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Earnings QualityEarnings Quality

Patricia M. Patricia M. DechowDechowCatherine Catherine SchrandSchrand

We thank the Association of Investment Management and Research (We thank the Association of Investment Management and Research (AIMR) for fundingAIMR) for funding

Accounting Quality ScandalsAccounting Quality Scandals

HIH HIH –– underestimation of underestimation of insurance liabilitiesinsurance liabilitiesHarvey Norman: franchisees Harvey Norman: franchisees revenue (Boston Chicken)revenue (Boston Chicken)ParmalatParmalat –– cash balance cash balance overstated

Enron Enron –– special purpose special purpose entities to hide debtentities to hide debtWorldCom WorldCom –– capitalization capitalization of expensesof expensesTyco Tyco –– disclosure of loansdisclosure of loansQwest International Qwest International ––network capacity swapsnetwork capacity swapsXerox Xerox –– longlong--term leases and term leases and cookie jar reservescookie jar reservesWaste Management Waste Management ––capitalization rules

overstated

capitalization rules

What has caused the observed What has caused the observed decline in earnings quality?decline in earnings quality?

Poor corporate governancePoor corporate governanceManagement compensation packagesManagement compensation packagesDecline in auditing qualityDecline in auditing qualityMovement away from manufacturing towards the Movement away from manufacturing towards the creation of intangible assets that are difficult to valuecreation of intangible assets that are difficult to valuePhilosophical change in accounting standard settingPhilosophical change in accounting standard settingLack of scrutiny by financial analystsLack of scrutiny by financial analystsGrowth of institutional investors with no interest in Growth of institutional investors with no interest in firm’s businessfirm’s businessState of the economyState of the economy

Outline of monographOutline of monograph

Define earnings quality (Define earnings quality (ChptChpt 2)2)Provide evidence from research on financial Provide evidence from research on financial statement analysis to assess earnings quality statement analysis to assess earnings quality ((ChptsChpts 33--6)6)Provide evidence on red flags that suggest Provide evidence on red flags that suggest potential earnings quality issues:potential earnings quality issues:

Incentives for earnings management (Incentives for earnings management (ChptChpt 7)7)Corporate governance (Corporate governance (ChptChpt 8)8)

Provide evidence of the role of voluntary Provide evidence of the role of voluntary disclosures in predicting disclosures in predicting earnings(Chptearnings(Chpt 9)9)

What is earnings quality?What is earnings quality?

Earnings quality is contextual depends on userEarnings quality is contextual depends on userStandard settersStandard settersAuditorsAuditorsCompensation committeesCompensation committeesDebt holdersDebt holdersInvestorsInvestorsFinancial analystsFinancial analysts

All would agree fraudulent reporting is low qualityAll would agree fraudulent reporting is low qualityWe adopt a financial analyst perspectiveWe adopt a financial analyst perspective

What is earnings quality?What is earnings quality?

Objective of the financial analystObjective of the financial analyst1.1. Forecast earningsForecast earnings2.2. Make stock recommendationsMake stock recommendations

Earnings are higher quality: Earnings are higher quality: 1.1. The more predictable and easier to forecast; The more predictable and easier to forecast;

ANDAND2.2. The better they map into intrinsic valueThe better they map into intrinsic value

1. Earnings predictability1. Earnings predictability

What factors make earnings easier to predict What factors make earnings easier to predict compared to cash flows?compared to cash flows?

