Earnig Quality Based On Corporate Investment PDF

DOI: 10.1111/j.1475-679X.2010.00397.
x
Journal of Accounting Research
Vol. 00 No. 0 xxxx 2011
Printed in U.S.A.
Earnings Quality Based

on Corporate Investment Decisions
FENG LI∗
Received 25 July 2007; accepted 20 September 2010
ABSTRACT
In this paper, I examine a new approach for measuring earnings quality, de-
fined as the closeness of reported earnings to “permanent earnings,” based on
firm decisions with regard to capital and labor investments. Specifically, I mea-
sure earnings quality as the contemporaneous association between changes
in the levels of capital and labor investment and the change in reported
earnings. This approach follows the reasoning that (1) firms make invest-
ment decisions based on the net present value (NPV) of investment projects
and (2) reported earnings with higher quality should more closely associate
with real investment decisions. I find that measures of earnings quality based
on managerial labor and capital decisions correlate positively with earnings
persistence and have incremental explanatory power relative to earnings-
quality measures used in the accounting literature. Furthermore, investment-
based earnings-quality measures are less informative when managers tend to
overinvest.
1. Introduction
Prior research on earnings quality generally relies on one of two ap-
proaches: studying the properties of accounting numbers or extracting
∗ Stephen M. Ross School of Business, University of Michigan. I thank Ray Ball, Phil Berger,
Ilia Dichev, Kenneth Merkley, workshop participants at the University of Chicago, and espe-
cially an anonymous reviewer and Richard Leftwich (the journal editor) for their comments.
1
Copyright
C , University of Chicago on behalf of the Accounting Research Center, 2011
2 F. LI
information from stock prices.1 This paper explores a new measure of earn-
ings quality by examining firm investment decisions.2 Managerial invest-
ment decisions likely contain information about earnings quality because
managers make many decisions based on future profitability, and arguably
have more precise and complete information about their firm’s profitability
than do other stakeholders. Therefore, to the extent that information asym-
metry exists between managers and outsiders, the earnings quality inferred
from managerial decisions can provide incremental information to existing
empirical measures based on the information set of outside investors or on
the properties of the accounting numbers.3
In this study, I examine whether corporate investment decisions contain
information about earnings quality. In a simplified setting, managers in-
vest more in projects with a higher net present value (NPV). All else be-
ing equal, if a firm’s expected future earnings or permanent earnings in-
crease, then it makes additional investment, because permanent earnings
are equivalent to annuitized NPV (Black [1980], Beaver [1998], Ohlson
and Zhang [1998]). Hence, if a firm experiences an increase in reported
earnings and management views this earnings innovation to be permanent
(i.e., the reported earnings have high “quality”), then that firm usually in-
creases its investment level. However, if the innovation in reported earnings
is purely transitory, then there should not be a corresponding change in the
investment level. This reasoning suggests that earnings surprises that are
more associated with changes in corporate investment decisions are more
likely to be permanent and of higher quality than are earnings surprises
that are less associated with such changes.
Inferring earnings quality from corporate investment decisions has lim-
itations. Because of agency problems, managers have incentives to over-
invest for empire building and other reasons (Stein [2003]). As a result,
project profitability does not solely determine observed investment deci-
sions and this reduces these decisions’ informativeness for assessing earn-
ings quality. Ultimately, whether one can derive useful and reliable mea-
sures of earnings quality from management investment decisions is an
empirical question.
In this paper, I provide empirical evidence to answer this question by
first examining whether corporate investment-based earnings-quality mea-
sures are informative about future earnings. I measure earnings quality by
examining decisions regarding capital and labor investments, two of the
1 See, for instance, Sloan [1996], Dechow and Dichev [2002], Francis LaFond and Olsson
[2005], Basu [1997], Collins Maydew and Weiss [1999], Francis and Schipper [1999], and
Ecker Francis and Kim [2006].
2 I define earnings quality as the closeness of reported earnings to the “permanent earn-
ings” following Dechow and Schrand [2004] and use earnings persistence to operationalize
this concept.
3 Consistent with this argument, prior papers find that managerial decisions, which include
dividend policy (Skinner and Soltes [2009]) and disclosure quality (Li [2008]), contain infor-
mation about earnings quality.
EARNINGS QUALITY AND CORPORATE INVESTMENT 3
most important investment decisions managers make. I construct earnings-

