Earnings quality: an international analysis

We construct an aggregate earnings quality measure based on seven earnings attributes (accruals quality, persistence, predictability, smoothness, value relevance, timeliness, and conservatism) to study earnings quality around the world. We first examine the relative importance of firm, industry, and country characteristics in explaining earnings quality. We find that firm characteristics are the major determinant of earnings quality, and that firm and industry characteristics have incremental explanatory power beyond country heterogeneity in explaining earnings quality worldwide. Our results hold across different levels of a country’s economic development and investor protection. We also find that firm and industry characteristics have become more important in the late 1990s, as accounting and financial globalization accelerated. We then examine the relationship between firm-level corporate governance and earnings quality. We find a negative relation between corporate governance and earnings quality, which suggests they have substitute roles. This relation is particularly strong in developed countries, in countries with strong investor protection, and for cross-listed firms. Thus, governance mechanisms seem to be able to make up for poorer earnings quality, especially in high-quality country environments. Finally, we investigate the relation between firm valuation and earnings quality. We find a positive relation between firm valuation and earnings quality, which suggests that firms with higher earnings quality are valued more highly in stock markets. This relation is particularly strong for firms with greater investment opportunities that need to access capital markets, and for firms in low investor protection countries. Our findings support the idea that investors require a premium for the information risk associated with lower-quality earnings.