Financial Reporting Quality: A Review of Its Applications and Measurements

(Abdulrahman Alomair)

---

Abstract

This study extensively examines various proxies used to capture financial reporting quality (FRQ), a critical factor in ensuring transparency in financial markets and maintaining robust corporate governance. Via conducting a comprehensive review of popular proxies from previous literature, the study emphasises the importance of FRQ in fostering investor confidence, supporting effective decision-making and enhancing overall financial market efficiency. The research systematically compares several models used to calculate discretionary accruals, a widely recognised proxy for earnings management. In doing so, it identifies the modified Jones model, developed by Dechow et al. (1995), and the performance-matched model, introduced by Kothari et al. (2005), as two of the most effective proxies for measuring FRQ. Furthermore, the study suggests that the performance-controlled model should be re-tested to ensure its theoretical consistency with the modified Jones model, potentially improving its applicability in future empirical research. Ultimately, this study contributes to the ongoing development of robust methodologies for accurately assessing FRQ and enhancing financial reporting standards.
KEYWORDS
Accruals model, corporate governance, discretionary accruals, earnings management, earnings persistence, market efficiency
PDF

References

Abdul Rahman, R. and Haneem Mohamed Ali, F. (2006). Board, audit committee, culture and earnings management: Malaysian evidence. Managerial Auditing Journal, 21(7), 783–804. DOI:10.1108/02686900610680549
Abou-El-Sood, H. and El-Sayed, D. (2022). Abnormal disclosure tone, earnings management and earnings quality. Journal of Applied Accounting Research, 23(2), 402–33. DOI:10.1108/JAAR-07-2020-0139
Alghamdi, S.A.L. (2012). Investigation into Earnings Management Practices and the Role of Corporate Governance and External Audit in Emerging Markets: Empirical Evidence from Saudi Listed Companies. PhD Thesis, Durham University, England.
Aljifri, K. (2007). Measurement and motivations of earnings management: A critical perspective. Journal of Accounting, Business and Management, 14(1), 75–95.
Ball, R. and Brown, P. (1968). An empirical evaluation of accounting. Journal of Accounting Research, 6(2), 159–78. DOI:10.2307/2490232
Barth, M.E., Li, K. and McClure, C.G. (2023). Evolution in value relevance of accounting information. The Accounting Review, 98(1), 1–28. DOI:10.2308/TAR-2019-0521
Basu, S. (1997). The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics, 24(1), 3–37. DOI:10.1016/s0165-4101(97)00014-1
Bernard, V.L. and Skinner, D.J. (1996). What motivates managers’ choice of discretionary accruals? Journal of Accounting and Economics, 22(1–3), 313–25. DOI:10.1016/s0165-4101(96)00431-4
Beuselinck, C., Cascino, S., Deloof, M. and Vanstraelen, A. (2019). Earnings management within multinational corporations. The Accounting Review, 94(4), 45–76. DOI:10.2308/accr-52274
Botosan, C.A. and Plumlee, M.A. (2002). A re-examination of disclosure level and the expected cost of equity capital. Journal of Accounting Research, 40(1), 21–40. DOI:10.1111/1475-679X.00037
Brown, W.D., He, H. and Teitel, K. (2006). Conditional conservatism and the value relevance of accounting earnings: An international study. European Accounting Review, 15(4), 605–26. DOI:10.1080/09638180601102198 
Bushman, R.M. and Williams, C.D. (2015). Delayed expected loss recognition and the risk profile of banks. Journal of Accounting Research, 53(3), 511–53. DOI:10.1111/1475-679X.12079
Cable, J.R. and Jackson, R.H. (2008). The persistence of profits in the long run: A new approach. International Journal of the Economics of Business, 15(2), 229–44. DOI:10.1080/13571510802134403