quality measures by regressing changes in the number of employees and
the amounts of capital and R&D expenditures on the change in reported
earnings, using rolling data from the last 10 years for every firm year. The
slopes from these regressions capture the sensitivity of investment to the
innovation in reported earnings and measure the information content of
those earnings for expected future profitability as reflected in corporate in-
vestment decisions. Because this regression approach requires a long time
series of data, I also construct two other earnings-quality measures calcu-
lated as the current changes in capital investment and labor investment (as
proxied by the number of employees) divided by the change in reported
earnings for every firm year.
The empirical findings can be summarized as follows. First, the earnings-
quality measures based on corporate investment decisions do not correlate
highly with other commonly used measures of earnings quality. This finding
suggests that the information contained in corporate investment decisions
differs somewhat from that reflected by stock prices and the properties of
historical accounting numbers. I then show that earnings-quality measures
based on corporate investment decisions positively associate with earnings
persistence. Furthermore, the predictive power of investment-based earn-
ings quality for earnings persistence still holds and is economically mean-
ingful even after controlling for typical measures of earnings quality such
as the absolute amount of accruals (Sloan [1996]), estimation errors in
accruals (Dechow and Dichev [2002]), the earnings–returns association,
and the volatility of earnings and accruals. I also find that the investment-
based earnings quality contains significant information about future earn-
ings only for firms with a relatively low tendency to overinvest, measured us-
ing the amount of free cash flows, the sensitivity of investment to cash flows,
and the amount of excess investment based on Richardson [2006]. Finally, I
find that the investment decisions are more informative about future earn-
ings for capital-intensive firms, firms from highly unionized industries, and
firms with a high frequency of earnings increases. These additional tests
further validate the utility of corporate investment decisions for assessing
earnings quality.
Overall, the evidence indicates that there is substantial information in
corporate investment decisions about earnings quality and it is incremental
to other commonly used earnings-quality measures. However, researchers
or investors need to consider the severity of possible overinvestment due
to agency problems when using the investment-based earnings-quality mea-
sures.
The remainder of this paper is organized as follows. Section 2 discusses
the literature on earnings quality and defines earnings-quality measures
based on corporate investment decisions. Section 3 presents the data, sum-
mary statistics of the measures, and their relation with firm characteristics
and other earnings-quality measures used in the literature. Section 4 pro-
vides a discussion of the empirical results, and section 5 concludes.
4 F. LI
2. Literature and Hypotheses Development

2.1 LITERATURE ON EARNINGS QUALITY
There is an extensive literature on the earnings quality (see Dechow
and Schrand [2004] for a comprehensive review). However, because of its
context-dependent nature, there is no consensus on the underlying con-
ceptual construct that “earnings quality” represents. In this paper, I follow
Dechow and Schrand [2004] and define earnings quality as the closeness
of reported earnings to the “permanent earnings” (Black [1980], Beaver
[1998], and Ohlson and Zhang [1998]). I use earnings persistence to oper-
ationalize this concept.
Earnings quality varies with many factors, including a firm’s business
model and economic situation, estimation errors (Dechow and Dichev
[2002]), and earnings management (Healy and Wahlen [1999]). To cap-
ture earnings quality, prior studies generally follow one of two approaches.
The first approach measures earnings quality by using properties of the ob-
served accounting numbers. The measures based on this approach include
the level of accruals (Sloan [1996]), the estimation error in accruals (De-
chow and Dichev [2002]), and the volatility of earnings (Dichev and Tang
[2009]). Because of the historical nature of the current accounting system,
the information contained in accounting numbers is unlikely to be com-
plete concerning future profitability. The second approach focuses on the
association between earnings and stock returns (e.g., Basu [1997], Collins
Maydew and Weiss [1999], Francis and Schipper [1999], and Ecker Fran-
cis and Kim [2006]). This approach assumes market efficiency and extracts
information about future earnings from stock prices.
I take a different approach by emphasizing the management perspective.
Managers arguably have more complete information about earnings qual-
ity than do outsiders. Therefore, earnings-quality measures based on the
information set of managers can provide better proxies for earnings qual-
ity than measures that are based on historical accounting numbers or on
the information set of outside equity investors.
2.2 EARNINGS QUALITY BASED ON FIRM INVESTMENT DECISIONS
In a simplified setting, making corporate investment decisions is straight-
forward: a firm invests more if the marginal NPV of the investment project
is positive. In accounting terms, the NPV of future investment is a mono-
tonic function of the expected “permanent earnings,” which is essentially
the annuitized NPV (Black [1980], Beaver [1998], and Ohlson and Zhang
[1998]). Therefore, a firm invests (disinvests) if its permanent earnings
increase (decrease). Ignoring potential agency problems, the association
between firms’ observed investment decisions and reported earnings cap-
tures the closeness of the reported earnings to the permanent earnings.
Hence, the investment-earnings association provides information on the
quality of the reported earnings. To the extent that managers have private
information that investors do not have, corporate investment decisions can
provide informative signals about earnings quality relative to the market-

