showthat
lossavoidanceisassociatedwithahigheraveragecostofequityandalowerleveloftrade.Whilethisevidencesupportsthe
assertionthatlossavoidancediminishesquality,weemphasizethataconclusionbasedononestudyispremature,especially
giventhemixedevidencefromthedeterminantsstudies.
3.2.Investorresponsivenesstoearnings
Theinvestorresponsivenesstoearningscategoryincludesstudiesthatexamineanearningsresponsecoefficient(ERC),most
oftenshortwindow,ortheR2fromtheearningsreturnsmodel,asameasureofinvestorresponsivenesstoearnings,38andthe
studiesexplicitlystate(oratleaststronglyimply)thatinvestorresponsivenesstoearningsisadirectproxyforearningsquality
(orforearningsinformativeness).TheresearcherscommonlyciteHolthausenandVerrecchia(HV)(1988)asthetheoreticalbasis
forthisassertion.ThestudiesthattesttheoriesofthedeterminantsandconsequencesofERCs,themostcommonempirical
measure of investor responsiveness, can provide evidence on the use of the ERC as a proxy for earnings quality, but the
conclusionsaresubjecttothecaveatthatthesupportingevidencecomesfromajointtestoftheunderlyingtheoryandwhether
theERCmeasuresinformativeness(ie,earningsquality).LiuandThomas(2000)
37Neitherstudyaddresseswhetherthestringsareachievedbyartificialsmoothing.38Weusetheterms''investorresponsiveness
toearnings,''''earningsresponsecoefficient,''and''ERC''interchangeably.SeeExhibit1fortheregressionmodelcommonlyused
toestimateearningsresponsecoefficients(ERCs).
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401367
isanimportantanddistinctstudythatprovidesmoredirectevidenceonERCsasaproxyforearningsquality.WediscusstheLiu
andThomasstudyinSection3.2.1.
It should not be surprising that a returnbased earnings response coefficient is used as a measure of earnings quality.
BeginningwithBeaver(1968)andBallandBrown(1967,1968),academicaccountingresearchershaveusedequitymarket
responsestoearningstoinferquality.39Becausethesestudiesshowthatearningsnewsiscorrelatedwithvariousequitymarket
attributes(longwindowreturnsandvolumeandvolatilitychangesaroundearningsannouncements)thatresultwheninvestors
changetheirequityvaluations,theauthorsconcludethatinformationinearningsiscorrelatedwiththeinformationusedby
investors in their equity valuation decisions. The use of equity markets to infer earnings quality was clearly an important
developmentintheliterature,butitisworthemphasizingthatthesestudiesspeakonlytothedecisionusefulnessofearningsin
equityvaluation.Whethertheresultshaveimplicationsforthe''qualityofearnings''tootherdecisionusers(suchascompensation
committeesorbondholders)isindeterminatefromthesestudies,andwecautionthattheresultsmaynotbegeneralizableto
decisionsotherthanequityvaluations.
3.2.1.DirectevidenceonERCsasaproxyforearningsquality
LiuandThomas(2000)providemoredirectevidenceontheERCasaproxyforearningsqualityrelativetothestudiesonthe
determinantsofERCs.Infact,LTspecificallystatethattheERCcanbeviewedasameasureofearningsquality(p.73).They
predictandfindthattheobservedERC(coefficientestimate)andtheR2oftheERCregressionarehighwhenthecorrelation
betweenunexpectedearningsandforecastrevisionsishigh.Unexpectedearningsismeasuredasactualearningsfortminusthe
forecastofperiodtearningsint1,andearningsforecastrevisionsforfutureperiodsaremeasuredusinginformationavailableat
timet.Thus,whencurrentperiodunexpectedearningsareinformativetoanalystsinthattheycauseaforecastrevision,whichLT
suggestmeansthatwhentheearningsareofhigherquality,theERCisalsohigher.However,LTalsorecognizethatthedegree
towhichtheERCcapturesdecisionusefulnessissensitivetothedegreeofheterogeneityinthecorrelationbetweenunexpected
earningsandforecastrevisionswithinthesample,andtheyattributelowvaluesoftheregressionR2tothisheterogeneity.Hence,
samplespecificcharacteristicsthataffectwithinsampleheterogeneity,suchasgrowth,areimportant.
WhileLTconcludethattheERCisameasureofquality,itisimportanttorememberhowtheyqualifythisconclusion.The
LTdefinitionof''quality''isoveralldecisionusefulnessforequityvaluation.Theycannotcommentonanyspecificdimensionsof
quality,suchaswhetherqualityiserodedduetoearningsmanagementorduetolowpersistenceoffundamentalperformance.
Hence,LT'sconclusionabouttheERCasameasureofearningsquality,broadlydefined,shouldnotbeconstruedtomeanthat
theERCisanappropriateproxytotestpredictionsaboutalldeterminantsorconsequencesofspecificdimensionsofquality.LT's
conclusionthattheERCisameasureofqualityisalsosubjecttotheircaveatregardingtheimportanceofsamplespecific
characteristicsthataffectwithinsampleheterogeneityinthecorrelationbetweenunexpectedearningsandforecastrevisions
withinthesample,suchasgrowth.
3.2.2.IndirectevidenceonERCsasaproxyforearningsqualitybasedondeterminants
Investorresponsivenesstoearnings,commonlymeasuredbyERCs,hasbeenusedtotestavarietyofpredictionsaboutthe
determinantsofearningsinformativenessincludingtheeffectsofaccountingmethods,auditorqualityandgovernance,firm
fundamentals,andleverage.Tohelpthereaderputtheresultsoftheliteratureincontext,wefirstprovideanoverviewofthe
majorfindings.WethendiscussourviewabouttheimplicationsofthesestudiesforERCsasaproxyforearningsquality.
3.2.2.1.Accountingmethods.Fivepapersexaminethecrosssectionalorlongitudinalrelationbetweenearningsmeasuredunder
alternativeaccountingmethodsandtheresultingERCs.40TheideaisthatamorepositivecorrelationwiththeERCindicatesthat
amethodismore''informative''or''useful''toinvestors.Oneapproachtocomparinginvestorresponsivenessacrossmethodsisto
exploitaregimeshiftfromonemandatorymethodtoanother;however,thisapproachissubjecttoconcernsaboutomitted
correlatedvariablesandtheendogeneityofthestandardsetter'sdecisiontomandatenewaccountingrules.Anotherapproachisto
conductacrosssectionalcomparisonoffirmsthatmakedifferentmethodchoices;however,thesestudiesrequireadifferences
indifferencesapproachorotherdesigntocontrolforendogeneityofthemethoddecision.Thesecaveatsaside,someofthe
choicesthathavebeenexaminedare:revenuerecognitionpreversuspostSAB101(Altamuroetal.,2005);R&Dcapitalization
versusexpensing(LoudderandBehn,1995);foreigncurrencytranslationgainsandlossesunderSFASNo.52(Collinsand
Salatka,1993);andcombinationsofincomeincreasingmethodsincluding,forexample,accountingchoicesrelatedtoinventory,
depreciation,investmenttaxcredits,
39Priortothesestudies,academicaccountingresearchfocusedonevaluatingthe''qualityofearnings''intermsofconformity
toaconsistentmeasurementsystemorconceptualframework. Muchofthedebatefocusedonwhetherearningsshouldbe
measuredusinghistoricalcostwithmatching(eg,Daines,1929;Littleton,1956;PatonandLittleton,1940),replacementcostor
entryvalues(eg,Sterling,1970),futurediscountedcashflows(eg,Fisher,1907,1930),ornetrealizablevaluesorexitcosts(eg,
Chambers,1956,1965).
40 Early papers examined differences in market responses to earnings measured under different accounting methods
(Mlynarczyk, 1969; Gonedes, 1969; Ball, 1972; Cassidy, 1976), with a general notion of exploring the degree of market
efficiency.Theydidnotassertthattheearningsnumberunderonemethodoranotherwasmoredecisionuseful.Rather,they
assumedthatbothearningsnumbersweredifferentrepresentationsofthesamefirmperformance,andtheresearchquestionwas
whethermarketsunderstoodthis.Thesestudiesgenerallydidnotcontrolforendogeneityofmethodchoice.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401368
andleases(DharanandLev,1993;Pincus,1993).41Hanlonetal.(2008)findthatfirmsthatswitchtoaccrualbasedaccounting
fortaxreportinghaveadecreaseinearningsinformativenessofbookearnings,suggestingthatdiscretionisusedtoreportless
informativeearnings.
TwostudiessuggestthatchangesinaccountingmethodsmayexplaindecliningERCsforUSfirmsovertime.42Levand
Zarowin (1999) suggest that conservatism in accounting standards associated with intangible assets and the increase in
intangibleintensivefirmsexplaindecliningERCs.GivolyandHayn(2000)suggestasanexplanationtheincreaseinfairvalue
accounting(egassetimpairmentsandtherecognitionofpensionliabilities),whichresultsintherecognitionofmoretransitory
lossesinearnings.
3.2.2.2.Auditorqualityandgovernance.Researchonauditorsasadeterminantofearningsinformativenessismotivatedbythe
assumptionthatauditorsprovideausefulservicethatis''demanded''byinvestors.Animplicationisthathigherauditquality
shouldprovidegreatercredibilitytothefinancialstatements.Ifthisisthecase,thenholdingeverythingelseconstant,better
auditswillbeassociatedwithhigherERCs.Withrespecttoauditors,TeohandWong(1993)reporthigherERCsforfirmswith
Big8auditors,whichtheyuseasameasureofauditquality.FrancisandKe(2006)findthatnonauditfees,whichtheyassert
indicatelowerindependence,arenegativelyrelatedtoERCs.HackenbrackandHogan(2002)findthattheaverageshortwindow
(2day)ERCforthetwoannualearningsannouncementsafteranauditorchangeislowerthantheERCforthetwoannualpre
change earnings announcements. Possible interpretations of this result are that the credibility of the financial statements
decreasedbecausethechangeresultedinlowerfeesbeingpaidtothenewauditor,whichsuggestslesseffectiveauditing;orthat
thechangerevisedinvestorbeliefsaboutthefirm'scommitmenttoqualityfinancialreporting.Theyalsoshowthattheaverage
ERCishigherforfirmsthatswitchforreasonsthattheauthorsclassifyasservicerelated.Thisresulthelpsidentifythedecrease
inERCsasevidencethatconflictrelatedswitchesinfluenceearningsinformativeness.Manryetal.(2003)reportthatquarterly
returnshaveastrongerassociationwithcontemporaneousearningslevelsforfirmsthathavetimelyauditorreviewsoftheir
interimearnings,buttheyhaveastrongerrelationwithlaggedearningsforfirmsthathaveretrospectiveauditorreviews.43
Withrespecttogovernance,thehypothesesarebasedontheassumptionthatbettergovernanceleadstoincreasedreliability
andcredibilityofthefinancialstatements,whichwillresultinhigherERCs.UsingbothshortandlongwindowERCs,Franciset
al.(2005b)findthatearningsarelessinformativeforfirmswithdualclassshares.Furtheranalysissuggeststhatmarketsviewthe
earningsoffirmswithadualclassstructureaslesscredibleprimarilybecauseoftheseparationofvotingrightsfromcashflow
rights,althoughthefirmswithdualclasssharesalsotendtohavegreatermanagerialownership.UsinglongwindowERCs,
Wang(2006)findsapositiveassociationbetweenfoundingfamilyownershipandearningsinformativeness,measuredasthe
regressioncoefficientinanannualreturnsearningsmodel.44
3.2.2.3.Firmfundamentals.ThereisverylittleevidenceonfirmfundamentalsasadeterminantofERCs.Aseriesofearlypapers
followingBallandBrown(eg,KormendiandLipe,1987;CollinsandKothari,1989)showthatERCsarepositivelyrelatedto
earningspersistence.Themotivationforthisresearchisanassumptionthatmorepersistentearningshavegreaterimplicationsfor
expectedfuturecashflowsassociatedwiththefirm'sfundamentalperformance.Thefindingsareconsistentwiththisassumption,
onaverage,inlargesamples.AsdiscussedextensivelyinSection3.1.1,however,theassumptionthatpersistenceisaproxyfor
fundamentalperformanceissubjecttoimportantcaveats.Forexample,persistencecanbemanaged,makingitlessinformative
aboutfundamentalperformance.Inaddition,growthmaybenegativelyassociatedwithpersistence,butearningsmaybemore
informativeforhighgrowthfirms.Thus,theseresults,whicharebasedontheviewthatpersistenceisafirmcharacteristic
associatedwithfundamentals,provideonlyveryindirectevidenceonERCsasaproxyforearningsquality.Researchonthe
associationbetweenlossesandERCsalsoprovidesonlyindirectevidenceonERCsasameasureofquality.ERCsarelowerfor
lossfirms,whichisconsistentwithlossesbeinguninformativeaboutfuturecashflows.Thispredictionfollowsbecausefirms
haveanabandonmentoptionandshouldnotcontinuetoengageinactivitiesthatgeneratelosses(Hayn,1995).Whilethisrelation
isconsistentwithERCsasaproxyforearningsquality,recentevidenceinLi(2010)findsthatinvestorstendtounderweight
losses,suggestingthattheyexpectthemtoreversemorequicklythantheyactuallydo.
Twopapersstudytheimplicationsoffundamentalperformanceonearningsqualitymoredirectly.BiddleandSeow(1991)
examine crossindustry ERCs. Their analysis is a directed search of industry characteristics that will affect earnings
informativeness.Theunderlyingassumptionofthecrossindustrydesignisthatindustriesarea''convenient''(p.184)wayto
partitionthedatatoobtainmeaningfulinterindustryheterogeneityandintraindustryhomogeneityinfundamental
41Pincus(1993)isanexampleofapaperthatspecificallymotivateshispaperasonethatinvestigatesthe''qualityof
earnings''andcitesLev(1989)asthesourceofhisinspiration.
42AdditionalstudiesofthechangeintheroleoffinancialreportingintheUSovertimeincludeCollinsetal.(1997),Francis
andSchipper(1999),Brownetal.(1999),Francisetal.(2002b),LandsmanandMaydew(2002),Coreetal.(2003),Ryanand
Zarowin(2003),Dontohetal.(2004),Beaveretal.(2005),KimandKross(2005),Collinsetal.(2007),Jorionetal.(2007),and
DichevandTang(2008).
43Duetodataconstraints,samplesizelimitsthepowerofthetests.Thereare328observationswithtimelyreviewsand84
retrospectivereviews.Theauthorsareunabletoaddressselectionissuesandtheauthorsacknowledgethattheresultsare''mixed''
acrossquartersandspecificationoftheearningsvariableinlevelsorchanges.
44Warfieldetal.(1995)documentasimilarrelationbetweenmanagerialownershipandanidenticalspecificationofthe
ERC,basedonthesametheoreticalarguments;however,theyusetheterm''earningsinformativeness''ratherthan''earnings
quality''tomotivatethetest.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401369
performance.Theindustrycharacteristicstheyexamineincludeproductdurability,operatingleverage,andcapitalstructure.
Ahmed(1994)alsomeasurestheassociationbetweenERCsandfirmcharacteristicsincludingcompetition,coststructure,and
growth.Animportantinnovationofhisanalysisistherecognitionthatpreviousstudiesemploymeasuresoffundamentalfirm
characteristicsthatareoutputsfromtheaccountingsystemandthereforerepresentf(X)ratherthanX.Ahmed(1994)exploits
R&Dexpendituresasamoreprimitivemeansofmeasuringtheimpactoffundamentalperformanceonearningsinformativeness.
Finally,twopapersdocumentanegativerelationbetweenanalystforecastdispersionandERCs(ImhoffandLobo,1992;
Burgstahleretal.,2002).Theyinterpretanalystforecastdispersionasameasureofinherentuncertaintyassociatedwiththefirm's
operations.Thus,moreuncertainoperationsareassociatedwithlowerearningsquality.
3.2.2.4.Leverage.OurdatabaseincludesstudiesbyDhaliwaletal.(1991)andCoreandSchrand(1999),whofindthatleverage
isassociatedwithnonlinearitiesinERCs.45Bothpapersrecognizethatequityisacalloptiononthevalueofthefirmand
predictthatafirm'sdebtstructurewillaffecttheshapeoftheearningsreturnsrelation(ERC).Therelationbetweenleverageand
ERCsappearstoresultfromvariationinthecapitalizationrateofearningsnewsintopriceasafunctionofleverage,ratherthan
fromanassociationbetweenleverageandthedecisionusefulnessofearningsforpredictingexpectedcashflows.Inotherwords,
itisnotthatleverageaffectstheinformativenessofearningsbutratheritaffectsreturnreactions,whicharetheotherelementof
anERC.ThepredictednonlinearityintherelationbetweenERCsandleverageisconsistentwiththeoptionlikecharacteristics
of equity, which is not envisioned in the Holthausen and Verrecchia model. Plummer and Tse (1999) find that ERCs
(contemporaneousreturnsandunexpectedearnings)decreaseasdefaultriskincreasesforequityreturns,buttheoppositeresult
holdsforbondreturns.
3.2.2.5.Kesimpulan.Thestudiesonthedeterminantsofinvestorresponsivenesshighlightseveralcautionsforresearcherswho
want to use investor responsiveness as a proxy for earnings quality. First, there is mixed evidence that the ERC captures
intentionalearningsmanagement;thusitsuseasaproxyforthisparticulardimensionofqualityisquestionable.Forexample,
Hanlonetal.(2008)suggestthatfirmsuseaccountingchoicestomanageearningsinthesenseofHealyandWahlen(1999).
DharanandLev(1993)interprettheirresultsasevidencethatchangingtoincomeincreasingmethodsmaybeawarningsignthat
thefirmismaskingfundamentalproblems,whichsupportsthebiasstory.LoudderandBehn(1995)andAltamuroetal.(2005),
however,suggestthatearningsmeasuredunderthemore''aggressive''policy,inthesensethatrevenuerecognitionisearlier
ratherthanlaterorexpenserecognitionisdelayed,areassociatedwithahighermarketresponse.Thesetwostudieschallengethe
premisethatearningsaggressivenessshouldbeviewedasdefactoevidenceofgreaterearningsmanagement,andhencelower
quality.
Second, whilethe ERCmay bea representationof the''conditional'' quality ofreported earnings, itis nota proxyfor
''unconditional'' earnings quality. For example, the studies of auditors as a determinant of quality suggest that earnings
informativeness can be influenced by better monitoring. If firms engage in better monitoring when earnings would be
''unconditionally''lessinformativebecauseoftheroleoffundamentalperformance(X)orbecauseofnoncontrollablefeaturesof
the accounting measurement system such as unbiased application of exogenously determined standards, and this better
monitoringimprovestheinformativenessofearnings,thentheERCrepresentsthe''conditional''qualityoftheearnings.Thatis,
theERCcapturestheoverallqualityofreportedearningsanddoesnotdistinguishbetweenthecontributionsofXandthe
accountingsystemthatmeasuresfundamentalperformance(f)tooveralldecisionusefulness.Itisatbestanoisymeasureof
eitherofthesecontributorstoqualitybecauseitalsoembedstheeffectsofotherdeterminantsofquality(monitoringinthe
exampleabove).Theproblemmaybemoresevereiftheotherdeterminantsofquality(again,monitoringintheexampleabove)
areendogenous,andrelatedtotheunconditionalearningsquality.
Finally,thelinearspecificationtypicallyusedtomeasureERCsmatchesthelinearspecificationofequityvaluationinHV,but
theoptionlikecharacteristicsofequitysuggestnonlinearitiesinERCsasafunctionofdefaultrisk.Thus,variationinERCsmay
reflectcrosssectionalvariationinqualitycharacteristicssuchaserrorfreemeasurement,butERCswillalsoreflectvariationin
defaultrisk,whichisunrelatedtotheabilityofearningstomeasurefundamentalperformance.
