Earnings quality research: Advances, challenges and future research☆

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Abstract

This discussion makes several observations regarding the earnings quality research reviewed in Dechow, Ge and Schrand (2010) (DGS). I discuss some of the factors that led to the large growth in the earnings quality literature over the past two decades, and note a few of the important contributions from this literature. I also present what I view as several major challenges the literature faces as well as some avenues for future research. In addition, I discuss the difficulties in evaluating such a diverse body of literature, and comment on DGS’s major conclusions.

Introduction

Dechow, Ge and Schrand (2010) (DGS) provides a comprehensive and detailed review of the earnings quality (EQ) research and contains numerous penetrating insights. The literature discussed in the review spans several decades, covering nearly 350 studies in more than a dozen topical areas. A distinctive feature of the review is that it includes an in-depth discussion of issues related to the convergent and divergent validity of the proxies most commonly used in the EQ literature. This approach is original to the literature and significantly enhances our understanding of issues related to EQ. DGS is ambitious and exhaustive, and succeeds in providing an excellent overview and critique of the EQ literature.

The purpose of this discussion is to offer a few additional observations on the EQ literature and to comment on some of DGS’s major conclusions. My remarks are not intended to be comprehensive but instead are limited to issues in the literature that I find particularly significant.

Section 2 begins with some conjectures about why the EQ literature has grown so rapidly over the past two decades and Section 3 discusses some of the literature’s important accomplishments. Section 4 notes several challenges researchers in the area face and Section 5 speculates on potential directions for future research. Section 6 discusses some of the difficulties inherent in reviewing such a broad literature and comments on DGS’s conclusions. Section 7 summarizes my observations.

Section snippets

Growth in the EQ literature

Research on EQ has grown dramatically over the past two decades. This is particularly true in the earnings management area, which comprises the majority of studies reviewed by DGS. While speculative, I believe the major drivers of the growth in the EQ area are likely to be the confluence of several factors that have both encouraged and facilitated this line of research. A factor encouraging this research was the SEC’s harsh allegations during the 1990s of widespread earnings management among

Progression of and accomplishments in the EQ literature

As it has expanded, the EQ literature has improved on several dimensions. One of the most dramatic improvements has been in the rigor of the EQ proxies, particularly the proxies measuring abnormal accruals. Abnormal accruals is by far the single most popular proxy used in the papers reviewed in DGS and a hallmark of the EQ research is the nearly continual innovations made to these proxies. Indeed, the measure used in the earliest study that employs abnormal accruals as a proxy (Healy, 1985),

Challenges in the EQ literature

While I think that the literature has made important advances, I also think there are many challenges in studying EQ. One is that all of our abnormal accruals models suffer from the inherent limitation that we are unable to validate the accuracy of their predictions. For example, we are unable to verify whether our estimates of discretionary accruals are the result of management’s opportunistic accounting choices, or just an artifact of the particular model we are using. This is a construct

Future directions for EQ research

Going forward, I think there are accounting developments on the horizon about which we know relatively little, and hence are logical prospects for future research. One example is fair-value accounting, which represents a potentially sea-changing development in the accounting environment. Fair-value accounting essentially follows from the explicit rejection of the concept of conservatism by standard setters in the newly proposed conceptual framework for financial reporting (IASB, 2008). Changing

Comments on DGS

DGS organizes their review around critiquing the construct validity of the proxies used in the EQ literature. As DGS acknowledges, however, EQ is not well defined in the accounting literature and has come to represent different concepts across the studies that employ this term. While the authors attempt to capture a commonality by using the definition of EQ provided in Statement of Financial Accounting Concepts (SFAC) No. 1, this definition is quite broad. As a result, the EQ studies evaluated

Summary

This discussion provides several observations on the EQ literature reviewed in DGS and comments on DGS’s major conclusions. I conjecture that key factors responsible for the large growth in EQ literature over the past two decades include the SEC’s harsh allegations of widespread earnings management by public companies, the literature’s adoption of the Jones model as a more-or-less generally accepted proxy for EQ, and the development and implementation of a set of internationally accepted

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    ☆

    I appreciate helpful comments from Michelle Hanlon (Editor), Mingyi Hung, Yaniv Konchitchki, Jeff McMullen and Karen Ton.

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