The higher persistence (The higher persistence (ββ close to one) close to one) EEt+1t+1 = = ββEEtt + + εεtt

The fewer transitory componentsThe fewer transitory componentsThe less volatileThe less volatile

On average, earnings is superior to current cash On average, earnings is superior to current cash flows on these dimensionsflows on these dimensions

Persistence of earnings Persistence of earnings vsvs cash flowscash flows

0.85

0.76 0.760.72 0.71 0.71

0.65

0.41

0.300.25

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Sales OperatingIncomeBefore

Depreciation

OperatingIncome AfterDepreciation

Pretax Income EarningsBefore

Special Items

IncomeBefore

ExtraordinaryItems

CFO FCF CFF CFI

Estim

ated

Per

sist

ence

Par

amet

er

2. Earnings and intrinsic value2. Earnings and intrinsic value

Do earnings map into value better than do cash flows?Do earnings map into value better than do cash flows?Measuring intrinsic valueMeasuring intrinsic value

Current stock priceCurrent stock priceActual future cash flowsActual future cash flowsResidual income model value (using future prices)Residual income model value (using future prices)

Stock prices Stock prices –– yes yes –– but functional fixation?but functional fixation?Future cash flows Future cash flows –– mixed mixed –– but it’s a noisy measurebut it’s a noisy measureIntrinsic value Intrinsic value –– generally yesgenerally yes

Suggests that on average, earnings map more easily into Suggests that on average, earnings map more easily into value than do current cash flows. value than do current cash flows.

What affects earnings predictability What affects earnings predictability across firms?across firms?

Stage of firms life cycle (steady state Stage of firms life cycle (steady state vsvs growing or growing or declining)declining)

Sources of competition particularly for growing firmsSources of competition particularly for growing firmsTransitory components and losses for declining firmsTransitory components and losses for declining firmsFinancial statement analysis of I/S and B/S componentsFinancial statement analysis of I/S and B/S components

Quality of forecasts and estimates made by management Quality of forecasts and estimates made by management imbedded in accruals (intentional and unintentional imbedded in accruals (intentional and unintentional estimation error)estimation error)Accounting standards followed by the firmAccounting standards followed by the firmManagement’s voluntary disclosuresManagement’s voluntary disclosures

Stage of life cycle and persistence: Stage of life cycle and persistence: Sales growthSales growth

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

1 2 3 4 5 6

Year Relative To Portfolio Formation Year

Sales Growth Rate

Source: Nissim and Penman (2001)

Stage of life cycle and persistence: Stage of life cycle and persistence: RNOA growthRNOA growth

Figure 4.2: Return on Net Operating Asset (RNOA) over time. Deciles formed on the magnitude of RNOA.

Source: Nissim and Pehman (2001).

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

1 2 3 4 5 6

Year Relative To Portfolio Formation Year

RNOA

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0 1 2 3 4 5 6 7 8 9

Asset Turnover

Prof

it M

argi

n

Industry Median ISO 14% Line

Health Services, Hospitals etc.

Water SupplyPulp Mills

Communications

Hotels, Lodging

Wholesale Grocers

Grocery StoresDurable Goods, Wholesale

Mobile Homes

Transportation

Mobile Homes Dealers

Accounting ServicesBusiness Services, Photocopying, Art

Petroleum Pipelines

Electric Services

Airport, Terminal Services

Warehouse Storage

Gold and Silver Ores

14% Iso-Return on Net Operating Asset Line

SolimanSoliman (2003) (2003) : This figure plots 248 three: This figure plots 248 three-- digit SIC industry groups from 1970digit SIC industry groups from 1970-- 2001. The sample 2001. The sample consists of 77,199 firmconsists of 77,199 firm--year observations. The points represent median profit margin anyear observations. The points represent median profit margin and median d median asset turnover by industry. The asset turnover by industry. The IsoIso-- RNOA line represents the profit margin and asset turnover RNOA line represents the profit margin and asset turnover combination that would result in an RNOA (return on net operatincombination that would result in an RNOA (return on net operating assets) of 14%.g assets) of 14%.

