Quantifying quality and performance of earnings through narrative disclosure in financial reports

Abstract

Management of earnings has been at the heart of accounting research over the last two decades. Numerous scandals have contributed to this direction, with Enron and Worldcom having attracted the lion’s share (Garefalakis et al, 2016). Firms apply earnings management procedures for various reasons such as to improve the view of their balance sheet aiming for a favorable impact to the share price, to avoid disturbing the contractual relationships with their parties, or to maneuver through anti-trust or other government regulations. Viewing earnings management from the fraud perspective, they affect the quality of earnings and the quality of information presented to financial statements.

Literature has utilized numerous earnings quality proxies such as ownership structure, CEO reputation, earnings announcement time, accruals quality and value relevance. Brown et al (2012) acknowledged that earnings announcement time is strategically important for a firm in order the influence the investors. Therefore, the adoption of IFRS could act as an obstacle to eliminate earnings manipulation from the side of an organization and improve stock market efficiency, while they would also tend to positively impact on firms’ stock returns and stock-related financial performance measures. Bassemir and Novotny-Farkas (2015) in their study on the determinants of financial reporting quality, they insisted on the determining role of incentives rather than accounting standards per se to affect the quality of earnings concluding that improved earnings quality is shown by private firms seeking access to financial markets. Building on the importance of incentives over standards, Christensen et al. (2015) focused on the German market with a sample of companies that could voluntarily adopt IFRS and concluded that the adoption of standards was associated with reduced earnings management. However, their analysis did not provide significant evidence of companies that was mandatory to adopt IFRS implying that reporting quality in the latter case would not necessarily improve with IFRS. Despite the existence of findings, there is not a common accepted measure for earnings quality (Perotti and Wagenhofer, 2014). The purpose of this study is not only to expand current literature on earnings quality depicted to financial statements focusing on its measures, but also to investigate if the management commentary reports could contribute to the prediction of accounting misstatements. Our motivation is to highlight the importance of information presented to narrative parts of the reports and to suggest a mechanism to improve earnings quality, which is a fundamental characteristic in corporate reporting.

Keywords: Earnings Quality; Management Commentary Reports; Narratives Information; F-Score; Management Comentary Index (Ma.Co.I.).