International Journal of Nonlinear Analysis and Applications

Analysis of EQ measurement criteria: Applications, weaknesses, and strengths

Document Type : Research Paper

Authors

1 Faculty of Management and Accounting, College of Farabi, University of Tehran, Qom, Iran

2 Faculty of Economic and Administrative Sciences, University of Qom, Iran

Abstract

Earnings, as one of the most important outputs of the accounting and financial reporting system, are of great interest to various users for making appropriate decisions in resource allocation. In addition to its quantitative value, if earnings lack appropriate quality, it can lead stakeholders astray and result in misinformed decisions. According to research literature, there are numerous definitions and classifications of earnings quality (EQ) and financial reporting quality (FRQ), along with measurement criteria, but there is no general consensus among them. The criteria examined in this study include a total of eight criteria based on accounting (accruals, persistence, predictability, and smoothness) and market-based (value relevance, timeliness, and conservatism) perspectives. For this purpose, after reviewing the research literature in this field, the advantages and disadvantages of these criteria were explored and critiqued. Research in this area can contribute to the development and determination of an optimal model in the context of the Iranian capital market.

Keywords

[1] M. Abbaszadeh and S. Arefi Asl, An overview of the concept of EQ and classification of its assessment criteria, Account. Accountab. Soc. Interes. 17 (2015), no. 5, 93–110.
[2] N.A. Abdollahzadeh, M. Taghavi, and M.K. Valahzaqhard, A study of the impact of cash and earning persistence on stock return in the Tehran Stock Exchange, Trans. Data Anal. Soc. Sci. 3 (2021), 30–39.
[3] H. Abou-El-Sood and D. El-Sayed, Abnormal disclosure tone, earnings management and earnings quality, J. Appl. Account. Res. 23 (2022), no. 2, 402–433.
[4] R. Ball, Accounting informs investors and earnings management is rife: Two questionable beliefs, Account. Hor. 27 (2013), no. 4, 847–853.
[5] R. Ball and L. Shivakumar, How much new information is there in earnings?, J. Account. Res. 46 (2008), 975–1016.
[6] Z.A. Barac, Financial reporting quality measurement- Approaches, issues and future trends, Proc. FEB Zagreb Int. Odyssey Conf. Econ. Bus., University of Zagreb, Faculty of Economics and Business, 3 (2021), no. 1, 1–13.
[7] M.E. Barth, Relative measurement errors among alternative pension asset and liability measures, Account. Rev. 66 (1991), no. 3, 433–463.
[8] M. Barth, Fair values and financial statement volatility,  C. Borio, W.C. Hunter, G. Kaufman and K. Tsatsaronis, (Eds.), Market discipline across countries and industries, London: The MIT Press, 2004, pp. 323–334.
[9] M.E. Barth, W.H. Beaver, and W.R. Landsman, Value-relevance of banks’ fair value disclosures under SFAS No. 107, Account. Rev. 71 (1996), no. 4, 513–537.
[10] M.E. Barth, W.H. Beaver, and W.R. Landsman, The relevance of the value relevance literature for financial accounting standard setting: another view, J. Account. Econ. 31 (2001), no. 1–3, 77–104.
[11] A. Barua, Using the FASB’s qualitative characteristics in earnings quality measures, Unpublished PhD Dissertation, The Graduate Factually of the Louisiana State University, Department of Accounting, 2006.
[12] S. Basu, The conservatism principle and the asymmetric timeliness of earnings, J. Account. Econ. 24 (1997), no. 1, 3–37.
[13] J.L. Bellovary, D.E. Giacomino, and M.D. Akers, Earnings quality: It’s time to measure and report, CPA J. 75 (2005), no. 11, 32–37.
[14] G. Bolo and M. Hasani Alghar, Experimental criteria for EQ, Account. Audit. Stud. 3 (2014), no. 12, 46–69.
[15] D.W. Collins, E.L. Maydew, and I.S. Weiss, Changes in the value-relevance of earnings and book values over the past forty years, J. Account. Econ. 24 (1997), no. 1, 39–67.
