Credibility Attributes and Investor Perceptions of Non‐GAAP Earnings Exclusions

Recent empirical evidence suggests that investors focus more on non‐GAAP (Generally Accepted Accounting Principles) than on traditional GAAP earnings because non‐GAAP earnings are believed to proxy for a firm's ongoing profitability, a measure useful for valuation. Managers determine these non‐GAAP earnings by excluding certain items from their GAAP income. However, because these non‐GAAP earnings are both unaudited and may be disclosed by a firm to manage investors’ perceptions as opposed to inform, investors must infer the credibility of the disclosure through observable firm attributes. In this study we examine whether firms with stronger credibility attributes (corporate governance, higher‐quality auditors, and higher historical information quality) will be perceived as providing more credible non‐GAAP exclusions than those with weaker attributes. Our expectation is that the market reaction to non‐GAAP earnings exclusions of firms with stronger credibility attributes will be greater than for those with weaker attributes. Our results support our expectation.     

The impact of financial reporting quality on debt maturity: the case of private firms

We examine whether the debt maturity structure of privately held firms is associated with the quality of their earnings numbers. We argue that earnings numbers that are better able to predict future cash flows lower information asymmetry between privately held firms and their creditors, improving privately held firms’ access to long-term debt. Furthermore, we examine whether the relationship between privately held firms’ earnings quality and their debt maturity differs between small and medium-sized enterprises (SMEs) and larger privately held firms. Using detailed financial statement information from a sample of privately held Belgian firms, we find that earnings quality is positively associated with the likelihood of having long-term debt and with the proportion of long-term debt in total debt. Further, we report evidence that these associations are more pronounced for SMEs than for larger privately held firms, which is consistent with smaller firms entailing more fundamental risk for creditors.     

Innovation,financial reporting quality,and audit quality

We examine the relation between innovation and financial reporting quality (FRQ) and the implications of audit quality for this relation. We first document a negative relation between innovation and FRQ. This result is consistent with greater earnings management at higher innovation firms, likely because of the more opaque information environment that gives managers the opportunity to act opportunistically. We then examine whether audit quality moderates the observed negative relation between innovation and FRQ because audit quality constrains managers’ opportunities to manage earnings. We find results consistent with the predicted moderating effect. Lastly, we verify that these findings hold in a difference-in-differences test designed around an exogenous event, state R&D tax credits.     

Overvalued equity,benchmark beating and unexpected accruals

We investigate the extent to which the overvaluation hypothesis provides incentives for managers to beat earnings benchmarks, and whether this benchmark beating can be reliably interpreted as evidence of earnings management. We carefully identify firms immediately above earnings benchmarks that have a priori, overvaluation‐based incentives to achieve the benchmark. We therefore focus on benchmark‐beating observations where manipulation is most likely, providing a more powerful test of the existence of opportunistic financial reporting. Consistent with overvaluation‐related incentives encouraging earnings management, we find that overvalued firms that just exceed levels‐related earnings benchmarks have higher unexpected accruals than firms with less extreme valuations.     

M&A Decisions and US Firms’ Voluntary Adoption of Clawback Provisions in Executive Compensation Contracts

We examine whether US firms’ M&A decisions influence the likelihood of voluntary adoption of clawback provisions in executive compensation contracts and whether clawback adoption improves subsequent M&A decisions. Because prior research finds that poor M&A decisions are associated with future earnings restatements, we predict that clawback adoption is more likely after these transactions. We further conjecture that M&A decisions will improve after clawback adoption, as its presence reduces executives’ willingness to manipulate post‐acquisition earnings. Consistent with our expectations, we find that (1) firms with more negative M&A announcement returns are more likely to adopt clawbacks; (2) firms that acquire targets with relatively poor accounting quality are more likely to adopt clawbacks; (3) clawbacks improve investor perception of M&A quality; and (4) executives are more responsive to the market when completing M&A deals if their compensation contracts include clawbacks. These results suggest that boards take a pro‐active approach and consider factors that may lead to restatements when adopting clawbacks. Our results have implications for US policymakers, as the Dodd‐Frank Act of 2010 requires mandatory adoption of clawbacks. Our results also suggest that non‐US firms can reduce managerial incentives to manipulate post‐takeover earnings by using clawbacks.     