Persistence is affected by nonPersistence is affected by non--operating componentsoperating components

Model ROEt-1 only Full Model Coefficient (Std. Dev) Coefficient (Std. Dev) Intercept 0.042 (0.004) 0.029 (0.005) ROE 0.664 (0.023) Gross margin 0.636 (0.022) SG&A 0.639 (0.022) Depreciation 0.629 (0.073) Interest 0.621 (0.019) Minority interest

{ Operating income components

0.615 (0.078) Non-operating income 0.548 (0.037) Income taxes 0.445 (0.028) Discontinued operations 0.003 (0.028) Extraordinary items 0.153 (0.058) Adjusted R2 42.3% (0.029) 49.0% (0.023)

Source: Fairfield, Sweeney, and Yohn (1996)

Persistence is predictable using I/S Persistence is predictable using I/S and B/Sand B/S

Signal

Measurement

Coefficient (predicted to be negative) (* for significant)

Inventory ∆Inventory - ∆Sales -0.017* Accounts Receivable ∆Accounts Receivable - ∆Sales 0.009* (wrong sign) Capital Expenditures ∆Industry CAPX - ∆Firm CAPX 0.005 (wrong sign) Gross Margin ∆Sales - ∆Gross Margin -0.031* Selling and Admin ∆SG&A - ∆Sales -0.010 (insignificant) Effective Tax Rate (Average ETR for past 3 years –

ETRt) x ∆EPSt -0.594*

Inventory Method 0 for LIFO, 1 for FIFO or other -0.006* Audit Qualification 0 for unqualified, 1 for qualified 0.014 (insignificant) Labor Force -1*(%∆ in sales per employee) -0.026*

Source: Abarbanell and Bushee (1997): regress the future change in earnings on current red flags

Persistence is a function of accrualsPersistence is a function of accruals

Sloan (1996)Sloan (1996)Earningst+1 = α + βEarningst + ε t+1, and (3.1)

Earningst+1 = α + γ1Accrualst + γ2Cash from Operationst + ε t+1. (3.2)

Sloan obtains the following result using 40,679 firm-years from 1962 – 1991:

Earningst only Accruals and cash flows Model Coefficient (t-statistic) Coefficient (t-statistic) Intercept 0.015 (32.57) 0.011 (24.05) Earnings 0.841 (303.98) Accruals 0.765 (186.53) Cash from operations 0.855 (304.56)

Various decomposition of accruals can provide Various decomposition of accruals can provide more insights into earnings persistencemore insights into earnings persistence

Decomposing accruals into inventory, A/R, A/P, tax Decomposing accruals into inventory, A/R, A/P, tax payable, etcpayable, etcDecomposing accruals into “discretionary” Decomposing accruals into “discretionary” vsvs“nondiscretionary” using Jones model“nondiscretionary” using Jones modelDecomposing accruals based on extent of “estimation Decomposing accruals based on extent of “estimation error”error”Taxable income versus book incomeTaxable income versus book incomeVolatility of cash flows versus magnitude of accrualsVolatility of cash flows versus magnitude of accrualsNature of the business and operating cycle will also Nature of the business and operating cycle will also affect the level of accrualsaffect the level of accruals

Persistence is a function of accrualsPersistence is a function of accruals

0.5

0.6

0.7

0.8

0.9

1

1.1

1 2 3 4 5 6 7 8 9 10

Rank of current accruals (difference between earnings and CFO)

Estim

ated

Per

sist

ence

Par

amet

er

Persistence of Earnings Persistence of CFO

Source: Dechow and Ge (2003)The sample consists of 98,624 firm-years from 1987 to 2002. Decile 1 consists of firms with the most negative accruals. Decile 10 consists of firms with the most positive accruals. Current accruals are calculated as the difference between earnings and CFO. The

persistence coefficients of earnings and operating cash flows (CFO) are estimated from the following regressions: Earningst+1 = at + bEarningst + et

CFOt+1 = at + bCFOt + et

Persistence is a function of both Persistence is a function of both current and longcurrent and long--term accrualsterm accruals

Fig1b. Persistence of Earnings and FCF Based on Ranks of Total Accruals

Persistence of Earnings

Persistence of FCF

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1 2 3 4 5 6 7 8 9 10

Ranks of Total Accruals

Pers

isten

Persistence of Earnings Persistence of FCF

Source: Dechow and Ge (2003)

What causes investors to What causes investors to misunderstand the nature of the misunderstand the nature of the

quality of accruals?quality of accruals?