3.2.3.TherelationbetweenERCsandnonearningsinformation
ThissectionreviewsstudiesthatdocumenttherelationbetweenERCsandnonearningsinformation.Understandingthe
relationbetweenERCsandotherattributesofafirm'sinformationenvironmentisimportantbecausetheobservedERCcaptures
theinformativenessofearningsholdingconstantotherinformationthatisavailable.Hence,asnotedpreviously,theERCmaybe
agoodproxyfortheconditionalinformativenessofearningstoinvestors,butnotfortheunconditionalinformativenessof
earningstoinvestors.Researchers,however,generallytesttheoriesthatrequireaproxyforunconditionalinformativeness;thatis,
fortheinformativenessofearningsthatdoesnotdependontheavailabilityofotherinformation.Forexample,ifonewantedto
testwhetherauditorsimproveearningsqualitybydecreasingerrorsinthefinancialstatements,thentheERCwouldnotbean
appropriateproxyforthisnotionofqualitybecauseitisdoesnotnecessarilyreflectvariationinthetypesoferrorsthatauditors
cancontroloraffect.
45SeealsoHayn(1995)andBurgstahlerandDichev(1997).
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401370
EmpiricalevidencesuggeststhatthereisarelationbetweenERCsandotherattributesofafirm'sinformationenvironment.
Thus,studiesthatusetheERCasaproxyforearningsqualitypotentiallysufferfromanomittedvariablebiasifthevariableof
interestiscorrelatedwithafirm'sinformationenvironment.Twostudiessuggestthatnonearningsinformationcomplementsand
improvesthedecisionusefulnessofearnings,suchthatERCswillbeanoverstatedmeasureoftheunconditionalqualityof
earnings(ie,intheabsenceoftheotherinformation).LougeeandMarquardt(2004),forexample,findthatconcurrentdisclosure
ofnonearningsinformationimprovestheearningsreturnsrelationforfirmswithpoorearningsinformativeness.Baberetal.
(2006)findthatthemarketdiscountthatinvestorsapplytoearningsthatarelikelytobeupwardlymanageddeclineswhen
balance sheet information is disclosed concurrent with the earnings announcement.46 Hanlon et al. (2005) provide related
evidence.Theyfindthatbookincomeandtaxableincomehaveincrementalexplanatorypowertoeachotherinexplaining
returns.Thus,nonearningsinformation(ie,taxableincomethatdoesnotconformtobookincome)affectsreturns,whichcan
affecttheinterpretationoftheERCasameasureofquality.Finally,twopapersprovideweak/mixedevidence.Amiretal.(1993)
characterizetheirevidenceas''mixed''onwhether20Fearningsreconciliationsimproveearningsinformativenessusingboth
longandshortwindowERCs.Francisetal.(2002a)findasignificantpositivecrosssectionalassociationbetweenaggregate
abnormalreturnstoanalystannouncements(aggregatedoverallannouncementspriortotheearningsannouncement)andthe
marketresponsetosubsequentquarterearnings,butevidenceontheassociationbetweenmeanabnormalreturnsandERCsis
mixed.Theyinterpretthetotalityoftheirevidenceasprovidinglittlesupportfortheviewthatcompetinginformationfrom
analystserodestheinformativenessofearnings.
Insummary,whiletheexactnatureoftherelationbetweeninvestorresponsivenesstoearningsandafirm'snonearnings
informationappearstobedisclosurespecific,nonearningsinformationisnonethelessapotentialomittedvariable.Investor
responsivenessonlyindicatestheinformativenessofearningsconditionalonotherinformationavailable.Itdoesnotrepresent
howinvestorswouldrespondtonewinformationinearnings,whichwouldbeabetterindicationofthequalityofthoseearnings.
ThisissuewiththeuseoftheERCasaproxyforearningsqualityisespeciallyproblematicifthehypothesizeddeterminantinthe
studyiscorrelatedwithafirm'sinformationenvironmentordisclosurechoices.
Thisomittedcorrelatedvariableproblemcanbesubtle.CollinsandDeAngelo(1990)documentthatthemarketismore
responsivetoearningsduringaproxycontest.Thisfindingrejectsoneproposedhypothesis,whichisthatearningsduringthis
periodarelessprecisebecausetheyarelikelytobeopportunisticallymanaged,inwhichcasetheERCshouldbelower.Rather,
theyinterprettheirfindingasevidencethataproxycontestisaperiodofheighteneduncertaintyandthattheearningsnumberis
especiallyusefulforvaluation.ThisevidencesuggeststhatERCsasaproxyforearningsqualitymaybespecifictoanevent
period.
TheimplicationsofnonearningsinformationforusingtheERCasaproxyforearningsqualityarefurthercomplicatedwhen
theinformationenvironmentisnotjustcorrelatedwiththeERC,butisendogeneouslydeterminedbythefirm's''earningsquality''
intheabsenceofadditionaldisclosure.Twostudiesfindthatwhenearningsarelessinformative,firmsvoluntarilydisclosemore
nonearnings informationsuch asbalance sheetinformation inearnings announcements(Chen etal., 2002)and proforma
earnings(LougeeandMarquardt,2004).Athirdstudy,however,findsthatwhenearningsaremoreinformative,firmsaremore
likelytoissuemanagementforecastsofearnings(LennoxandPark,2006).Theirexplanationfortheresultisthatamanager's
propensity to forecast is increasing in the manager's confidence about forecast accuracy, given reputation concerns. The
contrastingresultsforendogenousvoluntarydisclosuredecisionsrelatedtodifferenttypesofdisclosuresmakeitdifficultfora
researchertoevaluatewhetherthereisanendogeneityproblem,andifsohowtocontrolforit.
Inconclusion,whethertheavailabilityofnonearningsinformationisendogenousorexogenous,thefactthatthereisa
correlationbetweenERCsanditsavailabilityimpliesthattheERCcanbeviewedasaproxyforearningsqualityonlywhenthe
availabilityofotherinformationishomogeneouswithinthesample.ThisfindingisconsistentwiththeconclusionofLiuand
Thomas(2000)thatwithinsampleheterogeneityinthecorrelationbetweenunexpectedearningsandforecastrevisionsaffects
thedegreetowhichtheERCisareasonableproxyforearningsquality.
3.2.4.AfinalcautionaboutERCsasaproxyforearningsquality
Anotablemissingelementoftheliteraturethatusesinvestorresponsiveness(ERCs)asaproxyforearningsqualityis
considerationofvariationintheabilityofequitymarketstoreflectfundamentalvalue.47Variationinthereturngenerating
processacrossfirms(orcountries)affectsthevariationinthe''R''componentoftheERC,anditisunrelated(orrelatedinan
unknownway)totheearningsor''E''componentoftheERC,makingstatementsabouttheERCasaproxyforearningsquality
impossible.Variationinreturnsmaybeafunctionoffirmcharacteristicssuchastradingfrequencyofthefirm'sstock(eg,
ScholesandWilliams,1977),whichiscorrelatedwithfirmsizeandstockprice.Returnscanexhibitcrosssectionalandtime
seriesvariationduetochangesinmacroeconomicfactors(Johnson,1999;Hoitashetal.,2002)andcrosscountryvariation
becauseoftherelationbetweeneconomicandmarketdevelopment(Frostetal.,2006).
46ThisanalysisincorporatesthefindingsofChenetal.(2002),whichmodelsthefirm'sdecisiontovoluntarilydisclose
balancesheetinformationinearningsannouncements.
47Thepointthatvariationintheextenttowhichpricesreflectvalue(assumingmarketefficiency)createsapotentialomitted
correlatedvariableisageneralconcernforallstudiesthatusereturnbasedmeasuresasproxiesforquality,suchastimelyloss
recognition.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401371
3.3.Externalindicatorsofearningsmisstatements
Theexternalindicatorsofearningsmisstatementsinclude(1)SECAccountingandAuditingEnforcementReleases(AAERs),
(2)restatements,and(3)internalcontrolproceduredeficienciesreportedundertheSarbanesOxleyAct(SOX).Allthreeareused
asmeasuresofearningsmisstatements,eitherintentional(ie,earningsmanagement)orunintentional(ie,errors).
Externalindicatorshaveadvantagesanddisadvantagesasproxiesforearningsquality.Themostimportantadvantageisthat
anoutsidesourcehasidentifiedaproblemwith''quality''(whetherthatbetheSECinthecaseofAAERs,themanagementteam
itselfinthecaseofrestatements,ortheauditorinthecaseofSOXinternalcontroldeficiencies).Therefore,thesamplesare
especially useful for identifying misstatements; the researcher does not need to specify a model to identify misstatements.
Isolatingmisstatementsasaparticulardimensionofqualityisusefulasthehypothesizeddeterminantsandconsequencesof
misstatementsarelikelydifferentfromthoseofqualityproblemsassociatedwithproperapplicationofanaccountingsystem
(f).48Itisworthnoting,however,thatwhiletheexistenceofamisstatementismorecertaininallthreesamples,therestatement
andinternalcontroldeficiencysamples,inparticular,canincludebothintentionalandunintentionalmisstatements.
Thefactthatanexternalpartyidentifiesthemisstatementisthesourceoftheirgreatestadvantage,butitisalsothesourceof
theirgreatestdisadvantage:apotentialbiasinducedbyselectioncriteriausedbytheexternalparty.AAERfirms,restatement
firms,andSOXfirmsmayshareothercharacteristicsasidefromtheaccountingmisstatementthatcouldbecorrelatedwiththe
stimuliinvestigatedbytheresearchers.
Wediscusseachofthethreeexternalindicatorsthathavebeenusedasproxiesforearningsmisstatementsseparatelyin
Sections3.3.13.3.3,includingcommentsontheselectionissuesspecifictotheproxy.Duetothenumberofstudiesandthe
significantoverlapinthenatureoftheevidence,thediscussionsofthedeterminantsandconsequencesineachsectionbeginwith
alistingoftheevidence. The conclusions, basedonconsideringallofthelistedfindingstogether, are at the end of each
determinantandconsequencesection.
3.3.1.FirmssubjecttoSECenforcements:Accountingandauditingenforcementreleases(AAERs)
SamplesofAAERsusedinaccountingresearchtypicallyconsistofcaseswheretheSECallegesthatthefirmhasmisstatedor
overstatedearningsandexcludepuredisclosurecases.AlmosthalfoftheAAERfirmshaveoverstatedrevenue,and
overstatementsofinventoryandotherassetsarealsocommon(Dechowetal.,forthcoming).InmostAAERcases,theSEC
accusesmanagersofintentionallymisstatingfinancialstatements,whichisthedefinitionoffraudinSASNo.99.Insomecases,
however,theSECallegesthatmanagerswerenegligent(ie,''recklessinnotknowing''ofthemisstatement).Asignificantbenefit
oftheAAERsampletoidentifyfirmswithearningsqualityproblemsisthattheAAERsampleislikelytohavealowerTypeI
errorrateintheidentificationofmisstatementsthansamplesthatinfermisstatementfromearningsbasedmeasuressuchas
abnormalaccruals.However,researchersshouldconsiderthefollowingissueswhenusingAAERsasaproxyforearnings
quality.First,theSEChaslimitedresourcesthatconstrainitsabilitytodetectandprosecutemisstatements.Thus,theSECmay
notpursuecasesthatinvolveambiguityandthatitdoesnotexpecttowin.Asaresult,theAAERsampleislikelytocontainthe
mostegregiousmisstatementsandexcludefirmsthatareaggressivebutmanageearningswithinGAAP.Therefore,thereare
likelytobemanymanipulatingfirmsthatgoundetectedbytheSEC(highTypeIIerrorrate).Inaddition,thereisanecdotal
evidencethattheSECscrutinizesfirmsthatrestateearningsbecausethefirmshavealreadyadmittedtomakingamistake.Given
constrainedresources,thisimpliesthatfewerresourcesareavailabletodetectmisstatementsbythefirmsthatarenotvoluntarily
disclosingthem,whichcouldbethemostegregiousoffenders.Also,theSECisconcernedwiththemagnitudeofthecapital
marketimpactbecauseofitsdutytoprotectinvestors.Therefore,itislikelytomorecloselyscrutinizefirmswithlargemarket
capitalizationsaswellasIPOfirmsandfirmsraisingpublicdebtorequity.Finally,insomecases,theaccusedfirmdisagrees
withtheSECabouttheaccountingrules(asinthecaseofPrepaidLegal),whichmeansthatnotallAAERsrepresentintentional
misstatementsoutsideofGAAP(Bonneretal.,1998).
3.3.1.1.DeterminantsofAAERs.WefirstdiscusstheevidenceondeterminantsofAAERs.WhileAAERsmaynotrepresent
intentionalmisstatements,asdiscussedabove,thepresumptioninthemajorityofthestudiesisthattheAAERsareanindication
ofearningsmanagement,andthehypothesizeddeterminantsrepresenttheincentivesthatmightdrivemanagementtoengagein
earningsmanipulation.Wepresentouroverallconclusions,whichwebaseonaconsiderationofallofthefindings,attheendof
thesection.
Managerialcompensation:Dechowetal.(1996)andBeneish(1999)donotfindanassociationbetweentheexistenceofan
earningsbasedbonusplanandthelikelihoodofaccountingmanipulations.However,eventhoughtheAAERfirmsandcontrol
firmsusebonuscontractstoasimilarextent,thesetestsdonottelluswhethermanagersofAAERfirmsaremoresensitiveto
earningsbasedbonuses.
48Securitizationrules,forexample,allowforoffbalancesheetentitieswhoserisksmayberelevantforequityvaluationor
assessingfirmrisk.Therefore,thecurrentrulesmayreducethequalityofearningsastheyarenotafairrepresentationofthe
firm'sunderlyingperformance,whichwasthesecondreasonwearticulatedinSection2forwhyanaccountingmeasurement
system(f)wouldnotperfectlymeasureperformance.However,firmscorrectlyapplyingthesecuritizationruleswillnotbeinthe
AAER,restatement,orinternalcontroldeficiencysamples.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401372
Otherresearchersinvestigatewhethermanagersmanipulateearningsinordertoaffectinvestorperceptionsandmaintain
currentstockprices,whichinturncouldimpactthevalueofthestockoptionsandstockgrantsthatoftenmakeupalarger
proportionofmanagementcompensation.Johnsonetal.(2009)findthatmanagersofAAERfirmsfacestrongerincentivesfrom
unrestrictedstocksthanthoseofcontrolfirms.However,Ericksonetal.(2006)andArmstrongetal.(2010b)donotfinda
positiveassociationbetweenstockbasedincentivecompensationandthelikelihoodofaccountingfraud.Thisinconsistency
couldbeduetodifferencesinthecompensationmeasuresordifferencesinthecontrolfirms.Forexample,Armstrongetal.usea
propensitymatchingscoretocreateamatchedsamplethatcontrolsformanyothercharacteristicsinadditiontoindustryandsize.
Relatedevidencesuggeststhatmanagersengageinmanipulationinordertomakemoneybysellingtheirstockatinflatedprices
(SummersandSweeney,1998;Beneish,1999),althoughDechowetal.(1996)donotfindabnormallyhigherstocksaleactivities
fortheofficersanddirectorsoftheAAERfirmsduringthemanipulationyears.
Debtcovenants:Anotherpotentialmotivationforengaginginmanipulationistoavoiddebtcovenantviolation.Dechowetal.
(1996)findthatmanipulationfirmshavehigherleverageratiosandaremorelikelytoviolatedebtcovenantsduringandafterthe
manipulationperiodthancontrolfirms.Beneish(1999), however, doesnotfindstatisticallysignificantdifferencesbetween
manipulationfirmsandcontrolfirmsineitherleverageratiosordefaultrisk.
Capitalmarketincentives:Theneedtoraisefinancingatfavorablepricesisalsoapotentialreasonformanagerstowindowdress
thefinancialstatements.Dechowetal.(1996)findthatmanipulationfirmshavehigherexanteexternalfinancingdemandsand
higherexpostexternalfinancingactivitiesthannonmanipulationfirms.Beneish(1999)providesconflictingevidence,but
Dechowetal.(forthcoming)confirmtheresultusingamorecomprehensivesampleofAAERfirms.Notethatoverall,the
findingsofBeneish(1999)arequitedifferentfromthoseofDechowetal.(1996).Onemajordifferencebetweentheresearch
designsinthesetwopapersisthemethodofmatchingtocreatetheircontrolsamples.Beneish(1999)arguesthattheSEClikely
focusesmoreonyounggrowthfirms.Therefore,hecreatesacontrolsamplebasedonindustry,yearandfirmage,whereas
Dechowetal.(1996)matchonindustry,year,andfirmsize.Inaddition,thesamplesaredifferentsinceBeneish'ssample
includes10''fraud''firmsidentifiedfromasearchofthefinancialpressthatwerenotthesubjectofAAERs,whereasDechowet
al.'ssampleconsistsofjustover90AAERfirms,allofwhichoverstateearnings.Finally,severalofthekeyvariablessuchas
insidertradingaremeasureddifferently.
Corporategovernance:Researchershavealsoinvestigatedwhether''better''corporategovernancereducesthelikelihoodof
fraud.Theideabehindsuchtestsisthatifmanagersaremonitoredmorecarefully,thentheyhavelessopportunitytoengagein
fraudgiventheincentivetodoso.Notethatinmorerecenttimesandparticularlyafter2000,wemayexpectlessdifferencein
governancefeaturesforAAERfirmsversuscontrolfirmsbecauseregulatorsandstockexchangesnowrequire(andgeneral
publicopinioneffectivelyrequires)allfirmstohavecertaingovernancefeaturesaspartoftheirlistingrequirements.
WithrespecttocharacteristicsoftheboardofdirectorsandCEOs,AAERfirmstendtohaveasmallerpercentageofoutside
membersontheboardofdirectors,aremorelikelytohaveaCEOwhoalsoservesaschairmanoftheboardorfounderofthe
companyandarelesslikelytohaveanoutsideblockholderthancontrolfirms(eg,Dechowetal.,1996;Beasley,1996;Farber,
2005).Theseresultssuggestthatgreatermonitoringdoesappeartoreducetheabilitytomanipulate.Inaddition,Fengetal.(in
press)provideevidencesuggestingthatCFOsbecomeinvolvedinmisstatementsmainlyunderCEOpressureratherthanfortheir
ownimmediatefinancialbenefits.
Withrespecttoauditcommitteesandauditors,Dechowetal.(1996)findthatAAERfirmsarelesslikelytohaveanaudit
committee,butBeasley(1996)doesnotfindasignificantassociation.Farber(2005)showsthatfraudfirmstendtohavefewer
auditcommitteemeetingsandfewerfinancialexpertsontheauditcommittee.49Hedoesnot,however,findaneffectofaudit
committeeindependenceonaccountingfraud.Thissuggeststhatanactiveauditcommitteemaybemoreimportantthanan
independent (but passive) audit committee. The underlying motivation for the hypotheses in these studies is that a well
functioningauditcommitteehelpsempowertheinternalandexternalauditorsandotheremployeessinceitprovidesawayto
bypasstopmanagersandcommunicatedirectlywithdirectors.
Withrespecttoexternalauditors,neitherDechowetal.(1996)norBeneish(1999)findsasignificantdifferencebetween
misstatementfirmsandcontrolfirms,usingBigfourstatusasanindicationofauditfirmquality,butusingamorerecentsample,
Farber(2005)findsthatfraudfirmsarelesslikelytohaveBigfourauditfirms.Highprofilecasessuchasthemanipulationsat
EnronthatconcurrentlypaidhighfeestoArthurAndersenspurredregulationtoincreaseauditorindependence(ie,reducethe
ability of an audit firm to provide consulting services). However, interestingly, Geiger et al. (2008) do not find empirical
evidencethatauditorindependenceisassociatedwithfraud,althoughJoeandVandervelde(2007),usinganexperimentalsetting,
suggestthatitis.
