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Working Paper

Earnings quality and corporate governance

Vasiliki Athanasakou, Per Olsson
Finance, accounting and corporate governance
Earnings quality, business model, corporate governance, earnings management, accruals
We develop and test the proposition that earnings quality reflects both the scope for moral hazard (when associated mainly with volatile business fundamentals) and the outcome of moral hazard (when associated with management’s discretionary reporting choices). As a consequence, earnings quality can exhibit opposite sign associations with corporate governance structures depending on its source: business fundamentals (innate quality) and managerial incentives (discretionary quality). We provide consistent evidence in broad samples, using a methodology that splits earnings quality into an innate and discretionary component, and in subsamples likely to be dominated by either source of earnings quality. We further document interaction effects, i.e., corporate governance structures being increasingly effective on discretionary earnings quality as innate quality worsens. The study highlights the importance of specifying the source of earnings quality effects when researching associations with corporate governance, as a theoretical matter as well as in the empirical design.