based earnings-quality measures.
One point worth discussing is the parallel between a firm’s investment
decision and the valuation of its equity by outside investors. In both cases,
the involved parties (managers or investors) want to make their decisions by
doing valuations based on the expected profitability of the firm. Measuring
earnings quality by using stock price information requires a maintained as-
sumption of stock market efficiency, but assessing earnings quality through
managerial investment decisions relies on the assumption that managers
make optimal investment decisions.
I seek to contribute to the literature that explores the implications of
managerial decisions for earnings quality. Skinner and Soltes [2009] study
the information content of dividend decisions by firms for earnings qual-
ity. Investment and dividend policies are both important managerial deci-
sions and are likely to contain information about future earnings. Com-
pared with dividend policy, firm labor and capital-investment decisions are
simpler in the sense that they are less likely to be influenced by signaling
considerations. A subtle difference between this paper and Skinner and
Soltes [2009] is that their emphasis is on testing the dividend informa-
tion content hypothesis, which has been examined in the dividend liter-
ature and has not received much support. The purpose of this paper is to
test whether corporate investment decisions, despite potential agency prob-
lems, can provide information about earnings quality that is incremental to
other typical earnings-quality constructs. Consequently, it is important to
control for other measures of earnings quality.
Empirically, I examine two types of investment decisions and their asso-
ciations with reported earnings: labor and capital investment. Labor and
capital are the two major factors that determine the output of a firm and
they are also the main managerial decision parameters in microeconomics.
The labor- and capital-investment decisions can be affected by different eco-
nomic factors. Therefore, examining both decisions can complement each
other.
2.3 OVERINVESTMENT AND INVESTMENT- BASED EARNINGS QUALITY
In this subsection, I explore the implications of firms’ nonoptimal invest-
ment decision making for the investment-based earnings quality. My moti-
vation is the existence of agency problems, a central theme in the corporate
finance literature with a lineage going back to Berle and Means [1932] and
Jensen and Meckling [1976]. Agency problems can lead to overinvestment
by managers (Stein [2003] provides a comprehensive review of the litera-
ture). One consequence of the agency problem is that managers have an
excessive taste for running large firms, as opposed to simply profitable ones.
This “empire building” tendency is emphasized by Williamson [1964], Don-
aldson [1984], and Jensen [1986], among many other studies. Agency
problems can also give rise to overinvestment through channels other
than “empire building.” Bertrand and Mullainathan [2003] argue that a
managerial preference for the “quiet life”—effectively, a resistance to
6 F. LI
change—can lead to excessive continuation of negative-NPV projects. In

a somewhat similar vein, Baker [2000] builds a model in which reputa-
tional concerns deter managers from discontinuing negative-NPV projects,
because this would be an admission of failure.
Many empirical studies provide evidence on corporate overinvestment,
including evidence from specific industries (e.g., the oil industry overin-
vestment documented by Jensen [1986]) and evidence of poor acquisitions
(Blanchard de Silanes and Shleifer [1994]). More recently, Richardson
[2006] finds that investment decisions by firms are excessively sensitive to
current cash flows, which is a symptom of overinvestment.
Ceteris paribus, if a firm is more likely to overinvest, its labor- and capital-
investment decisions are less likely to be a useful signal of earnings quality
because the investment decisions can be affected by other considerations
(e.g., empire building motivations) and are not solely determined by the
profitability of the project. I therefore examine whether the information
content of the investment-based earnings-quality measures varies with the
overinvestment tendency cross-sectionally.
I use three empirical constructs to measure the overinvestment ten-
dency. First, Richardson [2006] shows that firms with a large amount of
free cash flows tend to overinvest. This finding implies that investment-
based earnings-quality measures are less informative for firms with more
free cash flows. Second, a high sensitivity of investment to the free cash
flows available for investment can indicate potential agency problems
(Stein [2003]).4 Richardson [2006] also finds that firms that tend to
overinvest have higher investment–cash flow sensitivity. Hence, I use the
investment–cash flow sensitivity as the second measure of the overinvest-
ment tendency. Third, I rely directly on the overinvestment measure con-
structed by Richardson [2006] for the cross-sectional tests. Because this
measure directly relates to capital expenditure, I focus on the capital
investment-based earnings-quality measures.
To summarize, I expect that for firms that are likely to overinvest (i.e.,
firms that have more free cash flows, higher sensitivity of investment to
cash flows, and more excess investment), the investment-based measures
of earnings quality less strongly associate with earnings persistence and are
less useful in predicting future earnings.
3. Estimation of Earnings Quality Based on Investment Decisions

