Has earnings quality declined over time? Australian evidence

Abstract

This paper examines earnings quality over time and across industries. We do an industry-level analysis using a sample of 340 Australian firms over the period 1992-2004 and measure earnings quality across four dimensions: accruals quality, earnings persistence, earnings predictability and earnings smoothness. We are motivated by two observed phenomena. First, there is increasing evidence of earnings management by firms when faced with specific economic incentives. Second, following corporate scandals in recent years, new legislation has been passed (e.g., Sarbanes-Oxley Act of 2002, Australian CLERP Act of 2004) to restore investors' confidence in capital markets. Our analyses of cash flow and earnings data provide evidence of no systematic decline in earnings quality over the sample period. Rather, we find some evidence of improved earnings quality over time. Thus, it is quite likely that firms engage in earnings management (and thereby reduce earnings quality) in the presence of specific economic incentives, but there is no evidence to suggest that earnings quality has deteriorated in the general population of firms. We also find that earnings quality varies across industries.