The Market Pricing of Earnings Quality

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