Earning Quality

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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

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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 quality because managers make many decisions based on future profitability, and arguably have more precise and complete information about their firm’s profitability than do other stakeholders. Therefore, to the extent that information asymmetry exists between managers and outsiders, the earnings quality inferred from managerial decisions can provide incremental information to existing empirical measures based on the information set of outside investors or on the properties of the accounting numbers.3

In this study, I examine whether corporate investment decisions contain information about earnings quality. In a simplified setting, managers invest more in projects with a higher net present value (NPV). All else being equal, if a firm’s expected future earnings or permanent earnings increase, then it makes additional investment, because permanent earnings are equivalent to annuitized NPV (Black [1980], Beaver [1998], Ohlson and Zhang [1998]). Hence, if a firm experiences an increase in reported earnings and management views this earnings innovation to be permanent (i.e., the reported earnings have high “quality”), then that firm usually increases its investment level. However, if the innovation in reported earnings is purely transitory, then there should not be a corresponding change in the investment level. This reasoning suggests that earnings surprises that are more associated with changes in corporate investment decisions are more likely to be permanent and of higher quality than are earnings surprises that are less associated with such changes.

Inferring earnings quality from corporate investment decisions has limitations. Because of agency problems, managers have incentives to overinvest for empire building and other reasons (Stein [2003]). As a result, project profitability does not solely determine observed investment decisions and this reduces these decisions’ informativeness for assessing earnings quality. Ultimately, whether one can derive useful and reliable measures of...
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