4

Measures of Earnings Quality

Earnings quality is a multi-dimensional concept; therefore, the choice

of an earnings quality measure will depend on the research question
posed (which dimension of earnings quality is implied by the research
question) and the availability of data and estimation models (which
measures can be estimated). Some research questions call for a measure
of earnings quality that is linked to investors perceptions of earnings.
For example, research that examines the value relevance of earnings
presumes earnings is useful to a particular class of market participants
(namely investors) whose aggregate judgments and decisions are sum-
marized by share prices and returns. In contrast, other research ques-
tions focus on direct measures of earnings quality constructed using
accounting data alone (i.e., without reference to stock prices or returns).
Yet another dimension that is important for some research questions is
the distinction among total, innate and discretionary earnings quality,
as discussed in Section 3.1

1 Every earnings quality measure discussed in this section can be thought of as having both
an innate component and a discretionary component. Indeed, as we note in the context
of the often-used abnormal accruals measure, even metrics which are viewed as having

294
 295

Francis et al. (2004) identify seven measures of earnings quality

(which they refer to as earnings attributes) that have been widely
used in accounting research. They characterize the seven earnings
attributes as either accounting-based or market-based depending
on the underlying assumptions about the function of nancial report-
ing, and they note that these assumptions will, in turn, inuence
the way the attributes are measured. The accounting-based earnings
attributes are accruals quality, persistence, predictability, and smooth-
ness. These attributes take cash or earnings (or other measures that can
be derived from these, such as accruals) as the reference construct, and
are estimated using accounting data (not market data). The market-
based attributes are value relevance, timeliness, and conservatism.
These attributes take returns or prices as the reference construct and
rely on both accounting data and returns data for their estimation. As
Francis et al. note, the dierences in reference constructs are based on
implicit or explict assumptions about the intended function of earn-
ings. Specically, accounting-based earnings quality measures assume
that the function of earnings is to allocate cash ows to reporting peri-
ods via accruals, while market-based earnings quality measures assume
that the function of earnings is to reect economic income as repre-
sented by stock returns.
The remainder of this section describes several measures of earnings
quality that have been used in accounting research.
(a) Accruals quality. Accruals quality as a measure of earnings qual-
ity is based on the view that earnings that map more closely into
cash ows are of better quality. Dechow and Dichev (2002) measure
of earnings quality captures the mapping of working capital accruals
into last-period, current-period, and next-period cash ows from opera-
tions. A typical DechowDichev accruals quality measure begins with a
model that relates current accruals to lagged, current, and future cash

been purged of the eects of factors believed to contribute to normal uctuations in the
metrics appear to show considerable correlation with factors viewed as innate with respect
to earnings quality.
296 Measures of Earnings Quality

ows from operations2 :

T CAj,t CF Oj,t1 CF Oj,t
= 0,j + 1,j + 2,j
Assetsj,t Assetsj,t Assetsj,t
CF Oj,t+1
+ 3,j + j,t (4.1)
Assetsj,t
where T CAj,t = rm js total current accruals in year t =
(CAj,t CLj,t Cashj,t + ST DEBTj,t ); Assetsj,t = rmjs
average total assets in year t and t 1; CF Oj,t , = cash ow from
operations in year t, is calculated as net income before extraordi-
nary items (NIBE, Compustat #18) less total accruals (TA), where
(TAj,t = CAj,t CLj,t Cashj,t + ST DEBTj,t DEP Nj,t ,
and CAj,t = rm js change in current assets (Compustat #4)
between year t 1 and year t, CLj,t = rm js change in cur-
rent liabilities (Compustat #5) between year t 1 and year t,
Cashj,t = rm js change in cash (Compustat #1) between year
t 1 and year t, ST DEBTj,t = rm js change in debt in cur-
rent liabilities (Compustat #34) between year t 1 and year t,
DEP Nj,t = rm js depreciation and amortization expense (Compus-
tat #14) in year t.
To obtain a rm-specic, time-series measure of accruals quality,
Equation (4.1) is estimated over some interval (e.g., rolling 10-year
windows in Francis et al. (2004)), with each estimation yielding rm-


Time-series
and year-specic residuals, j,t . To obtain a rm-specic, cross-
sectional measure of accruals quality, Equation (4.1) is estimated each
year at the industry level, with each estimation yielding rm- and


Cross-sectional
year-specic residuals, j,t . For both time-series and industry
cross-section estimations, the regression residuals are used to calculate
the accrual quality metric, AccrualQualityj,t = ( j,t ), equal to the
standard deviation of rm js estimated residuals.
2 McNichols (2002) discussion of Dechow and Dichev suggests adding variables capturing
the change in revenues and xed assets in place:

T CAj,T = 0,j + 1,j CF Oj,T 1 + 2,j CF Oj,T + 3,j CF Oj,T +1

+ 4,j Revj,T + 5,j P P Ej,T + j,T .