Manipulation of longManipulation of long--term and short term accrualsterm and short term accrualsEstimation error in extreme accruals that reversesEstimation error in extreme accruals that reversesMisunderstanding of future growthMisunderstanding of future growth

Declining returns to scaleDeclining returns to scaleOverOver--optimistic growth forecasts by analysts for high optimistic growth forecasts by analysts for high accrual firmsaccrual firms

Misunderstanding of temporary components Misunderstanding of temporary components (particularly for loss firms)(particularly for loss firms)

High accrual are “glamour” stock , low accrual are High accrual are “glamour” stock , low accrual are “value” stock so driven partly by market sentiment“value” stock so driven partly by market sentiment

Persistence is affected by accounting Persistence is affected by accounting standards usedstandards used

What is income?What is income?Income is an indicator of performance about an Income is an indicator of performance about an enterprise and its management; ORenterprise and its management; ORIncome is an enhancement of wealth or command Income is an enhancement of wealth or command over economic resources.over economic resources.

Standards moving away from performance Standards moving away from performance evaluation towards “balance sheet” focus evaluation towards “balance sheet” focus (measuring assets and liabilities)(measuring assets and liabilities)

Income is an enhancement of wealthIncome is an enhancement of wealth

Accounting rules focus on valuing assets and liabilities (the Accounting rules focus on valuing assets and liabilities (the balance sheet)balance sheet)

Fair value accountingFair value accountingSecuritizationSecuritizationEquity and debt securities “available for sale”Equity and debt securities “available for sale”Asset impairmentsAsset impairmentsGoodwill rulesGoodwill rulesDeferred taxesDeferred taxes

More transitory componentsMore transitory componentsFrequency of losses increasesFrequency of losses increases

Balance sheet approach implies a decline in earnings quality Balance sheet approach implies a decline in earnings quality under our definitionunder our definition

More difficult to forecast earnings More difficult to forecast earnings Harder to map earnings alone into valueHarder to map earnings alone into value

Frequency of special items has Frequency of special items has increased over timeincreased over time

0.000

0.005

0.010

0.015

0.020

0.025

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Spec

ial I

tem

s/To

tal O

pera

ting

Expe

nses

Q1Q2Q3Q4

Source: Bradshaw and Sloan (2002)

Relation between earnings and Relation between earnings and returns:returns:

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

Year

Adj

uste

d R-

squa

re

Source Francis and Source Francis and SchipperSchipper 19991999

Relation between book value and Relation between book value and market valuemarket value

0%

10%

20%

30%

40%

50%

60%

70%

80%

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

Year

Adj

uste

d R-

squa

re

Source Francis and Source Francis and SchipperSchipper 19991999

How has the market coped with decline in How has the market coped with decline in earnings quality? Rise of pro forma earningsearnings quality? Rise of pro forma earnings

PANEL A: QUARTER 1 PANEL B: QUARTER 2

-0.005

0.000

0.005

0.010

0.015

0.020

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

StreetGAAP

-0.005

0.000

0.005

0.010

0.015

0.020

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

StreetGAAP

Panel C: Quarter 3 Panel D: Quarter 4

-0.005

0.000

0.005

0.010

0.015

0.020

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

StreetGAAP

-0.005

0.000

0.005

0.010

0.015

0.020

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

StreetGAAP


Are Are proformaproforma higher quality than higher quality than GAAP?GAAP?

Proforma adjustments reported in 1,149 press releases (source Bhattacharya, Black, Christensen, and Larson (2002))

0%

5%

10%

15%

20%

25%

Depreciationand

amortization

Stockcompensation

costs

Merger andacquisition

costs

R&D costsand w rite-offson purchased

in-processR&D

Gains andlosses on

sales

Extraordinaryitems and

discontinuedoperations

Alteration ofnumber of

sharesoutstanding

for EPS

Otheradjustments

Perc

enta

ge

Are Are proformaproforma higher quality than higher quality than GAAP?GAAP?


