Part 3: Accounting quality in capital markets research

Question 1

What are the firm-level incentives for disclosure?

Answer 1

Capital market incentives

• Performance
• Financing needs
• Globalisation and complexity of operations
• Ownership structure
• Propriety costs

Legitimisation incentives

Question 2

What are the managerial incentives for disclosure?

Answer 2

Typically, agency or contractually based, where managers want to maximize own utility, rather than shareholder benefit. For example, a contract that aligns the interest of managers and shareholders, can motivate managers to be more transparent and provide more relevant, firm-specific disclosures.

Question 3

Why is earnings quality important?

Answer 3

Current earnings are believed to be the best indication of future earnings which means that investors ability to predict future performance is dependent on the quality. Earnings are a number made up of different components, which are subject to more or less judgement, meaning that earnings are a function of their specific context.

Question 4

What are the three hierarchical dimensions of earnings quality?

Answer 4

Accounting standards followed
Accounting policy or method chosen
Judgements made

Question 5

What are the two proxies for earnings quality measures?

Answer 5

Earnings properties

External indicators of earnings quality

Question 6

What are the five earnings properties?

Answer 6

• Earnings persistence (positive)
• Earnings smoothness (negative)
• Abnormal accruals (negative)
• Earnings timeliness (positive but could be negative)
• Target beating (negative) or at least when “just” beating a target

Question 7

What are the external indicators of earnings quality?

Answer 7

Value relevance

Intermediaries’ evaluation

Question 8

What are abnormal accruals?

Answer 8

Accruals that do not reflect performance

Question 9

What is earnings timeliness?

Answer 9

How quickly information is provided about some underlying economic event. If perfectly timely, prudence would not be met

Question 10

Firm characteristics of higher/lower earnings quality

Answer 10

• Firm growth (lower due to lower persistence and measurement errors)
• Firm size (Higher in the sense that large firms have better controls. Lower in the sense that there are usually more incentives)
• Leverage (Lower due to avoidance to violate debt covenants)
• Firm performance (Lower with low performance because of incentives to show positive prospects)