 297

The rst idea behind AccrualQuality as a measure of earnings

quality is that cash from operations is the reference construct; large
(small) values of the measure correspond to poor (good) accruals qual-
ity because there is less (more) precision about the mapping of current
accruals into current, last-period and next-period cash ows. The sec-
ond idea behind the AccrualQuality measure is that the variability of
the residuals from Equation (4.1) and not their magnitudes drives the
measure. This idea captures the notion that systematically large (or
small) residuals in a regression of accruals on cash ows do not create
an inference problem for investors, in terms of being able to predict
future earnings, because the systematic component of the residual can
be identied and adjusted. The standard deviation of a series of system-
atically large positive residuals may very well be low, indicating that
there is little inference problem. AccrualsQuality therefore is consistent
with the view that high-mean, low-variance rms have good (not poor)
earnings quality.
One limitation of the AccrualQuality measure is that it uses a rel-
atively modest portion of total accruals; specically, it focuses on the
mapping of current accruals into lagged, current and one-year-ahead
cash ows from operations. The measure does not capture the eects of
larger, more numerous and arguably more complicated accruals, such
as pensions, depreciation, asset retirement obligations, and deferred tax
assets and liabilities. For a sample of rms with a long time series of
accounting data (21 years), Ecker et al. (2005) estimate that mean ratio
of current accruals to total assets is 1.6%, as compared to a mean ratio
of total accruals to total assets of 5.1%. Therefore, for their sample, the
non-current portion of accruals is over three times the size of the cur-
rent portion. Ecker et al. (2005) use a variety of statistical methods to
estimate the relation between total accruals (that is, both current and
non-current accruals) and prior, current and future period free cash
ows. Their analysis is complicated by the fact that, unlike current
accruals which should reverse within one year, the reversal periods of
non-current accruals vary by the type of accrual as well as by accounting
implementation choices. Allowing for rm-specic reversal periods as
long as 21 years, their study nds that estimates of noncurrent accruals
quality are signicantly positively correlated with estimates of current
298 Measures of Earnings Quality

accruals quality. This result suggests that the easier-to-compute and

less data-intensive current accruals measure may be a reasonable proxy
for the more dicult-to-operationalize but conceptually preferred mea-
sure of total accruals quality that encompasses both current accruals
and noncurrent accruals.
(b) Abnormal accruals. Abnormal accruals as a measure of earn-
ings quality is based on the view that accruals which are not well
explained by accounting fundamentals (xed assets and revenues) are
an inverse measure of earnings quality. The abnormal accruals measure
is typically estimated using some version of the Jones (1991) approach.
Similar to the DechowDichev model, estimations of abnormal accru-
als use either a rm-specic, time-series approach, or a cross-sectional
estimation-by-industry-year approach, to obtain residuals from the fol-
lowing regression:
TAj,t 1 Revj,t PPE j,t
= 1 + 2 + 3 + j,t .
Assetj,t1 Assetj,t1 Assetj,t1 Assetj,t1
(4.2)
Regardless of the estimation procedure (time-series or cross-sectional),
the parameter estimates from Equation (4.2) are used to estimate rm-
specic normal accruals (NA) as a percent of lagged total assets:
1 (Revj,t ARj,t ) PPE j,t
N Aj,t =
1 +
2 +
3 ,
Assetj,t1 Assetj,t1 Assetj,t1
where ARj,t = rm js change in accounts receivable (Compustat #2)
between year t 1 and year t, and to calculate abnormal accruals (AA)
T Aj,t
in year t, AAj,t = Assetj,t1 N Aj,t .3
Abnormal accruals are traditionally viewed as capturing manage-
ments nancial reporting decisions (or discretion). When studying
earnings quality questions, researchers tend to focus on the absolute
value of abnormal accruals (|AAj,t |) because the research question typ-
ically does not impose a directional sign on managements expected
3 The original Jones (1991) model has been extended in two ways. The rst is the inclusion
of the change in accounts receivable in the estimation of normal accruals. The second is
an adjustment of the abnormal accruals by performance-matching (Kothari et al. (2005);
McNichols (2000)). Based on Francis et al. (2005a) nding that variations of the |AAj,t |
measure from these extensions yield similar results, we do not discuss these extensions or
adjustments in more detail.
 299

