Understanding earnings quality: A review of the proxies, their determinants and their consequences

Abstract

Researchers have used various measures as indications of "earnings quality" including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because "quality" is contingent on the decision context. We also point out that the "quality" of earnings is a function of the firm's fundamental performance. The contribution of a firm's fundamental performance to its earnings quality is suggested as one area for future work. Over the years, researchers have devised various measures of "earnings quality" to represent decision usefulness in specific decision contexts. These measures, however, have become proxies for "earnings quality" in a generic sense, absent a decision context. The result is that some papers use a proxy for earnings quality that does not match the hypothesized form of decision usefulness in their study, but they nonetheless find results that are consistent with their hypothesis. Other papers are intentionally agnostic and find robust results across multiple proxies for earnings quality. The fact that researchers find consistent and robust results across proxies suggests that there is common component to the various measures of quality, which is the firm's fundamental earnings process. Existing research does not clearly distinguish the impact of a firm's fundamental earnings process on the decision usefulness ("quality") of its earnings from the impact of the application of accounting measurement to that process. Research attention has focused on earnings management that reduces the reliability of earnings rather than on the ability of specific features of an accrual-based accounting system to provide a more decision-useful measure, conditional on the firm's fundamental earnings process. September 2009Thanks to Michelle Hanlon (the editor), Shiva Rajgopal, Terry Shevlin, Nemit Shroff, Richard Sloan, and Rodrigo Verdi for helpful comments. The framework for this review is based on Schrand's discussion of earnings quality at the April 2006 CARE Conference sponsored by the Center for Accounting Research at the University of Notre Dame. *Title Page/Author Identifier Page/Abstract 1 Understanding earnings quality: A review of the proxies, their determinants and their consequencesWe begin with a definition of "earnings quality" that sets the scope of our review. Higher quality earnings more faithfully represent the features of the firm's fundamental earnings process that are relevant to a specific decision made by a specific decision-maker. Our definition implies that the term "earnings quality" is meaningless without specifying the decision context, because the relevant features of the firm's fundamental earnings process differ across decisions and decision makers. Consistent with this broad definition, we review approximately 350 published papers on e...

The Role of Earnings Persistence in Valuation Accuracy and the Time Horizon

“…The results documented in Table 2 show that high persistence earnings are a better input into the valuation process (Dechow et al, 2010). Moreover, these findings are consistent with evidence that considerations regarding high earnings volatility and low persistence of earnings bring substantial improvements to the prediction of earnings and valuation process (Dichev & Tang, 2009).…”

“…These two variables are well documented in the literature as strong predictors of information environment and earnings quality (Dechow et al, 2010).…”

“…In this regard, Dechow et al (2010) suggest that firms with more persistent earnings have a more 'sustainable' earnings and cash flow stream, which work as more useful inputs into equity valuation models.…”

“…As a consequence, earnings persistence should play, at the same time, two relevant roles, one in the equity market, as a valuation input, and one in compensation decisions as a measure of the time horizon (Dechow, Ge, & Schrand, 2010).…”

Endividamento e decisões contábeis: a relação não linear entre dívida e qualidade dos lucros

“…Compreender se existe tal relação não linear entre endividamento e accruals, ou se a mesma possui relação negativa e linear, como defendido por Dechow et al, 2010, é extremamente relevante para os tomadores de decisão que utilizam métodos baseados em informações sobre lucros e fluxos de caixa passados. A forma côncava apontaria níveis de endividamento nos quais os accruals são mais elevados e, portanto, as estimativas de fluxo de caixa mais imprecisas.…”