This paper provides a new approach to test for accrual-based earnings management. Our approach exploits the inherent property of accrual accounting that any accrual-based earnings management in one period must reverse in another period. If the researcher has priors concerning the timing of the reversal, incorporating these priors can significantly improve the power and specification of tests for earnings management. Our results indicate that tests incorporating reversals increase test power by around 40% and provide a robust solution for mitigating model misspecification arising from correlated omitted variables.

This paper suggests a new measure of one aspect of the quality of working capital accruals and earnings. One role of accruals is to shift or adjust the recognition of cash flows over time so that the adjusted numbers (earnings) better measure firm performance. However, accruals require assumptions and estimates of future cash flows. We argue that the quality of accruals and earnings is decreasing in the magnitude of estimation error in accruals. We derive an empirical measure of accrual quality as the residuals from firm-specific regressions of changes in working capital on past, present, and future operating cash flows. We document that observable firm characteristics can be used as instruments for accrual quality (e.g., volatility of accruals and volatility of earnings). Finally, we show that our measure of accrual quality is positively related to earnings persistence.

This study investigates firms subject to accounting enforcement actions by the Securities and Exchange Commission for alleged violations of Generally Accepted Accounting Principles. We investigate: (i) the extent to which the alleged earnings manipulations can be explained by extant eamings management hypotheses; (ii) the relation between eamings manipulations and weaknesses in firms' internal govemance structures? and (iii) the capital market consequences experienced by firms when the alleged eamings manipulations are made public. We find that an important motivation for eamings manipulation is the desire to attract external financing at low cost. We show that this motivation remains significant after controlling for contracting motives proposed in the academic literature. We also find that firms manipulating eamings are: (i) more likely to have boards of directors dominated by management; (ii) more likely to have a Chief Executive Officer who simultaneously serves as Chairman of the Board; (iii) more likely to have a Chief Executive Officer who is also the firm's founder, (iv) less likely to have an audit committee; and (v) less likely to have an outside blockholder. Finally, we document that firms manipulating eamings experience significant increases in their costs of capital when the manipulations are made public.Resume. Les auteurs analysent les entreprises assujetties aux mesures d'ex6cution prises par la Securities and Exchange Commission dans les cas de pr6somption de transgression des principes comptables g^neralement reconnus. Us s'interessent aux aspects suivants de la question: i) la mesure dans laquelle les pr^somptions de manipulations des benefices peuvent etre expliquees par les hypotheses existantes de gestion des b6n6fices; ii) la

Researchers have used various measures as indications of "earnings quality" including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because "quality" is contingent on the decision context. We also point out that the "quality" of earnings is a function of the firm's fundamental performance. The contribution of a firm's fundamental performance to its earnings quality is suggested as one area for future work. Over the years, researchers have devised various measures of "earnings quality" to represent decision usefulness in specific decision contexts. These measures, however, have become proxies for "earnings quality" in a generic sense, absent a decision context. The result is that some papers use a proxy for earnings quality that does not match the hypothesized form of decision usefulness in their study, but they nonetheless find results that are consistent with their hypothesis. Other papers are intentionally agnostic and find robust results across multiple proxies for earnings quality. The fact that researchers find consistent and robust results across proxies suggests that there is common component to the various measures of quality, which is the firm's fundamental earnings process. Existing research does not clearly distinguish the impact of a firm's fundamental earnings process on the decision usefulness ("quality") of its earnings from the impact of the application of accounting measurement to that process. Research attention has focused on earnings management that reduces the reliability of earnings rather than on the ability of specific features of an accrual-based accounting system to provide a more decision-useful measure, conditional on the firm's fundamental earnings process. September 2009Thanks to Michelle Hanlon (the editor), Shiva Rajgopal, Terry Shevlin, Nemit Shroff, Richard Sloan, and Rodrigo Verdi for helpful comments. The framework for this review is based on Schrand's discussion of earnings quality at the April 2006 CARE Conference sponsored by the Center for Accounting Research at the University of Notre Dame. *Title Page/Author Identifier Page/Abstract 1 Understanding earnings quality: A review of the proxies, their determinants and their consequencesWe begin with a definition of "earnings quality" that sets the scope of our review. Higher quality earnings more faithfully represent the features of the firm's fundamental earnings process that are relevant to a specific decision made by a specific decision-maker. Our definition implies that the term "earnings quality" is meaningless without specifying the decision context, because the relevant features of the firm's fundamental earnings process differ across decisions and decision makers. Consistent with this broad definition, we review approximately 350 published papers on e...

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