Earnings Quality

The bottom-line income has at all times been the focus of investors.

High-quality earnings are important for investors’ decision usefulness. However, the academic and literature has not reached a consensus definition of earnings quality (Penman et al., 2002). Penman et al. (2002) argue that the earnings quality is good if reported earnings before extraordinary items can be used to predict future earnings well. Dechow et al. (2010) argue that “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.”

Schipper et al. (2003) examine four types of earnings quality constructs from the perspective of decision usefulness, which is derived from qualitative concepts of the Financial Accounting Standard Board’s (FASB) Conceptual Framework, and from

a representational faithfulness perspective on economics-based earnings launched by Hicks (1939). The first type of earnings quality construct is the time series properties of earnings, including persistence, predictability, and variability. The second type stems from selected qualitative characteristics in the FASB’s Conceptual Framework, which consists of the correspondence of relevance, reliability, and comparability. The third type is the association among income, cash, and accruals. The measures include ratio of cash from operations to income, changes in total accruals, discretionary accruals, and accruals-to-cash relations. The last type is related to implementation decisions. Since the effects of underlying business models and the economic environment are significant determinants of earnings quality, they believe that some of these constructs, which calibrate earnings quality against the representational faithfulness, can signal low-quality earnings.

Numerous studies examine the determinants of earnings quality. Some studies find that earnings quality is poor if the extent of earnings management is large (e.g., Ball et al., 2008; Chan et al., 2006; Hribar et al., 2007). The reason is that earnings management may mislead stakeholders about the underlying economic performance of the company (Healy et al., 1999).

Chan et al. (2006) investigate whether accruals provide information about earnings quality. Their empirical results reveal that low-quality earnings and inferior stock returns would emerge afterwards when a remarkable increase in earnings is accompanied by high accruals. The results also exhibit that two principal components of accruals, changes in inventory and accounts receivable, have superior predictive power. Besides, the effect of accruals varies among different industries and is positively correlated with industry level of noncash working capital.

Ball et al. (2008) argue that IPO firms need to abide substantially greater regulatory scrutiny and accept the inspections from market monitors during the transition from private to public status in order to meet the market requirements. Thus, they examine the impact of market and regulations on earnings quality around the time of IPOs. The empirical results indicate significant improvement in earnings quality and more conservative financial reports around the time of IPOs.

Except the effects of earnings management on earnings quality, Penman et al.

(2002) propose that conservative accounting affects the earnings quality. They further propose that changes in the amount of investments have some influences on the quality of earnings. Increasing in investments would result in a decline in reported earnings and an increase in unrecorded reserves, and vice versa. The effects on rates of return are temporary if the variation in investments is temporary, and it denotes lower earnings quality. They find that the measures of the joint effect of conservative accounting and investment can identify poor-quality earnings and forecast how future core return on net operating assets may vary from current levels.

Some studies find that the ownership structure may also affect earnings quality (e.g., Fan et al., 2002; Francis et al., 2005; Wang, 2006). Fan et al. (2002) examine the financial transparency of corporations in East Asia by measuring the earnings-return relation and ownership structure of 977 East-Asia firms. The evidence suggests that the information effect will dominate the incentive alignment effect when ultimate owners effectively control the operation rights of these companies. The findings are consistent with the entrenchment effect that the discrepancy of earnings informativeness between cash flow rights and voting rights shrinks after controlling voting rights levels. The findings also prove the existence of information effect. Firms

with high ownership concentration tend to engage in rent-seeking activities and lower the information quality.

Francis et al. (2005) compare the informativeness of earnings and dividends between single-class and dual-class companies. They find that both within-sample and across-sample results indicate less informative earnings for firms with dual-class ownership structure. The results also show that in some cases dividends are more salient for non-controlling shareholders of dual-class firms, since controlling owners tend to induce current or prospective non-controlling owners to hold shares of inferior-class stock. Their findings support the empirical results of Fan et al. (2002) that concentrated ownership, which is achieved by cross-holding and stock pyramids, is positively related to less informative earnings.

Wang (2006) investigates the relationship between founding family ownership and earnings quality. He proposes that there are two possible ways that founding family ownership affects the earnings quality: entrenchment effect and alignment effect. The results show that the relation between family ownership and earnings quality is nonlinear and positive correlated. Especially, the evidence suggests that founding family ownership is related to greater earnings informativeness, lower abnormal accruals, and less persistence of transitory loss components in earnings.

Francis et al. (2008) examine the relations among voluntary disclosure, earnings quality and cost of capital. They find that the degree of voluntary disclosure is positively associated with earnings quality; that is, there is a significant complementary effect between voluntary disclosure and earnings quality. The relation between voluntary disclosure and cost of capital is significantly positive without controlling for earnings quality. Nevertheless, after controlling for earnings quality,

the complementary effect on cost of capital is substantially diminished or fully disappears.