Earnings Quality and Financial Reporting Credibility: An Empirical Investigation

Topics - Equities Defensive ESG Investing

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Earnings Quality and Financial Reporting Credibility: An Empirical Investigation

Working paper

Firms with extremely high accruals experience subsequent reductions in earnings and are more likely to be subject to SEC enforcement actions for GAAP violations. In this paper, we show that analysts do not anticipate the earnings reductions in their earnings forecasts, and auditors do not signal the GAAP violations through their audit opinions.

Previous research has demonstrated that stock prices act ‘as if’ investors do not anticipate negative future consequences associated with high accruals. Our findings reinforce this interpretation by demonstrating that even professional investment intermediaries do not communicate the negative information associated with high accruals to investors.

Our results add to the growing body of evidence pointing to the conclusion that accrual accounting leads to temporary resource misallocation. That is not to say that other systems, such as cash accounting, would result in better resource allocation. It does, however, undermine the role of the efficient market hypothesis, on which academics have relied to gloss over many of the features of the accrual accounting system that seem to preoccupy managers and investors.

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Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. The hypothetical performance shown was derived from the retroactive application of a model developed with the benefit of hindsight.  Hypothetical performance results are presented for illustrative purposes only.


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