Earnings Quality: Definitions, Measures, and Financial Reporting

154 Pages·2020·2.362 MB·English

by  Elisa Menicucci

Earnings Quality
Definitions, Measures,
and Financial Reporting
Earnings Quality
Elisa Menicucci
Earnings Quality
Definitions, Measures, and Financial Reporting
Elisa Menicucci
University of Roma Tre
Rome, Italy
ISBN 978-3-030-36797-8 ISBN 978-3-030-36798-5 (eBook)
https://doi.org/10.1007/978-3-030-36798-5
© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer
Nature Switzerland AG 2020
This work is subject to copyright. All rights are solely and exclusively licensed by the
Publisher, whether the whole or part of the material is concerned, specifically the rights
of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction
on microfilms or in any other physical way, and transmission or information storage and
retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology
now known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specific statement, that such names are
exempt from the relevant protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and
information in this book are believed to be true and accurate at the date of publication.
Neither the publisher nor the authors or the editors give a warranty, expressed or implied,
with respect to the material contained herein or for any errors or omissions that may have
been made. The publisher remains neutral with regard to jurisdictional claims in published
maps and institutional affiliations.
Cover illustration: © Melisa Hasan
This Palgrave Pivot imprint is published by the registered company Springer Nature
Switzerland AG
The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland
P
reface
In recent years, earnings quality (EQ) has received more and more
attention from investors, creditors, regulators, and researchers in dif-
ferent areas. Financial statements are the main source of information
for stakeholders, and especially, income represents the most impor-
tant accounting information that managers, directors, investors, and
other stakeholders rely on for their decisions. In this regard, one issue
is whether accounting information copes satisfactorily with such a wide
variety of information needs.
Since earnings are assumed as the basis for most of decisions, assess-
ment models, and stock pricing, the income statement needs to be
of high quality to assure reliability, accuracy, and informativeness of
accounting information. However, the amount of earnings cannot be
always a good criterion for investors’ decision-making since sometimes
earnings are manipulated by management. Hence, users of financial
reporting have to note both the quantity and the quality of earnings. In
this context, researchers have proposed different definitions of EQ since
it is a multi-dimensional and broad concept encompassing many deter-
minants. Moreover, there is not a generally accepted approach to meas-
ure EQ, although a variety of proxies have been developed in recent
years.
The purpose of this book is to provide an overview for understand-
ing EQ in the context of financial reporting and to offer suggestions for
defining and measuring it. We also turn our attention to earnings man-
agement (EM) and its effect on EQ. EM occurs when managers make
v
vi PREFACE
discretionary accounting choices that are regarded as either an efficient
communication of private information to improve the informativeness
of a firm’s current and future performance or a distorting disclosure to
mislead the true performance of the firm. The intentional manipulation
of earnings by managers, within the limits allowed by the Accounting
Standards, may alter the usefulness of financial reporting and imply a
lower quality of earnings.
The book goes on to elaborate on EQ in the context of International
Financial Reporting Standards (IAS/IFRSs) and in particular the ques-
tion focused on both the degree of EM and the value relevance of
reported earnings in such a setting. The use of Fair Value in financial
reporting has developed a current debate about the impact of Fair Value
Accounting (FVA) on EQ. Sometimes, the high degree of subjectiv-
ity in estimating Fair Value could allow opportunities for managers to
exercise judgments and intentional bias which can decrease the quality
of financial reporting. In this regard, management discretion can result
in a higher EM and thus in a reduced amount of EQ. Especially dur-
ing periods of financial distress, managers engage in EM to mask the
negative effects of the turmoil (e.g., low profitability and bad financial
performance).
The book is organized as follows. The first chapter offers a brief lit-
erature review on the concept of EQ and provides an overview of its
possible definitions as accounting literature does not provide an explicit
and unique definition of EQ. Despite the importance of earnings within
financial reporting, the term EQ is vague and has different interpreta-
tions. In Chapter 2, we present the multiplicity of proxies that can be
used to measure EQ. We analyze the existing plenty of acceptable meth-
ods for EQ measurement that depends on the research question posed
and the availability of data and estimation models. Chapter 3 describes
the relationship between EQ and EM since they can be considered
related challenges in financial reporting. Chapter 4 deepens the issue of
IAS/IFRSs and their impact on accounting quality. Given the emphasis
on the use of Fair Value and the greater disclosure requirements recom-
mended by IAS/IFRSs, the adoption of these Standards has some effects
on the quality of earnings reported by companies. Finally, Chapter 5
discusses the theoretical background of FVA and focuses on the impact
it might have on EQ. We investigate how FVA influences earnings
PREFACE vii
manipulation (i.e., EM), value relevance, and informativeness of reported
earnings in periods of financial distress as accruals and earnings smooth-
ing are attempts of managers to reduce abnormal variations of earnings,
especially during a turmoil.
Rome, Italy Elisa Menicucci
c
ontents
1 Earnings Quality: How to Define 1
1.1 Introduction 1
1.2 Earnings Quality: Background 3
1.3 Earnings Quality: Definitions 6
1.4 Usefulness and Informativeness of Earnings Quality 12
1.5 Earnings Quality and Financial Reporting 14
Bibliography 18
2 Measures of Earnings Quality 23
2.1 Introduction 23
2.2 Measurement of Earnings Quality 24
2.3 Earnings Attributes 26
2.3.1 Earnings Persistence 29
2.3.2 Earnings Predictability 31
2.3.3 Earnings Variability and Earnings Smoothness 34
2.3.4 Value Relevance 37
2.4 Timely Loss Recognition, Conservatism, and Accruals 38
2.5 Different Methods to Measure Earnings Quality 43
Bibliography 46
3 Earnings Quality and Earnings Management 53
3.1 Introduction 53
3.2 Earnings Management: Literature Review 55
ix
x CONTENTS
3.3 Earnings Management: Definitions 56
3.4 Earnings Management and Accrual Accounting 60
3.5 Earnings Management and Earnings Smoothing 62
3.6 Earnings Management and Accounting Conservatism 67
3.7 Earnings Management and Earnings Informativeness 71
3.8 Earnings Quality and Earnings Management 75
Bibliography 77
4 IAS/IFRSs, Accounting Quality and Earnings Quality 83
4.1 Introduction 83
4.2 Accounting Standards and Accounting Quality 85
4.2.1 Qualitative Characteristics and the Quality
of Financial Reporting 89
4.3 Accounting Standards and Earnings Quality 91
4.3.1 IAS/IFRSs and Earnings Quality 93
4.4 The Effects of IAS/IFRSs Adoption on Earnings Quality 95
Bibliography 101
5 Fair Value Accounting and Earnings Quality 107
5.1 Introduction 107
5.2 Fair Value Accounting and Financial Reporting 108
5.2.1 The Shift from Historical Cost Accounting
to Fair Value Accounting 108
5.2.2 The Informativeness of Fair Value 110
5.2.3 Fair Value Accounting and Earnings Volatility 114
5.3 Fair Value Accounting and Its Influence on Earnings
Quality 116
5.4 The Effect of Fair Value Accounting on Earnings
Response Coefficient (ERC) 118
5.5 The Impact of Fair Value Accounting on Earnings
Quality During a Financial Crisis 120
5.5.1 Fair Value Accounting and Earnings
Management 123
5.5.2 Fair Value Accounting and Earnings
Management in Banking Sector 126
5.6 Conclusions 130
Bibliography 133
Index 139
L t
ist of abLes
Table 2.1 Summary of EQ proxies 37
Table 2.2 EQ criteria 45
xi