Carrera, N., Carmona, S. and Sohail, T. (2017). Audit committees’ social capital and financial reporting quality. Accounting and Business Research, 47(6), 633–72. DOI:10.1080/00014788.2017.1299617
DeAngelo, L.E. (1986). Accounting numbers as market valuation substitutes: A study of management buyouts of public stockholders. The Accounting Review, 61(3), 400–20. 
Dechow, P.M. and Dichev, I.D. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(1), 35–59. DOI:10.2308/accr.2002.77.s-1.35
Dechow, P., Ge, W. and Schrand, C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50(2–3), 344–401. DOI:10.1016/j.jacceco.2010.09.001
Dechow, P.M., Sloan, R.G. and Sweeney, A.P. (1995). Detecting earnings management. The Accounting Review, 70(2), 193–225. 
DeFond, M. and Zhang, J. (2014). A review of archival auditing research. Journal of Accounting and Economics, 58(2–3), 275–326. DOI:10.1016/j.jacceco.2014.09.002
DeFond, M.L. and Jiambalvo, J. (1994). Debt covenant violation and manipulation of accruals. Journal of Accounting and Economics, 17(1–2), 145–76. DOI:10.1016/0165-4101(94)90008-6
Dou, Y., Hope, O., Thomas, W.B. and Zou, Y. (2018). Blockholder exit threats and financial reporting quality. Contemporary Accounting Research, 35(2), 1004–28. DOI:10.1111/1911-3846.12404
Duong, H.K., Schuldt, M. and Gotti, G. (2018). Investor sentiment and timely loss recognition. Review of Accounting and Finance, 17(3), 383–404. DOI:10.1108/RAF-07-2016-0104
Dutta, S., Patatoukas, P.N. and Wang, A.Y. (2024). Identifying the roles of accounting accruals in corporate financial reporting. Journal of Accounting, Auditing and Finance, 39(1), 133–59. DOI:10.1177/0148558X211035224
Easton, P.D. and Harris, T.S. (1991). Earnings as an explanatory variable for returns. Journal of Accounting Research, 29(1), 19–36. DOI:10.2307/2491026
Enomoto, M., Kimura, F. and Yamaguchi, T. (2015). Accrual-based and real earnings management: An international comparison for investor protection. Journal of Contemporary Accounting and Economics, 11(3), 183–98. DOI:10.1016/j.jcae.2015.07.001
Francis, J., LaFond, R., Olsson, P.M. and Schipper, K. (2004). Costs of equity and earnings attributes. The Accounting Review, 79(4), 967–1010. DOI:10.2308/accr.2004.79.4.967
Francis, J., Olsson, P., LaFond, R. and Schipper, K. (2005). The market pricing of accruals quality. Journal of Accounting and Economics, 39(2), 295–327. DOI:10.1016/j.jacceco.2004.06.003
Francis, J. and Schipper, K. (1999). Have financial statements lost their relevance? Journal of Accounting Research. 37(2), 319–52. DOI:10.2307/2491412
Francis, J.R. (2004). What do we know about audit quality? British Accounting Review, 36(4), 345–68. DOI:10.1016/j.bar.2004.09.003
Gaynor, L.M., Kelton, A.S., Mercer, M. and Yohn, T.L. (2016). Understanding the relation between financial reporting quality and audit quality. Auditing: A Journal of Practice and Theory, 35(4), 1–22. DOI:10.2308/ajpt-51453
Habbash, M. (2010). The Effectiveness of Corporate Governance and External Audit on Constraining Earnings Management Practice in the UK. PhD Thesis, Durham University, England.
Healy, P.M. (1985). The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics, 7(1–3), 85–107. DOI:10.1016/0165-4101(85)90029-1
Healy, P.M. and Wahlen, J.M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, 13(4), 365–83. DOI:10.2308/acch.1999.13.4.365
Ho, L.J., Liao, Q. and Taylor, M. (2015). Real and accrual‐based earnings management in the pre‐and post‐IFRS periods: Evidence from China. Journal of International Financial Management and Accounting, 26(3), 294–335. DOI:10.1111/jifm.12030
