Earnings Quality Measures and Excess Returns

Pietro Perotti, Alfred Wagehnofer

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This paper examines how commonly used earnings quality measures fulfill a key objective of financial reporting, i.e., improving decision usefulness for investors. We propose a stock‐price‐based measure for assessing the quality of earnings quality measures. We predict that firms with higher earnings quality will be less mispriced than other firms. Mispricing is measured by the difference of the mean absolute excess returns of portfolios formed on high and low values of a measure. We examine persistence, predictability, two measures of smoothness, abnormal accruals, accruals quality, earnings response coefficient and value relevance. For a large sample of US non‐financial firms over the period 1988–2007, we show that all measures except for smoothness are negatively associated with absolute excess returns, suggesting that smoothness is generally a favorable attribute of earnings. Accruals measures generate the largest spread in absolute excess returns, followed by smoothness and market‐based measures. These results lend support to the widespread use of accruals measures as overall measures of earnings quality in the literature.
Original languageEnglish
Pages (from-to)545-571
Number of pages27
JournalJournal of Business Finance and Accounting
Issue number5-6
Early online date19 Apr 2014
Publication statusPublished - 1 Jun 2014


  • earnings quality
  • excess returns
  • abnormal returns
  • accruals quality
  • smoothing
  • value relevance


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