1.1 Introduction
Financial statements are one of the key elements of decision-making process in capital markets, and especially, income represents the most important accounting information that investors, managers, directors, and regulators rely on for their decisions. Accuracy, reliability, assurance, predictability, timeliness, and realization of income have a direct relationship mainly with investment appraisals. Therefore, the income statement needs to be of high quality to insure reliability, accuracy, and informativeness of accounting information since the bottom line of the income statement is assumed as the basis for most of decisions, assessment models, and stock pricing.
There is a large amount of literature investigating the impact of companiesâ information on analystsâ forecasts. The information environment of a company is considered a key driver of forecastsâ accuracy, as the quantity and the quality of the available information may reduce uncertainty about future prospects and thus may contribute to reduce forecast errors. One of the main attributes of the information setting of an entity is the extent of financial disclosure, and in this regard, several papers have shown that financial reporting is an important source of information used by financial analysts for predictive purposes (e.g., Aktas & Kargin, 2012; Armstrong, Gyay, & Weber, 2010; Peek, 2005). However, it is not yet clear whether it is the quantity or the quality of financial information that drives analystsâ forecasts. The analystsâ forecasts may significantly depend on the accounting policies adopted by various companies, as different valuation and recognition models may lead to different properties of quality of the information environment.
In particular, investors, analysts and policy makers require credible accounting information to assess the real firmâs economic performance and to take subsequently optimal decisions. Earnings are the primary information source for investors rather than any other performance indicators (such as dividend and cash flows). Hence, the main aim of earningsâ reporting is to provide useful information for those people who have high interest in financial reports (Francis, LaFond, Olsson, & Schipper, 2004). One issue is whether accounting information of firms is able to cope satisfactorily with such a wide variety of needs. The other issue is that the users are by definition concerned with the future disposition of resources in making economic decisions. Users would therefore like to be provided with information which either predicts what is going to happen to the firm or enables them to make their own predictions using the accounting information.
Anyway, the volume of accounting earnings cannot be always a good criterion for investorsâ decision-making since sometimes earnings are manipulated by management. Hence, financial analysts have to note both the quantity and the quality of earnings. Quality of earnings is crucial for the well-functioning of markets, and it was put forward to help investors in making proper decisions. The reactions of investors to reported earnings are based upon the idea that high-quality earnings provide useful information for equity valuation. Therefore, when the quality of the information is high, there should be a tighter relationship between accounting information and investorsâ decisions.
Earnings quality (EQ) is an important aspect of evaluating an entityâs financial health, and it is a significant summary characteristic of accounting systems. Although investors, creditors, and other financial statementsâ users often overlook it, EQ is lately becoming of considerable interest to participants in the financial reporting process (including Standard Setters, preparers, auditors, regulators, analysts, and financial press commentators) and to accounting researchers. In this context, researchers have proposed different measures of EQ, e.g., the value relevance of earnings, timeliness, conservatism, accruals quality, persistence, and predictability, among other measures. The fundamental differences among these measures are expected to make them differentially effective in capturing the multidimensional construct of EQ, as well as to be different approaches to the measurement of it. It is noted that in academic research, the empirical measures applied to assess EQ are likely to be sensitive to differences in firm-level economic circumstances and business models (Schipper & Vincent, 2003). According to Balsam, Krishnan, and Yang (2003), several measures of EQ exist in literature since different procedures capture the various manifestations and interpretations of EQ (Kirschenheiter & Melumad, 2002).
1.2 Earnings Quality: Background
The concept of EQ is a significant and critical issue attracting interest within the financial reporting process (Teets, 2002). The emphasis on EQ, as well as, on earnings management (EM) increased during the 1990s when the U.S. Securities and Exchange Commission (SEC) criticized managers and auditors. SEC accused managers to focus on opportunistic EM, and it suspected auditors to operate as managersâ accomplices in deceiving the public. Managers had incentives to manage earnings and to meet capital market expectations due to the general importance of both firmsâ stock market valuations together and their stock-based compensations (Dechow & Skinner, 2000). SECâs criticism against managers and auditors made researchers more likely to study both issues related to how managers meet earnings targets and matters related to the role of audit quality in earnings reporting (DeFond, 2010).
Later, in the early of 2000s, big financial scandals in the USA and Europe broke out (e.g., Enron, WorldCom, Parmalat). During this period, EQ literature continued to grow as the consequence of these financial scandals even if the concerns regarding it existed since long before. In order to restore investorsâ confidence, the importance of financial reporting quality, with a special emphasis on EQ, was highlighted. In recent years, the quality of financial reporting and the quality of earnings have becoming a common subject in accounting research, as documented by the multiple literature that have reviewed the research on this topic (e.g., Dechow & Schrand, 2004; Demerjian, Lev, Lewis, & McVay, 2013; Gaio & Raposo, 2011; GutiĂ©rrez & RodrĂguez, 2019; Penman, 2003). Despite the increased attention on EQ and the big volume of the literature concerning it, yet the concept is not well defined.
The term âearnings qualityâ is vague and it is difficult to define. The literature on EQ currently embraces various aspects of this nebulous concept and no unique definition of it can be found. Evidence from prior research suggests that EQ is also a multidimensional concept (GutiĂ©rrez & RodrĂguez, 2019) that makes people consider quality of earnings differently. Referring to Teets (2002), âsome consider quality of earnings to encompass the underlying economic performance of a firm, as well as the accounting statements that report on the underlying phenomenon, others consider quality of earnings to refer only to how well accounting earnings convey information about the underlying phenomenonâ. In this regard, Dechow and Schrand (2004) stated in their preface of EQ monograph that: âunderstanding a companyâs quality of earnings requires expertise in finance, accounting and corporate strategy and a strong knowledge of the industry in which the company operates and the governance mechanisms monitoring and rewarding employees and managersâ. Regardless of the definition of EQ, there are some factors on which might depend its meaning. Those factors include the special characteristics of firmsâ business model, the features of financial reporting system that firms implement, the expertise of auditors, or the goals and the incentives of managers when they make reporting choices.
Schipper and Vincent (2003) stated that: âalthough the phrase âearnings qualityâ is widely used, there is neither a unique meaning assigned to the phrase nor a generally accepted approach to measuring earnings qualityâ. Furthermore, Barker (2004) noted that no definition of earnings has been provided in the Financial Accounting Standard Board (FASB) Conceptual Framework,1 which makes EQ difficult to interpret. Nevertheless, for the particular interest of this issue, the definition utilized by Dechow and Schrand (2004) is considered the most appropriate one to be adopted as it considers all the elements for high quality of earnings (i.e., persistence, predictability, and lack of variability) in one definition. The authors defined earnings to be of high quality when the earningsâ number âis one tha...