Panel A: Earnings Response Coefficient

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

8604

8702

8704

8802

8804

8902

8904

9002

9004

9102

9104

9202

9204

9302

9304

9402

9404

9502

9504

9602

9604

9702

9704

Year-Quarter

Ear

ning

s Res

pons

e C

oeff

icie

nt

StreetGAAP

Pro forma more likely to beat analyst Pro forma more likely to beat analyst forecastsforecasts

EPS Above versus Below Mean Analyst Forecast

38.7%

77.5% 80.1%

61.3%

22.5% 19.9%

0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%90.0%

GAAP IBES Pro Forma

EPS at or above Mean Forecast EPS below Mean Forecast

Are items excluded from Are items excluded from proformaproformareally transitory?really transitory?

-10.0%0.0%

10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%

1988 1990 1992 1994 1996 1998

Hed

ge R

etur

n

Total ExclusionsOther Exclusions

Source: Doyle, Source: Doyle, LundholmLundholm and and SolimanSoliman (2003)(2003)

Results suggest that items are not as “transitory” as investors Results suggest that items are not as “transitory” as investors thinkthink




Provide evidence of the role of voluntary Provide evidence of the role of voluntary disclosures (disclosures (ChptChpt 9)9)

Earnings Management Around the World(Leuz, Nanda and Wysocki, 2003)

0

5

10

15

20

25

30

Aust

ria

Gre

ece

Kore

a (S

outh

)

Portu

gal

Italy

Taiw

an

Switz

erla

nd

Sing

apor

e

Ger

man

y

Japa

n

Belg

ium

Hon

g Ko

ng

Indi

a

Spai

n

Indo

nesi

a

Thai

land

Paki

stan

Net

herla

nds

Den

mar

k

Mal

aysi

a

Fran

ce

Finl

and

Phili

ppin

es

Uni

ted

Kin

gdom

Sw

eden

Nor

way

Sou

th A

frica

Can

ada

Irela

nd

Aust

ralia

Uni

ted

Stat

es

Agg

rega

te E

arni

ngs

Man

agem

en

What accounts are managed most?What accounts are managed most?

0%

10%

20%

30%

40%

50%

60%

70%

80%

Ove

rsta

te re

venu

ean

d ac

coun

tsre

ceiv

able

/Und

ersta

teba

d de

bt a

llow

ance

Und

ersta

te a

nex

pens

e (o

ther

than

COG

S)

Ove

rsta

tein

vent

ory/

Und

ersta

teCO

GS

Und

ersta

te A

/Rdi

scou

nts/a

llow

ance

sot

her t

han

bad

debt

s

Ove

rsta

te P

PE

Ove

rsta

te in

tang

ible

san

d ot

her l

ong-

term

asse

ts

Miss

tate

men

t of

accr

ued

liabi

litie

s

Ove

rsta

te se

curit

yva

luat

ion

Perc

enta

g

The sample is collected from the Accounting and Auditing Enforcement Releases from AAER 1 to AAER 1745. The releases that involve manipulations of annual financial statements are identified. The final sample consists of 294 separate firms that had manipulated 426 different accounts. Firms can manipulate more than one account, so the percentages add up to more than 100%.

