Magazine article Strategic Finance

Measuring Accounting Quality: The SEC Is Developing a Software Model to Measure the Accounting Quality of Its Registrants' Filings. Accounting Professionals Should Be Aware of the Implications

Magazine article Strategic Finance

Measuring Accounting Quality: The SEC Is Developing a Software Model to Measure the Accounting Quality of Its Registrants' Filings. Accounting Professionals Should Be Aware of the Implications

Article excerpt

The value of financial accounting is determined largely by its quality. The central concept of accounting quality is that some accounting information is better than other accounting information at communicating what it purports to communicate. For that reason, accounting quality is of great interest to participants in the financial reporting supply chain. For example, to a reporting entity, better accounting quality can translate into a lower cost of capital. To an investor, better accounting quality can translate into a more-profitable allocation of capital.

In this month's column, I'll provide background information on accounting quality and describe a recent accounting-quality project of the U.S. Securities & Exchange Commission (SEC). I'll also explain the implications of the project for accounting professionals--implications that you may find disturbing.

Defining Accounting Quality

There is no single, widely accepted, specific definition of the term "accounting quality." In practice, definitions of accounting quality vary significantly across individuals, projects, and organizations.

Many definitions of accounting quality can be found in published research. Examples include "the precision with which financial reporting informs equity investors about future cash flows" (in the May 20, 2011, article "Accounting Quality, Stock Price Delay and Future Stock Returns" by Jeffrey L. Callen, Mozaffar Khan, and Hai Lu; available at http://ssrn.com/abstract=1416213) and "the extent to which accounting information accurately reflects the company's current operating performance, is useful in predicting future performance, and helps assess firm value" (in the April 27, 2010, article "A New Measure of Accounting Quality" by Paul Hribar, Todd D. Kravet, and Ryan J. Wilson; available at http://ssrn.com/abstract=1283946).

Although there are many different definitions of accounting quality, they all ultimately serve the same purpose: to enable people to make value judgments about accounting information. But how can someone measure the quality of accounting information in order to make value judgments about it?

Approaches to Measuring Accounting Quality

Many different approaches have been used to measure accounting quality, and new approaches are continually being developed. Accounting professionals usually expect measures of accounting quality to be determined directly from the financial information that entities report, as many measures are. For example, one measure of accounting quality is the Beneish model's "M-Score," which is computed from eight variables that are based on quantitative accounting metrics such as days' sales in receivables. The M-Score quantifies the degree to which an entity's reported earnings are likely to have been manipulated by management.

But measures of accounting quality may be based on information other than the financial information that an entity reports. One such measure is based on the fees that companies pay their external auditors. Accounting quality has also been measured on the basis of forecasts made by securities analysts, who often use reported financial information to forecast the earnings and cash flows of the companies they follow. The key concepts underlying this measurement approach are that:

* Analysts' forecasts exhibit varying degrees of accuracy (the difference between the average of forecasted results and actual results) and precision (the "tightness" of the range of forecasted results).

* Higher accounting quality should result in higher accuracy and higher precision in analysts' forecasts.

By measuring the error (a statistical measure of accuracy) and dispersion (a statistical measure of precision) of analysts' forecasts, it's possible to infer the quality of the accounting information on which those forecasts are based.

Accrual Quality as a Measure of Accounting

One significant general approach to measuring accounting quality is the accrual quality (AQ) approach. …

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