Idris, M., Siam, Y.A. and Nassar, M. (2018). Board independence, earnings management and the moderating effect of family ownership in Jordan. Management and Marketing, 13(2), 985–94. DOI:10.2478/mmcks-2018-0017.
Jones, J.J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29(2), 193–228. DOI:10.2307/2491047
Khalifa, M., Zouaoui, H., Ben Othman, H. and Hussainey, K. (2024). The impact of climate risk on accounting conservatism: Evidence from developing countries. Journal of Applied Accounting Research, 25(3), 570–93. DOI:10.1108/JAAR-01-2023-0028
Kayed, S. and Meqbel, R. (2024). Earnings management and tone management: Evidence from FTSE 350 companies. Journal of Financial Reporting and Accounting, 22(4), 842–67. DOI:10.1108/JFRA-10-2021-0373
Khuong, N.V., Rahman, A.A.A., Meero, A., Anh, L.H.T., Liem, N.T., Thuy, C.T.M. and Ly, H.T.N. (2022). The impact of corporate social responsibility disclosure and accounting comparability on earnings persistence. Sustainability, 14(5), 2752.   DOI:10.3390/su14052752 
Kothari, S.P., Leone, A.J. and Wasley, C.E. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39(1), 163–97. DOI:10.1016/j.jacceco.2004.11.002
Lang, M., Smith Raedy, J. and Wilson, W. (2006). Earnings management and cross listing: Are reconciled earnings comparable to US earnings? Journal of Accounting and Economics, 42(1), 255–83. DOI:10.1016/j.jacceco.2006.04.005
Li, Y., Dong, W. and Bao, S. (2008). Supervision of board of directors, management compensations and earnings management: The empirical evidences from China. In: The Fourth International Conference on Wireless Communications, Networking and Mobile Computing, Dalian, China, 12–17/10/2008. DOI:10.1109/WiCom.2008.2264
McNichols, M.F. (2002). Discussion of the quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(4), 61–9. DOI:10.2308/accr.2002.77.s-1.61
Nicolò, G., Santis, S., Incollingo, A. and Tartaglia Polcini, P. (2024). Value relevance research in accounting and reporting domains: A bibliometric analysis. Accounting in Europe, 21(2), 176–211. DOI:10.1080/17449480.2023.2292654
Ohlson, J.A. (1995). Earnings, book values, and dividends in equity valuation. Contemporary Accounting Research, 11(2), 661–87. DOI:10.1111/j.1911-3846.1995.tb00461.x
Peasnell, K.V., Pope, P.F. and Young, S. (2005). Board monitoring and earnings management: Do outside directors influence abnormal accruals? Journal of Business Finance and Accounting, 32(7–8), 1311–46. DOI:10.1111/j.0306-686X.2005.00630.x
Penman, S.H. (2013). Financial Statement Analysis and Security Valuation. London: McGraw-hill.
Perotti, P. and Wagenhofer, A. (2014). Earnings quality measures and excess returns. Journal of Business Finance and Accounting, 41(5–6), 545–71. DOI:10.1111/jbfa.12071
Ronen, J. and Yaari, V. (2008). Earnings Management: Emerging Insights in Theory, Practice, and Research. New York: Springer.
Sloan, R.G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(3), 289–315.
Schipper, K. (1989). Commentary on earnings management. Accounting Horizons, 3(4), 91–102.
Scott, W.R. (2015). Financial Accounting Theory. London: Pearson. 
Shleifer, A. and Vishny, R.W. (1997). A survey of corporate governance. The Journal of Finance, 52(2), 737–83. DOI:10.1111/j.1540-6261.1997.tb04820.x
Smith, S.R. (2003). Audit Committees: Combined Code Guidance. London: Financial Reporting Council.
Walker, M. (2013). How far can we trust earnings numbers? What research tells us about earnings management. Accounting and Business Research, 43(4), 445–81. DOI:10.1080/00014788.2013.785823
Watts, R.L. (2003). Conservatism in accounting part II: Evidence and research opportunities. Accounting Horizons, 17(4), 287–301. DOI:10.2308/acch.2003.17.4.287
Zhong, Y. and Li, W. (2017). Accounting conservatism: A literature review. Australian Accounting Review, 27(2), 195–213. DOI:10.1111/auar.12107.