nancial reporting decisions. In contrast, research questions related to

earnings management typically impose a directional prediction, so the
focus is on a variable which reects that directional prediction, such as
the signed value of abnormal accruals (AAj,t ). We distinguish earnings
management research (which posits a specic reporting context and
incentive structure and focuses on whether signed abnormal accruals
are consistent with predictions) from earnings quality research (which
may or may not examine a specic setting, but typically does not gen-
erate predictions about the sign of abnormal accruals). We think of
the absolute value of abnormal accruals as an accruals-based proxy for
earnings quality, with larger values of |AAj,t | indicating poorer accruals
quality.
The abnormal accruals measure of earnings quality (|AAj,t |) diers
from the DechowDichev accruals based measure (AccrualQuality) in
that the former is intended to reect the portion of accruals that is not
driven by accounting fundamentals (or what we term innate factors),
whereas the latter measure includes accruals that arise from both innate
and discretionary sources. The fundamental or innate factors driving
accruals in the Jones model are changes in revenues and xed assets;
the ability of these factors to explain the ratio of total accruals to total
assets determines the magnitude of normal accruals, from which abnor-
mal accruals are determined by subtracting estimated normal accruals
from total accruals. Abnormal accruals are intended to reect reporting
inuences on earnings quality, not innate inuences.
Given this distinction, it is natural to ask whether these two
accruals-based measures of earnings quality (AccrualsQuality and
|AAj,t |) capture similar constructs, given that one is intended to mea-
sure total accruals quality while the other is intended to measure
discretionary accruals quality. The answer to this question lies in the
completeness of the innate factors used to capture the determinants of
normal accruals. Specically, should this set include other fundamen-
tals, beyond the change in revenues and xed assets? Summary data
reported in Francis et al. (2008b, Table 2, Panel C) indicate that sev-
eral innate factors proposed by Dechow and Dichev (2002) and others
(the standard deviation of cash ows, the standard deviation of sales
revenues, rm size as measured by the log of total assets, operating
300 Measures of Earnings Quality

cycle, incidence of loss observations, intangibles intensity, and capital

intensity) explain about 52% of the variation in the DechowDichev
measure of accruals quality and over 65% of the variation in |AAj,t |.
Assuming that the set of innate factors explains normal uctua-
tions in accruals arising from the rms business model and operat-
ing environment, Francis et al.s (2008b) nding implies that residuals
obtained from estimations of modied Jones type models will contain
sizable amounts of accruals that are not unusual; that is, they would be
expected given the business model and operating environment. Stated
dierently, the nding that innate factors explain 65% of an abnormal
accruals measure raises questions about whether the measure is, in fact,
abnormal, in the sense of capturing eects of managements reporting
decisions, as opposed to capturing the nancial reporting eects of
business fundamentals. It is not our intent to comment on the appro-
priateness of the fundamental variables used in Jones-type estimations.
Rather, our point is that, in the context of earnings quality research
where distinctions between innate and discretionary sources are impor-
tant, we believe it is not appropriate to treat the abnormal accruals
measure (as conventionally estimated) as capturing only discretionary
accrual behaviors. Rather, we believe |AAj,t | should be viewed as a
measure of total accruals quality, distinct from the DechowDichev
measure.
(c) Persistence. Persistence as a measure of earnings quality is pred-
icated on the view that more sustainable earnings are of higher quality.
In its simplest form, earnings persistence is measured as the slope coef-
cient estimate, 1,j , from an autoregressive model of order one (AR1)
for annual split-adjusted earnings per share (Xj,t , measured as rm js
net income before extraordinary items in year t divided by the weighted
average number of outstanding shares during year t):
Xj,t = 0,j + 1,j Xj,t1 + j,t . (4.3)
Equation (4.3) is typically estimated in time-series, rm-by-rm, using
maximum likelihood estimation. The resulting estimate of 1,j captures
rm js persistence of earnings. Values of 1,j close to one imply highly
persistent (i.e., high quality) earnings, while values of 1,j close to zero
imply highly transitory (i.e., low quality) earnings.
 301

