Earnings Quality: Evidence from the Field

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday October 8, 2012 at 8:37 am
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Editor’s Note: The following post comes to us from Ilia Dichev, Professor of Accounting at Emory University; John Graham, Professor of Finance at Duke University; Campbell Harvey, Professor of Finance at Duke University; and Shiva Rajgopal, Professor of Accounting at Emory University.

In the paper, Earnings Quality: Evidence from the Field, which was recently made publicly available on SSRN, we provide insights about earnings quality from a new data source: a large survey and a dozen interviews with top financial executives, primarily Chief Financial Officers (CFOs). Why CFOs? While it is clear that there are important consumers of earnings quality such as investment managers and analysts, we focus on the direct producers of earnings quality, who also intimately know and potentially cater to such consumers. In addition, CFOs commonly have a formal background in accounting, which provides them with keen insight into the determinants of earnings quality, including the advantages and limitations of GAAP accounting. CFOs are also key decision-makers in company acquisitions (see Graham, Harvey and Puri 2012), which implies that they have working knowledge of how to evaluate earnings quality from an outside perspective.

Although field studies suffer from their own problems (potential response bias, limited number of observations, whether questions on a survey instrument are misinterpreted, do respondents do what they say, do they tell the truth, do they recall the most vivid or their most representative experience), surveys offer a potential way to address often intractable issues related to omitted variables and the inability to draw causal links that are endemic to large-sample archival work. Surveys and interviews also allow researchers to (i) discover institutional constraints that impact practitioners’ decisions in ways that academics may not fully appreciate; and (ii) ask key decision makers directed questions about their behavior as opposed to inferring intent from statistical associations between proxy variables surrogating for such intent. Critically, we try to provide some idea about “how it all fits together,” i.e., about the relative importance of individual factors and how they come together to shape reported earnings. Our intent is to provide evidence on earnings quality, complement existing research, and provide directions for future work.

Our key findings fall in three broad categories. The first includes results related to the definition, characteristics, and determinants of earnings quality. On definition, CFOs believe that earnings are high quality when they are sustainable, and are backed by actual cash flows. More specific quality characteristics include consistent reporting choices over time, and avoidance of long-term estimates. This view of earnings quality is consistent with a valuation perspective, where investors typically view the firm as a long-life profit-generating entity, and value is based on estimating and discounting the stream of future profits. Consistent with this view, current earnings are considered to be high quality if they serve as a good guide to the long-run profits of the firm. The dominance of the valuation perspective is confirmed in our survey responses as well. However, we also find that the stewardship uses of earnings (debt contracts, managerial compensation) and internal uses (in managing own company) rank closely behind the valuation use. In addition, executives often refer to the reliance on “one number” for both external and internal reporting. The resulting impression is that the reported earnings metric has consistent and integrated utility across these different uses, and thus earnings quality is shaped by and in turn influences all of these uses. In terms of determinants, CFOs estimate that innate factors (beyond managerial control) account for roughly 50% of earnings quality, where business model, industry, and macro-economic conditions play a prominent role.

The second set of results relates to how standard setting affects earnings quality. CFOs feel that reporting discretion has declined over time, and that current GAAP standards are somewhat of a constraint in reporting high quality earnings. A large majority of CFOs believe that FASB’s de- recognition of matching and over-emphasis on fair value are misguided and adversely affect earnings quality. CFOs would like standard setters to issue fewer rules, and to converge U.S. GAAP with IFRS to improve earnings quality. Further, they believe that earnings quality would improve if reporting choices were to at least partly evolve from practice rather than being mandated from standards. As one consequence of such inflexible rules, CFOs say that the accounting standards sometimes drive operational decisions, rather than the other way around. CFOs also feel that the rules-orientation of the FASB has centralized the audit function, depriving local offices of discretion in dealing with clients, and stunting the development of young auditing professionals. Overall, CFOs have come to view financial reporting largely as a compliance activity rather than as a vehicle of innovation designed to inform stakeholders and lower the cost of capital.

Our third set of results relates to the prevalence, magnitude, and detection of earnings management. Our emphasis is on observable GAAP earnings and a clear definition of earnings management, asking for within-GAAP manipulation that misrepresents performance (i.e., we rule out outright fraud and performance-signaling motivations). The CFOs in our sample estimate that, in any given period, roughly 20% of firms manage earnings and the typical misrepresentation for such firms is about 10% of reported EPS; thus, perhaps for the first time in the literature, we provide point estimates of the economic magnitudes of earnings management. CFOs believe that 60% of earnings management is income-increasing, and 40% is income-decreasing, somewhat in contrast to the heavy emphasis on income-increasing results in the existing literature but consistent with the inter-temporal settling up of accruals in settings like cookie jar reserves and big baths. A large majority of CFOs feel that earnings misrepresentation occurs most often in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives. Finally, while CFOs caution that earnings management is difficult to unravel from the outside, they suggest a number of red flags that point to potential misrepresentation. The three most common flags are persistent deviations between earnings and the underlying cash flows, deviations from industry and other peer experience, and large and unexplained accruals and changes in accruals. There are also a number of red flags that relate to the role of the manager’s character and the firm’s culture, which allow and perhaps even encourage earnings management.

Our findings raise a host of possible directions for future research. Here we only discuss a few broad themes, with more specific suggestions given at appropriate places later in the paper. One broad direction is increased attention to the sustainability of earnings, and the inter-temporal relation between earnings and cash flows. Another broad direction is closer attention to the role of standard setting in the determination and quality of earnings. Our survey suggests that standard setting has a first-order effect on the utility of earnings but there is a relative paucity of research that examines this connection. In addition, the evidence leaves little doubt that there is a sharp dissonance between standard setters’ and CFOs’ views on the proper determination of earnings, e.g., the roles of matching and fair value accounting. Research can help to bridge this gap, and more generally these are issues that go to the heart of accounting and affect much wider constituencies, so this is an area with much potential for significant work. Finally, there is considerable potential for further research into the detection of opportunistic earnings management, a topic of much interest to investors, auditors and regulators. Here, our point estimates of earnings management can be used for the calibration of existing and future models. A promising direction is to emphasize the “human element,” such as a deeper analysis of the character of the managers running the firm, and the firm’s corporate culture. New data sources and techniques, including text-processing programs and data on the academic and professional background of managers, may help in this endeavor.

The full paper is available for download here.

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  2. [...] before you place too much emphasis on one quarter’s earnings, keep in mind that the quality of those numbers might not always be great due to fairly widespread “earnings management,” according to a recent study. (Harvard Law [...]

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