Overvaluation and earnings management: Does the degree of overvaluation matter?

We examine whether the choice of earnings management strategies employed by managers of overvalued firms depends on the degree of market overvaluation. By distinguishing between substantially overvalued (SOV) and relatively overvalued (ROV) firms, we find that SOV firms significantly inflate earnings using both accruals-based and real earnings management. In contrast, managers of ROV firms do not engage in accruals-based earnings management and their firms’ accounts tend to report higher discretionary expenses. The reported higher discretionary expenses of ROV firms are comparable to the discretionary expenses of firms in the expanding stage of their business life cycle, a pattern consistent with ROV firms increasing discretionary expenses to finance growth and hence justify the high market valuation. Overall, we show that the existing evidence on income-increasing earnings management by overvalued firms is mainly driven by the pressure to sustain the high market valuation of firms that are substantially overvalued.     

Voluntary Disclosure, Earnings Quality, and Cost of Capital

We investigate the relations among voluntary disclosure, earnings quality, and cost of capital. We find that firms with good earnings quality have more expansive voluntary disclosures (as proxied by a self‐constructed index of coded items found in 677 firms' annual reports and 10‐K filings in fiscal 2001) than firms with poor earnings quality. In unconditional tests, we find that more voluntary disclosure is associated with a lower cost of capital. However, consistent with the complementary association between disclosure and earnings quality, we find that the disclosure effect on cost of capital is substantially reduced or disappears completely (depending on the cost of capital proxy) once we condition on earnings quality. Extensions probing alternative proxies show that our findings are robust to measures of earnings quality and cost of capital, but not to other measures of voluntary disclosure. In particular, we find opposite relations for voluntary disclosure measures based on management forecasts and conference calls, and we find no relations for a press release based measure.     

Earnings Quality Measures and Excess Returns

This paper examines how commonly used earnings quality measures fulfill a key objective of financial reporting, i.e., improving decision usefulness for investors. We propose a stock‐price‐based measure for assessing the quality of earnings quality measures. We predict that firms with higher earnings quality will be less mispriced than other firms. Mispricing is measured by the difference of the mean absolute excess returns of portfolios formed on high and low values of a measure. We examine persistence, predictability, two measures of smoothness, abnormal accruals, accruals quality, earnings response coefficient and value relevance. For a large sample of US non‐financial firms over the period 1988–2007, we show that all measures except for smoothness are negatively associated with absolute excess returns, suggesting that smoothness is generally a favorable attribute of earnings. Accruals measures generate the largest spread in absolute excess returns, followed by smoothness and market‐based measures. These results lend support to the widespread use of accruals measures as overall measures of earnings quality in the literature.     

Corporate Life Cycle and Earnings Benchmarks

We examine whether and how corporate life cycle significantly influences meeting or beating earnings benchmarks (MBE). We find that corporate life cycle plays a significant role in a firm's meeting or beating earnings benchmarks behaviour. Developing strategies that fit into the stage of corporate life cycle is crucial for corporate success. MBE is an important financial goal that requires strategies. In this study, we examine whether and how corporate life cycle significantly influences MBE. Specifically, we focus on the incentives of MBE in growth and mature firms. We find that corporate life cycle significantly influences a firm's tendency to meet or beat zero earnings, prior earnings and analysts’ earnings forecasts. Based on logit regressions for the period from 1988 to 2008, the results indicate that growth firms are more likely to meet or beat all three earnings benchmarks. Overall, the results of this study indicate that a firm's MBE behaviour should be examined in the context of its life cycle stage.     

