Earnings Quality Based on Corporate Investment Decisions



    1. Stephen M. Ross School of Business, University of Michigan. I thank Ray Ball, Phil Berger, Ilia Dichev, Kenneth Merkley, workshop participants at the University of Chicago, and especially an anonymous reviewer and Richard Leftwich (the journal editor) for their comments.
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In this paper, I examine a new approach for measuring earnings quality, defined as the closeness of reported earnings to “permanent earnings,” based on firm decisions with regard to capital and labor investments. Specifically, I measure earnings quality as the contemporaneous association between changes in the levels of capital and labor investment and the change in reported earnings. This approach follows the reasoning that (1) firms make investment decisions based on the net present value (NPV) of investment projects and (2) reported earnings with higher quality should more closely associate with real investment decisions. I find that measures of earnings quality based on managerial labor and capital decisions correlate positively with earnings persistence and have incremental explanatory power relative to earnings-quality measures used in the accounting literature. Furthermore, investment-based earnings-quality measures are less informative when managers tend to overinvest.