Content area
Full Text
INTRODUCTION
This commentary discusses empirical measures used in academic research to assess earnings quality and relates these measures both to decision usefulness, from the Financial Accounting Standards Board's (FASB) Conceptual Framework, and to the economics-based definition of earnings developed by Hicks (1939). Hicksian income corresponds to the amount that can be consumed (that is, paid out as dividends) during a period, while leaving the firm equally well off at the beginning and the end of the period (Hicks 1939, 176). This measure of income corresponds to the change in net economic assets other than from transactions with owners.
We focus on decision usefulness for two reasons. First, the FASB's Conceptual Framework states that the purpose of financial reporting is to provide information that is useful for business decisions (Concepts Statement No. 1, FASB 1978, para. 34 and following), and considers decision usefulness the overriding criterion for judging accounting choices (Concepts Statement No. 2, FASB 1980, paras. 30 and 32). Decision usefulness thus presumably captures the intent of financial reporting standards. The FASB's shift to a focus on decision usefulness, and away from the long-standing focus on the stewardship function of accounting and the relation of reported earnings to economic earnings constructs, was driven by concerns about operationality (e.g., Beaver 1998). Economic income constructs, of which Hicksian income is an example, cannot be used to achieve consensus on financial reporting standards. Second, and equally important, decision usefulness is empirically tractable and commonly used in accounting research.
Because of its context-specificity, assessments of earnings quality from the perspective of decision usefulness inevitably confront a myriad of users and uses: the FASB's Concepts Statement No. 1, paras. 24-30, discusses over a dozen users and uses of financial reports. As a result, the decision usefulness of accounting earnings is evaluated in the context of assumptions about both the user and the use of the earnings number, and the conclusions are conditional on the context chosen. We complement the context-specific, empirically tractable decision usefulness perspective on earnings quality with the context-neutral but empirically non-operational perspective of representational faithfulness to Hicksian income.
We define earnings quality as the extent to which reported earnings faithfully represent Hicksian income, where representational faithfulness means "correspondence or agreement between a measure or description and the...