Firm Accrual Quality Following Restatements: A Signaling View

We consider whether and how firms improve their financial reporting credibility following a restatement by comparing two alternative views. The compliance view predicts that firms simply correct errors to comply with regulations; the signaling view predicts that improvements are broader to allow firms to signal higher reporting quality and thereby reduce information uncertainty. We find that accrual quality improves significantly following the restatement and that this improvement is observed for both earnings and non‐earnings error restatements. We also find that the extent of real earnings’ management decreases significantly. Further, we find that improvements in accrual quality are higher for firms with CEO turnover and higher incentives to improve, but lower for firms switching to an auditor of lower quality. Collectively, our findings suggest that firms signal improved reporting credibility following a restatement through higher accruals quality and lower real earnings management.     

Sneaking in the back door? An evaluation of reverse mergers and IPOs

I examine whether the financial reporting quality of firms that access capital markets through reverse mergers differs from that of firms that rely on the traditional and more onerous IPO process. Using a broad sample of reverse merger firms and a propensity-score matched sample of IPOs, I find that reverse merger firms exhibit lower earnings quality as measured by several earnings attributes established in prior literature: accrual quality, earnings persistence, earnings predictability, cash persistence, cash predictability, earnings smoothness, timeliness, and value relevance. I document similar results for firms with low levels of institutional ownership. Differences in earnings quality, however, are attenuated for reverse merger firms with higher levels of institutional ownership. Given recent U.S. Securities and Exchange Commission enforcement actions against Chinese reverse merger firms, I also use a difference-in-differences technique and find that the lower financial reporting of reverse merger firms is actually driven by the non-Chinese reverse merger firms.     

Managerial academic experience,external monitoring and financial reporting quality

This study examines the effect of managerial academic experience on firms’ financial reporting quality. Using data from China, we find that firms with top managers possessing academic experience exhibit lower levels of both accrual and real earnings management, along with a lower probability of future restatements. This effect is more pronounced for firms with inefficient external monitoring, suggesting that the higher financial reporting quality is mainly explained by the managers’ intrinsic motivation to report truthfully. The results hold when we use firm fixed‐effect regressions, instrumental variable two‐stage regressions, and a propensity score matching (PSM) approach to mitigate the omitted variable and endogeneity concerns. Our study suggests that academic experience can serve as a source of valuable expertise for corporate executives.     

Supplier Financing and Earnings Quality

In this paper we investigate the effect of earnings quality on supplier credit in a sample of small and medium‐sized firms. After controlling for other determinants of trade credit, we show that firms whose earnings present lower variability, higher smoothing and predictability, and higher accruals quality have access to more trade credit from suppliers. This association suggests that earnings attributes associated to lower volatility and higher precision with respect to cash flows facilitate access to trade credit.     

Distress Risk,Growth and Earnings Quality

We extend and complement prior work by investigating the earnings quality of firms with different financial health characteristics and growth prospects. By using three alternative measures of default likelihood and two alternative measures of growth options, without being limited to a specific event, we provide a more comprehensive setup for analysing the earnings characteristics of the universe of firms than examining distressed firms with persistent losses, dividend reductions or bankruptcy‐filings. Our dataset consists of 15,049 healthy U.S. firms over the period 1990–2004. Results show that the relation between earnings quality and financial health is not monotonic. Distressed firms have a low level of earnings timeliness for bad news and a high level for good news, and manage earnings toward a positive target more frequently than healthy firms. On the other hand, healthy firms have a high level of earnings timeliness for bad news. Growth aspects play an important role in a firm's ability to manage earnings. In contrast to the findings of prior studies, growth firms have greater earnings timeliness for bad news, whereas value firms manage earnings toward a positive target more frequently than growth firms.     

Earnings Quality Based on Corporate Investment Decisions

In this paper, I examine a new approach for measuring earnings quality, defined as the closeness of reported earnings to “permanent earnings,” based on firm decisions with regard to capital and labor investments. Specifically, I measure earnings quality as the contemporaneous association between changes in the levels of capital and labor investment and the change in reported earnings. This approach follows the reasoning that (1) firms make investment decisions based on the net present value (NPV) of investment projects and (2) reported earnings with higher quality should more closely associate with real investment decisions. I find that measures of earnings quality based on managerial labor and capital decisions correlate positively with earnings persistence and have incremental explanatory power relative to earnings‐quality measures used in the accounting literature. Furthermore, investment‐based earnings‐quality measures are less informative when managers tend to overinvest.     