Insummary,intuitivelyitwouldseemthatthelowTypeIerrorratewouldmakeAAERsanexcellentproxyforearnings
management.However,themixedevidenceonopportunisticreportingincentivesasadeterminantofAAERshighlightstwo
significantissuesforresearcherstoconfront.Thefirstisamethodologicalissue.Thesamplesaregenerallysmall,whilethe
numberofpotentialsourcesofincentivesformisstatementislarge,andthetestssimplymaynotbepowerfulenoughtodetecta
relation.Bettermatchingcouldhelp,butmatchingisdifficult.WhenresearcherscomparecharacteristicsofAAERfirmstothose
ofcontrolfirms,theyassumethatthecontrolfirmsarenotengaginginearningsmanagementanddo
49Usinganexperimentalsetting,McDanieletal.(2002)findthatfinancialexpertshelpauditcommitteesfocuson
monitoringmoreimportantfinancialreportingissues.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401373
notfaceincentivessimilartothoseoffraudfirms.However,issuesofearningsmanipulationandqualityofearningsdoappearto
clusterbyindustry.Forexample,problemswithoffbalancesheetentitiesrelatedtosecuritizationsareclusteredinthefinance
industry, problems with barterrevenue arrangements are clustered in internet industries, and problems with inventory are
clusteredinhighgrowthbusinessesthatsubsequentlydecline.Thus,whenresearchersmatchonsizeandindustry,theymay
unintentionallybematchingonfirmsthathadsimilarincentivestotheAAERfirmbutjustwerenot''caught''ordidnotpushover
the GAAP line. In addition, better measurement of the determinants variables could increase power, but executivelevel
compensationincentivesandgovernancemeasuresarenoisy.Inparticular,currentwaysofmeasuringgovernancemechanisms
cannottellushowempowereddirectorsareandwhethertheytrulycaninfluencemanagers'decisions.
Second,keepinmindthatthesearejointtestsofwhethertheAAERsareanindicationofearningsmanagementandthe
predictionaboutthehypothesizeddeterminant;thusthemixedevidencemaysaymoreaboutthepredictionthanaboutAAERsas
aproxyforearningsmanagement.Forexample,certaingovernancemechanismsthatmightbeassociatedwithbettermonitoring
ofamanager,generallyspeaking,maynotbeassociatedwithbettermonitoringofamanager'sfinancialreportingdecisions.See
furtherdiscussionofthisissueinSection5.Inaddition,inaworldwithefficientand''optimally''setcontracts,wemaynotexpect
toseesuchvariablesdifferingacrosscontrolandAAERfirms(eg,Armstrongetal.,2010b;Larckeretal.,2007).
3.3.1.2.ConsequencesofAAERs.WefirstsummarizetheevidenceonconsequencesofAAERs.Aswiththedeterminants,the
presumptioninthemajorityofthestudiesisthattheAAERsareanindicationofearningsmanagement,andthehypothesized
consequencesrepresentpenaltiesformisstatements;thatis,formisstatementsthatarecaught.Weprovideouroverallconclusions
basedonconsideringallofthefindingstogetherattheendofthesection.
Managerturnover:Ferozetal.(1991)findthat42of58AAERfirmsbetween1982and1989(72.4%)havemanagement
turnover(ie,firingorresignation)afterthepublicdisclosureofthemisstatement.Beneish(1999)documentsthatonly35.9%of
misstatementfirmshaveCEOturnoversubsequenttothediscoveryofaccountingmisstatements(duringtheyearofdiscovery
andfouryearsfollowingthediscovery)forAAERfirmsbetween1987and1993.Karpoffetal.(2008a)focusonindividuals
identifiedbytheSECastheresponsiblepartyandfindthat93%ofthemleavethecompanybytheendoftheenforcement
period,andtheseculpableindividualssufferseriouslegalpenalties(eg,criminalcharges)andmonetarylosses.Firmvalue:A
consistentresultisthatinvestorsreactnegativelytonewsofmisstatements.Ferozetal.(1991)andDechowetal.(1996)finda
negativestockreturnof9%to10%onthefirstannouncementdayoftheaccountingmisstatements(seealsoMiller,2006).
Dechowetal.(1996)documentasignificantincreaseinbidaskspreadsandasignificantdeclineinanalystfollowingafterthe
discoveryofaccountingmisstatements.Karpoffetal.(2008b)findthattheenforcementfirmsonaverageloseatotalof38%of
theirmarketvaluesmeasuredoverallannouncementdatesrelatedtotheenforcementaction.Theysuggestthattwothirdsofthe
declinerepresentslostreputation,whichtheydefineas''thedecreaseinthepresentvalueoffuturecashflowsasinvestors,
customers,andsuppliersareexpectedtochangethetermsoftradewithwhichtheydobusinesswiththefirm.''Theremaining
onethirdrepresentslegalpenalties,andreadjustmentsinvaluationsassociatedwiththe''restated''financialinformation.Farber
(2005)findsthatonlyfirmsthatimprovetheircorporategovernance(eg,byincreasingthepercentageofoutsidemembersonthe
board)experienceimprovedstockmarketperformanceinthethreeyearpostdetectionperiodaftercontrollingforchangesin
operatingperformance.
Auditors:Ferozetal.(1991)findthatlargeauditorsoftheAAERfirmsarelesslikelytobecensuredbytheSECand
generallysufferlighterpenaltiesthansmallauditors.Theysuggesttwoexplanations:largeauditorsareassociatedwithless
extremecases,and/orlargeauditorscanaffordmoreresourcestonegotiatewiththeSECtolowerpenalties.Bonneretal.(1998)
documentthatauditorsfacelitigationin38%ofAAERfirmsintheirsample.Thelitigationriskforauditorsishigherwhenthe
typeoffraudoccursfrequentlyacrosscompanies(ie,commonfrauds)orwhenthefraudiscausedbyfictitioustransactions.
Takentogether, studies ofthe consequencesof AAERsprovide consistentand compellingevidence thatinvestors react
negativelytothediscoveryofamisstatement.TheimplicationsoftheseresultsforwhetherAAERsreflectearningsquality,
however,islessclear.KeepinginmindthatmostsamplesofAAERsconsistoffirmsthathaveoverstatedearnings,thereareat
leastfourexplanationsforanegativemarketreaction.First,anAAERcouldcauseinvestorstoadjusttheirforecastsoffuture
cashflowsifforecastsarebasedonhistoricalearningsandtheAAERrevealsthathistoricalearningsarelowerthanpreviously
reported.Second,anAAERcouldcauseinvestorstoreassesstheexpectedgrowthratetheyapplytothecashflowforecasts.
Third,anAAERcouldcauseinvestorstoincreasetheirestimateofthediscountrateappliedtocashflowsiftheAAERcauses
themtorevisedownwardtheirexpectationsabouttheprecisionofthefirm'saccountinginformation.Finally,anAAERcould
causeinvestorstorevisetheirexpectationsoffuturecashflowsbecausetheyexpecttheAAERtocreateadditionalcoststhatthe
firmwouldotherwisenothaveincurred,suchaslitigationcostsorreputationloss.
Whiletheevidenceconsistentlysuggeststhatinvestorsreactnegativelytothediscoveryofamisstatement,theydonot
distinguishamongthesefourreasons.Thethirdpotentialsourceofnegativereturnsthatinvestorschangetheirassessmentof
theprecisionoftheaccountingmeasurementandreportingsystemshouldbeofparticularinteresttoaccountants,butitis
difficult to disentangle this explanation from the others. The market reactions to AAERs, however, would have empirical
advantagesfordocumentingrevaluationsduetochangesininformationrisk.Manyoftheannouncementsareasurprise,theevent
windowisfairlyshort,andtheeventsarenotclusteredincalendartime.Karpoffetal.(2008b)tookausefulfirststep
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401374
towarddifferentiatingamongthepossibleexplanationsforthenegativestockmarketreactions,andwewouldencouragetheuse
ofAAERstoidentifythespecificimplicationsofmisstatementsforearningsquality.
3.3.2.Restatements
Theearlystudiesthatusearestatementasaproxyforanearningsmisstatementidentifiedtherestatementsampleusingkey
wordsearchesintheLexisNexisNewsLibraryandSECFilingLibrary(eg,Palmroseetal.,2004).Morerecentpapersusethe
GAOFinancialStatementRestatementDatabase(eg,Desaietal.,2006).ThisdatabasewasconstructedusingaLexisNexistext
search based on variations of the word 'restate' and contains approximately 2,309 restatements between January 1997 and
September2005.
AswiththeAAERsample,asignificantbenefitofusingtherestatementsampletoidentifyfirmswithearningsquality
problemsisalowerTypeIerrorrateintheidentificationofmisstatements.Inaddition,therestatementsamplehastheadded
advantageofsize;restatementsamplesaresignificantlylargerthansamplesofAAERfirmsinanygivenyear.50However,the
increase in size comes at a cost. The restatement sample, in addition to misstatements, includes firms that are correcting
unintentionalerrors,orapplyingnewpronouncementsretrospectively(eg,SAB101requiredretrospectiverestatement).TheSEC
requiresarestatementforanyAAERthatallegesarecognitionmisstatement(asopposedtoadisclosureomission),buttheGAO
database also contains many restatements that do not trigger SEC investigations, including restatements required due to
unintentionalbookkeepingerrorsandrestatementsofimmaterialoreconomicallyinsignificantamounts(PlumleeandYohn,
2010;Hennesetal.,2008).Hennesetal.(2008)documentthattheproportionofsuchrestatementsinthedatabasehasincreased
inrecentyears.Hence,restatementsareanoisyproxyforintentionalmisstatements.
LiketheAAERsample,therestatementsampleissubjecttoconcernsaboutpotentialselectionbias,butthenatureofthe
selectionconcernisdifferentinthetwosamples,anditisnotclearwhichisabiggerconcern.Restatementscanbetriggeredby
theSEC,thefirm,orthefirm'sauditor.Ontheonehand,havingmultiplesourcesthatidentifyrestatementsmightsuggestthatthe
selectionissuesimplycreatesnoiseintheanalysisratherthanbias.Ontheotherhand,knowingthesourceoftheselectionbiasin
theAAERsamplemaymakeiteasiertocontrolforthepotentialbias.
3.3.2.1. Determinantsof restatements. Wefirst summarizethe evidenceon determinantsof restatements. Asin theAAER
sample, the majority of the studies presume that a restatement indicates earnings management and assess whether the
restatementsareassociatedwithincentivesfor(determinantsof)earningsmanagement.Weprovideouroverallconclusions
basedonconsideringallofthefindingstogetherattheendofthesection.
Managerialcompensation:BurnsandKedia(2006)findthatthesensitivityoftheCEO'soptionportfoliotostockpriceis
significantly positively associated with the likelihood of restatements, but the sensitivity of other components of CEO
compensation(ie,equity,restrictedstock,longtermincentivepayouts,andsalaryplusbonus)isnotrelated.Efendietal.(2007)
findthatthelikelihoodofrestatementsincreaseswhentheCEOhasconsiderableholdingsofinthemoneystockoptions.51
However,Armstrongetal.(2010b)donotfindasignificantassociationbetweenCEOequityincentivesandrestatementsusinga
propensitymatchingscoreapproach.
Boardofdirectorsandauditors:RestatementfirmstendtohaveCEOswhoserveaschairmanoftheboardorhavefounder
statusandhaveboardorauditcommitteedirectorswithfinancialexpertise(AgrawalandChadha,2005;Efendietal.,2007).
Independenceoftheboardorauditcommitteeisnotadeterminantofthelikelihoodofrestatement(AgrawalandChadha,2005).
Larckeretal.(2007)findthatonlytwooutoffourteendimensionsofgovernance(insiderpowersuchaspercentageofinsiders
on board, and debt variables such as the ratio of book value of debt to the market value of equity) are associated with
restatements.
Nonauditfees,whicharepresumedtoaffectauditorindependenceandhencemaycompromiseauditorquality,arenot
associatedwithrestatementsonaverage(AgrawalandChadha,2005).Kinneyetal.(2004)alsofindnoassociationbetweenfees
forfinancialinformationsystemsdesignandimplementationorinternalauditservicesandrestatements,buttheyfindsome
associationbetweenfeesforunspecifiednonauditservicesandrestatements.WhenusingasampleofUKfirms,Fergusonetal.
(2004)findapositiveassociationbetweennonauditfeesandrestatements.
Thegenerallyweakandmixedevidenceacrossthedeterminantsofrestatementssuggeststhattheyarenotareliableindicator
ofintentionalmisstatements,whichisaspecificdimensionofearningsqualitythatresearchersmighthavethoughtrestatements
wouldindicate.Insupportofthisconclusion,thecompensationvariablesthatwouldprovideincentivesforintentionalearnings
management and the monitors that would constrain intentional earnings management are not consistently associated with
restatements.52Themixedevidenceisperhapsnotsurprising.Asnotedpreviously,adisadvantageoftherestatementsampleis
thatitcombinesintentionalandunintentionalmisstatements.Carefulscreening
50SeeDechowetal.(forthcoming)foradetailedcomparisonofdifferentdatabasesrelatedtoaccountingmisstatements.51
Efendietal.(2007)alsofindthatrestatementsaremorelikelywhenfirmsareconstrainedbyaninterestcoveragedebtcovenant
andwhentheyraiseexternalfinancing.Thispaperistheonlyoneinourdatabasethatexaminesdebtcontractingandequity
marketincentivesasdeterminantsofrestatements.
52SupportforthisconclusionalsocomesfromarelatedstudybyKinneyandMcDaniel(1989),whichfindsthatfirmsthat
correctpreviouslyannouncedquarterlyearningsaresmaller,arelessprofitable,havehigherdebt,aremoreslowlygrowing,and
facemoreseriousuncertainties.Theyinterprettheirevidenceassuggestingthataccountingerrorsaretheoutcomeofaweak
accountingsystem(ie,weakinternalcontrolprocedures)ratherthanopportunisticearningsmanagement.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401375
ofthesamplehasthepotentialtoyieldmorepowerfultestsofthedeterminantsandconsequencesofunintentionalversus
intentionalmisstatements(Hennesetal.,2008).
3.3.2.2.Consequencesofrestatements.Wefirstsummarizetheevidenceonconsequencesofrestatements,thengiveour
conclusions.
Managers/Directors:Managersatrestatementfirmsexperiencesignificantlyhigherturnover(Desaietal.,2006;Hennesetal.,
2008)anddirectorturnover(Srinivasan,2005)thancontrolfirms.Desaietal.(2006)alsofindthatitismoredifficultforthese
displacedmanagerstofindsubsequentemploymentthandisplacedmanagersofcontrolfirms.Srinivasan(2005)findsthatthe
directorturnoverrateishigherformoresevererestatementsandforauditcommitteedirectors.
Firm value: Palmrose et al. (2004) document an average marketadjusted return of 9.2% over a twoday restatement
announcementwindow;theaverageis20%forrestatementsassociatedwithfraud.53Levetal.(2008)documentthatthe
restatementsthatsignificantlychangethehistoricalpatternofearnings(eg,shorteninghistoriesofearningsgrowth)havemore
negativestockmarketconsequences.Gleasonetal.(2008)findthatrestatementannouncementscausestockpricedeclinesfor
nonrestatementfirmsinthesameindustry.HribarandJenkins(2004)documentasignificantincreaseinafirm'scostofequity
capital, measured based on the residual income model, in the month following a restatement. Kravet and Shevlin (2010)
documentasignificantincreaseinthepricingofinformationriskafterrestatementannouncements.
Litigation:Palmrose andScholz (2004)find that38% ofrestatements areassociated withlitigation, including litigation
actionsagainstthecompany,officers,directors,andauditors.Theydocumentthatthelikelihoodoflitigationincreaseswiththe
impactofrestatementsonearnings(magnitude)andthefraudulentnatureofrestatements.Restatementsofcoreearnings(ie,
recurringearningsfromprimaryoperations)andrestatementsthatinvolveagreaternumberofaccountstendtoresultinahigher
likelihoodoflawsuitsandlargerpaymentsbydefendants.Levetal.(2008)findthatrestatementsthatcurtailhistoriesofearnings
growthorpositiveearningshaveahigherlikelihoodofclassactionlawsuitsthanotherrestatements.
Inconclusion,researchershavemadeprogressinidentifyingspecificdimensionsofquality,particularlythroughevidenceon
themarketconsequencesofrestatements.AswiththeAAERs,anegativemarketreactiontoarestatement(anoverstatement)
wouldsuggestthattherestatedearningschangedthemarket'sdecisionaboutfirmvaluation.Thus,theearningsthatwereinitially
reportedwerelessdecisionuseful(oflowerquality)intermsofequityvaluationthantherestatedearnings.FortheAAERfirms,
wewereleftwiththisbroadconclusion,andwesuggestthatresearchersattempttodisentanglewhytheequityvaluationchanged
inordertogainmoreinsightsintowhyearningsaredecisionuseful.Studiesofrestatementshavemademoreprogressinthis
direction,nodoubtduetothelargersamplesizewhichallowsforcrosssectionalpartitioningofthedataandidentificationofthe
explanationfortherestatement.Forexample,HribarandJenkins(2004)andKravetandShevlin(2010)suggestthatrestatements
reflecterrorsthatcauseinvestorstorevisetheirbeliefsaboutinformationprecisionassociatedwiththefirm'searnings.Thus,
theyidentifytheeffectofearningsoninvestorbeliefsaboutinformationprecisionasanimportantfeatureofearningsthataffects
theirdecisionusefulness.
3.3.3.Internalcontrolweaknesses
Themajorityofthestudiesoninternalcontrolweaknessesasaproxyforearningsmisstatementsareconductedinthepost
SarbanesOxley(SOX)regime.UnderSection302oftheSarbanesOxleyActof2002,whichbecameeffectiveonAugust29,
2002,managementisrequiredtocertifyin10Qsand10Kstheirconclusionsabouttheeffectivenessofthefirms'internal
control procedures. Section 404 of SOX, which became effective on November 15, 2004 for accelerated filers, requires
companiestoincludemanagement'sassessmentoftheeffectivenessoftheinternalcontrolstructureandproceduresintheannual
report;thefirm'spublicaccountantsmustattesttothisassessment.54Priortothesereports,companies(withtheexceptionofthe
bankingindustry)wererequiredtodisclosesignificantinternalcontroldeficienciesin8Ksonlywhendisclosingachangein
auditors(GeandMcVay,2005;Krishnan,2005;AltamuroandBeatty,2010).
Studieshaveshownapositiveassociationbetweeninternalcontrolqualityandvariousearningsqualitymeasuressuchas
discretionaryaccrualsandearningspersistence(eg,Doyleetal.,2007a;AshbaughSkaifeetal.,2008).Theseassociationstudies
providepreliminaryjustificationforusingtheinternalcontroldeficienciesreportedunderSOXasanindicationofearnings
quality.
However,likeAAERsandrestatements,internalcontroldeficiencydisclosuresaresubjecttoapotentialselectionbiasthat
needstobeevaluatedbeforetheyareusedasaproxyforearningsquality.Internalcontroldeficiencydisclosuresareaffectedby
bothmanagerandauditorincentivestodiscoveranddisclosetheweaknesses.Therelationbetweeninternal
53Desaietal.(2006)findthatshortsellersaccumulatepositionsinrestatementfirmsbeforerestatementannouncementsand
unwindthesepositionsafterstockpricesdeclineduetotherestatement.Theirfindingsuggeststhatshortsellersareableto
identifyfirmsthatwilllikelyrestateinadvanceoftherestatementannouncement.Itdoesnot,however,explainshortsellers'
assumptionsregardingmarketefficiency.Onepossibilityisthattheshortsellersbelievethestockisoverpricedduetothe
valuationimplicationsofthemisstatedearnings;theyexpecttherestatementtorevealthemispricingandthepricetocorrect.
Anotherpossibilityisthattheshortsellersanticipatethatmarketswillreactnegativelytorestatementsonaverage,regardlessof
theimplicationsoftherestatementforvaluation.Moreresearchisneededtointerprettheimplicationsofthisevidencefor
earningsquality.54InternalcontroldisclosuresunderSection404areavailableinmachinereadableformfromAuditAnalytics.
