Research Bytes: Earnings quality

Is earnings management harmful from an information perspective? Not necessarily, because investors are generally able to elicit the essential decision-useful information; it is only the cost of earnings management that makes it undesirable. Thus argue Ralf Ewert and Alfred Wagenhofer of University of Graz, Austria, in ‘Accounting Standards, Earnings Management, and Earnings Quality’ ( >www.ssrn.com).

The paper opens by acknowledging that earnings quality is an important characteristic of financial reporting systems. “It is commonly used to examine changes in earnings quality over time, to assess the effects of changes in accounting standards and the institutional environment, to compare financial reporting across countries, and to measure market price and returns effects of firms exhibiting different earnings quality.”

Exploring how different characteristics of accounting systems and institutional factors of the accounting environment affect earnings quality, the authors find that the effect of a variation of characteristics on earnings quality results from a subtle interaction between the accounting system and earnings management, which together determine the information content and the effect on earnings quality.

Importantly, the paper challenges conventional wisdom. “For example, an accounting standard that recognises a greater portion of future cash flows does not always increase earnings quality, and an increase in the cost of earnings management (e.g., less discretion, higher audit and enforcement quality) reduces earnings quality.”

Suggested study for the standard-setters, too.