(d) Predictability. Predictability, dened as the ability of earnings to

predict itself (Lipe, 1990), as a measure of earnings quality is based on
the view that an earnings number that tends to repeat itself is of high
quality. This view is not dissimilar to the view, implied by Dechow and
Schrand (2004), that a high quality earnings number is representative,
that is, a good predictor, of future earnings. One common measure of
earnings predictability is derived from the same rm-specic models
used to estimate earnings persistence; this measure is the square
root
of the error variance from Equation (4.3), P redictability = 2 ( j ).
Large (small) values of Predictability imply lower (higher) quality
earnings.
A second common measure of earnings predictability is based on
analysts forecast errors; this measure is the average absolute forecast
error of analysts annual earnings forecasts. Forecast error is typically
measured as the analysts forecast of EPS less reported EPS, scaled by
share price 10 days before the forecast date. Relative to the time-series
based measure of predictability, the analyst-based measure contains
two additional behavioral inuences that have no bearing on earnings
quality. The rst inuence reects analyst biases that aect their earn-
ings forecasts (self-selection, cognitive, or incentive-based) and the sec-
ond reects managements earnings guidance (e.g., Bartov et al., 2002).
Both inuences aect forecast errors, but are not related the quality of
the earnings number itself.
(e) Smoothness. The smoothness of earnings is typically measured
relative to some measure of cash ows. This measurement uses cash
ow as the reference construct for unsmoothed earnings, and therefore
assumes that cash ows are unmanaged. As an indicator of earnings
quality, smoothness reects the idea that managers use their private
information about future income to smooth out transitory uctuations
and thereby achieve a more representative (i.e., normalized) reported
earnings number. To the extent that current earnings which are more
representative of future earnings are of higher quality, smoother earn-
ings indicate higher quality earnings.
Not all researchers accept the premise that managers use their pri-
vate information about the future to manipulate accruals with the goal
of achieving a more representative earnings number. An alternative
302 Measures of Earnings Quality

view, expressed by, for example, Leuz et al. (2003), is that smoothness
reects the extent to which accounting standards (as well as other inu-
ences on earnings such as regulatory oversight mechanisms and legal
regimes) allow managers to articially reduce variability in earnings,
presumably to obtain some capital market benets associated with a
smooth earnings stream. Under this view, smoother earnings would
indicate poorer earnings quality.
Results reported by Francis et al. (2004) suggest that capital market
participants reward smoother earnings streams with reduced costs of
equity and debt capital. This nding is consistent with a view that
earnings smoothness is desirable (at least in the eyes of investors)
because it reects higher quality nancial reporting decisions. How-
ever, results in Francis et al. cannot rule out the possibility that
investors reward earnings smoothness for reasons unrelated to earnings
quality.
Smoothness has been measured in several ways, all of which are
likely to be highly correlated: (1) the ratio of rm js standard devi-
ation of net income before extraordinary items divided by beginning
total assets, to its standard deviation of cash ows from operations
divided by beginning total assets (Francis et al., 2004); (2) the ratio of
the rms standard deviation of operating income scaled by assets, to
the standard deviation of cash ows from operations scaled by assets
(Leuz et al., 2003); and (3) the ratio of the standard deviation of
non-discretionary net income (equal to operating cash ows plus non-
discretionary accruals) to the standard deviation of cash ows from
operations (Hunt et al., 2000).
(f) Earnings variability. Earnings variability, typically measured as
the standard deviation of (scaled) earnings, is statistically and con-
ceptually related to both smoothness and accrual quality. Therefore,
the presumptions that would make earnings variability a measure of
earnings quality are similar to the presumptions needed to support
smoothness and accrual quality as indicators of earnings quality. As
documented by Dechow and Dichev (2002, Table 4) earnings variability
is the strongest instrument for their accrual quality measure. Earnings
variability is also an instrument for smoothness, since the two mea-
sures dier only in the presence or absence of standardization by cash
 303