TheearlypaperscollectedthereportsfromComplianceWeekor10KWizard.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401376
controlproceduresandtheseincentivesaffectsinterpretationoftheresults.Forexample,HoganandWilkins(2008)document
thatauditfeesintheyearpriortothedisclosureofaninternalcontroldeficiencyarehigherthanthefeesforamatchedsample
thatdoesnotreportdeficiencies.Oneexplanationforthisfindingisthatauditorschargehigherfeesfortheextraauditeffort
requiredtoauditfirmswithweakcontrols.Inthiscase,wewouldpredictapositiveassociationbetweenfeesandweakinternal
controls,butnotnecessarilybetweeninternalcontrolsandearningsquality.Iftheauditor'sextraeffortresultsindetectingand
reportingerrors, thenthefeesshouldnotbeassociatedwiththeobservedqualityofthereported(andcorrected)earnings.
Anotherexplanationisthatauditorschargehigherfeeswhentheassessedauditriskishigher,andweakcontrolsarecorrelated
withauditriskassessments(ie,thefeesrepresentapureriskpremium).Inthiscase,wewouldpredictarelationbetweeninternal
controlsandearningsquality.HoganandWilkinsemphasizethefirstexplanationwhileacknowledgingthattheycannotruleout
theriskpremiumstory.
Althoughitisbasedonasmallnumberofstudies,evidenceonthedeterminantsofinternalcontroldeficienciesdisclosed
underSOXSection302isconsistent,suggestingthatsuchdeficienciesmeasurethepropensityformisstatements.55Ashbaugh
Skaifeetal.(2007)andDoyleetal.(2007b)findthatfirmswithhighercontrolriskassociatedwithorganizationalcomplexity
andsignificantorganizationalchangesaremorelikelytohaveinternalcontroldeficiencies.Theweaknessfirmsalsoappeartobe
moreconstrainedintheirresourcestoinvestininternalcontrolsystems(ie,firmsize,financialstrength).56
EvidenceontheconsequencesofreportedinternalcontrolweaknessessuggeststhattheSection302disclosuresprovidean
indicationofdeficiencies,butSection404disclosuresdonotappeartobeasourceofinformationaboutfinancialreporting
qualitytoinvestors.ForinternalcontrolweaknessesreportedunderSection302,Hammersleyetal.(2008)andBeneishetal.
(2008)findthatdisclosuresoftheweaknessesareassociatedwithnegativestockpricereactions.Beneishetal.(2008)alsofind
thatSection302disclosuresareassociatedwithadecreaseinanalystforecastrevisionsandanincreaseincostofequitycapital.
However,disclosuresofinternalcontrolweaknessesunderSection404arenotassociatedwithanegativestockpricereaction,a
decreaseinanalystforecastrevisions,oranincreaseincostofequitycapital(Ognevaetal.,2007;Beneishetal.,2008).Onlyone
studydocumentsasignificantincreaseinthecostofequitycapitalfollowingSection404disclosures(AshbaughSkaifeetal.,
2009),arguingthatOgnevaetal.'sfindingssufferfromlookaheadbiasintheclassificationofinternalcontrolquality.57
ThereareseveralexplanationsforthedifferenceintheconsequencesofSection302andSection404reports.First,the
threshold for Section 404 material weaknesses may be lower than that for Section 302. Second, the Section 404 samples
examinedarelimitedtoacceleratedfilersthathavearicherinformationenvironment.Third,thereisambiguityregardingwhether
disclosureofmaterialweaknessesismandatoryunderSection302,andasaresult,lessseverematerialweaknessesmaynotbe
disclosed (Doyle et al., 2007a). Fourth, the Section 404 disclosures are made in the annual report, while the Section 302
disclosurescanbemadeondateswithoutconfoundingannouncementsintheeventwindow.
Variationinthetypesoferrorsreflectedinthenatureofinternalcontrolweaknesses(andforthatmatterrestatementsand
SECenforcementreleases)providesanopportunitytoexaminethecompletepathfromapredicteddeterminant(ie,weakinternal
controlprocedures)toaparticulartypeofearningsqualityandthentoapredictedconsequence.Forexample,onecouldaddress
whetherthemarketconsequencesofamisstatementaredifferentifaninternalcontrolweaknessratherthananagencyproblem
causesit.Suchtestswouldhelptoclarifythetypesofimplementationissuesthaterodethedecisionusefulnessofearnings.
4.Crosscountrystudies
Thissectiondiscussesthepapersinourdatabasethatexaminecrosscountryvariationinearningsqualityproxies.Thestudies
provideevidenceonproxiesforearningsqualitysimilartothosediscussedinSection3,includingearningsresponsecoefficients
(eg,Alfordetal.,1993;AliandHwang,2000);smoothness(eg,Leuzetal.,2003;Langetal.,2006;FrancisandWang,2008);
accrualsanddiscretionaryaccruals(Hung,2000;Hawetal.,2004;Pincusetal.,2007);timelylossrecognition(Balletal.,
2008)58;smallpositiveprofits(Leuzetal.,2003;Langetal.,2006);andscoresbasedonacombinationofqualitymeasures(eg,
Leuzetal.,2003).However,wediscusstheabovecrosscountrystudiesinthissectionseparatelyduetouniquefeaturesofthe
datathataffectthemeasurementoftheearningsqualityproxiesandthenatureoftheresearchapproachtoevaluatethem.
55Earlyresearchonthedeterminantsofinternalcontrolweaknesseswerelimitedandprovidedweakevidenceduetodata
availability.Forexample,WillinghamandWright(1985)surveyauditfirmpartnersanddonotfindanassociationbetween
auditors'assessmentofinternalcontroleffectivenessandfinancialstatementerrorsdetectedbyauditors.Kinney(2000)also
notesthatlackofaccesstodatawasabarriertoresearchoninternalcontrolprocedures.Someveryearlyworkanalyzedthe
designandtestsofinternalcontrolsystems(eg,Cushing,1974;Kinney,1975).Krishnan(2005),alsonotusingSOXdata,finds
thatindependentauditcommitteesandauditcommitteeswithfinancialexpertisearesignificantlylesslikelytobeassociatedwith
theincidenceofinternalcontrolproblems.
56Studiesthatexaminewhetherinternalcontrolproceduresareadeterminantofanotherearningsmeasure(eg,discretionary
accrualsorpersistence)arediscussedinSection5.3.
57ArelatedstudybyChangetal.(2006)findsthatfirmsthathaveCEOsandCFOscertifytheirfinancialstatementsunder
SOXexperienceadeclineinbidaskspreads.
58Studiesthatexamineasymmetrictimelinessortimelylossrecognition,whethertheyusecountrylevelproxiesorfirm
levelproxiesforinternationalfirms,arediscussedinSection3.1.4.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401377
Themainmethodologicaladvantageofthecrosscountrystudiesforunderstandingtheearningsqualityproxiesisgreater
heterogeneityacrosscountriesthanwithincountriesindeterminantvariablessuchasaccountingstandards,legalsystems,and
incentivesprovidedbycapitalmarkets.Thisheterogeneityallowsfortestsofhypothesesthatarenotpossibleusingdatafora
singlecountry.Thismethodologicaladvantage,however,hasimplicationsforinterpretationoftheresultsonearningsquality.For
example,afindingthatgreaterinvestorprotectionisassociatedwithhigherERCsdoesnotimplythatERCsareagoodproxyfor
earningsquality,evenunderthemaintainedassumptionthatinvestorprotectionimprovesquality.Thefindingonlysuggeststhat
ERCsareagoodproxyfordecisionusefulness(ie,quality)associatedwithdecisionsanddecisionmakerssubjecttogood
investorprotection. As emphasized throughout this review, thedefinitionof''quality'' is decisionspecific, andthedecision
environmentinthesestudiesisuniquebydesign.
We focus the discussion on what we can learn only from crosscountry studies due to the methodological differences
comparedtostudiesofUSfirms.Itisbeyondthescopeofthisreviewtocommentonearningsqualityinothercountries,
particularlyrelativetotheUS,ortocommentonwhatoptimalaccountingpoliciesshouldlooklikegivenacountry'sinstitutional
environment.Werestrictourattentiontoobservationsabouttheevidenceinthesecrosscountrystudiesrelatedtoevaluatingthe
proxiesforearningsquality.
Ourfinalobservationbeforeweproceedtoadiscussionofthestudiesisareminderabouttheimpactofwellrecognizeddata
limitationsontheinterpretationoftheresults.Whileaccesstomachinereadablefirmlevelfinancialdataacrosscountriesoutside
theUSisimproving,itisstillrelativelyconstrained,asisdatarequiredtomeasurethedeterminantsandconsequences.Asa
result, the increase in power afforded by greater heterogeneity in determinants of earnings quality is potentially offset by
increasednoiseinthemeasurementoftheEQproxiesaswellasinthemeasurementofthedeterminants.Forexample,investor
protection is often measured using indicator variables equal to one for common law countries (good protection) and zero
otherwiseorbybroadindices(eg,LaPortaetal.,2006).Likewise,thedefinitionandmeasurementofaccrualsasaproxyfor
earnings quality are constrained by data availability, and little effort is devoted to controlling for variation in the return
componentofthereturnbasedproxiesforearningsquality,despiteevidenceofvariationintherelationbetweeneconomicand
capitalmarketdevelopment(Frostetal.,2006).Focusingonasmallersetofcountriesforwhichdataaremorereliablyavailable
couldreducethenoise,butthisapproachmitigatesthebenefitsofcrosscountryheterogeneity.
Wenowproceedtoadiscussionofthepapers,keepinginmindthatourpurposeistoexploitthemethodologicaladvantages
ofthecrosscountrystudiesforprovidingevidenceontheabilityoftheearningsqualityproxiestocapturedecisionusefulness.
Thefirstsignificantcomponentoftheliteratureprovidesevidenceoncrosscountryvariationininvestorresponsivenessto
earnings.Alfordetal.(1993)documentcrosscountryvariationinlongwindowERCsandearningsbasedhedgeportfolioreturns
for17countries.TheydonottesthypothesesaboutpredictabledifferencesinERCsacrosscountries.Rather,theyprovidethe
readerwithasummaryofimportantinstitutionalcrosscountrydifferences(eg,interimreportingfrequency)tohelpinterpretthe
resultsexpost.AlaterstudybyAliandHwang(2000)examinesthetwomeasuresofinvestorresponsivenesstoearnings(ERCs
andearningsbasedhedgeportfolioreturns)fromAlfordetal.(1993)plustwoadditionalmeasuresvaluerelevanceofaccruals
andcombinedvaluerelevanceofearningsandbookvalueofequityacrosspartitionsof16countriesthattheypredictwill
exhibitvariationinearningsinformativenessexante.Theyinvestigatesixcountrylevelinstitutionalfactors,buttheyemphasize
thefollowingresults:investorresponsivenesstoearningsislowerincountrieswherefinancialsystemsarebankorientedrather
thanmarketorientedandwheretheaccountingrulesarelesslikelytobetiltedtowardpreferencesofequitymarketsbecauseof
the standardsetting process. Hung(2000) investigatescountryspecific accrualaccounting intensityas acountrylevel EQ
determinantandusesearningsbasedhedgeportfolioreturnstomeasurecountrylevelinvestorresponsivenesstoearnings.She
findsthatacross21countries,moreextensiveuseofaccrualaccountingratherthancashaccountingisassociatedwithlower
earningsresponsesonlyincountrieswithweakshareholderprotection.59
Insummary,wefeellimitedinourabilitytodrawconclusionsaboutinvestorresponsivenessasaproxyforearningsquality
fromtheabovestudies.Theyarejointtestsofthetheorythataparticularinstitution/regulationaffectsinvestorresponsivenessto
earnings and that the investor responsiveness proxy measures earnings quality. In our opinion, given the concerns noted
previouslyregardingmeasuringthedeterminantvariables,thesestudiesspeakmoretothetheoriesthantotheassumptionthat
investorresponsivenessisaproxyforquality. The authors of these studies (and most crosscountry studies) recognize the
measurementproblemofthedeterminantvariablesandmanyeitheruseempiricalmethodstocontrolforunmodeledsourcesof
crosscountryvariationinthedeterminantsormodelexpectedsourcesofvariationsuchasindustryconcentration.However,even
observablevariablessuchasnaturalresourceendowmentsandthelevelofeconomicdevelopmentarenotfrequentlymodeled
andlessconsiderationisgiventounobservableculturaldifferencessuchasreligionortrustingovernancemechanisms(Guisoet
al.,2009).
Thesecondsignificantcomponentofthisliteratureisstudiesthatfocusonearningsmanagementasaspecificdimensionof
quality.Leuzetal.(2003)isaninfluentialpaperintermsofmeasuringcountrylevelearningsmanagement.Theirscore
59Hung(2000)developsherowncountryspecificaccrualaccountingintensityindexbasedontheaccountingtreatmentof
(1)goodwill,(2)equitymethodinvestments,(3)depreciation,(4)purchasedintangibles,(5)internallydevelopedintangibles,(6)
researchanddevelopmentcosts,(7)interestcapitalization,(8)leasecapitalization,(9)percentageofcompletionallowances,(10)
pensions,and(11)postretirementbenefits.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401378
aggregatesfourindividualmeasuresofearningsmanagement:
(i)Opportunisticsmoothnessdefinedasthecountry'smedianratioofthefirmlevelstandarddeviationofoperatingearnings
dividedbythefirmlevelstandarddeviationofcashflowfromoperations(wherescalingbythecashflowsisacontrolfor
differencesinthevariabilityofeconomicperformance).Alowerratioindicatesmoresmoothing.(ii)Opportunisticsmoothness
definedasthecontemporaneouscorrelationbetweenchangesinaccountingaccrualsandchangesinoperatingcashflows
obtainedfrompooledfirmyearcountryobservations.Astrongernegativecorrelationindicatesmoresmoothing.(iii)The
country'smedianoftheabsolutevalueoffirms'accrualsscaledbytheabsolutevalueoffirms'cashflowfrom
operations.Alargerratioisindicativeofmoreearningsmanagement.60(iv)Smalllossavoidance(ratioofsmallprofitsto
smalllosses).
Usingthisscore,Leuzetal.findlessearningsmanagementforcountrieswithdevelopedstockmarkets,dispersedownership,
stronginvestorrights,andstronglegalenforcement.
Fourlaterstudiesalsodocumentanegativeassociationbetweeninvestorprotectionandearningsmanagementusingdifferent
measuresofearningsmanagement.Theypredictthatstrongerprotectionreducesearningsmanagementbecauseitlimitsinsiders'
abilitytoacquireprivatebenefits,whichthenreducesthefirm'sincentivestomaskfirmperformance.Thefirststudyisthatof
Langetal.(2006),whocomparetheextentofearningsmanagementbetweenasampleofnonUSfirmsthatarecrosslistedin
theUSandasampleofUSfirms.TheydocumentthatthecrosslistednonUSfirmsexhibitmoreevidenceofsmoothness,a
greatertendencytoreportsmallprofits,andlowerERCs(allofwhichareassumedtoproxyforearningsmanagement)thanUS
firms,andthatthisdifferenceisgreaterforfirmsfromcountrieswithpoorinvestorprotection.61ThesecondstudyisthatofHaw
etal.(2004),whodocumentthatearningsmanagement(measuredbytheunsignedmagnitudeofdiscretionaryaccruals)that
stemsfromtheconflictsbetweencontrollingshareholdersandminorityshareholdersislowerincountrieswithstrongprotection
ofminorityshareholders'rightsandstronglegalenforcement.ThethirdstudyisthatofFrancisandWang(2008),whofindthat
earnings quality (measured by the magnitude of discretionary accruals, the likelihood of reporting a loss, and timely loss
recognition)ispositivelyrelatedtocountrylevelinvestorprotection,butonlyforfirmswithBigfourauditors.Theysuggestthat
investorprotectionaffectsearningsqualitythroughtheincentivesofBigfourauditors(ie,litigationriskandreputationrisk).
Finally,Burgstahleretal.(2006)documentinteractionsbetweentheeffectsofinstitutionsandpublicequitymarketsonearnings
management.Usingasampleofprivateandpublicfirmsfrom13EuropeanUnioncountries,theyfindthatprivatecompanies
manageearningsmore,consistentwithlesspressureforearningsquality,andtheysuggestthatstrongerlegalinstitutionscurb
earningsmanagementinbothprivateandpublicfirms.TheBurgstahleretal.(2006)earningsmanagementmeasuresaresimilar
tothoseusedinLeuzetal.(2003),buttheyareconstructedattheindustrylevelandincludesomeadditionalcontrolvariables,
whichisausefulattempttocontrolforfundamentalperformance.
Aswiththecrosscountryinvestorresponsivenessstudies,thestudiesoninvestorprotectionandearningsmanagementare
jointtestsofthetheorythatinvestorprotectionaffectsearningsmanagementandthattheLeuzetal.scoreorotherproxies
measureearningsmanagement.Theconvergenceoftheresultsdemonstratingarelationbetweeninvestorprotectionandearnings
managementacrossthevariousproxies,includingsmoothness,smallprofits,lossavoidance,anddiscretionaryaccruals,suggests
thatthesevariables,whenmeasuredatthecountrylevel,arelikelypickinguptheearningsmanagementdimensionofearnings
quality. There was no such convergence documented in the investor responsiveness studies; they each examined different
determinants(orwereagnosticaboutthedeterminantsinthecaseofAlfordetal.,1993).Nonetheless,theconclusionthatthe
countrylevelearningsmanagementproxiesaremeasuringearningsmanagementissubjecttothemaintainedassumptionthatthe
proxiesusedforinvestorprotectionareassociatedwithinvestorprotectionandthatsuchinvestorprotectionreducesearnings
management.62
Likethemajorityofthedeterminantsstudies,thefourpapersinourdatabasethatexamineconsequencesofcountrylevel
earnings quality provide evidence specifically on proxies for the earnings management dimension of earnings quality.
Bhattacharyaetal.(2003b)findthatpoorcountrylevelearningsquality(measuredasearningsaggressivenessusingaccruals,
lossavoidance,andearningssmoothness)isassociatedwithahighercountrylevelcostofequitycapitalandlowertrading
volume.Theyinterpretthisfindingasevidencethatearningsaggressivenessisassociatedwithgreateropacity.Pincusetal.
(2007)findthattheaccrualanomaly,whileaglobalphenomenon,isconcentratedinfourcountries:Australia,Canada,theUnited
Kingdom,andtheUS,allofwhicharecommonlawcountries.Theaccrualanomalyis
60ThesmoothnessandaccrualmeasuresaredifferentfromthosecommonlyusedinstudiesofUSfirms.Forexample,in
studiesofUSfirms,theabsolutevalueofaccrualsistypicallyscaledbyassets.
61Langetal.(2006)donotusetheLeuzetal.(2003)measureofartificialsmoothness.Theydeveloptheirownmeasureof
artificialsmoothnessthatsimilarlyattemptstocontrolforsmoothnessoffundamentalperformance.Theymeasuresmoothnessas
thevarianceoftheresidualsfromaregressionofannualchangesinnetincomescaledbytotalassetsoncontrolvariablesfor
fundamentalfirmcharacteristics.Theiranalysisalsousesamatchedsampledesignwithmatchingbasedonpastsalesgrowthand
industry,whichreflectsanefforttocontrolforfundamentalvariability.Langetal.alsoexaminetimelyrecognitionoflosses,but
notasaproxyforearningsmanagement.
