The Market Pricing of Earnings Quality

43 Pages Posted: 26 Jun 2003

See all articles by Jennifer Francis

Jennifer Francis

Duke University

Ryan LaFond

Algert Global, LLC

Per Olsson

Duke University

Katherine Schipper

Duke University - Fuqua School of Business

Date Written: October 2002

Abstract

We provide large sample evidence on whether the equity and debt markets impound information about the quality of earnings. We examine eight proxies for earnings quality (four based on the modified Jones approach to estimating abnormal accruals; three based on the Dechow and Dichev [2002] approach which relates working capital accruals to cash flows; and one based on a factor analysis of the other seven). Across all eight metrics, we find that firms with lower quality earnings have higher costs of capital as evidenced by lower debt ratings, larger realized costs of debt, larger industry-adjusted earnings-price ratios, larger equity betas, and positive loadings on an earnings quality factor added to one-factor and three-factor asset pricing regressions. The documented effects are statistically significant and economically meaningful: The results show, for example, that firms with the best earnings quality enjoy discounts of 80-160 basis points in their costs of debt and 150-300 basis points in their costs of equity relative to firms with the poorest earnings quality.

Keywords: costs of capital, earnings quality

JEL Classification: M41, G12

Suggested Citation

Francis, Jennifer and LaFond, Ryan and Olsson, Per Mikael and Schipper, Katherine, The Market Pricing of Earnings Quality (October 2002). Available at SSRN: https://ssrn.com/abstract=414140 or http://dx.doi.org/10.2139/ssrn.414140

Jennifer Francis (Contact Author)

Duke University ( email )

Fuqua School of Business
Durham, NC 27708
United States
919-660-7817 (Phone)
919-648-2818 (Fax)

Ryan LaFond

Algert Global, LLC ( email )

One Maritime Plaza
Suite 1525
San Francisco, CA 94111
United States

Per Mikael Olsson

Duke University ( email )

Box 90120
Durham, NC 27708-0120
United States

Katherine Schipper

Duke University - Fuqua School of Business

Box 90120
Durham, NC 27708-0120
United States

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