Identifying Accounting Quality
55 Pages Posted: 23 Aug 2014 Last revised: 15 Sep 2017
Date Written: February 1, 2017
I develop a new approach to understanding accounting accruals. Unlike prior studies, I explicitly address the economic role of accruals in performance measurement. I characterize accounting quality in terms of a new construct, namely, the degree to which accruals facilitate performance measurement. Further, I develop a flexible empirical strategy for identifying accounting quality. The core identifying assumptions derive from institutional properties of both earnings and cash flows: that both are noisy measures of the same economic performance and they converge as the time horizon extends. These assumptions characterize moments of earnings, cash flows, and accruals solved to recover the variance of performance and accounting error in accruals. I implement several model specifications and consider a number of generalizations. My analysis suggests that the variance of the performance component exceeds accounting error and explains a high fraction of accruals’ variance. I conclude that accruals generate a better measure of firm performance than operating cash flows do, thus meeting their primary objective.
Keywords: Accounting quality, Earnings quality, Accruals, Identification, Estimation error
JEL Classification: M41
Suggested Citation: Suggested Citation