[16] B. Cornell and W. Landsman, Accounting valuation: Is earnings quality an issue?, Financ. Anal. J. 59 (2003), 20–29.
[17] L.E. DeAngelo, Accounting numbers as market valuation substitutes: A study of management buyouts of public stockholders, Account. Rev. 61 (1986), no. 3, 400–420.
[18] P. Dechow and I. Dichev, The quality of accruals and earnings: the role of accrual estimation errors, Account. Rev. 77 (2002), 35–59.
[19] P. Dechow, W. Ge and C. Schrand, Understanding earnings quality: A review of the proxies, their determinants and their consequences, J. Account. Econo. 50 (2010), no. 2–3, 344–401.
[20] P.M. Dechow and R.G. Sloan, Executive incentives and the horizon problem: An empirical investigation, J. Account. Econ. 14 (1991), no. 1, 51–89.
[21] P.M. Dechow, R.G. Sloan, and A.P. Sweeney, Detecting of earnings management, J. Account. Rev. 70 (1995), no. 2, 193–225.
[22] M. DeFond, C. Lennox, and J. Zhang, Some controversies in the auditing literature, Working paper, University of Southern California and The University of Texas at Dallas, 2016.
[23] I.D. Dichev, J.R. Graham, C.R. Harvey and S. Rajgopal, Earnings quality: Evidence from the field, J. Account. Econ. 56 (2013), no. 2–3, 1–33.
[24] S. Dostian and S. Mashayekh, Designing a rating model of companies from the perspective of accounting EQ, Exper. Account. Res. 9 (2019), no. 4, 201–220.
[25] V. Eftekhari and A. Parvaii, An overview of the concept of EQ and existing ambiguities in research, Account. Audit. Stud. 10 (2014), no. 3, 143–160.
[26] H. Etemadi and S. Babaei, The value-relevance of accounting information, Account. Audit. Stud. 26 (2018), no. 6, 5–16.
[27] G.A. Feltham and J.A. Ohlson, Valuation and clean surplus accounting for operating and financial activities, Contemp. Account. Res. 11 (1995), no. 2, 689–731. 
[28] Financial Reporting Council, Understanding research findings and evidence on corporate reporting: An independent literature review, The Financial Reporting Council Limited, London, 2020.
[29] N.C. Fonou-Dombeu, J. Mbonigaba, O.M. Olarewaju, and B.C. Nomlala, Earnings quality measures and stock return volatility in South Africa, Future Bus. J. 8 (2022), no. 1, 1–15.
[30] J. Francis, R. LaFond, P.M. Olsson, and K. Schipper, Costs of equity and earnings attributes, Account. Rev. 79 (2004), no. 4, 967–1010.
[31] D. Givoly, C.K. Hayn, and S.P. Katz, Does public ownership of equity improve earnings quality?, Account. Rev. 85 (2010), no. 1, 195–225.
[32] I. Gow, G. Ormazabal, and D. Taylor, Correcting for cross-sectional and time-series dependence in accounting research, Account. Rev. 85 (2010), no. 2, 483–512.
[33] M. Gros and D. Worret, The challenge of measuring audit quality: some evidence, Int. J. Critic. Account. 6 (2014), no. 4, 345–374.
[34] T. Harris, E. Huh, and P. Fairfield, Gauging profitability on the road to valuation, Strategy report, global valuation and accounting, Morgan Stanley Dean Witter, 2000.
[35] H.A. Hashim, The influence of culture on financial reporting quality in Malaysia, Asian Soc. Sci. 8 (2012), no. 13, 192.
[36] P.M. Healy, The effect of bonus schemes on accounting decisions, J. Account. Econ. 7 (1985), no. 1–3, 85–107.
[37] S.K. Herath and N. Albarqi, Financial reporting quality: a literature review, Int. J. Bus. Manag. Commerce 2 (2017), no. 2, 1–14.
[38] P. Hribar and D.C. Nichols, The use of unsigned earnings quality measures in tests of earnings management, J. Account. Res. 45 (2007), 1017–1053.
[39] A. Hunt, S. Moyer, and T. Shevlin, Earnings volatility, earnings management and equity value, Working paper, Department of Accounting, University of Washington, 2000.
[40] International Accounting Standards Board (IASB), Conceptual framework for financial reporting, https://www.ifrs.org/content/dam/ifrs/publications/pdf-standards/english/2021/issued/part-a/conceptualframework-for-financial-reporting.pdf, 2018.
[41] A.B. Jackson, Discretionary accruals: Earnings management or not?, Abacus 54 (2018), no. 2, 136–153.