3.1 EMPIRICAL ESTIMATION OF EARNINGS QUALITY
I obtain my sample from the Compustat annual industrial and research
files between 1952 and 2004. For every firm i in year T , I estimate the
4 The corporate finance literature also argues that firms with higher investment–cash flow
sensitivity tend to have more severe financing constraints, in addition to overinvestment prob-
lems. Nevertheless, the financial constraint interpretation of the investment–cash flow sensi-
tivity also leads to a prediction of suboptimal investment for firms with higher investment–cash
flow sensitivity.
following two regressions using the data from year T − 9 to T :

(NEMP i,t − NEMP i,t−1 )/TAi,t−1 = αL,iT + βL,iT (E i,t − E i,t−1 )/TAi,t−1 + L,it
(1)
and
(CAPX i,t + RND i,t − CAPX i,t−1 − RND i,t−1 )/TAi,t−1
= αC,iT + βC,iT (E i,t − E i,t−1 )/TAi,t−1 + C,it , (2)
where T − 9 ≤ t ≤ T , NEMP is the number of employees at the end of a fis-
cal year (#29 of the Compustat annual files), CAPX is the amount of capital
expenditure for the year (#128), RND is the amount of R&D expenditure
for the year (#46), E is the operating earnings (#178) with some possible
adjustment (details in the next paragraph), and TA is the book value of
assets at the end of the fiscal year (#6).
Similar to prior studies (e.g., Richardson [2006]), I include R&D expen-
diture in the capital investment together with capital expenditure. My mo-
tivation is the fact that, even though R&D is fully expensed under current
U.S. generally accepted accounting principles (U.S. GAAP), prior studies
show that the market views it more like an investment (Lev and Sougiannis
[1996]). There is also a potential endogeneity problem in the estimation
procedure—an increase in capital and R&D expenditures in a given year
reduces the reported earnings because of additional expensing. This reduc-
tion leads to a mechanical negative relation between investment and earn-
ings. To mitigate this problem, I adjust the reported earnings by adding
back the current R&D expense and the depreciation expense due to the
new capital expenditure. Specifically, for firm i in year t, E it is calculated as
E it = #178 + RND it + CAPX it /(PPE it /DEP it ), (3)
where PPE is the average of the beginning and end values of the gross
amount of property, plant, and equipment (#7) and DEP is the depreci-
ation expense (#14). This adjustment assumes that the new assets, due to
current capital expenditure, are depreciated using the same rate as existing
assets-in-place with a straight-line depreciation method.
Item #29 of Compustat represents the number of company workers (in-
cluding all employees of consolidated domestic and foreign subsidiaries, all
part-time and seasonal employees, full-time equivalent employees, and offi-
cers, and excluding consultants, contract workers, directors, and employees
of unconsolidated subsidiaries) as reported to shareholders.5 The amount
of salary expense is a better variable to capture the amount of investment in
labor than the number of employees, especially when the scaling variable
is the book value of assets. However, only about 20% of firm years in Com-
pustat report a nonmissing labor expense (#42), but about 95% of the firm
5 This figure is reported by some firms as an average number of employees and by others
as the number of employees at year end. If both are given, the year-end figure is used. There
is no reason to believe that this difference introduces a systematic bias to our estimates.
8 F. LI
years have the number of employees (#29). Using the number of employ-
ees therefore can increase the number of observations dramatically. The
number of employees scaled by the book value of assets captures the labor
intensity (i.e., the number of employees per dollar of assets). To the ex-
tent that the salary per employee remains relatively stable over time for the
same firm, scaling the number of employees by total assets is not a problem.
In unreported analysis, I also redo all the tests by replacing the dependent
variable in equation (1) with log(NEMP t /NEMP t−1 ) and the results are sim-
ilar.
I use a firm-level regression because managerial decisions most natu-
rally apply at the firm level. I expect that a firm-level specification is bet-
ter than cross-sectional specifications because the regression coefficients
are likely to differ across firms because managers have firm-specific infor-
mation about future profitability. The β L and β C are the “response coef-
ficients” of corporate investment level to current reported earnings. For a
firm to have β L and β C estimated in year t, it needs to have nonmissing data
in the 10 years from t − 9 to t to estimate equations (1) and (2).
Because this regression approach uses 10 years of rolling data and there-
fore shrinks the sample size greatly, I also construct two other measures
of earnings quality based on investment decisions for firm i in year T as
follows:
γL,iT = (NEMP iT − NEMP i,T −1 )/(E iT − E i,T −1 ) (4)
and
γC,iT = (CAPX iT + RND iT − CAPX i,T −1 − RND i,T −1 )/(E iT − E i,T −1 ), (5)
where all the definitions of the variables are the same as in equations (1)
and (2). Thus, γ L and γ C capture the response of investment to the change
in earnings in a given year. Compared with β L and β C , the advantage of
these measures is that they require only two years of data, but the cost is that
they might not measure the association between earnings and investment
precisely and that it is more difficult to interpret the measures when the
change in earnings is negative.6
Also, I construct two measures that combine the information content of
both the capital and labor investment decisions. To smooth out any possible
nonlinear effect of the variables, I average the measures based on capital
and labor decisions using their decile ranks
EQ 1 = (Decile(βL ) + (Decile(βC ))/2 (6)
and
EQ 2 = (Decile(γL ) + (Decile(γC ))/2, (7)
where De cile (·) is the decile rank of a variable in a year.
6 This is especially true during recession years.

