Earnings Quality and Financial Reporting Credibility: An Empirical Investigation

Abstract

Existing research indicates that firms with high accruals are more likely to experience future earnings reversals and SEC enforcement actions for GAAP violations, but that investors do not appear to anticipate these consequences. In this paper, we directly examine the published opinions of two types of professional investor intermediaries to see if they anticipate the consequences of high accruals. First, we examine the earnings forecasts of sell-side analysts. We show that analysts' earnings forecasts do not anticipate the future earnings reversals associated with high accruals. Second, we examine the audit opinions of independent auditors. We find no evidence that auditors signal the higher likelihood of GAAP violations through their audit opinions. Overall, our evidence indicates that even professional investor intermediaries act as if they do not anticipate the consequences of high accruals.

JEL Classification: G12, M41, M49, G29