Earnings Quality Based on Corporate Investment Decisions

Abstract:     
This paper examines a new approach of measuring earnings quality based on firms' capital and labor investment decisions. More specifically, I measure earnings quality as the contemporaneous association between the changes in the level of capital and labor investment and the change in reported earnings. The approach relies on the following intuition: (1) firms make investment decisions based on the net present value (NPV) of the investment projects; and (2) a reported earnings with higher quality (i.e., it is closer to the permanent earnings or the annuitized NPV) should be more associated with the real investment decisions. I find that the measures of earnings quality based on managerial labor and capital decisions are positively correlated with earnings persistence and have incremental explanatory power relative to the earnings quality measures used in the literature.

Number of Pages in PDF File: 49

Keywords: corporate investment, earnings quality, earnings persistence

JEL Classification: G31, M41, M44, G12

working papers series