62Itisnotuniversallyacceptedthatinvestorprotectionwillbeassociatedwithlowerearningsmanagement.Forexample,one
couldarguethatwheninvestorshavenorights,managerswouldnolongerneedtomanipulateearningsbecausetheyarefully
entrenched.However,thedataconstraintsassociatedwithdefiningspecifictypesofinvestorrightstypicallylimitaresearcher's
abilitytoovercomethisissue.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401379
positivelyassociatedwiththeHung(2000)indexofaccrualaccountingintensityandnegativelyassociatedwithshareownership
concentration.Pincusetal.(2007)alsoprovidesomewhatweakerevidencesuggestingthattheaccrualanomalyisnegatively
relatedtoinvestorrights.Theyinterprettheresults,takentogether,assuggestivethatearningsmanagementisassociatedwiththe
accrualanomaly.BiddleandHilary(2006),usingtheLeuzetal.(2003)measure,documentthatsmoothnessisassociatedwith
lowerinvestmentefficiencyasmeasuredbyinvestmentcashflowsensitivitymetrics(seealsoBiddleetal.,2009).Finally,
lookingat26countries,DeFondetal.(2007)documentapositiveassociationbetweenaveragecountrylevelearningsquality,
measuredbasedonascoredevelopedinLeuzetal.(2003),andabnormalreturnvarianceduringatwodayannualearnings
announcementwindow.Theyalsofindthatabnormalreturnvariancearoundearningsannouncementsishigherincountrieswith
betterenforcedinsidertradinglaws,stronginvestorprotection,andlessfrequentinterimreporting.Thesefourstudiesagain
provideconsistentevidencethatthevariousearningsqualityproxies,whenmeasuredatthecountrylevel,reflectvariationin
earningsmanagement.Theevidenceonsmallprofitsasaproxyforearningsmanagementcontrastswithmuchoftheevidence
basedonUSdata.Theevidenceonaccrualsisnotasincrementallyvaluableforunderstandingaccrualsqualityingeneral,given
thenoiseintheproxiesforaccrualsinthecrosscountrystudiescomparedtostudiesofUSfirms.63Theevidenceonsmoothness
conflictswithevidencefromstudiesofUSfirms(eg,TuckerandZarowin,2006;Subramanyam,1996).Oneexplanationforthe
conflictisdifferencesinthemeasurementofsmoothness,andinparticularintheabilityofthesmoothnessmeasurestoidentify
theopportunisticelementofsmoothness.Analternativeexplanation,however,isthattherearerealdifferencesinthedecision
usefulnessofsmoothnessacrosscountriesbecauseofthedifferentinstitutions.Futureresearchcouldattempttosortoutthese
explanations.
Finally,weconcludethissectionwithareminderofanimportantcaveatthatwemadeatthebeginning.Theconclusionsthat
the earnings management measure examined in these studies captures earnings management that would erode decision
usefulness,andthus,earningsquality,arespecifictodecisionsanddecisionmakersmadeinthecountriesstudied.
5.Thedeterminantsofearningsquality
Inthissection,wereviewtheliteratureonthedeterminantsofearningsquality.Therearesixcategoriesofdeterminants:(1)
firmcharacteristics,(2)financialreportingpractices,(3)governanceandcontrols,(4)auditors,(5)equitymarketincentives,and
(6)externalfactors.ManyofthepaperswerealreadydiscussedinSection3,butinthissectionwehavejuxtaposedthestudies
accordingtothedeterminantofearningsqualitythatisexamined.Thepurposeofthisdiscussionisfourfold.First,andmost
importantly,thisreviewhighlightstheconvergentordivergentvalidityofthehypothesizeddeterminantsofearningsquality
acrossthevariousEQproxies.Second,weprovidedeterminantspecificconclusionsandinsightsthatwereabsentfromSection
3.Inparticular,researchdesignissuestendtobedeterminantspecific,andourdiscussionhighlightsanumberofsuchissues.
Third,Section3.1didnotdiscussthedeterminantsandconsequencesofabnormalaccrualsbecausetherearealmostonehundred
papersusingabnormalaccrualstomeasureearningsquality.Thisliteratureisdiscussedhere.Finally,thissectionprovidesa
convenientreferencetoolforreaderswhoareinterestedinreviewingtheresultsrelatedtoaspecificdeterminantofearnings
quality.
5.1.Firmcharacteristicsasdeterminantsofearningsquality
Severalstudies providedescriptive evidencethat firmoperating characteristics, broadlydefined, are associatedwith the
variousproxiesforearningsquality,includingafirm'schoiceofaccountingprinciples(HagermanandZmijewski,1979;Jung,
1989;Lindahl,1989),propertiesofitsearningssuchaspersistenceandvolatility(Lev,1983),andaccruals(Dechow,1994).
Insightsaboutfourspecificfirmcharacteristicsdeserveaseparatediscussion:(1)firmperformance,(2)debt,(3)growthand
investment,and(4)size.
Firmperformance:Researchershaveinvestigatedwhetherfirmsthatareperformingpoorlyengageinaccountingtacticsto
improve their earnings and hence lower earnings quality. Specifically, weak performance provides incentives to engage in
earningsmanagement(Petroni,1992;DeFondandPark,199764;Balsametal.,1995;KeatingandZimmerman,1999;Doyleet
al.,2007a;KinneyandMcDaniel,1989).However,Francisetal.(1996)donotfindanassociationbetweenweakperformance
andwriteoffs,andDeAngeloetal.(1994)suggestthatsustainedweakperformancecanlimitopportunitiestomanageearnings.
Debt:Ifhigherleverageisindicativeofafirmthatisclosertoadebtcovenantrestriction,thenmanagersinmorehighly
leveredfirmscouldbetakingactiontoboostincomeormanipulatethefinancialstatementssoastoavoidviolatingacovenant
(WattsandZimmerman,1986).Suchactioncouldreducethequalityofearningsforotherdecisions.Thereissubstantialevidence
thatdebtlevelsareassociatedwithvariousmeasuresofearningsquality,includingincomeincreasingaccountingmethodchoices
(eg,Bowenetal.,1981;ZmijewskiandHagerman,1981;DaleyandVigeland,198365;JohnsonandRamanan,1988;Malmquist,
1990;Balsametal.,1995;LaBelle,1990),assetsalesasaformofrealearningsmanagement
63Wearenotquestioningthecontributionsoftheresultsforotherpurposes;wearequestioningonlywhattheyrevealabout
theproxiesforearningsquality.
64Elgersetal.(2003)suggestthattheresultsinDeFondandPark(1997)aresensitivetothemethodusedto''backout''abnormal
accruals.65DaleyandVigeland(1983)alsofindthatthefirmsthatchooseincomeincreasingvoluntaryaccountingmethods
havehigherratiosofdividendstoretainedearnings,whichisanotherproxyfortheextenttowhichdebtcovenantsarelikelytobe
binding.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401380
(Bartov,1993),expostproxiesforpoorqualitysuchasearningsannouncementcorrections(KinneyandMcDaniel,1989),
restatements (Efendi et al., 2007), and weak evidence with AAERs (Dechow et al., 1996; Beneish, 1999; Dechow et al.,
forthcoming).Studiesthatusemoredirectmeasuresofproximitytocovenantviolationalsogenerallysupportthedebtcovenant
hypothesis for accounting choices (Sweeney, 1994), abnormal accruals (DeFond and Jiambalvo, 1994), and target beating
(DichevandSkinner,2002),althoughDeAngeloetal.(1994)findrelativelylittledifferencebetweenaccrualsforfirmswithand
withoutbindingcovenants.
Thus,higherleverageisassociatedwithlowerqualityearningsusingamultitudeofproxies.However,whetherthelower
quality is due to closeness to covenants versus other incentives (eg, bankruptcy concerns, financial distress, the need for
financing)ormoregenerallytodifferencesintheinvestmentopportunitysetisalingeringquestion(eg,Zimmer,1986;Skinner,
1993).Studiesthatusemoredirectproxiesforclosenesstocovenantsdosuggestthatmanagersmakeaccountingchoicestoavoid
covenantviolation,butthisresultdoesnotnecessarilyimplythatearningsqualityiscompromised.Ifdecisionmakersadjustfor
theeffectsofthechoices,eitherbecausetheyobservethemorbecausetheyrationallyinferthatincomeincreasingaccounting
choicesaretakentoavoidcovenantviolations,thensuchactionsmaybenefitallcontractingparties.
Firm growth and investment: Researchers have investigated the role of growth and earnings quality on a number of
dimensions.Whengrowthismeasuredintermsofsalesgrowthornetoperatingassetgrowth,thenitappearsthathighgrowth
firmshavelowerearningspersistence(NissimandPenman,2001;PenmanandZhang,2002),asdiscussedextensivelyinSection
3.1.1. The negative relation between growth and earnings quality proxies is suggested by other proxies as well, including
measurementerrorinearningsandearningsmanagementopportunities(Richardsonetal.,2005),targetbeating(McVayetal.,
2006),AAERs(Dechowetal.,forthcoming),andinternalcontrolweaknesses(Doyleetal.,2007b;AshbaughSkaifeetal.,
2007).Leeetal.(2006),however,donotfindevidencesupportingtheassociationbetweengrowthandrestatedamounts.
Firmsize:Studiessuggestarelationbetweenfirmsizeandseveralearningsmetrics,buttherelationisnotthesameacross
measures.Earlypaperspredictthatfirmsizewouldbenegativelyassociatedwithearningsqualitybecauselargerfirmswould
makeincomedecreasingaccountingmethodchoicesinresponsetogreaterpolitical/regulatoryscrutiny(JensenandMeckling,
1976; Watts and Zimmerman, 1986). The evidence is mixed and depends on the nature of the accounting method choice
examinedandthesample/setting(eg,HagermanandZmijewski,1979;ZmijewskiandHagerman,1981;Bowenetal.,1981;
Zimmer,1986).Moreover,Moses(1987)findsthatfirmsizeandmarketshare(marginally)areassociatedwithaccounting
method changes to smooth (as opposed to decrease) earnings. However, more recent studies predict and find that size is
positively associated with earnings quality because of fixed costs associated with maintaining adequate internal control
proceduresoverfinancialreporting,assuggestedbyBallandFoster(1982).Smallfirmsaremorelikelytohaveinternalcontrol
deficienciesandaremorelikelytocorrectpreviouslyreportedearnings(KinneyandMcDaniel,1989;GeandMcVay,2005;
Doyleetal.,2007a;AshbaughSkaifeetal.,2007).
Taken together, theabove studiesthat examinefirm characteristicsas determinantsof earningsquality revealthat firm
characteristics (eg, firm size, performance, etc.) are most commonly documented to be associated with accounting method
choice.Thisrevelationisimportantfortworeasons.First,studiesthatuseaccountingchoices,includingmethodchoicesand
estimates,asanindicationofearningsmanagementandhenceearningsqualitymustcontrolforfundamentaldifferencesinfirm
characteristicsbeforeinferringopportunism.
Second,accountingmethodchoicesarerelativelytransparentcomparedto,forexample,accrualearningsmanagement.Ifthe
earnings managementis transparentto decisionmakers, either becausethe accountingchoices areobvious (eg, accounting
method changes) or because the decision makers rationally infer that incomeincreasing actions are taken to meet certain
objectives(eg,toavoidcovenantviolation),thenearningsquality(itsdecisionusefulness)isnotimpairedfromtheperspectiveof
the decisionmaker who detects it. However, there is limited evidence that investors are able to unwind incentives and to
incorporate an expectation of rational earnings management into their pricing. Studies such as Aboody et al. (1999) and
Shivakumar(2000)suggestthatinvestorsdetectearningsmanagementandviewitasavaluemaximizingactivitythatisthe
outcomeofefficientcontracting.However,theirevidenceisfordebtandequityrelatedincentives,whichareamongthestrongest
documentedincentivesforearningsmanagementandpotentiallythemosttransparenttoinvestors. The limited research on
whetherearningsmanagementisdetectedturnsouttobeacommonproblemthatweidentifyinotherpartsofSection5aswell;
thuswediscussthisissueinmoredetailintheconclusion(Section7).
5.2.Financialreportingpracticesasdeterminantsofearningsquality
Thissectiondiscussesthreefeaturesoffinancialreportingpracticesthatresearcherspredicttoaffectearningsquality:
(1)accountingmethods,broadlydefinedtoincludeprinciples(eg,fullcostversussuccessfulefforts),estimatesassociatedwith
accountingprinciples(eg,straightlineversusaccelerateddepreciation),orestimates(eg,pensionaccountingassumptions),(2)
otherfinancialreportingpracticesincludingfinancialstatementclassificationandinterimreporting,and(3)principlesbased
versusrulesbasedmethods.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401381
Thereareonlyasmallnumberofpapersinthefirstcategory,likelyduetoresearchdesignissuessuchasendogeneity(ie,
firms choose to follow different methods). Early studies, while acknowledging the endogeneity issue, nonetheless provide
evidenceontherelationofspecificaccountingmethodstoearningssmoothnessandtoearningsinformativeness(Gonedes,1969;
BarefieldandComiskey,1971;Beidleman,1973;Moses,1987).Whenaccountingmethodsaremandatory(ie,exogenous),there
isnocrosssectionalvariationtoexamine.Analternativeistostudyfirmsindifferentmandatoryreportingregimes(ie,different
countriesordifferenttimeperiods),butthisapproachcreatesanomittedcorrelatedvariablesproblem.Thesmallnumberof
paperspublishedafterthemid1970seitherusesimulations(Dharan,1987;Healyetal.,2002)orexaminespecificaccounting
methodsinspecificsettingsorforspecificsamplesallowingthemtoovercometheresearchdesignissues(LoudderandBehn,
1995;LevandSougiannis,1996;Aboodyetal.,1999;SivakumarandWaymire,2003;Altamuroetal.,2005),whichimproves
internalvaliditybutattheexpenseofgeneralizability.
Overall, thenotionthataccountingmethodchoice, on average, leadstolowerqualityearningsbecausemanagersmake
opportunisticchoicesratherthanchoicesthatimproveearningsinformativenessdoesnothavemuchsupport.Forexample,cash
flowmethodsdonotdominateaccrualbasedmethods(thatinvolveestimation)inforecastingcashflows(Dharan,1987),and
more''aggressive''incomerecognitionmethodsareviewedasopportunisticbyinvestors(LoudderandBehn,1995;Altamuroet
al.,2005).Moreover,investorsappeartoadjusttheirvaluationdecisionstoreflectinformationthatisnotreported(eg,R&D
expenditure) (Lev and Sougiannis, 1996). Investors also appear to adjust their valuations when they anticipate earnings
management(Aboodyetal.,1999).
Regardingotherfinancialreportingpractices,priorresearchhasexaminedtheeffectsoffinancialstatementclassificationand
interimreportingonearningsquality.McVay(2006)suggeststhatfirmsopportunisticallyusediscretionoverincomestatement
classificationwithinaperiodtoshiftexpensesintocategoriesthatmightbeperceivedaslesspersistent(specialitems)tomeet
analystforecasts.Relatedtointerimreporting,severalpapersindicatethatfirmstimeincomerecognitionacrossperiodswithina
fiscalyear,whichaffectstherelativequalityofinterimversusfourthquarterearnings,butthepapersprovidemixedevidenceon
directionality.KersteinandRai(2007)andJacobandJorgensen(2007)documentthatthekinkinearningsisstrongestforfiscal
yearsforwhichtheincentivesforearningsmanagementaregreatestrelativetoannualperiodsendingatthefirstthreefiscal
quarters.Incontrast,BrownandPinello(2007)suggestthatfirmsusemoreearningsmanagementtoavoidnegativeearnings
surprisesatinterimquartersthanatfiscalyears,becausethefinancialauditingprocessincreasesopportunitiesforearnings
managementininterimperiods.
Finally, the evidence on the impact of principlesbased versus rulesbased standards on earnings quality is mixed.
Conceptually, a potential advantage of principlesbased standards is that removing alternative accounting treatments for a
transactioninfavorofasingleprinciplethatreflectsunderlyingperformancewouldresultinamoreinformativeearningsnumber
becauseitreducesopportunitiesforearningsmanagement.Managerscannotopportunisticallyapplyaninappropriatemethodor
estimatebutcanclaimthattheywerefollowingstatedaccountingprinciplessuchasUSGAAPorIASasadefense.Apotential
disadvantageisthatprinciplesbasedstandardsconstrainamanager'suseofdiscretionallowedwithinthestandardstoprovide
relevantinformation.66
Twostudies,afieldexperimentandasurvey,concludethatprinciplesbasedstandardslikelywillnotdiminishopportunistic
earningsmanagement(Cucciaetal.,1995;Nelsonetal.,2002).However,twoempiricalanalysesreachtheoppositeconclusion.
Mergenthaler(2009)documentsthataccountingstandardswithmorerulebasedcharacteristicsareassociatedwithagreater
dollar magnitude of misstatements using a sample of GAAP violation firms. Barth et al. (2008) argue that International
Accounting Standards (IAS) are principlesbased and find evidence that the use of IAS is associated with less earnings
management,moretimelylossrecognition,andgreatervaluerelevance.Theyarecarefultoacknowledgethattheseexpost
characteristics of earnings also are a function of differences in institutions, which affect the demand for information,
enforcement,andfundamentalfirmcharacteristicsoftheIASadopters.Whiletheyattempttocontrolforthesedifferences,the
resultsarestillsubjecttothiscaveat.
5.3.Governanceandcontrolsasdeterminantsofearningsquality
AccordingtotheterminologyofJensenandMeckling(1976),internalcontrolsincludemonitoringmechanisms,optimally
chosenbytheprincipalintheprincipalagentrelationship,aswellasbondingmechanisms,optimallychosenbytheagentat
somecost.ThemechanismswediscussinthissectionincludecharacteristicsoftheBoardofDirectors(BOD),internalcontrol
procedures,67managerialshareownership,managerialcompensation,andmanagerialchange.Studiesoftheassociationbetween
BOD characteristics and internal control procedures generally view these internal control mechanisms as monitors of the
financial reporting system that constrain a manager's opportunity or ability to manage earnings, while managerial share
ownershipandmanagerialcompensationaregenerallypredictedtoaffectearningsqualitybecausetheyprovideincentivesfor
earningsmanagement.68Inbothcases,internalcontrolsarepredictedtoaffectearningsmanagement,commonlyproxiedby
discretionaryaccrualsandaccountingmisstatements.
66SeeBarthetal.(2008)forathoroughdiscussionofthedebate.67Weemphasizethedistinctionbetween''internalcontrols,''a
termusedbroadlybyJensenandMeckling(1976)toincludewhatresearcherscommonlyrefertoascorporategovernance
mechanismsaswellasbondingmechanisms,andinternalcontrol''procedures.''Wewillusetheterm''internalcontrol
procedures''forthetasksperformedtomonitorthefinancialreportingsystem,forexample,byaninternalauditdepartment.
68SeeNgandStoeckenius(1979),Lambert(1984),Verrecchia(1986),Dye(1988)andLiang(2004).
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401382
Theevidenceconsistentlysuggeststhatinternalcontrolproceduresareassociatedwithlessearningsmanagement(Doyleet
al., 2007a;AshbaughSkaifeetal., 2008)andthatmanagerialturnoverisadiscipliningmechanismthatmitigatesearnings
management(Moore,1973;DeAngelo,1988;CollinsandDeAngelo,1990;DechowandSloan,1991;Pourciau,199369;Geiger
andNorth,2006).However,evidenceongovernancemechanismsotherthaninternalcontrolproceduresisweakormixed.
RelatedtocharacteristicsoftheBOD,studiesdocumentthatmoreindependentboards(eg,measuredbyagreaterproportionof
outsiders),andhigherauditcommitteequality(eg,measuredbyindependenceandmeetingfrequency)areassociatedwithless
earnings management (eg, Beasley, 1996; Klein, 2002; Abbott et al., 2004; Krishnan, 2005; Vafeas, 2005; Farber, 2005).
However,Larckeretal.(2007)findmixedevidenceofassociationsbetweenthefourteengovernancefactorsandearningsquality
asmeasuredbydiscretionaryaccrualsandrestatements.
