Earning Quality
DOI: 10.1111/j.1475-679X.2010.00397.x
Journal of Accounting Research
Vol. 49 No. 3 June 2011
Printed in U.S.A.
Earnings Quality Based on Corporate Investment Decisions
FENG LI∗
Received 25 July 2007; accepted 20 September 2010
ABSTRACT
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 earningsquality measures used in the accounting literature. Furthermore, investmentbased earnings-quality measures are less informative when managers tend to overinvest. 1. Introduction
Prior research on earnings quality generally relies on one of two approaches: studying the properties of accounting numbers or extracting
∗ Stephen M. Ross School of Business, University of Michigan. I thank Ray Ball, Phil Berger,
Ilia Dichev, Kenneth Merkley, workshop participants at the University of Chicago, and especially an anonymous reviewer and Richard Leftwich (the journal editor) for their comments.
721
Copyright
C
, University of Chicago on behalf of the Accounting Research Center, 2011
722
F. LI
information from stock prices.1 This paper explores a new measure of earnings quality by examining firm investment decisions.2 Managerial investment decisions likely contain information about earnings
Journal of Accounting Research
Vol. 49 No. 3 June 2011
Printed in U.S.A.
Earnings Quality Based on Corporate Investment Decisions
FENG LI∗
Received 25 July 2007; accepted 20 September 2010
ABSTRACT
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 earningsquality measures used in the accounting literature. Furthermore, investmentbased earnings-quality measures are less informative when managers tend to overinvest. 1. Introduction
Prior research on earnings quality generally relies on one of two approaches: studying the properties of accounting numbers or extracting
∗ Stephen M. Ross School of Business, University of Michigan. I thank Ray Ball, Phil Berger,
Ilia Dichev, Kenneth Merkley, workshop participants at the University of Chicago, and especially an anonymous reviewer and Richard Leftwich (the journal editor) for their comments.
721
Copyright
C
, University of Chicago on behalf of the Accounting Research Center, 2011
722
F. LI
information from stock prices.1 This paper explores a new measure of earnings quality by examining firm investment decisions.2 Managerial investment decisions likely contain information about earnings