ow variability. Francis et al. (2004) document, for example, Pearson

(Spearman) correlations between EarnVar and AccrualQuality of 0.77
(0.84) and between EarnVar and Smoothness of 0.57 (0.66), respec-
tively.
Measures of earnings variability are typically estimated using
a rm-specic time-series of scaled earnings. For example, Dechow
and Dichev (2002) measure earnings variability as the rolling stan-
dard deviation of rm js net income before extraordinary items,
scaled by beginning of year total assets, EarnV arj,t = (N IBEj,t ).
Larger (smaller) values of EarnVar indicate more (less) volatile
earnings.
(g) Value relevance. Value relevance as a measure of earnings quality
is based on the idea that accounting numbers should explain the infor-
mation that is impounded in returns. Therefore, value relevance is the
ability of one or more accounting numbers to explain variation in stock
returns. Earnings with greater explanatory power are viewed as more
desirable; that is, earnings that explain greater variation in returns
are of higher quality. Typically, in accounting research (e.g., Francis
and Schipper (1999); Collins et al. (1997); Bushman et al. (2004)),
value relevance is based on the explanatory power (the adjusted R2 )
of the following regression of returns on the level and change in
earnings:

RETj,t = 0,j + 1,j EARNj,t + 2,j EARNj,t + j,t . (4.4)

Small (large) values of the adjusted R2 imply less (more) value relevant
earnings.
In estimating regressions like expression (4.4) the researcher chooses
an earnings metric and estimation periods. Earnings periodicity can be
annual or quarterly. For example, RETj,t = rm js 15-month return
ending 3 months after the end of scal year t; EARNj,t = rm js
income before extraordinary items in year t (NIBE ), scaled by market
value at the end of year t 1; EARNj,t = change in rm js NIBE
in year t, scaled by market value at the end of year t 1. Expressions
like (4.4) can be estimated in time-series, in cross-section, and in pooled
time-series cross-sections. To obtain a rm-specic estimate of value
304 Measures of Earnings Quality

relevance, the sample is limited to rms with a sucient time-series of

data to estimate (4.4) at the rm-level.
(h) Earnings informativeness (or earnings response coecient).
Earnings informativeness (or the earnings response coecient) is mea-
sured as the estimated slope coecient on the level or change in earn-
ings, or some aggregation of the estimated slope coecients on both the
level and change in earnings, from expressions like (4.4). The dependent
variable could be a long-term measure (e.g., annual returns) or an indi-
cator of a short term market reaction to an event, such as a three-day
cumulative abnormal return surrounding an earnings announcement.
The use of the slope coecient on earnings (level or change) as an
indicator of earnings quality is based on Teoh and Wongs (1993) ana-
lytical model of the relation between share price responses to earnings
and the precision of the earnings signal.4 Teoh and Wong show a posi-
tive relation between the credibility of accounting information and the
coecient relating returns to earnings.
Because many factors aect the slope coecient relating returns to
earnings,5 most prior research tends to control for these other factors in
estimating earnings informativeness. Stated dierently, earnings infor-
mativeness likely proxies for earnings quality as well as other factors.
Thus, to understand the portion of earnings informativeness that is
associated with earnings quality, researchers typically posit an inter-
vening variable that causes earnings quality to vary (e.g., Teoh and
Wong (1993) posit audits by a Big 8 auditor) and test for an incremen-
tally positive slope coecient for rms with better earnings quality
based on that intervening variable (e.g., rms with Big 8 auditors are
posited to have better earnings quality and therefore greater earnings
informativeness). Under this approach, researchers typically do not cal-
culate a rm-specic estimate of earnings informativeness; rather, they

4 Their model draws on Holthausen and Verrecchia (1988) model of the determinants of
the magnitude of the price response to an information release. Specically, the share price
response to earnings (that is, earnings informativeness) is an increasing function of the
amount of prior uncertainty about rm value () and a decreasing function of the noise
(i.e., the lack of credibility) of the earnings signal ().
5 Prior research (Easton and Zmijewski (1989); Collins and Kothari (1989)) shows that the

slope coecient varies with earnings persistence, rm size, and interest rates.
 305