Theevidenceonownershipisevenmoremixed.Somestudiessuggestthatgreatermanagerialownershiphasanentrenchment
effectcontrollingshareholdersextrapolateprivatebenefitsattheexpenseofminorityshareholdersthroughaccountingmethod
choice(Smith,1976;Dhaliwaletal.,1982)andlessconservatism(LaFondandRoychowdhury,2008).Otherstudies,however,
supportanincentivealignmenteffectofmanagerialownershipbasedondiscretionaryaccrualsandERCs(Warfieldetal.,1995;
Guletal.,2003),althoughLarckeretal.(2007)getoppositeresultsfortherelationbetweeninsiderpower,primarilymeasured
bymanagerialownership,anddiscretionaryaccruals.Likewise,twostudiesusingdatafromcountrieswithhighownership
concentration(ie,controllingshareholdersrelativetominorityshareholders)suggestanentrenchmenteffect(FanandWong,
2002;KimandYi,2006),whileWang(2006)providesevidenceinsupportoftheincentivealignmenteffectforfoundingfamily
ownershipintheUS70
Finally, evidence on the relation between characteristics of managerial compensation and earnings management is
voluminous.Thestudiesincludedinthisliteratureareasfollows:sevenstudiesonbonusplansandearningsbasedcompensation
asadeterminantofaccountingchoices(HagermanandZmijewski,1979;Bowenetal.,1981;Healy,1985;Skinner,1993;
Holthausenetal.,1995;Gaveretal.,1995;Guidryetal.,1999)71;tenstudiesonequitybasedcompensationincludingexecutive
stockoptions(BergstresserandPhilippon,2006;BurnsandKedia,2006;Efendietal.,2007;Johnsonetal.,2009;Balsametal.,
2003;Bakeretal.,2003;Colesetal.,2006;McAnallyetal.,2008;Ericksonetal.,2006;Armstrongetal.(2010b)72;andthree
studiesoninsidertrading(Beneish,1999;SummersandSweeney,1998;DarroughandRangan,2005).
Theresultsofthesestudiesagainaremixed.Wemakenoattempttosummarizeandcomparethembecauseeachpaper
matches aspecific formof compensationrelatedincentives (eg, insidertrading orequity incentives)to aspecific earnings
management objective (eg, smoothing or meeting an earnings target), and each paper identifies a specific mechanism (eg,
discretionaryaccruals)thatwillbeusedtoachievetheobjective.Studiesofincentivesprovidedbycontractbasedcompensation,
forexample,canpredictthatmanagerswillmanageanyelementofreportedearningsexceptforthosethatcanbeeasilyobserved
bycompensationcommitteesoreventhosecontractuallyexcludedfromthebonuscalculation.Infact,thedegreeofmixed
evidenceacrossthesestudieslikelyreflectsthedifficultiesofcorrectlymatchingthecompensationincentivestotheearnings
managementtools.Thefactthattheresultsarevariableanddecisionspecificisapointwehaveemphasizedthroughoutthe
review.
As a whole, the literature on internal control mechanisms (other than internal control procedures) yields the following
insights.First,notallinternalcontrolmechanismsshouldbepredictedtohaveanequalimpactonthevariousproxiesfor
earningsquality.Thisinsightsupportsourconclusionabouttheliterature,takenasawhole,thattheearningsqualityproxies
shouldnotbetreatedassubstitutes,asdiscussedinSection2.Thestudiesconsistentlysuggestanegativeassociationbetween
auditcommitteequalityandearningsmanagement(withtheexceptionofLarckeretal.,2007).Thisresultisnotsurprising
becausetheauditcommittee'sprimaryresponsibilityistooverseethefinancialreportingprocess.Thus,inferencesfromstudies
thatpredictanassociationbetweenauditcommitteequalityandaccrualsqualityhavethegreatestinternalvalidityamongallthe
governancemechanisms,ceterisparibus.TheexplanationforanassociationbetweenBODqualityandearningsmanagement,
however,isweaker.Directorsareusuallyinvolvedwithdecisionsatahighlevel,suchassettingoverallstrategy(Adamsetal.,
2008).Hence,whileitmaybereasonabletoargueacorrelationbetweenBODqualityandthequalityofM&Adecisions,for
example,theargumentthatBODcharacteristicscanexplaincrosssectionalvariationinearningsmanagementislesscompelling.
Testsbasedonanoverallgovernancescoreasaproxy
69DechowandSloan(1991)andPourciau(1993)findconflictingevidenceabouttheassociationbetweentheuseofincome
increasingaccrualsandmanagementturnover.AkeydifferencebetweenthestudiesisthatDechowandSloan(1991)study
retireeswithexpecteddeparturedates,whilePourciau(1993)studiesnonroutineexecutiveturnover.Theconflictingresults
emphasizethedifficultyofidentifyingwhetherandwhenmanagersexpecttodepart.
70ThefindingsfortheAsianfirmsaredifferentfromthefindingsbasedonUSdata.Therecouldbetwoexplanationsforthe
differencesbetweenWang'sresultsandthoseinFanandWong(2002).First,foundingfamilyfirmscouldbedifferentfromother
firmswithconcentratedownershipbecauseoftheincentivetoprotectthefamily'sreputation.Second,Wang'sfindingsarebased
ondatafromtheUS,wherelegalprotectionforminorityshareholdersisstrongerthaninothercountries(eg,Korea).
71SeeChristie(1990)forametaanalysisofearlyresearchthatexaminedwhethermanagerschooseaccountingmethodsto
maximizeearningsbasedcompensation.
72Severalstudiessuggestthatmanagersattempttodeflatethefirm'sstockprice,andhencetheESO'sstrikeprice,priortoa
grantviathetimingofdisclosuresaroundgrantdates.AboodyandKasznik(2000)examinefirms'voluntarydisclosuresandfind
thatunderafixedgrantingschedule,badnewstendstoprecedegrantdatesandgoodnewstendstofollow.Theyalsofindthat
stockreturnsaresystematicallylowerpriortograntdatesandincreaseafterwards(ChauvinandShenoy,2001;Yermack,1997).
Arelatedlineofresearchexaminesbackdating,inwhichgrantdatesareretroactivelyassignedtohistoricallylowshareprices
(HeronandLie,2006;Narayananetal.,2006).
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401383
forinternalcontrolsthatmightconstrainearningsmanagementmustassumethatvariationinthescoreiscorrelatedwiththe
qualityofmechanismsthatspecificallyaffectearningsmanagementopportunitiesorincentives.
Asecondsignificantissueinthisliteratureisthatmanyinternalcontrolmechanismsaresubstitutesorcomplements.Krishnan
(2005),forexample,emphasizesthecomplementarityoftwointernalcontrolmechanisms(ie,auditcommitteesandinternal
controlprocedures).Usingonlyalimitedsetofcorporategovernancemeasuresresultsineconometricproblems(eg,inconsistent
coefficientestimates)thatcanleadtoinvalidinferences.Toaddressthisissue,Larckeretal.(2007)startwithacomprehensive
listof39governancevariablesanduseprincipalcomponentanalysistoextractfourteengovernancefactors.Theyfindmixed
evidenceofassociationsbetweenthegovernancefactorsandearningsmanagement.Athirdnotabledeficiencyofthisliteratureis
thatourdatabasedoesnotcontainanystudiesthatattempttopredictthatequitybasedcompensationwillhaveconsequencesfor
EQproxiesotherthanearningsmanagement.Thisomissionissurprisinggiventhatvariationincompensationcontractformis
commonlypredictedtoaffectvariationininvestmentrisktaking(eg,RajgopalandShevlin,2002),whichinturnshouldaffect
earningspersistence.
Lastly,despitethelongstandingrecognitionthatoptimalcontractsmayleadtoaccountingchoicesthatbenefittheagentatthe
expenseofthefirmor,alternatively,toefficientaccountingchoicesthatmaximizethevalueofthefirm,thedebateoverwhich
effectisdominantisstillopen.73ChristieandZimmerman(1994)andBowenetal.(2008)bothconcludethatcontracting
efficiency is the main explanation. Their findings raise the question of whether and when equityholders recognize that
discretionaryaccountingchoicesareexpostefficientversusopportunistic.Likewise,Colesetal.(2006)provideevidencethat
equityinvestorsinferthatearningsmaybemanagedafterESOcancellationsandthattheyarenotmisledbythediscretionary
accruals.However,researchthatexplorestheextenttowhichequityinvestorsinferrationalearningsmanagementandviewitas
anefficientcontractingchoice,andperhapsreactfavorablytoit,islimited.
5.4.Auditorsasdeterminantsofearningsquality
Researchershypothesizethatauditorsareadeterminantofearningsqualitybecauseoftheirroleinmitigatingintentionaland
unintentionalmisstatements.Theabilityofanauditortomitigatemisstatementsisafunctionoftheauditor'sabilitybothtodetect
amaterialmisstatementandtoadjustfororreportit(DeAngelo,1981).Researcherspredictthatanauditor'sabilitytodetect
errorsisafunctionofauditoreffortandeffectivenessandthatanauditor'sincentivestoreportorcorrecterrorsdependonfactors
suchaslitigationrisk,reputationcosts,andauditorindependence.74
Whilethe basicpremise thatauditors couldmitigate misstatementsis straightforward, compellingempirical evidenceis
limitedbecauseauditoreffort/effectivenessandincentivesareunobservable,anddatatocreateproxiesfortheseconstructsare
oftenunavailable.Themostdirectempiricalproxiesforeffort/effectivenessincludehoursspentauditing(CaramanisandLennox,
2008)andauditorindustryexpertise(Krishnan,2003),andbotharenegativelyassociatedwithdiscretionaryaccruals.Evidence
ontherelationbetweenauditortenureasaproxyforeffort/effectivenessanddiscretionaryaccrualsismixed(Johnsonetal.,
2002;Chenetal.,2008),asistheevidenceontherelationbetweenmisstatementsandrevolvingdoorauditors,whomaylack
effort/effectivenessbecauseoftheirpotentiallycompromisedindependence(MenonandWilliams,2004;Geigeretal.,2008).
Whenauditeffortisinferredfromtheauditor'sincentivesorabilitiestodetectmisstatements,greatereffortdetersexpost
observedfinancialreportingirregularities(eg,Phillips,1999;SchneiderandWilner,1990;Barronetal.,2001;Hirst,1994),
althoughperceivedaggressivenessoftheauditordoesnotdeterexanteearningsmanagementbehavior(Ueckeretal.,1981).
Moreover,greatereffortmaynotresultinhigherqualityearnings,butratherinlowqualityearningsaccompaniedbyaqualified
auditopinion(Whittred,1980).
Evidencebasedonauditorsizealsosuggestsarelationwithaccrualsquality.Withfewexceptions,75studiessuggestthat
firmswithBigXauditors76havesignificantlylowerdiscretionaryaccrualsthanfirmswithnonBigXauditors(Beckeretal.,
1998;DeFondandSubramanyam,1998;Francisetal.,1999;Kimetal.,2003).However,thevoluminousevidenceonthe
relationbetweenauditfeesandaccrualsqualityismixedanddependsheavilyonthetypeoffees(eg,auditversusnonaudit),
samplefirms,andspecificmeasureofaccrualsquality(Frankeletal.,2002;Ashbaughetal.,2003;ChungandKallapur,2003;
Guletal.,2003;Fergusonetal.,2004;LarckerandRichardson,2004;FrancisandKe,2006;Ruddocketal.,2006;Guland
Srinidhi,2007).
Insummary,reviewingtheaboveliteratureonauditorsyieldsthefollowingconclusions.First,forbothauditorsizeandfees,
onemustusecautionwheninterpretingtheevidence.Theauditorsizeresultsdonotidentifywhetherthefindingsaredrivenby
detectionabilityorreportingincentivesbecausebotharecorrelatedwithauditorsize.Eveninthefeeandtenurestudies,itisstill
difficulttodisentanglethereasonfortheauditor'simpactonquality.Auditfeesandauditortenurearepredictedtobepositively
correlatedwithauditorexpertise,andhencewithdetectionability,buttheyarealsopredictedtobenegativelyassociatedwith
auditorindependenceandhencewithdecreasedreportingincentives(DeAngelo,1981).
73SeeDyeandVerrecchia(1995),FischerandVerrecchia(2000),andStockenandVerrecchia(2004).Thesestudiesuse
variedmodelingtechniquestoyieldpredictionsaboutaccountingmethodchoiceandconditionsthataffectefficiency.
74SeeNelsonetal.(2002)forsurveyevidencethatauditorsdoadjustforattemptedearningsmanagement,especiallywhen
attemptedearningsmanagementincreasescurrentyearearnings.
75SeeBeasley(1996),alongwithGaverandPaterson(2001),andDechowetal.(1996).76Bigeight,Bigsix,orBigfive,
dependingonthetimingofthestudy.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401384
Second,evidenceontheauditors'roleinaffectingearningsqualityislimitedtotheconclusionthatauditorsconstrainincome
increasingdiscretionaryaccruals,whichissensiblegiventheauditor'sroleinthefinancialreportingprocess.However,the
empiricalevidencealsosuggestsapositiverelationbetweenauditoreffortandERCsandearningsproperties(eg,Francisand
Wang,2008;TeohandWong,1993;HackenbrackandHogan,2002).Suchstudiesmustdealwithsubstantialconcernsabout
alternativeexplanationsforresults,includingauditorselfselectionandomittedcorrelatedvariables.Inparticular,ERCsand
earningspropertiesareaffectedbytheabilityoftheaccountingsystemtocapturethefirm'sfundamentalperformance,whichis
notadimensionofqualitythatauditorscontroloraffect.
Third,anotablyunderrepresentedelementoftheliteratureisresearchthatrecognizestheimportantrolesofentitiesotherthan
auditors,suchasactuaries,venturecapitalists,orunderwriters,whoaredirectlyinvolvedinthefinancialreportingprocessor
affectfinancialreportingincentives.ExamplesofsuchstudiesincludeGaverandPaterson(2001),MorsfieldandTan(2006),Jo
etal.(2007),andBushee(1998).
5.5.Capitalmarketincentivesasdeterminantsofearningsquality
Thissectionsummarizesstudiesthatexaminetheinfluenceofcapitalmarketincentivesonfirms'accountingchoices,making
thempotentialdeterminantsofearningsquality.
5.5.1.Incentiveswhenfirmsraisecapital
Alargecollectionofstudieshypothesizethatthecost/benefittradeoffsofaccountingchoiceschangeduringperiodswhena
firmraisescapital.Greaterlitigationrisk,forexample,mayincreasethecostsofopportunisticaccountingchoices.Greaterutility
associatedwiththeavailabilityorpriceofcapitalmayincreasethebenefitsofopportunisticaccountingchoices.Hence,thefirm's
accountingchoices,andthusitsearningsquality,maydifferwhenafirmisraisingcapital.
Reviewingthesestudiestogetheryieldsthefollowingconclusions.First,incentivestoinfluenceequitymarketvaluationsaffect
firms'accountingchoices,inparticulartheiraccrualchoices.Thisconclusionisbasedonfourstudiesinourdatabaseofaccruals
aroundafirm'sinitialpublicoffering(Aharonyetal.,1993;Friedlan,1994;Teohetal.,1998a;MorsfieldandTan,2006),andsix
studiesaroundothertypesofissues(DeAngelo,1986;PerryandWilliams,1994;Teohetal.,1998b;Rangan,1998;Ericksonand
Wang,1999;Hawetal.,2005).Twoadditionalstudiesinfercapitalmarketincentivesfromcrosslistingstatusoraroundthe
crosslistingevent(Langetal.,2003;Ndubizu,2007).Resultsusingoutcomebasedmeasuresofearningsmanagementsuchas
AAERsandrestatementsalsosuggestthatcapitalraisingactivitiesareassociatedwithearningsmanagement(Dechowetal.,
1996;Efendietal.,2007;Dechowetal.,forthcoming).Overall,whilethestudiesprovidefairlyconsistentevidenceofaccruals
managementwhenfirmsraisecapital,theydonotexpandtheanalysistoexaminecrosssectionalvariationinaccruals
management,acrosseitherfirmsorspecificaccrualchoices,basedonvariationinthedegreetowhichtheaccrualsmanagement
isdetectable.Thesestudiesassumethatequitymarketsprovideincentivesfortheseaccountingchoices,butthatassumptionis
reasonableonlyifequitymarketparticipantscannotdetecttheearningsmanagement(oriftheearningsmanagementisnot
costly).77
Second,thestudiesgenerallyfocusoneventdrivenincentivesforaccountingchoices(eg,IPOs).Theseonetimeaccounting
choices, however, can have longterm consequences, including a diminished reputation for credible reporting.78 Adverse
selectionmodelsofvoluntarydisclosurepredictthatacommitmenttocredibledisclosurereducesafirm'scostofcapital.Thatis,
afirm'sreputationforhighqualitydisclosureswouldbenegativelyaffectedbyonetime,eventspecificopportunisticaccounting
choices,whichinturnmaynegativelyaffectequityvaluationduetodecreasedreportingcredibility.Yettheempiricalresearchon
eventspecificaccountingchoicesdoesnotincorporatetheimpactofthesecostsorconsiderthetradeoffbetweentheshortterm
benefitsoftheaccountingchoiceatthetimeoftheevent(eg,theIPO)andthepotentiallongtermreputationlossduetothese
oneoffearningsmanagementdecisions.
Third,onlyonepaperinourdatabaseexamineswhetherraisingcapitalindebtmarketsprovidesincentivesforaccounting
choice(Dietrichetal.,2000).Moreworkwithinpublicdebtmarketsandonthetradeoffsbetweendebtandequitymarket
incentiveswouldbeinteresting.
5.5.2.Incentivesprovidedbyearningsbasedtargets79
Anumberofstudiesprovideevidenceofearningsmanagementtomeetorbeatearningstargets(Kasznik,1999;Dasand
Zhang,2003;Roychowdhury,2006).Targetsundoubtedlyprovideincentivesforearningsmanagement,butthe
77TwoexceptionsareShivakumar(2000),whosuggeststhatinvestorsundoearningsmanagementatseasonedequity
offerings,andArmstrongetal.(2010c),whofindthat,aftercontrollingforcashflows,discretionaryaccrualsatthetimeofthe
IPOdonotpredictfuturereturns.
78Motivatedbyasomewhatsimilarobservation,ChristieandZimmerman(1994)findthattakeovertargetsaremorelikelyto
useincomeincreasingaccountingchoicesthananindustrymatchedsample.Thechoicestheyexaminehaveonlyasmalleffect
onincomebuthaveasubstantialimpactonretainedearningsoverlongperiods.Theyarguethatthesechoicesreflect''economic
Darwinism.''Firmsaremorelikelytobetakenoveriftheyusesuboptimalaccountingchoicesorselecttheaccountingrulesfor
opportunisticreasonsratherthansignalingreasons.
79Section3.1.5alsoreviewsevidencerelatedtobenchmarks/targets.Inthatsection,wereviewstudiesthatusemeetinga
target as a proxy for earnings quality. Those studies test the determinants of reporting earnings that meet a target or the
consequencesofdoingso.Thepapersinthissection,incontrast,treatmeetingatargetastheindependentvariableandexamine
theincentivesthattargetsprovideforearningsmanagement.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401385
contributionofthesestudiesistoprovideevidenceonspecifictools,suchasdiscretionaryaccruals,workingcapitalaccrualsand
realearningsmanagement,thatfirmsusetomanageearningstomeetparticulartargets.However,thestudiesdonotprovide
evidenceonhowfirmschooseamongearningsmanagementtools.BartonandSimko(2002)pursuetheideathatafirm'schoice
withrespecttoaparticulartoolmightbeconstrained.Also,asnotedinSection3.1.5,awellrecognizedproblemwithstudiesthat
useanalystforecastsasthetargetisthatbeatingananalystforecastdependsnotonlyonthefirm'saccountingchoices,butalsoon
theanalyst'sforecastingactions.
5.6.Externalfactorsasdeterminantsofearningsquality
Considerableevidencesuggeststhatexternalfactors,includingcapitalrequirements,politicalprocesses,andtaxandnontax
regulation,areassociatedwithaccountingchoices.80Wecatalogueeightstudiesthatdocumentthatfirmsengageinincome
decreasingearningsmanagement,commonlymeasuredbydiscretionaryaccruals,acrossawidevarietyofsettingsinwhich
profitswouldgeneratecostlyregulatoryinterventionorpoliticaloutcomes(Jones,1991;Cahan,1992;Mensahetal.,1994;Key,
1997;HanandWang,1998;Navissi,1999;Monem,2003;JohnstonandRock,2005).
