Earnings Quality, Accounting Horizons
This article examines several earnings quality constructs from the perspective of decision usefulness, as described in the Financial Accounting Standards Board's Conceptual Framework, and from the perspective that earnings are of high quality to the extent they faithfully represent Hicksian income, which is, conceptually, the change in total wealth. The earnings quality constructs we consider pertain to persistence, predictive ability, and the time-series variance of earnings; the relations among cash, accruals and income; the correspondence to relevance, reliability, and comparability; and the effects of implementation decisions. We link these earnings quality constructs to empirical measures, and to examples from academic research. We note that, in addition to well-known estimation issues, some earnings quality measures are sensitive to choice and measurement of both the earnings metric and the cash flow variable. We argue that calibrating earnings quality constructs against the representational faithfulness criterion reveals that some constructs can signal low-quality earnings because of effects of business models and the economic environment, as well as financial reporting effects. We believe that the effects of the underlying business model and the economic environment are important determinants of earnings quality, which can and do operate separately from the effects of reporting rules and implementation decisions.
Katherine Schipper, Linda Vincent
Schipper, Katherine, and Linda Vincent. 2003. Earnings Quality. Accounting Horizons. 17(Supplement): 97-110.