Corporate social responsibility and earnings quality: Evidence from China

We examine the association between corporate social responsibility (CSR) and earnings quality using CSR ranking data from Rankins (RKS) and four measures of earnings quality. Using a sample of 2580 Chinese listed firms for fiscal years 2009–2015, with 14,807 firm-year observations, we find that CSR firms and those with higher CSR ratings are less likely to engage in earnings management than non-CSR firms and those with lower CSR ratings, and their earnings are more persistent and more accurately predict future cash flows from operations. State ownership and marketization moderate the relationship between CSR disclosures and earnings quality.     

Regulations,earnings management,and post-IPO performance: The Chinese evidence

In this study, we examine whether government regulatory initiatives in China involving IPO by SOEs may have contributed to opportunistic behaviors by the issuer. We focus on two sets of IPO regulations issued between January 1, 1996 and February 11, 1999: pricing regulations, which stipulate that IPO prices be a function of accounting performance, and penalty regulations, which penalize IPO firms for overly optimistic forecasts. We find that IPO firms that report better pricing-period accounting performance have larger declines in post-IPO profitability, lower first-day stock returns and worse long-run post-IPO stock performance. Furthermore, IPO firms that make overoptimistic forecasts also have lower first-day returns and worse post-IPO stock performance. Using non-core earnings as the proxy for earnings management, we document some evidence that IPO firms that report higher pricing-period accounting performance have engaged in more income-increasing earnings management. Hence, pricing regulations may have induced IPO firms to inflate pricing-period earnings and affect the post-IPO performance negatively. On the other hand, penalty regulations have deterred IPO firms from making overoptimistic earnings forecast and therefore have a positive impact on the behavior of IPO firms.     

Analyst revenue forecast reporting and the quality of revenues and expenses

We decompose earnings quality into revenue and expense quality and examine their associations with analyst propensity to supplement their earnings forecasts with revenue forecasts. Analysts report more revenue forecasts to I/B/E/S when expense quality is low to compensate for the low accuracy of their earnings estimates, which has a positive association with expense quality. Expense quality is unassociated with revenue forecast accuracy, thus revenue forecasts become increasingly useful for valuing firms when expense quality is low. Analysts report fewer revenue forecasts when revenue quality is low because both earnings and revenue forecast accuracy decline as revenue quality deteriorates. To control for endogeneity, we use firm‐fixed effects to control for unobserved time‐invariant heterogeneity across firms, instrumental variables regressions and regression in changes.     

International Accounting Standards and Accounting Quality

We examine whether application of International Accounting Standards (IAS) is associated with higher accounting quality. The application of IAS reflects combined effects of features of the financial reporting system, including standards, their interpretation, enforcement, and litigation. We find that firms applying IAS from 21 countries generally evidence less earnings management, more timely loss recognition, and more value relevance of accounting amounts than do matched sample firms applying non‐U.S. domestic standards. Differences in accounting quality between the two groups of firms in the period before the IAS firms adopt IAS do not account for the postadoption differences. Firms applying IAS generally evidence an improvement in accounting quality between the pre‐ and postadoption periods. Although we cannot be sure our findings are attributable to the change in the financial reporting system rather than to changes in firms' incentives and the economic environment, we include research design features to mitigate effects of both.     

Forced Versus Voluntary Dividend Reduction: An Agency Cost Explanation

We examine whether the agency cost arising from shareholder‐bondholder conflict is an important determinant of the timing of dividend reduction decisions. Firms forced to reduce dividends owing to bond covenant violations experience lower earnings, more frequent losses, and greater earnings declines around the dividend reduction year than do firms that voluntarily reduce dividends. Relative to voluntary‐reduction firms, forced‐reduction firms have higher debt‐to‐equity ratios and managerial holdings. These findings coupled with the increased dividend payout ratios and lower announcement period returns suggest that financially distressed firms that anticipate poor performance have greater incentives to delay reducing dividends to avoid a wealth transfer to bondholders.