TABLE 1
Summary Statistics
Standard 25th 50th 75th
Variable N Mean Deviation Pctl Pctl Pctl p-Value
βC 34,594 0.187 0.561 −0.080 0.142 0.426 0.00
RSQC 34,594 0.166 0.185 0.022 0.096 0.252 –
βL 34,594 0.035 0.067 0.000 0.013 0.048 0.00
RSQL 34,594 0.223 0.223 0.035 0.147 0.355 –
γC 83,848 0.209 1.584 −0.442 0.162 0.982 0.00
γL 83,848 0.050 0.533 −0.009 0.009 0.078 0.00
DD 34,594 0.024 0.016 0.012 0.020 0.031 –
ABSACC 83,848 0.060 0.060 0.020 0.043 0.080 –
VOL CFO 34,594 0.060 0.032 0.036 0.053 0.077 –
VOL ACC 34,594 0.052 0.030 0.029 0.045 0.067 –
VOL EARN 34,594 0.044 0.029 0.023 0.038 0.058 –
βR 28,948 3.234 5.815 0.328 1.678 4.391 0.00
SALGRW 34,594 0.088 0.064 0.048 0.085 0.125 –
MTB 74,348 1.506 1.422 0.960 1.183 1.640 –
OPCYC 77,100 0.051 0.549 0.014 0.020 0.036 –
DIV 83,628 0.702 0.458 0 1 1 –
This table presents the summary statistics of the investment-based earnings-quality measures and other
variables. The p-value is for the test that examines whether the variable is significantly different from zero.
The β C is estimated for every firm year as the slope coefficient from the regression of change in capital
and R&D expenditures (scaled by lagged book value of assets) on the change in reported earnings (adjusted
for the impact of current capital and R&D expenditures and scaled by lagged book value of assets) using
data from the last 10 years. The RSQ C is the adjusted R-squared from the regression. The β L is estimated
for every firm year as the slope coefficient from the regression of change in the number of employees
(scaled by lagged book value of assets) on the change in reported earnings (scaled by lagged book value
of assets) using data from the last 10 years. The RSQL is the adjusted R-squared from the regression. For
a firm year to have β C and β L , it must have nonmissing data for the last 10 years. The γ C is the change
in capital and R&D expenditures divided by the change in reported earnings. The γ L is the change in the
number of employees divided by the change in reported earnings. The DD is estimated for every firm year
as the standard deviation of the Dechow and Dichev [2002] residuals from the regression of accruals on
lagged CFO (operating cash flows), current CFO, and next year’s CFO using the last 10 years of data. The
ABSACC is the absolute amount of accruals scaled by lagged book value of assets. The VOL CFO, VOL ACC,
and VOL EARN are the volatility of operating cash flows, accruals, and earnings (all scaled by lagged book
value of assets) calculated using data from the last 10 years. The β R is estimated for every firm year as the
slope coefficients from the regression of stock returns on the change in reported earnings (scaled by lagged
book value of assets) using data from the last 10 years. The SALGRW is the average sales growth in the last
10 years. The MTB is the market value of a firm’s asset divided by the book value of the assets. The OPCYC is
the operating cycle of a firm, calculated as 360/(Sales Average AR) +360/((Cost of Goods Sold)/(Average
Inventory)). The DIV is a dummy variable that equals 1 if a firm pays dividend and 0 otherwise.
To summarize, β L , β C , and E Q 1 (i.e., the decile rank average of β L

and β C ) capture the earnings quality inferred from labor- and capital-
investment decisions by using a regression approach; γ L , γ C , and E Q 2 (i.e.,
the decile rank average of γ L and γ C ) represent the response of corporate
investments to earnings innovation in the current year.
3.2 SUMMARY STATISTICS