Thesinglemostcommonlyresearchedregulationiscapitalrequirements.Muller(1999),forexample,examinesincentives
providedbytheLondonStockExchangeshareholderapprovalrequirements.However,mostresearchershavefocusedoncapital
regulationswithinthebankingandinsuranceindustries,andthemostcommonlystudiedaccrualusedtomeettheseregulationsis
theloanlossprovision.Fourpapersfocusexclusivelyontheincentivesprovidedbycapitalregulations(Petroni,1992;Kimand
Kross,1998;Ahmedetal.,1999;SchrandandWong,2003).Anadditionalfivepapersstudytheimpactofcapitalrequirements
relativetootherincentives(Moyer,1990;Beattyetal.,1995;Mensahetal.,1994;ChenandDaley,1996;GaverandPaterson,
1999). The general conclusion based on these studies is that other incentives are of secondorder importance when capital
requirementsarelikelytobebinding.Inparticular,equitymarketincentivesreceivelittlesupportasadeterminantofaccounting
choiceswhenmeasuredrelativetoincentivesprovidedbyexternalfactors.
Wecautionthatalthoughtheevidencethatcapitalrequirementsareassociatedwithearningsmanagementisstrong,this
conclusionmaynotgeneralizetofirmsinothersettings.Thefinancialservicesindustryprovidesasettingfortestswithgreater
powertodetectspecificearningsmanagementresponsestoregulationsgiventhedirectlinkbetweenthecapitalrequirementsand
thelossprovisionaccountsandthesignificanceandvariationofthelossprovisionaccountsacrossbanks/insurancecarriers.
Tax regulations are another commonly studied determinant of earnings quality, again because the regulations affect
accountingchoices. Several studies specifically examine the impact of the LIFO conformity rule in the US tax system on
accountingmethodchoice(LeeandHsieh,1985;Hunt,1985;DopuchandPincus,1988).Evidenceonother(noninventory)
accountingchoicescomesfromteststhatusenaturalexperimentsandismorelimited(KeatingandZimmerman,1999;Guenther
etal.,1997).FivepapersinourdatabaseexaminewhetherratechangesassociatedwiththeTRAcausedincomeshiftingfromthe
pretopostTRAperiod.ThreeoftheseconcludethattheTRAhadaonetimeimpactonaccrualchoicesaroundtheperiodofthe
change(Scholesetal.,1992;Guenther,1994;Maydew,1997),buttwopapersprovideinconsistentevidenceonincomeshifting
intheoppositedirectiontoavoidtheUScorporatealternativeminimumtax(Boyntonetal.,1992;Choietal.,2001).81
ThethirdmostcommonlystudiedregulationisSOX.Preliminaryevidencesuggeststhatearningsmanagementactivities
usingaccrualsdeclinesfollowingSOX,butthatfirmssubstituteothermechanismssuchasrealearningsmanagementactivities
and''expectationsmanagement''(Cohenetal.,2008;Kohetal.,2008).Thus,theoveralleffectofSOXonthedecisionusefulness
ofearningsisambiguous.Theseresultsreinforceapointwehavemadeinprevioussections:accrualsmanagement,ceteris
paribus,mayimpairearningsquality,butitrepresentsonlyonechoicewithinthefirm'sportfoliooffinancialreportingchoices.
Withinthestudiesdiscussedinthissection,Huntetal.(1996)andBeattyetal.(1995)aretwoexamplesofstudiesthatexamine
bothmultipletoolsandmultipleincentives.
Threepapersinourdatabasestudyotherexternalfactorsthatprovideincentivesforearningsmanagementbutdonotfitinto
thecategoriesdefinedabove.HallandStammerjohan(1997)examinepotentiallitigationawards;Bowenetal.(1995)examine
ongoingimplicitclaimswiththirdpartiesincludingcustomers,suppliers,employees,andshorttermcreditors;andRosner(2003)
examinesincentivestoavoidbankruptcy.Allthreepapersdocumentaccrualschoicesthatrespondtotheseincentives.
Takentogether,animportantinsightfromreviewingthestudiesofexternalfactorsisthatearningsqualitywillbetime
varyingiftheexternalfactorsleadtoaccrualsmanagement.However,ifexternalfactorsaffectaccountingmethodchoiceor
inducechangesinfirmbehavior(eg,SOXinducingfirmstoimproveinternalcontrols),thentheeffectonEQwillbeongoing
(Calegari,2000;Klassenetal.,1993).Ineithercase,externalfactorsthatareclusteredincalendartime
80 Regulators and regulation may be viewed as monitors like auditors and boards, discussed in Sections 5.3 and 5.4.
However,regulationisimposedonafirmandassuchisdistinctfromcontrolsthatareoptimallychosenbyaprincipal,suchas
compensation,andbyanagent,suchasdebtcovenants(KoseandKedia,2006).ConsistentwiththeKoseandKediaframework,
wetreatregulationasadistinctcontrolmechanismanddiscussitseparately.
81SeeHanlonandHeitzman(2010)foradetailedreviewoffinancialreportingfortaxpurposes.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401386
(eg,theTRAorbankcapitalrequirementchanges)willleadtovariationinearningsqualitythatisclusteredincalendartimeas
well.82
Finally, we propose several opportunities for future research. It would be interesting to investigate whether/how firms
communicatetoequitymarketsduringperiodsofregulatoryscrutinytooffsetthemessagesenttoregulators/politiciansbythe
''managed''earnings.83Doequitymarketparticipantsrationallyinfertheearningsmanagementwithoutassistancebythefirmin
theformofvoluntarydisclosure?Dofirmsassumemarketsalsoarefooledbytheearningsmanagementandforgoaccessing
capitalduringtheseperiods,orpossiblyaccessadditionalcapital?Itwouldalsobeinterestingtoinvestigatemacroeconomic
conditionsasadeterminantofearningsquality.Althoughweinitiallydefinedacategoryforsuchpapers,ourjournalsearch
foundonlyonepaperthatfocusesprimarilyonmacroeconomicfactors(eg,businesscycle)asadeterminantofearningsquality
(LiuandRyan,2006)andonepaperthatgivesthemsignificantalbeitsecondaryattention(Aboodyetal.,1999).84Bothstudies
predictthatmacroeconomicfactorsarecorrelatedwithincentivesforearningsmanagement.Wedidnotfindanystudiesthat
hypothesize macroeconomic conditions as a determinant of earnings quality for other reasons, for example, because the
conditionsaffecttheabilityofaccrualstocapturefundamentalperformance.
6.Theconsequencesofearningsquality
Inthissection,wereviewtheliteratureontheconsequencesofearningsquality.Thereareninecategoriesofconsequences:
(1) litigation propensity, (2) audit opinions, (3) market valuations, (4) real activities including disclosure, (5) executive
compensation,(6)labormarketoutcomes,(7)afirm'scostofequitycapital,85(8)afirm'scostofdebtcapital,and(9)analyst
forecast accuracy. Thus, the decision makers considered include plaintiffs, auditors, capital market participants,
boards/compensationcommittees,andanalysts.
Thefeaturethattheconsequencestudieshaveincommonisthatanearningsqualityproxyistheindependentvariable.The
papersareasubsetofthosediscussedinSection3,butorganizedbytheconsequence(dependentvariable)ratherthanbythe
earnings quality proxy (independent variable). Similar to the objective of Section 5, which organizes the papers by the
determinant,theobjectivesofthissectionaretohighlighttheconvergentordivergentvalidityofthehypothesizedconsequences
of earnings quality across the various EQ proxies, to provide consequencespecific conclusions/insights, to discuss the
consequencesofabnormalaccruals,andtoprovideaconvenientreferencetoolforreaderswhoareinterestedinreviewingthe
resultsrelatedtoaspecificconsequenceofearningsquality.
Anumberofstudieshavereturns(longorshortwindow)asaconsequence(dependentvariable).Theindependentvariablein
themajorityofthesestudiesisearningspersistence(oraccrualpersistence),andthisliteraturewasdiscussedextensivelyin
Section3.1.1.SincethereareonlyafewstudiesthatuseotherEQproxies,thereisnoaddedbenefittodiscussingthemagain.
ThecategoryofmarketvaluationsaboveisanexceptionbecausetheEQproxyistypicallyrelatedtodifferenttypesofearnings
managementvariables,offeringsomevariationtocomparetheconsequencesacrossEQmeasures.
Onenoteworthyfeatureoftheconsequencesexaminedisthatmanyofthemarealsothedeterminantsvariablesdiscussedin
Section5,whichemphasizestheimportanceofconsideringcausalitywheninterpretingtheevidence.
6.1.Litigationpropensity
Studiesthatexaminetheconsequencesofrestatementsconcludethatrestatementsincreaselitigationpropensity(Palmroseand
Scholz,2004),specificallyrestatementsthatchangethepreviouspatternofreportedearnings(Levetal.,2008).Theyarguethata
restatementisthetypeofevidenceaboutearningsqualitythatincreasesthelikelihoodthatplaintiffswillprevailinshareholder
litigation.Moreover,studiesthatfocusonhighrisksettings(eg,IPOs),inwhichabnormalaccrualsarelikelytorepresent
misstatementsoutsidetheboundariesofGAAP,alsofindanegativerelationbetweenEQandlitigationpropensity(Gongetal.,
2008;Ducharmeetal.,2004).However,thereisnoevidencethat
82SeeShackelfordandShevlin(2001)foracomprehensivereviewofincomeshiftingbymultinationals,particularlyfollowing
theTRA.83Twostudiesproviderelateddiscussions/evidence.AharoniandRonen(1989)developamodelthatshowsthat
highertaxratesareassociatedwithchoicesofincomeincreasingaccountingmethods,exceptingaccountingmethodssubjectto
booktaxconformity.Akeyassumptionofthemodelisthatequitymarketparticipantswillseethroughtheearningsmanagement
andvaluethefirm'sequitycorrectly.BeattyandHarris(1999)comparesecuritygainsandlossesinpublicbankstothosein
privatebanks,bothofwhicharesubjecttocapitalrequirements,todeterminehowearningsmanagementdiffersunderthe
assumptionthatpublicbankshavegreaterincentivestoengageinearningsmanagementthanprivatebanksduetoequitymarket
incentives.However,thispaperdoesnottesthowandwhenbankstradeofftheequitymarketincentivesagainstotherearnings
managementincentivesthatfirmsface.
84Wilson(1987)findsthathisresultsaredrivenbytwoobservations(1981and1982)andconjecturesthatthecausemightbea
''macroeconomicphenomenon,''giventhatbothwereyearsofsignificanteconomicdownturn.BernardandStober(1989),
however,findnoevidenceforthisconjecture.85Measuresofthecostofcapitalincludeafirm'sbidaskspread,beta,andan
impliedorexantecostofequitycapital,whichisthediscountratethatequatescurrentmarketvaluewiththesumofthepresent
valueofexpectedfuturecashflowsinanequityvaluationmodel.SeeFrankelandLee(1998),BotosanandPlumlee(2002),
Kasznik(2004),Bravetal.(2005),EastonandMonahan(2005),andBotosanandPlumlee(2005)forspecificationsand
discussionsofimpliedcostofequitycapitalmetrics.SeeCallahanetal.(1997)andMohanramandRajgopal(2009)for
discussionsofspreads(andPIN)asmeasuresoftheadverseselectioncomponentofthecostofcapital.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401387
abnormalaccrualswithintheboundariesofGAAPorothermeasuresofpoorearningsqualityincreasethelikelihoodoflitigation.
6.2.Auditopinions
Highaccrualfirmsaremorelikelytogetmodifiedauditopinions(FrancisandKrishnan,1999),butabnormallyhighworking
capital accruals are not associated with adverse audit opinions or auditor turnover (Bradshaw et al., 2001). There are two
explanationsforthemixedresults.OneexplanationisthatFrancisandKrishnan(1999)examinereportsin1987and1988,
whereasBradshawetal.(2001)examinereportsaftertheissuanceofSAS58and59(AmericanInstituteofCertifiedPublic
Accountants(AICPA),1988a,b).Bradshawetal.(2001)alsoprovideasecondexplanation:''yearningsqualityissuesofthetype
thatweinvestigatearebeyondthescopeoftheaudit.Inotherwords,auditorsmayunderstandthatinflatedaccrualsimplya
greaterlikelihoodoffutureearningsdeclinesandGAAPviolations,butarenotrequiredtocommunicatethisinformationto
investorsthroughtheirauditopinions.''(p.46/47)Thesecondexplanationissupportedbyevidencethattheassociationbetween
abnormal accrualsand auditopinions isprimarily drivenby arelation betweenlarge negativeaccruals andgoing concern
opinions(Butleretal.,2004).
6.3.Marketvaluations
Firmsthatconsistentlymeetorbeatpriorperiodearningstargetsoranalystexpectationsarerewardedwithhighervaluations
(Barthetal.,1999;KasznikandMcNichols,2002;Myersetal.,2007),evenifthereisevidenceofearningsmanagementto
achieve the results (Myers et al., 2007). However, firms that manage earnings through discretionary loss reserves are not
rewardedwithhighervaluations(Petronietal.,2000;BeaverandMcNichols,1998;BeaverandEngel,1996).Whenfirms
subsequentlymissatarget,theyarelikelytolosetheextravaluationimmediately(eg,SkinnerandSloan,2002;Myersetal.,
2007).Wecanthinkofseveralexplanationsforthiscombinationofresults:(1)themarketrewardssometypesofearnings
managementandnotothers,(2)greatermarketmispricingoflesstransparentearningsmanagement,and(3)''rationalbubbles''
causedbyanassociationbetweenreportedgrowthandinvestorsynchronizationrisk(see,forexample,AbreuandBrunnermeier,
2002).Moreresearchonthisobservedphenomenonisnecessarytodisentangletheseexplanationsandprovideothers.
Incontrasttotheabovefindings,firmssubjecttoAAERs,asanindicatorofextremeearningsmanagementandlikelyfraud,
incur substantial losses in market value that include reputational penalties for the misstatement. Reputational penalties
presumablycapturethenegativeeffectsofdetectedmisstatementsonthefirm'sfuturecashflowsduetolowersalesandhigher
contractingandfinancingcosts(Karpoffetal.,2008b).
6.4.Realactivities
Researchershavedocumentedanassociationbetweenearningsqualityproxiesandinvestmentefficiency,buttheexplanations
aredifferent.BiddleandHilary(2006)proposethathighaccountingquality(ie,conservatism,lossavoidance,andearnings
smoothing) reduces information asymmetry between managers and outside suppliers of capital and therefore improves
investmentefficiency(seealsoBiddleetal.,2009).Twootherpapersinsteadproposethataccountingchoices,andtheresulting
earningsnumber,affecttheinputstoamanager'sinternalinvestmentdecisionmodel(McNicholsandStubben,2008;Jacksonet
al.,2009).Forexample,McNicholsandStubben(2008)findthatrestatementfirmsoverinvestduringthemisstatementperiod.
Theyprovidetwointerpretations:(1)managersbelieveinthemisreportedgrowthtrends,whichrespondstothequestionofwhy
thequalityoftheexternallyreportedearningsnumberwouldaffectinternaldecisionmaking;or(2)managersareawareofthe
misstatementbutdecidetoeffectivelybettheranchinordertoimprovefirmperformance.Theydonotattempttodisentangle
thesetwointerpretations.Theysuggestthatineithercase,themisstatement''distorts''investmentdecisions.Futureresearchcould
attempttodistinguishexplanationsforwhylowerqualityreportedearningswouldbeassociatedwithpoorinternaldecisions.
Three studies suggest that voluntary disclosure decisions are endogenously determined by earnings quality (Lougee and
Marquardt,2004;Chenetal.,2002;LennoxandPark,2006).Assumingthatequitymarketparticipantssetpricesbasedonall
availableinformation,notjustearnings,thesefindingsraisequestionsaboutthevalidityofinferencesfromteststhatmeasurethe
association between earnings quality proxies and market consequences without considering the endogenously determined
availabilityofnonearningsinformation.Thisconcerniscomplicatedbythefactthatsomedisclosuresareinverselyrelatedto
commonlyusedproxiesforearningsquality(LougeeandMarquardt,2004;Chenetal.,2002),whilemanagementforecastsare
positivelyrelated(LennoxandPark,2006).
6.5.Executivelevelcompensation
Payforperformance sensitivities, on average, are positively associated with various measures of earnings persistence
(Balsam,1998;Baberetal.,1998;Nwaezeetal.,2006).Theaveragehidesanimportantpattern,however.Dechowetal.(1994)
findthatspecialitems,whicharemostfrequentlynegative,arefilteredoutwhendeterminingexecutive
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401388
compensation.However,GaverandGaver(1998)findthattransitorygains,whichalsodecreaseearningspersistence,aretreated
asregularincome.Similarly,Dechowetal.(2009)findthatcompensationisassensitivetohighlydiscretionarysecuritization
gainsasitistoothercomponentsofearnings.Oneinterpretationoftheseresultsisthatthenegativespecialitemsaremore
observable, and the Board understands their lower persistence. ThisinterpretationsuggeststhatBoards, like other decision
makers,adjustforlowerqualitywhenearningsqualityisobservable,butthereisheterogeneityinthedegreeofobservability
acrossearningsqualitydeterminants.
Studiesalsosuggestthatexpectedearningsquality,measuredprimarilybytimeliness,isassociatedwithexantecompensation
contract design, while changes in earnings quality, measured by the incidence of restatement, are associated with ex post
recontracting(Bushmanetal.,2004;ChengandFarber,2008).
6.6.Executivelevellabormarketoutcomes
Fourstudiessuggestsignificantnegativelabormarketconsequencesforindividualsatfirmswithlowearningsquality(Desai
et al., 2006; Karpoff et al., 2008a; Srinivasan, 2005; Menon and Williams, 2008).86 These studies use restatements,
misstatementsorauditorresignationstomeasureEQ,allofwhicharehighlytransparentindicatorsofpoorquality.Therefore,it
isnotclearwhetheritispoorqualityitselforfearoftheperceptionofpoorqualitythatmotivatesaBoard'sturnoverdecision.In
addition, these EQ proxies capture extreme cases of poor earnings quality. Therefore, whether a CEO would be fired for
manipulatingearningswithinGAAP(whichislesstransparentorobservable)isanopenquestion.Engeletal.(2003)istheonly
studythatprovidesevidenceontheturnoverconsequencesofearningsinformativenessratherthanextreme,publiclyreported
earningsmanagement.Theyfindastrongersensitivityofturnoverdecisionstoaccountinginformationwhenearningsaremore
informative,measuredbyasymmetrictimeliness.
Taken together, the results across the above consequences emphasize the importance of considering the context when
determiningtheappropriateproxyfordecisionusefulness.Forexample,aninvestor'sdecisiontolitigatedependsonwhetheran
earningsmisstatementissevereortransparentenoughtoincreasetheprobabilityofprevailingasaplaintiff. The auditor's
reportingdecision,incontrast,dependsonwhetheranearningsmisstatementissevereortransparentenoughtodecreasethe
probabilityofprevailingasadefendant.ABoard'scompensationcontractdesignproblemdependsontheexanteinformativeness
ofavailablesignalsoftheagent'sperformance,whileitsvariablecashcompensationandrecontractingdecisionsdependonthe
expostinformativenessoftheavailablesignals.TheBoard'sturnoverdecisionmayalsodependontheextenttowhichfirm
credibilityisimpaired.TheabovefindingsreinforceourearlierconclusionthattheEQproxiesarenotsubstitutes,astheir
decisionusefulnessdependsonthedecisioncontext.