infer lower or higher earnings informativeness for subsamples of rms,

separated by variation in the intervening variable.6
(i) Earnings opacity. Bhattacharya et al. (2003) dene earnings
opacity as the extent to which the distribution of reported earnings
fails to accurately reect the true distribution of (unobservable) eco-
nomic earnings.7 They note that earnings opacity at a point in time
should be inversely related to the average level of earnings informative-
ness at that same point in time. Bhattacharya et al.s proxy for earnings
opacity is an index that combines earnings aggressiveness, loss avoid-
ance, and earnings smoothing. Each of these constructs, as well as the
opacity index, could be viewed as a measure of earnings quality; there-
fore, the reasoning to support earnings opacity as a measure of earnings
quality parallels previously presented discussions.
Earnings aggressiveness is measured as total accruals scaled by
lagged total assets. Larger (smaller) fractions of accruals are viewed
as being more (less) aggressive. Loss avoidance is measured as the
ratio of the percentage of rms reporting small positive earnings (i.e.,
ratios of net income to total assets between 0% and 1%) to the percent-
age of rms reporting small negative earnings (i.e., ratios of net income
to total assets between 1% and 0%). The higher is this ratio (that
is, the more likely are small positive earnings relative to small negative
earnings), the greater is loss avoidance. Finally, earnings smoothing
is measured as the correlation between accruals and cash ows, both
scaled by lagged assets.
(j) Timeliness. Timeliness is similar to value-relevance, in that the
reference construct for this measure is stock returns and the measure
itself is based on explanatory power. Timeliness captures the ability
of earnings to reect good news and bad news that is impounded
in returns, and is measured as the explanatory power of a reverse
regression of earnings on returns. The use of timeliness as a measure

6 Nothing precludes estimation of the slope coecients at the rm-specic level using time-
series data. However, prior research suggests that such estimates would not be likely to
reect solely (or perhaps even mostly) the eects of earnings quality.
7 Bhattacharya et al.s focus is on the pricing eects of earnings opacity world wide. There-

fore, they measure earnings opacity at the country level not the rm level. Of the individ-
ual measures used to form their earnings opacity index, only loss avoidance is not readily
amenable to calculation at the rm level.
306 Measures of Earnings Quality

of earnings quality is based on the same presumptions that support

value relevance as an earnings quality measure. Following Ball et al.
(2000) and Bushman et al., the measure of timeliness is the adjusted
R2 from Equation (4.5). Smaller values of Timeliness imply less timely
(i.e., lower quality) earnings. Equation (4.5) is typically estimated on
a rm-specic basis in time series.
EARNj,t = 0,j + 1,j N EGj,t + 1,j RETj,t
+ 2,j N EGj,t RETj,t + j,t , (4.5)
where N EGj,t = 1 if RETj,t < 0 and 0 otherwise; all other variables are
as previously dened.
(k) Conservatism: Watts (2003) argues that conservatism is a desir-
able attribute of earnings because conservative reporting constrains
overpayments to stakeholders. This approach is based more on an
ex post contracting/stewardship approach to earnings quality than the
ex ante capital allocation approach we have adopted in this discussion
review.
Taking a market-based approach, Ball et al. (2000) dene con-
servatism as the dierential ability of accounting earnings to reect
economic losses (measured as negative stock returns) versus economic
gains (measured as positive stock returns). Following Basu (1997), Ball
et al. measure conservatism as the ratio of the slope coecients on neg-
ative returns to the slope coecients on positive returns in a reverse
regression of earnings on returns, as, for example, in Equation (4.5).8
Accounting-based measures of conservatism include Penman and
Zhangs (2002) C-Score, equal to the sum of the LIFO reserve, esti-
mated R&D assets and estimated advertising assets, scaled by net oper-
ating assets. C-Score is a balance sheet measure of conservatism which
captures the notion that rms with larger unrecorded assets (larger
C-Scores) are more likely to have conservatively reported nancial
statements than rms with smaller C-Scores. Penman and Zhang also
calculate a Q-score which captures the eect of conservatism on the
income statement.
8 The combination of timeliness and conservatism is sometimes termed transparency,
viewed by some researchers as a desirable attribute of earnings (see, for example, Ball
et al. (2000)).
 307

