Earnings Quality and Corporate Governance

There are two seemingly contradictive perspectives in the literature on the relation between corporate governance and earnings quality. One perspective predicts that firms compensate inherent limitations in the ability of accounting information to reflect underlying economics (i.e., poor earnings quality) with stronger governance mechanisms. The other perspective predicts that stronger governance structures constrain earnings management, leading to better earnings quality. These two perspectives have been largely examined in isolation, and empirical results are often inconsistent also within each perspective. We develop a framework to separate the innate and discretionary portions of earnings quality. Unlike traditional approaches that identify managerial discretion as a regression residual, we model earnings quality directly on managerial incentives. We find that poor innate earnings quality is associated with more effective governance structures, and that more effective governance structures are associated with better discretionary earnings quality. Both perspectives can thus be accommodated within a single framework, provided a valid separation of the innate and discretionary portions of earnings quality. The analysis shows how earnings quality shapes and is shaped by corporate governance, depending on its source.

This seminar is organised by the Erasmus Accounting Research Group.