6.7.Costofequitycapital
Evidenceontheconsequencesofearningspropertiesasproxiesforearningsqualityisasfollows.Earningspersistenceis
negativelyassociatedwiththeimpliedcostofequitycapital,butearningspredictabilityisnot(Francisetal.,2004).Earnings
predictability,however,isassociatedwithbidaskspreads(AffleckGravesetal.,2002).Smoothnessisassociatedwiththe
impliedcostofequitycapitalatthefirmlevelandcountrylevel(Francisetal.,2004;Bhattacharyaetal.,2003b).Jayaraman
(2008)findsaUshapedrelationbetweensmoothnessandspreadsandsuggeststhatwhenearningsaretoosmoothrelativeto
cashflowsormuchmorevolatile,thenmarketpricesappeartoreflectgreaterasymmetry.However,McInnis(2010)documents
thattheassociationbetweenearningssmoothnessandthecostofequitycapitaldocumentedinpriorresearchisdrivenby
optimisminanalysts'longtermearningsforecasts.Petronietal.(2000)findapositiveassociationbetweenlossreserverevisions
ofP&Cinsurersasameasureofdiscretionaryaccrualsandbeta.
Studies on earnings quality as a priced risk factor represent an emerging literature with a somewhat controversial
interpretationoftheresults;thuswediscussthesestudiesinrelativelymoredetail.Francisetal.(2005a)ranktheirmeasureof
accrualquality(discussedinSection3.1.2)intoquintilesandshowvariationacrossthequintilesinthecostofdebt(interestto
averagedebt),industryadjustedEPratios,andbetasfromCAPMtyperegressions.Theyalsocalculatethedifferenceinreturns
eachmonthbetweenthetoptwoquintilesandthebottomtwoquintilestodeterminewhethertheAQfactorispriced(hasa
significantcoefficient):
R
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R
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j
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R
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R
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SMB
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HML
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AQfactor
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FLOSfindasignificantcoefficientone
j
.WhentheAQfactorisdecomposedintotheinnateanddiscretionarycomponent,they
findthattheresultisdrivenmainlybytheinnatecomponent,althoughthediscretionarycomponentisstillsignificant.FLOS's
interpretationisthataccrualqualityplaysaneconomicallymeaningfulroleindeterminingthecostofequitycapital.
Thetheoreticalunderpinningsfortheanalysisaswellastheempiricalmethodsfordocumentingthataccrualqualityisa
pricedriskfactorhavegeneratedcontroversy.FLOSmotivatethepredictionthatinformationuncertaintyriskispricedusinga
modelbyEasleyandO'Hara(2004),butLambertetal.(2007)andHughesetal.(2005)challengetheEasleyand
86Beneish(1999)foundnoevidenceofabnormalturnoverforCEOsorexecutivesofthemisstatementfirms,buthedidnot
identifywhetherthespecificexecutiveswereimplicatedinthefraud.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401389
O'Harapredictions.Inaddition,Coreetal.(2008,p.7)suggestthatthetestsareinsufficienttoestablishaccrualqualityasa
pricedriskfactor.OtherstudiesattemptingtosortoutthepricingofaccrualqualityincludeAboodyetal.(2005),Liuand
Wysocki(2006),andKravetandShevlin(2010).Empiricalevidenceontherelationbetweenearningsqualityandthecostof
equitycapitalwillsurelyevolvealongwiththetheoriesthatrelateinformationprecisionaboutdiversifiableandnondiversifiable
sourcesofrisktothecostofcapital.
WithrespecttotheconsequencesofexternalindicatorssuchasrestatementsandAAERsasaproxyforearningsmanagement,
theevidencesuggeststhatfirmswithlowearningsqualityexperienceanincreaseincostofequitycapital(HribarandJenkins,
2004;Dechowetal.,1996).TheonlyinconsistentevidenceisinPalmroseetal.(2004),whodonotfindasignificantchangein
bidask spreads following restatements. In addition, CEO/CFO certifications (required by SOX) are associated with lower
spreads(Changetal.,2006),andauditorindependenceisassociatedwithalowerimpliedcostofequitycapitalfortheaudit
client(KhuranaandRaman,2006).However,thereismixedevidenceonwhetherrevelationsofinternalcontroldeficiencies
underSOX404affectafirm'scostofequitycapital(Beneishetal.,2008;Ognevaetal.,2007;AshbaughSkaifeetal.,2009).
Tosummarize,eachstudyprovidesstatisticallysignificantevidenceofanegativeassociationbetweenoneormoreearnings
qualityproxiesandafirm'scostofcapital,butitisdifficulttocomparetheeconomicsignificanceofthefindingsacrossstudies
andhenceacrossproxies.Theresultsemphasizethesubstitutabilityproblem.Itappearsthatalloftheproxiesaremeasuring
decisionusefulnesstoequitymarketstosomeextent,butthatisafairlyweakstatement.Francisetal.(2004)runmoreofahorse
raceacrosstheEQproxiesandfindthataccrualquality,amongalltheEQmeasurestheyexamine,hasthelargesteffectonthe
impliedcostofequitycapital,butitisstillnotclearwhetheritshouldbethelargestandhowmuchlargeritshouldbe.Future
research should attempt to identify the distinct contributions of each proxy. Such research must provide clear theoretical
argumentstoexplainexactlyhowaspecificEQproxyaffectsinformationasymmetry,andhowthatspecifictypeofinformation
asymmetryaffectsafirm'scostofequitycapital.
6.8.Costofdebtcapital
Whileonly fourpapers inour databaseexamine debtmarket consequencesof earningsquality, the limitedevidence is
nonethelessconsistentwithevidencefromequitymarkets.Overall,thecostofdebtseemstobehigherwhenEQproxiesindicate
lowearningsquality.Francisetal.(2005a)findthatfirmswithlowerqualityaccrualshaveahigherratioofinterestexpenseto
interestbearingoutstandingdebtandlowerS&PIssuerCreditRatings.Andersonetal.(2004)findthatfirmswithhigherboard
independence,higherauditcommitteeindependence,andlargerboardsizehavelowercostsofdebtmeasuredastheyieldspread.
Grahametal.(2008)documentthatbanksusetighterloancontractingtermsfollowingtheirclientfirms'restatements.Bhojraj
andSwaminathan(2007)findthatfirmswithhighoperatingaccrualshavesignificantlyloweroneyearaheadbondreturns,
consistentwithbondinvestorsmispricinghighandlowaccrualfirmsinmuchthesamewaythatequityinvestorsdo.
Debtmarketsnotonlyprovideausefulopportunitytovalidatethefindingsinequitymarkets,butalsoprovidetwoadditional
opportunities:1)toexamineaccountingchoicesthatareirrelevanttoqualitycharacteristicsofinteresttoequitymarkets,and2)
toassesstradeoffsbetweenmultipleincentivesforproducinghighqualityearnings.
6.9.Analysts
Fourstudiesinourdatabaseexamineanalystforecastingasafunctionofearningsquality.Thestudiesassumethatanalysts
areunbiasedandqualifiedpredictorsoffutureearnings.Underthisassumption,variationintheirforecastaccuracyreflects
attributesofearningsthatarerelatedtoquality.Thismethodologyisakintothatofstudiesthatusemarketreturnstoinfer
earningsquality.Thus,similartoinferencesaboutearningsqualityfromreturnsbasedstudiesthataresubjecttothecaveatthat
theyrelyonanassumptionofmarketefficiency,inferencesaboutearningsqualityfromthesetestsaresubjecttothecaveatthat
theyrelyonanassumptionofanalystefficiency.
ThefourstudiesareBrown(1983)andElliottandPhilbrick(1990),whoprovideevidenceonspecificaccountingmethods
thatimprovepredictability(ie,reduceanalystforecasterror);AshbaughandPincus(2001),whosuggestthatIASisofhigher
qualitythanafirm'shomecountryGAAP;andBhattacharyaetal.(2003a),whoshowthatproformaearningsareofhigher
qualitythanGAAPoperatingearnings.Further,KimandSchroeder(1990)showthatanalystsarenotmisledbydiscretionary
accrualsthatmanagersusetomaximizebonuscompensation.Thisresultisconsistentwithpreviouslydocumentedfindingsthat
earningsmanagement,whenrecognizedbyequityholders,isdiscounted.Butifthedecisionmaker(ie,theanalyst)recognizesit
inhisdecisionmodel(ie,forecast),thenitisaquestionofsemanticswhether''quality''isaffected.
Usinganalystforecaststoinferearningsqualityratherthanusingmarketpriceshastheadvantagethattheanalystforecast
relatesonlytoearnings,whileamarketpricereflectsinformationotherthanearnings.Hence,teststhatinferearningsquality
usingmarketpricesandassumingmarketefficiencyconfoundinterpretationoftheimpactofearningsqualityaloneondecision
usefulness.Adisadvantageofusinganalystforecasts,however,isthenecessaryassumptionthatanalystsareunbiasedandexpert
forecasters,giventhatevidenceonthevalidityoftheseassumptionsisquestionable.Severalstudiesconcludethatwhenanalysts
canrationallyanticipateaccrualsmanagement,theyappropriately
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401390
incorporatetheimplicationsofaccrualsintotheirforecasts(KimandSchroeder,1990;Colesetal.,2006;BurgstahlerandEames,
2003).87However,Bradshawetal.(2001)andElliottandPhilbrick(1990)providecontradictoryevidence.Abarbanelland
Lehavy(2003)possiblyreconciletheseresults.Theyshowthatanalystsfundamentallyunderstandtheimplicationsofaccruals
forearningspredictability,asevidencedbytheirrecommendationdecisions,butthatforecastsarenonethelessbiased.88
7.Conclusion
Ourapproachinthisreviewistodefineearningsqualitybroadlytobedecisionusefulnessinanydecisionbyanydecision
maker.Thusthenumberofrelevantarticlesisover300,andbynecessityourdiscussionisbroad.
Weemphasizetwosignificantconclusionsbasedonoursurveyoftheearningsqualityliteratureasawhole.First,becauseall
oftheproxiesforearningsqualitythatinvolveearnings(ie,propertiessuchaspersistence,timelylossrecognition,smoothness,
andsmallprofits,aswellastheERCs)haveattheircorethereportedaccrualbasedearningsnumber,theseproxiesareaffected
both by the firm's fundamental performance and by the measurement of performance. Future research could more clearly
recognizethedistinctionbetweenperformanceandperformancemeasurementwhenmakingpredictionsandevaluatingresults.
Thiswouldhelpusasaprofessiontodeterminethecontributionoftheaccountingmeasurementsystemtothequalityofreported
earnings.
Second, although all of the proxies based on reported earnings are affected by both fundamental performance and its
measurement, the proxies are not equally affected by these two factors. Therefore, the proxies do not measure the same
underlyingconstruct.Inaddition,becausetheproxiesfocusondifferentelementsofdecisionusefulness,weshouldnotexpect
theproxiestoworkequallywellinallcircumstancesinvestigatedbyresearchers.Wehopethebreadthofthediscussionofeach
proxy has shed light on the contextspecific dimensions of quality captured by each proxy and on the sometimes subtle
distinctionsbetweenthem.
Aspartofourreviewprocess,wenotedfiveareasofresearchthathavereceivedrelativelylittleattention;webelievethat
furtherresearchonthesetopicswouldsubstantiallyenhanceourunderstandingofearningsquality.
(1)Whenmakingchoicesthataffectreportedearnings,amanager'sobjectivefunctioncanincludemultiple,andperhaps
competing,objectives.Theseobjectivescouldrelatetocompensationordebtcontractprovisions,litigationrisk,proprietarycosts,
orincentivestoinfluencestockprice,tonameafew.Therearetwonoteworthyfeaturesofthemanager'sdecisionproblem.First,
managersareconstrainedtoreportonlyoneearningsnumber,buttheexistenceofmultipleobjectivesmayrequiretradeoffs.
Second,managerschooseaset(orportfolio)ofaccountingchoices,notjustone,thatdeterminesearnings,whichsuggeststhat
theymighthavetheflexibilitytotailorindividualelementsofthesettodifferentobjectives.89Twointerestingpathsforfuture
researchare(i)toexaminehowmanagerschoosebetweencompetingobjectivesand(ii)toexaminechoicesabouttheportfolioof
accountingchoices,specificallywithinthecontextofmeetingmultipleobjectives.
The existingliterature includesempirical studiesthat examinecompeting multipleincentives (mostcommonly financial
reporting,taxandregulatoryobjectivesforfinancialinstitutions),butthesestudiestypicallyexamineasingleaccountingchoice
(eg,loanlossprovisions).Theliteraturealsoincludesempiricalstudiesthatexaminemultipleaccountingchoicestoachievea
singleobjective(eg,usingrealearningsmanagementversusdiscretionaryaccruals),butstudiesofthistypearerelativelylimited.
The literature includes almost no evidence on whether firms optimize over a set of accounting choices to meet multiple
objectives,despitevariationintheabilityofspecificaccountingchoicestomeetspecificobjectives.90Alltypesofaccrual
choices,forexample,mayenableafirmtoavoiddebtcovenantviolation,buttheymightdifferintheirtransparencytoequity
markets,andhenceintheirimpactonequityvaluationdecisions.
Theorypapershaveexaminedtheimpactofmultipleincentivesonaccountingchoice(eg,Demski,1973;EvansandSridhar,
1996;Liang,2004;Chenetal.,2007)andanalyzedtheeffectofvariationsinoptimalcontracts(SridharandMagee,1996).These
models,however,aregenerallyconcernedwiththeimplicationsofmultipleobjectivesonasingleaccountingchoice;theydonot
addresstheissueofthefirmmakingaportfolioofaccountingchoicesthatintheaggregateaffectearnings.Christensenetal.
(2005)specificallyrecognizethepotentialforaninteractionbetweencompetingincentivesandindividualaccountingchoices:
''Increasingthepersistentcomponentsandreducingthereversiblecomponentsaregenerallydesirableforvaluation,butnotfor
contracting. Eliminating transitory components of earnings is generally desirable for valuation, but not necessarily for
contracting.'' (p. 265) Kirschenheiter and Melumad (2002) make a related point. Assuming an objective of equity value
maximization,theyshowthatthenatureofthemanager'sprivateinformationaboutcashflows(''good''newsor''bad''news)
determineswhethertheoutcomeofheraccountingchoiceswillbesmootherearningsorbigbaths.Thisresulthasimplications
forunconditionallyinterpretingsmoothnessasaproxyforearningsmanagement.
Researchersalsocanthinkabout''multiple''incentivesaschangesinincentivesthroughtime.Domanagerstradeoffthe
immediatebenefitsofopportunisticaccountingchoicesatthetimeofaneventsuchasanIPOorSEOagainstthepotentiallong
termreputationlossduetotheseoneoffearningsmanagementdecisions?
87SeealsoHirstandHopkins(1998).88SeeFrancisetal.(2004)forasummaryofevidenceonanalysts'incentivestoissue
accurateandunbiasedforecasts.89SeeSivakumarandWaymire(2003)forawellarticulateddiscussionofthisissue.90Notable
exceptionsareBeattyetal.(1995)andHuntetal.(1996),whoexaminebothmultipletoolsandmultipleincentives.
P.Dechowetal./JournalofAccountingandEconomics50(2010)344401391
(2)Studiesconsistentlyfindthatwheninvestorsareabletoobserve,orrationallyinfer,increasedestimationerror(intentional
orunintentional),theyinternalizeitseffectonprice.Forexample,investorsdiscountupwardearningsmanagementwhenbanks
arehighlyleveredandclosetocapitalmarketconstraints.Investorsdiscountdownwardearningsmanagementwhentheyare
awarethatmanagerswillbeissuedrepricedoptions.Investorsdiscountthediscretionaryaccrualcomponentofearningswhen
informationonaccrualsisdisclosedattheearningsrelease.Investorscorrectlypricepropertyandcasualtyinsurers'futurepayout
accrualsbecauseofthenatureofrelatedmandatoryfootnotedisclosures.Meetingorbeatinganalystforecastsonanadhocbasis
doesnotleadtohighervaluations,butmeetingorbeatingregularlydoes.91Theseresultsareconsistentwithpredictionsfrom
partiallyrevealingequilibriummodelsofearningsmanagementwithimperfectinformation(eg,FischerandVerrecchia,2000).
Thisdocumentedrelationisachallengetoresearchersmakinginferencesaboutthedecisionusefulnessofearningsforequity
valuationfromananalysisoftheassociationbetweenasingleincentive(suchascapitalregulation)andasingleaccounting
choice (such as a loan loss provision). If equity investors undo the effects of earnings management, then the earnings
management does not reduce ''earnings quality'' as we have defined it. In fact, an accounting choice to meet regulatory
requirements,whichwouldqualifyas''earningsmanagement''accordingtoHealyandWahlen(1999),couldbeviewedasa
valuemaximizingactivityfromtheperspectiveofanequityholder,evenifitdistortstheabilityofearningstoreflectthefirm's
fundamentalperformance.
Recognizingthatequityinvestorsmightinferrationalearningsmanagementtomeetotherobjectivesraisesopportunitiesfor
futureresearch.First,thereareopportunitiestoresearchcomplementaryaccountingchoices.Forexample,managersmaybe
more willing to provide earnings guidance, informally or through additional supplemental disclosure within the financial
statements,toequityinvestorswhentheyfacemultipleobjectives.Forexample,firmsthatmakeaccountingchoicestoprevent
debt covenant violation might supplement these choices with additional disclosure that makes the earnings management
transparenttoequityinvestorssoasnottoerodethedecisionusefulnessofearningsinequityvaluations.SeeZechman(2010)for
ananalysisofthistype.Second,thereareopportunitiestoinvestigatethefactorsthatallowequityinvestorstounderstandafirm's
incentivesforreporting.
(3)Wearenotawareofstudiesaboutafirm'searningsrelatedaccountingchoiceswhentheanticipatedimpactofthechoice
onearningspropertiesislimitedbecausethepropertyisprimarilydrivenbythefirm'sfundamentalperformance.Forexample,if
afirmcannotproduceapersistentearningsnumbergiventhenatureofoperations,doesitbothertomakechoicestoproducethe
mostpersistentnumberpossible?Or,doesthefirmgiveuponproducingapersistentearningsstreamandinsteadoptimizeover
accountingchoicesthatachieveanothergoal?Doesthefirmsubstituteforfundamentallylowpersistenceearningswithadditional
disclosure,alongthelinesexaminedinFrancisetal.(2008)?Thiscommentisrelatedtoourobservationonmultipleobjectives
(comment#1above).Itsuggeststhatafirm'sincentivesacrossobjectivesmayvarywithitsfundamentalperformance.
(4)Severalstudieshaveattemptedtovalidateanearningsmetricbyshowingthatitiscorrelatedinapredictablewaywith
anothermeasure,forexample,characterizingdiscretionaryaccrualsandtotalaccrualsatSECenforcementfirms(Beneish,1997;
BayleyandTaylor,2007;Dechowetal.,forthcoming).Otherstudieshaverun''horseraces''acrossaccrualsmodels(eg,Guayet
al.,1996;Jonesetal.,2008),orhaveconsideredextensionsandimprovementstospecificmodels(eg,Dechowetal.,1995,and
Kotharietal.,2005,oftheJonesmodel;McNichols,2002,Francisetal.,2005,andWysocki,2008,oftheDechow/Dichev
model).Inaddition,researcherscasuallyapplytheapproachofCronbachandMeehlbyexaminingtheconvergentanddivergent
validityoftheearningsmetricsinaparticularsetting.Fewpapers,however,employclassicalmethodsforconstructvalidation.
Eckeretal.(2006),whoperformaconstructvalidityanalysisoftheir''eloading''variableforaccrual(earnings)quality,isthe
onlystudyinourdatabase.92Additionalformalanalysisonconstructvaliditywouldbeuseful.
(5)Mostoftheempiricalpaperstestapredictionabouteitheradeterminantofqualityoraconsequenceofquality,butnot
both.However,thesourceofearningsqualityislikelytoaffectitsconsequences.Forexample,externalauditorsandinternal
controlsmaybothaffectabnormalaccruals,andabnormalaccrualsmayaffectthecostofcapital,butanopenquestioniswhether
theimpactofaccrualsonthecostofcapitalisthesamewhenexternalauditorsratherthaninternalcontrolsmitigatetheerrors.
Bowenetal.(2008),Xie(2001),andLiuandThomas(2000)providegoodexamplesofthistypeofresearch.Their''complete
path''approachoffersinsightsthatarenotavailablefromstudiesthatexamineonlyoneside(ie,determinantorconsequence)of
earningsquality.
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