We ask nearly 400 CFOs about the definition and drivers of earnings quality, with a special emphasis on the prevalence and detection of earnings misrepresentation. CFOs believe that the hallmarks of earnings quality are sustainability, absence of one-time items, and backing by actual cash flows. Earnings quality is determined in about equal measure by controllable factors like internal controls and corporate governance, and non-controllable factors like industry membership and macroeconomic conditions. On earnings misrepresentation, CFOs believe that in any given period a remarkable 20% of firms intentionally distort earnings, even though they are adhering to generally accepted accounting principles (GAAP). The economic magnitude of the misrepresentation is large, averaging about 10% of reported earnings. The main consequences from poor earnings quality are investor confusion and lack of trust, leading to stock prices decreases and higher cost of capital. Finally, CFOs provide a list of red flags that can be used to detect earnings misrepresentation.
Dichev, Ilia, John Graham, Campbell Harvey, and Shivaram Rajgopal. "The Misrepresentation of Earnings." Columbia Business School, 2015.
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