Incentives for earnings managementIncentives for earnings management

Extensively studied by academicsExtensively studied by academicsBoost stock priceBoost stock price

Cheaper to raise new financing, acquire other firmsCheaper to raise new financing, acquire other firmsBoost value of stock option grant/insider tradeBoost value of stock option grant/insider trade

Meet analysts’ forecastsMeet analysts’ forecastsKeeps interest in the stock high (affects liquidity)Keeps interest in the stock high (affects liquidity)Reputation of managementReputation of management

Contractual incentivesContractual incentivesEarnings based bonuses Earnings based bonuses Debt covenants, unions, etcDebt covenants, unions, etc

Regulatory incentives Regulatory incentives –– loan loss reserve, link to taxesloan loss reserve, link to taxes

Corporate governance and the opportunity to Corporate governance and the opportunity to engage in earnings managementengage in earnings management

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Company has

an auditcommittee

Company hasan

independentoutside

blockholderthat owns

more than 5percent of the

stock

The companyhas a big six

auditor

CEO is alsoChairman of

the Board

CEO is alsothe founder ofthe company

More than 50percent of the

Board areinsiders

Percentage of each sample

SEC enforcement sampleControl sample

Figure 8.1: Comparison of governance structures for firms that violate GAAP to a control group, Source: Dechow, Sloan, and Sweeney (1996)

Earnings quality and audit firmEarnings quality and audit firm

Research generally indicates firms report lower discretionary Research generally indicates firms report lower discretionary accruals whenaccruals when

The auditor has industry expertiseThe auditor has industry expertiseThe auditor has performed the audit for a longer time periodThe auditor has performed the audit for a longer time periodWhen a big 4When a big 4--66--8 auditor is used (client selection may drive this)8 auditor is used (client selection may drive this)

But, are not more likely provide qualified opinions on high But, are not more likely provide qualified opinions on high accrual firms even though more of these firms end up restating accrual firms even though more of these firms end up restating earnings and having SEC enforcement actions. earnings and having SEC enforcement actions. Audit changes are a red flagAudit changes are a red flag

Have low accruals prior to switch more normal level of accruals Have low accruals prior to switch more normal level of accruals afterwardsafterwardsAuditor too conservative or firms want to boost earningsAuditor too conservative or firms want to boost earningsFirms that switch are more likely to have debt covenant violatioFirms that switch are more likely to have debt covenant violations, higher ns, higher leverage, declining earnings (poor performance)leverage, declining earnings (poor performance)

Earnings quality and audit firmEarnings quality and audit firm

Does nonDoes non--audit services reduce earnings quality?audit services reduce earnings quality?Public disclosures on fees only recently disclosed in USPublic disclosures on fees only recently disclosed in USGenerally a little bit is Okay, too much is badGenerally a little bit is Okay, too much is badTax advisory services may not hurt as much as consulting? Tax advisory services may not hurt as much as consulting? -- firms are less likely to restate earnings when they provide firms are less likely to restate earnings when they provide tax advisory services (Kinney, tax advisory services (Kinney, PalmrosePalmrose, and , and ScholzScholz 2003 2003 –– private source of data) private source of data) Frankel, Johnson, Nelson (2003): yes Frankel, Johnson, Nelson (2003): yes –– higher higher discretionary accruals, more likely to meet analyst forecastsdiscretionary accruals, more likely to meet analyst forecastsMore on this tomorrow!More on this tomorrow!

Do analysts play a monitoring role?Do analysts play a monitoring role?

Not much direct evidence on analysts playing a Not much direct evidence on analysts playing a positive monitoring role in marketspositive monitoring role in marketsUnfortunately evidence suggestsUnfortunately evidence suggests

Do not fully adjust forecasts for the fact that high Do not fully adjust forecasts for the fact that high accrual firms are likely to have a decline in EPSaccrual firms are likely to have a decline in EPSParrot what management tell themParrot what management tell themForecasts start optimistic and end pessimistic (so Forecasts start optimistic and end pessimistic (so management can beat the forecast)management can beat the forecast)




Provide evidence of the role of voluntary Provide evidence of the role of voluntary disclosures (disclosures (ChptChpt 9)9)

Can voluntary disclosure improve the Can voluntary disclosure improve the predictability of earnings?predictability of earnings?

