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CFOs Surveyed on Earnings Quality

Earnings Quality: Evidence from the Field.

CFOs Surveyed on Earnings Quality
Survey by Ilia D. Dichev - Emory University - Goizueta Business School, John R. Graham - Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER), Campbell R. Harvey - Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER), Shivaram Rajgopal - Emory University - Goizueta Business School (September 9, 2012).

We provide new insights into earnings quality from a survey of 169 CFOs of public companies and in-depth interviews of 12 CFOs and two standard setters. Our key findings include:
- (i) high-quality earnings are sustainable and are backed by actual cash flows; they also reflect consistent reporting choices over time and avoid long-term estimates;
- (ii) about 50% of earnings quality is driven by non-discretionary factors;
- (iii) about 20% of firms manage earnings to misrepresent economic performance, and for such firms 10% of EPS is typically managed;
- (iv) CFOs believe that earnings manipulation is hard to unravel from the outside but suggest a number of red flags to identify managed earnings;
- and (v) CFOs disagree with the direction the FASB is headed on a number of issues including the sheer number of promulgated rules, the top-down approach to rule-making, the de-emphasis of the matching principle, and the over-emphasis of fair value accounting. CFOs lament that a rules-based culture makes the audit function centralized and mechanical, and stunts the development of audit professionals.

The concept of earnings quality is fundamental in accounting and financial economics. Yet, there are deep disagreements about how to define and measure it. The list of candidate measures is long: earnings persistence, predictability, asymmetric loss recognition, various forms of benchmark beating, smooth earnings, magnitude of accruals, income-increasing accruals, absolute value of discretionary or abnormal accruals, and the extent to which accruals map into cash flows. Complicating the measurement of earnings quality, archival research cannot satisfactorily parse out the portion of managed earnings from the portion resulting from the fundamental earnings process (Dechow, Ge and Schrand 2010). Relatedly, a number of vexing questions have been difficult to address with archival work because answers often rely on unobservable managerial intent. Examples of such questions include the following: What opportunities and constraints do managers trade off to choose one set of earnings attributes over the other? How prevalent is earnings management? What is the typical magnitude of earnings management? Would certain accounting policies promote higher quality earnings? How can an outside investigator tell whether ex-ante earnings quality is poor before observing ex-post outcomes such as restatements and SEC enforcement actions?

In this paper, we provide insights about earnings quality from a new data source: a large survey and a dozen interviews with top financial executives, primarily Chief Financial Officers (CFOs). Why CFOs? While it is clear that there are important consumers of earnings quality such as investment managers and analysts, we focus on the direct producers of earnings quality, who also intimately know and potentially cater to such consumers. In addition, CFOs commonly have a formal background in accounting, which provides them with keen insight into the determinants of earnings quality, including the advantages and limitations of GAAP accounting. CFOs are also key decision-makers in company acquisitions (see Graham, Harvey and Puri 2012), which implies that they have working knowledge of how to evaluate earnings quality from an outside perspective...

Read more. Download the survey (PDF 74 pages in English):

Mercredi 10 Octobre 2012

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