Table 1 presents the summary statistics of the investment-based earnings-
quality measures and other variables needed in later analysis. Every year,
if a firm has nonmissing data for the past 10 years, its β L is the estimation
of the slope coefficient in the regression of the change in employment on
the change in earnings following equation (1), and β C is the estimation of
10 F. LI
the slope coefficient in the regression of the change in capital investment

on the change in earnings using equation (2). Because of the 10-year data
requirement, the sample size is relatively small (34,594 firm years or about
800 firms per year).7
As predicted, current changes in reported earnings positively relate to
the contemporaneous changes in the level of labor and capital. As indi-
cated in table 1, the mean coefficient on earnings change in the labor re-
gression (β L ) is 0.035 and the median is 0.013. The mean and median of
β C are 0.187 and 0.142, respectively. The RSQL and RSQC are the adjusted
R-squared from the regressions that have a mean of 0.223 and 0.166, re-
spectively, and indicate that earnings changes can explain 17–22% of the
variations in the changes of labor and capital investment. Based on the
cross-sectional distribution of the coefficients, β L and β C are both statisti-
cally significant with p-values of 0.00. The variations in the two measures are
substantial: the standard deviations of β L and β C are 0.067 and 0.561 and
their inter-quartile ranges are 0.048 and 0.506, respectively.
Table 1 also presents the summary statistics of γ L and γ C , the estimates
of earnings quality defined in equations (4) and (5). Because the estimates
only require two years of data, the sample size is much bigger—83,848 firm
years (or about 2,000 firms per year). The γ L and γ C have a mean of 0.050
and 0.209, respectively and both have substantial variations with standard
deviations of 0.533 and 1.584.
The table also presents the summary statistics of other commonly used
measures of earnings quality. The DD is the standard deviation of accruals
that cannot be explained by cash flows as defined in Dechow and Dichev
[2002], and is calculated using data from the last 10 years. The β R is the
earnings–returns association calculated as the slope coefficient in the re-
gression of stock returns on the change in reported earnings using data
from the last 10 years. The ABSACC is the absolute amount of accruals
scaled by lagged book value of assets. The V OL CF O, V OL ACC, and
V OL E ARN are the volatilities of cash flows, accruals, and earnings (all
scaled by lagged book value of assets) calculated using data from the last 10
years.
3.3 INVESTMENT- BASED EARNINGS QUALITY AND OTHER MEASURES

OF EARNINGS QUALITY
In this subsection, I examine the associations between the earnings-
quality measures developed in this paper (i.e., β L , β C , γ L , and γ C ) and firm
characteristics and other earnings-quality measures, such as the Dechow
and Dichev [2002] measure, absolute value of accruals, volatility of earn-
ings, earnings–returns association, growth, market-to-book ratio, and firm
operating cycle. Table 2 presents the Pearson correlation coefficients be-
tween the investment-based earnings-quality measures and these variables.
7 To remove the influence of extreme observations, all variables are winsorized at the 1%
and 99% levels.

