Identifying Accounting Quality
62 Pages Posted: 23 Aug 2014 Last revised: 15 May 2018
Date Written: April 25, 2018
In this paper, I develop a new approach to modeling and understanding accounting accruals. I introduce a model that explicitly incorporates the role of accruals in measuring firm performance. Using this model, I characterize accounting quality by the degree to which accruals fulfill their performance measurement objective. To identify accounting quality, the model exploits the institutional properties of accounting information that both earnings and cash flows represent noisy measures of the unobservable economic performance, and that they converge as the measurement horizon extends. These properties allow decomposing the variance of accruals into both the performance measurement component and the accounting error component, as well as identifying the variance of the unobservable economic performance itself. I implement several model specifications and consider a number of generalizations. My analysis suggests that, on average, the portion of accruals that facilitates performance measurement significantly exceeds the level of accounting error in accruals. I conclude that accruals successfully meet their primary objective.
Keywords: Accounting quality, Earnings quality, Accruals, Identification, Estimation error
JEL Classification: M41
Suggested Citation: Suggested Citation