Understanding Earnings Quality: A Review of the Proxies, Their Determinants and Their Consequences
Social Science Research Network
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
... "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. We 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 earnings. 1 We do not require that the researcher use the term earnings quality. This broad scope is motivated by the varied and often imprecise use of the term "earnings quality" by practitioners (including regulators, enforcement agencies, and courts), the financial press, and academic researchers. Lev (1989) popularized the adjective "quality" as a descriptive characteristic of earnings for academic researchers when he stated that one explanation for low R 2 s in earnings/returns models is that: "No serious attempt is being made to question the quality of the reported earnings numbers prior to correlating them with returns." Lev's statement implicitly suggests that he defines earnings quality as decision-usefulness in the context of equity valuation decisions. This use of the term "quality" is consistent with O'Glove's practitioner-oriented financial statement analysis textbook, Quality of Earnings, published in 1987, and even with Graham and Dodd's use of the term in Security Analysis, published in 1934. Graham and Dodd describe the Wall 1 We searched four journals starting with the first issue (in parentheses) An important feature of our review is the method we use to organize our discussion of the papers. We apply the approach that Chronbach and Meehl (1955) suggest to assess the validity of a latent construct in general to the specific case of earnings quality. For each paper, we identify its proxy for earnings quality. We use three broad earnings quality (EQ) categories: (i) statistical properties of earnings; (ii) investor responsiveness to earnings; and (iii) external indicators of financial reporting quality. The properties of earnings category includes: a) persistence and accruals, b) earnings smoothness, c) asymmetric timeliness and timely loss recognition; and d) benchmarking, in which the distance of earnings from a benchmark is viewed as a measure of its quality (e.g., small profits). The investor responsiveness to earnings category includes papers that use an earnings response coefficient (ERC) as a measure of earnings informativeness or earnings quality. The category for external indicators of financial reporting quality includes: AAERs, restatements, and internal control procedure deficiencies reported under SOX. Table 1 , Panel A, lists the EQ proxies and the sections of this survey in which we discuss them. Exhibit 1 provides a brief summary of the intuition behind each measure and comments on its use as a proxy for earnings quality. By juxtaposing the papers against other papers that examine the same EQ proxy, we are able to draw conclusions about the contexts in which the proxy is decision-useful. We then classify the papers into two groups according to whether they provide evidence on 1) the determinants of the earnings quality proxy, or 2) the consequences of the earnings quality proxy. Table 1 , Panels B and C, list the categories of determinants and consequences. The determinants papers propose or test theories about features of the firm (or the firm's environment) that cause an earnings outcome; the earnings quality proxy is the dependent variable in the analysis. The consequences papers propose or test theories about earnings quality that cause an outcome; the and Schipper (2006) ; Lo (2008). These reviews typically provide a definition of earnings quality in an equity valuation context and discuss only the literature related to that definition.