TABLE 2
Pearson Correlation Coefficients of the Investment-Based Earnings-Quality Measures with Other Variables
βC βL γC γL DD ABSACC VOL CFO VOL ACC VOL EARN βR SALGRW MTB OPCYC DIV
βC 0.23 0.12 0.01 0.01 0.02 0.00 0.01 0.03 0.07 0.16 0.03 0.01 0.01
<.0001 <.0001 0.01 0.87 <.0001 0.65 0.27 <.0001 <.0001 <.0001 0.00 0.02 0.01
βL 0.04 0.08 0.04 0.02 0.03 0.13 −0.01 0.04 0.22 −0.01 0.01 0.05
<.0001 <.0001 <.0001 < 0.001 <.0001 <.0001 0.06 <.0001 <.0001 0.02 0.10 < 0.001
γC 0.17 −0.01 0.03 −0.01 −0.01 −0.02 0.02 0.05 0.04 0.00 0.01
<.0001 0.02 <.0001 0.02 0.06 0.02 0.00 <.0001 <.0001 0.47 0.00
γL 0.00 0.03 0.01 0.01 −0.01 0.02 0.04 0.02 0.01 0.01
0.58 <.0001 0.10 0.01 0.25 0.00 <.0001 <.0001 0.14 0.02
This table presents the Pearson and Spearman correlations between investment-based earnings-quality measures and other firm characteristics. The p-values are below the
correlation coefficients.
The β C is estimated for every firm year as the slope coefficient from the regression of change in capital and R&D expenditures (scaled by lagged book value of assets) on the
change in reported earnings (adjusted for the impact of current capital and R&D expenditures and scaled by lagged book value of assets) using data from the last 10 years. The β L
is estimated for every firm year as the slope coefficient from the regression of change in the number of employees (scaled by lagged book value of assets) on the change in reported
earnings (scaled by lagged book value of assets) using data from the last 10 years. For a firm year to have β C and β L , it must have nonmissing data for the last 10 years. The γ C is the
change in capital and R&D expenditures divided by the change in reported earnings. The γ L is the change in the number of employees divided by the change in reported earnings.
DD is the standard deviation of the Dechow and Dichev [2002] residuals from the regression of accruals on lagged CFO (operating cash flows), current CFO, and next year’s CFO
using the last 10 years of data. ABSACC is the absolute amount of accruals scaled by lagged book value of assets. VOL CFO, VOL ACC, and VOL EARN are the volatility of operating
cash flows, accruals, and earnings (all scaled by lagged book value of assets) using data from the last 10 years. β R is the slope coefficients from the regression of stock returns on the
change in reported earnings (scaled by lagged book value of assets) using data from the last 10 years. SALGRW is the average sales growth in the last 10 years. MTB is the market
value of a firm’s asset divided by the book value of the assets. OPCYC is the operating cycle of a firm, calculated as 360/(Sales Average AR) +360/((Cost of Goods Sold)/(Average
Inventory)). DIV is a dummy variable that equals 1 if a firm pays dividend and 0 otherwise.
EARNINGS QUALITY AND CORPORATE INVESTMENT
11
12 F. LI
Table 2 shows a correlation between β L and β C with a Pearson correlation

coefficient of 0.23 (p-value < 0.001); similarly, the Pearson correlation co-
efficient between γ L and γ C is 0.17 (p-value< 0.001). This finding suggests
that labor- and capital-investment decisions capture common information
in earnings.
The evidence in table 2 also shows that the earnings-quality measures
developed from corporate investment decisions do not have a strong cor-
relation with other common measures of earnings quality. For instance, DD
(the standard deviation of accruals that cannot be explained by CF O t−1 ,
CF Ot , and CF O t+1 based on Dechow and Dichev [2002]) has a Pearson
correlation of 0.01 (p-value = 0.87) with β C , 0.04 (p-value < 0.001) with β L ,
−0.01 (p-value = 0.02) with γ C , and 0.00 (p-value = 0.58) with γ L . These
results show that DD captures a different set of information from that of
the investment-based earnings-quality measures. Sales growth is the variable
with the largest correlation with the investment-based earnings-quality mea-
sures: firms with a high sales growth rate tend to have stronger associations
between earnings and investment. For instance, β L has a Pearson correla-
tion of 0.22 (p< 0.001) with the 10-year sales growth rate (SALGRW ).
In table 3, I examine the relation between β C , β L , γ C , and γ L and other
earnings-quality measures and firm characteristics using a Fama–MacBeth
regression approach. Every year, I regress the investment-based earnings-
quality measures on other variables, and the table reports the means and
t-statistics based on the time-series distribution of the coefficients. Since
the data that estimates β C and β L is the rolling data from the last 10 years,
there are serial correlations in the error terms when they are the dependent
variables. To mitigate this concern, I adjust the Fama–MacBeth t-statistics
for serial correlations using the Newey–West procedure with a lag of three.8
Consistent with the univariate correlations reported in table 2, there
seems to be no robust relation between the investment-based earnings-
quality measures and many of the commonly used earnings-quality vari-
ables. For instance, DD, the standard deviation of the accruals residuals
based on Dechow and Dichev [2002], is negatively associated with β C (co-
efficient on DD = −0.921 and t = −1.98), but is positively related to β L (co-
efficient 0.760 and t = 3.34). As another example, although the volatility of
earnings is consistently negatively associated with the earnings-quality mea-
sures based on corporate investment, it is statistically significant only for
β L and γ L . The only robust and significant factor that explains β C , β L , γ C ,
and γ L is SALGRW , the 10-year sales growth rate, which is positively and
significantly associated with all four variables.
Overall, the correlations between the investment-based earnings-quality
measures and other typical measures of earnings quality are modest, which
suggests that corporate investment decisions capture information about
8 Newey and West [1994] suggest that the optimal length for the Newey–West adjustment is
T 1/4 , where T is the time-series length of the data.

