Identifying Accounting Quality
62 Pages Posted: 23 Aug 2014 Last revised: 15 Jan 2019
Date Written: December 1, 2018
I develop a new approach to understanding accounting accruals. I start by introducing 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, I exploit the property that both earnings and cash flows represent noisy measures of the unobservable economic performance, and that they converge as the measurement horizon extends. This allows 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 generalizations. My analysis suggests that the variance of accruals explained by performance measurement significantly exceeds the variance explained by accounting error. 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