[42] N. Jafari Azarki and M.M. Noorbakhsh Langrudi, The impact of interest rate changes on stock returns of private banks accepted in Tehran Stock Exchange, Trans. Data Anal. Soc. Sci. 2 (2020), no. 1, 1–9.
[43] G. Jonas and J. Blanchet, Assessing quality of financial reporting, Account. Hor. 14 (2000), no. 3, 353–363.
[44] J.J. Jones, Earnings management during import relief investigations, J. Account. Res. 29 (1991), no. 2, 193–228.
[45] K.L. Jones, V. Gopal V. Krishnan, and K. Melendrez, Do models of discretionary accruals detect actual cases of fraudulent and restated earnings? An empirical evaluation, Contemp. Account. Res. Forthcoming, Available at SSRN: https://ssrn.com/abstract=895541 or http://dx.doi.org/10.2139/ssrn.895541
[46] M. Kashanipour, G. Karami, and H. Moradi Joz, A model for evaluating the ranking of EQ measures in Iran, Exper. Stud. Financ. Account. 16 (2019), no. 62, 127–150.
[47] S.P. Kothari, A.J. Leone, and C.E. Wasley, Performance matched discretionary accrual measures, J. Account. Econ. 39 (2005), no. 1, 163–197.
[48] W. Landsman, An empirical investigation of pension fund property rights, Account. Rev. 61 (1986), no. 4, 662–691.
[49] B.B. Lee and W. Vetter, Critical evaluation of accrual models in earnings management studies, J. Account. Financ. 15 (2015), no. 1, 62.
[50] E. Lee, M. Walker, and C. Zeng, Does IFRS convergence affect financial reporting quality in China? ACCA research report, ACCA Research Report: ACCA, 2013.
[51] C. Leuz, D. Nanda, and P. Wysocki, Earning management and investor protection: an international comparison, J. Financ. Econ. 69 (2003), 505–527.
[52] B. Lev, On the usefulness of earnings and earnings research: Lessons and directions from two decades of empirical research, J. Account. Res. 27 (1989), 153–192.
[53] M. McNichols, Discussion of the quality of accruals and earnings: the role of accrual estimation errors, Account. Rev. 77 (2002), 61–69.
[54] M.H. Miller and F. Modigliani, Some estimates of the cost of capital to the electric utility industry, 1954-57, Amer. Econ. Rev. 56 (1966), no. 3, 333–391.
[55] H. Nikoomaram, E., Norouzi, and A. Mehr Azin, Evaluation of models based on accruals to discover earnings management, Manag. Res. 82 (2009), 1–20.
[56] S. Penman and X. Zhang, Accounting conservatism, the quality of earnings and stock returns, Account. Rev. 77 (2002), no. 2, 237–264.
[57] P. Perotti and A. Wagenhofer, Earnings quality measures and excess returns, J. Bus. Financ. Account. 41 (2014), 545–571.
[58] A. Rahmani and N. Bashirimanesh, Examining the discovery power of earnings management models, Account. Audit. Res. 4 (2013), no. 9, 54–73.
[59] Z. Rezaee and M.H. Safarzadeh, Corporate governance and earnings quality: the behavioral theory of corporate governance (evidence from Iran), Corporate Governance: Int. J. Bus. Soc. 23 (2023), no. 1, 189–218.
[60] M.H. Safarzadeh, EQ and its measurement criteria, Account. Soc. Benefits 3 (2013), no. 2, 125–145.
[61] A. Saghafi and R. Baghomian, Value relevance of accounting information: measurement and behavioral aspects, Account. Stud. 7 (2009), no. 25, 1–52.
[62] K. Schipper and L. Vincent, Earnings quality, Account. Hor. 17 (2003), 97–110.
[63] S. ˇSodan, The impact of fair value accounting on earnings quality in eastern European countries, Proc. Econ. Financ. 32 (2015), 1769–1786.
[64] J. Tucker and P. Zarowin, Does income smoothing improve earnings informativeness?, Account. Rev. 81 (2006), 251–270.
[65] U. Velury, The effect of institutional ownership on the quality of earnings, Unpublished PhD Dissertation, University of South Carolina, Darla Moore School of Business, UMI Number: 9928350, 1999.
[66] P. Wysocki, Assessing earnings and accruals quality: US and international evidence, Unpublished working paper, MIT Sloan School of Management, Cambridge, 2009.
International Journal of Nonlinear Analysis and Applications
Volume 16, Issue 3
March 2025
Pages 299-313
  • Receive Date: 12 December 2023
  • Accept Date: 28 February 2024