Earning Quality Essay

DOI: 10. 1111/j. 1475-679X. 2010. 00397. x

Log of Accounting Research

Volume. 49 Number 3 June 2011

Branded in U. S. A.

Earnings Top quality Based

about Corporate Investment Decisions

FENG LI∗

Received 25 September 2007; accepted 20 September 2010

SUBJECTIVE

In this conventional paper, I look at a new procedure for testing earnings quality, defined while the nearness of reported earnings to " permanent earnings, ” based on firm decisions for capital and labor assets. Specifically, My spouse and i measure revenue quality because the contemporaneous association between changes in the levels of capital and labor expense and the change in reported revenue. This approach employs the reasoning that (1) firms generate investment decisions based on the web present worth (NPV) of investment projects and (2) reported income with high quality should more closely relate with actual investment decisions. I find that actions of earnings quality depending on managerial labor and capital decisions correlate positively with earnings determination and have incremental explanatory electric power relative to earningsquality measures used in the accounting literature. Furthermore, investmentbased earnings-quality measures are less informative when managers usually overinvest.

1 ) Introduction

Before research about earnings quality generally depends on one of two techniques: studying the properties of accounting figures or removing

∗ Sophie M. Ross School of Business, University of Michigan. I give thanks to Ray Ball, Phil Bergerot, Ilia Dichev, Kenneth Merkley, workshop participants at the University or college of Chicago, and especially an anonymous reporter and Rich Leftwich (the journal editor) for their responses. 721

Copyright laws

C

, School of Chi town on behalf of the Accounting Research Center, 2011

722

F. LI

data from share prices. 1 This conventional paper explores a new measure of income quality by simply examining firm investment decisions. 2 Bureaucratic investment decisions likely include information about revenue quality because managers generate many decisions based on upcoming profitability, and arguably have an overabundance precise and information about their very own firm's profitability than carry out other stakeholders. Therefore , to the extent that information asymmetry exists between managers and outsiders, the earnings quality deduced from bureaucratic decisions can provide incremental information to existing empirical measures based on the info set of outside the house investors or on the properties of the accounting numbers. three or more

In this study, I look at whether corporate investment decisions contain details about earnings top quality. In a simplified setting, managers invest more in projects with a bigger net present value (NPV). All else getting equal, if a firm's expected future profits or long term earnings increase, then it makes additional expense, because long lasting earnings happen to be equivalent to annuitized NPV (Black [1980], Beaver [1998], Ohlson and Zhang [1998]). Therefore, if a firm experiences an increase in reported income and administration views this earnings development to be long lasting (i. electronic., the reported earnings have high " quality”), in that case that firm usually improves its investment level. Yet , if the advancement in reported earnings can be purely transitory, then there should not be a corresponding difference in the expenditure level. This kind of reasoning suggests that earnings surprises that are even more associated with changes in corporate expenditure decisions are more inclined to be permanent and of higher quality than happen to be earnings surprises that are less associated with this kind of changes.

Inferring earnings quality from corporate investment decisions has limits. Because of organization problems, managers have bonuses to overinvest for disposition building and also other reasons (Stein [2003]). Therefore, project profitability does not only determine seen investment decisions and this minimizes these decisions' informativeness pertaining to assessing income quality. In the end, whether one can possibly derive beneficial and dependable measures of...

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