(l) e-loadings. Ecker et al. (2006) put forward a returns-based mea-

sure of earnings quality. The e-loading is the slope coecient from
a regression of excess returns on a factor mimicking portfolio that
captures earnings quality (AQfactor ), controlling for other factors
known to aect returns (market risk premium, size, and book-to-market
ratio). The calculation of AQfactor follows the FamaFrench proce-
dures for calculating factor-mimicking portfolios; the exact procedures
are explained in Ecker et al. (2006).9
Because AQfactor is time-specic, not rm-specic, it can be corre-
lated with the returns of any rm to determine that rms exposure to
poor earnings quality. This use of AQfactor is analogous to correlating
a rms excess returns with the market risk premium and interpreting
the resulting rm-specic beta estimate as a measure of investors per-
ception of that rms exposure to market risk. The specic correlation
measure Ecker et al. use, that is, the e-loading is the coecient esti-
mate on AQfactor obtained from 1-factor (superscript 1f ) and 3-factor
(superscript 3f ) asset pricing regressions which include AQfactor as an
independent variable:
1f 1f
1-factor : Rj,t RF,t = j,T + j,T (RM,t RF,t )

+ e1f 1f
j,T AQf actort + j,t (4.6)
3f 3f
3-factor : Rj,t RF,t = j,T + j,T (RM,t RF,t ) + s3f
j,T SMB t
3f
+ hj,T HMLt + e3f 3f
j,T AQfactor t + j,t (4.7)

Expressions (4.6) and (4.7) can be measured using daily, weekly or

monthly returns, over intervals that are a research design choice.
Assuming use of daily returns, t = index for a trading day in year T ;
Rj,t = rm js return on day t; RF,t = the risk free rate on day t;
RM,t = the market return on day t; SMB t = FamaFrench small-minus-
big factor on day t; HMLt = FamaFrench high-minus-low book-to-
market factor on day t.

9 Ecker et al. (2006) calculate a factor-mimicking portfolio based on the DechowDichev

(2002) accruals quality measure. However, the same procedures could be used to create a
factor-mimicking portfolio based on alternative earnings quality measures.
308 Measures of Earnings Quality

For the 1-factor (3-factor) specication, e1f 3f

j,T (ej,T ) is the estimate
of rm js sensitivity to poor earnings quality in year T and is there-
fore a returns-based representation of earnings quality. The other slope
1f 3f 3f
coecients, j,T (or j,T ), sj,T and h3f
j,T , capture the rms exposure to
returns-based representations of market risk, size, and book-to-market,
respectively, in year T . Larger values of the loadings (slope coecients)
imply greater sensitivity to the factor; thus, larger e-loadings imply a
greater sensitivity to poor earnings quality.
Ecker et al. estimate 1-factor and 3-factor e-loadings for each rm-
year, using daily data for year t = 19702003, for all rms with at
least 100 trading returns in year t. They perform several construct
validity tests to determine whether e-loadings behave as one would
expect if they indeed capture earnings quality. High e-loading rms,
for example, have smaller earnings response coecients and greater
dispersion and lower accuracy of analyst forecasts. Higher e-loadings
also characterize rms in nancial trouble, as indicated by bankruptcy
lings, restatements or shareholder lawsuits over nancial reporting.
Chen et al. (2007b) also validate the e-loading as a measure of
earnings quality. They nd that dividend-decreasing rms show a pre-
dictable increase in their e-loadings following the announcement of the
dividend decrease. They interpret this result as evidence that the divi-
dend decrease signals to investors a deteriorating assessment of future
performance, thus creating greater uncertainty about the sustainability
of current earnings.
Ecker et al. discuss several advantages of the e-loading, relative to
other measures of earnings quality. These advantages relate to sample
size, sample selection, and exibility. The sample size and sample selec-
tion advantages arise because the data requirements for estimating a
rms e-loading are modest, relative to the data requirements for esti-
mating other earnings quality proxies. An e-loading can be estimated
for any rm with sucient daily returns in a given year to estimate a
CAPM (or 3-factor) asset pricing regression. Sample sizes will therefore
be larger and exhibit less selection bias than if, for example, 10 years
of rm-specic accounting data were required to estimate an earnings
quality proxy. The exibility advantage of e-loadings relative to other
 309

earnings quality measures arises because e-loadings can be calculated

with daily returns data, they need not be aligned with reporting periods
and they can be estimated over intervals as short as 45 days. This ex-
ibility means that e-loadings can be used to examine shifts in earnings
quality over short intervals and around events. In comparison, other
measures of earnings quality are linked to annual or quarterly report-
ing periods, cannot be applied to short intervals, and cannot be specic
to a given nancial statement date because they are constructed from
current and prior data.