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

-0.51

-0.45

-0.39

-0.33

-0.27

-0.21

-0.15

-0.09

-0.03 0.0

30.0

90.1

50.2

10.2

70.3

30.3

90.4

5More

Deviation from consensus forecast

Perc

enta

ge o

f firm

-qua

rter

s

No Guidance Guidance

Source: Hutton (2003). Sample consists of NIRI members (pre REG. FD)

Management guidance tends to be pessimistic Management guidance tends to be pessimistic

(reduce analyst forecast of EPS(reduce analyst forecast of EPS))Proportion of On Target Management Forecast

0.20.210.220.230.240.250.260.27

1993-1997 1998-2001 Pre RegFD Post RegFD

Year

Prop

ortio

n

Proportion of Pessimistic Management Forecast

0

0.1

0.2

0.3

0.4

0.5

0.6


Year

Prop

ortio

n

Source: Cotter, Tuna, and Source: Cotter, Tuna, and WysockiWysocki (2003)(2003)A pessimistic forecast of EPS is A pessimistic forecast of EPS is below actual reported EPS, an below actual reported EPS, an optimistic forecast is above actual optimistic forecast is above actual reported EPS.reported EPS.

Proportion of Optimistic Management Forecast

0

0.1

0.2

0.3

0.4

0.5


Year

Pro

porti

on

Management forecasts improve Management forecasts improve analyst forecast accuracyanalyst forecast accuracy

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

1 2 3

Earn

ings

Sur

pris

e

Earnings Surprise based on: Analysts’ prior forecasts Managers’ forecasts Analysts’ posterior forecasts

Source: Source: FengFeng (2003) The graph plots the median of earnings surprises based o(2003) The graph plots the median of earnings surprises based on analysts’ prior n analysts’ prior forecasts, managers’ forecasts and analysts’ posterior updated fforecasts, managers’ forecasts and analysts’ posterior updated forecasts for each group.orecasts for each group.

Voluntary disclosure and Voluntary disclosure and predictability of earningspredictability of earnings

Generally more disclosure is associated with lower costs Generally more disclosure is associated with lower costs of capital (advantage of voluntary disclosure)of capital (advantage of voluntary disclosure)Better MD&A disclosure in annual report is associated Better MD&A disclosure in annual report is associated with lower forecast errors, less dispersion of errorswith lower forecast errors, less dispersion of errorsAcross country results indicates that countries with Across country results indicates that countries with better disclosure have more accurate analystsbetter disclosure have more accurate analystsFirms disclose more when they have financing needs Firms disclose more when they have financing needs and less when there are higher potential proprietary and less when there are higher potential proprietary costs or litigation costs. costs or litigation costs. Firms are more likely to disclose bad news early (before Firms are more likely to disclose bad news early (before earnings announcement).earnings announcement).

Do management act in their self Do management act in their self interest when providing guidance?interest when providing guidance?

Evidence that management release bad news Evidence that management release bad news before option grantsbefore option grantsEvidence that managers like to release all the Evidence that managers like to release all the bad news early but leak out the good news so bad news early but leak out the good news so they can have positive earnings surprisethey can have positive earnings surprise

SummarySummary

Provide an analysts’ perspective on earnings qualityProvide an analysts’ perspective on earnings qualityCareful financial statement analysis can improve the ability to Careful financial statement analysis can improve the ability to forecast earningsforecast earningsQuality of earnings depends on the nature of the business as welQuality of earnings depends on the nature of the business as well l as the integrity and quality of managementas the integrity and quality of managementCorporate governance and auditors play a role in improving Corporate governance and auditors play a role in improving earnings qualityearnings qualityImportant to understand management’s incentives Important to understand management’s incentives –– who are who are they trying to please? What do they want? Are the overly they trying to please? What do they want? Are the overly concerned with stock price and meeting forecasts?concerned with stock price and meeting forecasts?Recent accounting rules generally have not improved earnings Recent accounting rules generally have not improved earnings quality from the perspective that we adopt. quality from the perspective that we adopt.

earnings quality - university of new south · pdf fileearnings quality patricia m. dechow ......

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