TABLE 3
Regressions of the Investment-Based Earnings-Quality Measures on Other Earnings-Quality Measures
and Firm Characteristics
E Q = α 0 + α 1 × DD + α 2 × ABSACC + α 3 × V OL EARN + α 4 × β R + α 5 × SALGRW + α 6
×MTB + α 7 × OP CY C + α 8 × DI V + ε
(1) (2) (3) (4)
EQ Proxied by
βC βL γC γL
Intercept 0.091 0.035 −0.026 −0.028
(4.30) (2.84) (−0.42) (−1.22)
[0.021] [0.012] [0.062] [0.023]
DD −0.921 0.760 −0.510 0.720
(−1.98) (3.34) (−0.44) (2.01)
[0.465] [0.228] [1.159] [0.358]
ABSACC 0.075 −0.047 0.148 0.193
(0.59) (−1.96) (0.53) (3.20)
[0.127] [0.024] [0.279] [0.060]
VOL EARN −0.243 −0.415 −1.131 −0.350
(−0.41) (−3.40) (−1.57) (−2.17)
[0.593] [0.122] [0.720] [0.161]
βR 0.003 0.000 0.000 0.000
(1.18) (0.73) (0.25) (0.23)
[0.003] [0.000] [0.000] [0.000]
SALGRW 1.679 0.299 0.751 0.436
(6.56) (4.82) (3.22) (3.56)
[0.256] [0.062] [0.233] [0.122]
MTB −0.012 −0.003 0.125 0.000
(−1.01) (−2.02) (3.56) (0.01)
[0.012] [0.001] [0.035] [0.000]
OPCYC −0.286 0.055 0.085 0.335
(−2.05) (3.65) (0.62) (2.31)
[0.140] [0.015] [0.137] [0.145]
DIV −0.012 −0.012 0.110 0.018
(−0.87) (−1.96) (3.13) (1.29)
[0.014] [0.006] [0.035] [0.014]
Average adj. R-squared 0.049 0.092 0.021 0.020
Average N 646 646 646 646
This table presents the Fama–MacBeth regressions of the investment-based earnings quality on other
earnings-quality measures and firm characteristics. The dependent variables are β C , β L , γ C , and γ L , re-
spectively. The β C is estimated for every firm year as the slope coefficient from the regression of change in
capital and R&D expenditures (scaled by lagged book value of assets) on the change in reported earnings
(adjusted for the impact of current capital and R&D expenditures and scaled by lagged book value of assets)
using data from the last 10 years. The β L is estimated for every firm year as the slope coefficient from the
regression of change in the number of employees (scaled by lagged book value of assets) on the change in
reported earnings (scaled by lagged book value of assets) using data from the last 10 years. For a firm year
to have β C and β L , it must have nonmissing data for the last 10 years. The γ C is the change in capital and
R&D expenditures divided by the change in reported earnings. The γ L is the change in the number of em-
ployees divided by the change in reported earnings. Fama–MacBeth t-statistics (standard errors) adjusted
for Newey–West autocorrelation (lag = 3) are in parentheses (brackets).
The independent variables are defined as follows. DD is the standard deviation of the Dechow and
Dichev [2002] residuals from the regression of accruals on lagged CFO (operating cash flows), current
CFO, and next year’s CFO using the last 10 years of data. ABSACC is the absolute amount of accruals scaled
by lagged book value of assets. VOL EARN is the volatility of earnings (scaled by lagged book value of assets)
using data from the last 10 years. ABSACC is the absolute amount of accruals scaled by lagged book value of
assets. β R is the slope coefficient from the regression of stock returns on the change in reported earnings
(scaled by lagged book value of assets) using data from the last 10 years. SALGRW is the average sales
growth in the last 10 years. MTB is the market value of a firm’s asset divided by the book value of the assets.
OPCYC is the operating cycle of a firm, calculated as 360/(Sales Average AR) + 360/((Cost of Goods Sold)
(Average Inventory)). DIV is a dummy variable that equals 1 if a firm pays dividend and 0 otherwise.
14 F. LI
future earnings that is somewhat different from that reflected in the other
variables.
4. Empirical Results
4.1 INVESTMENT- BASED EARNINGS QUALITY AND EARNINGS PERSISTENCE
In this subsection, I present evidence that the earnings-quality measures
based on firm labor and capital changes are informative about earnings
persistence. To test this prediction, I estimate the following regression:
(E i,t+1 /TAi,t−1 ) = α0 + α1 (E it /TAi,t−1 ) + α2 EQ it + α3 EQ it (E it /TAi,t−1 )
+ α4 CONTROL it + α5 CONTROL it (E it /TAi,t−1 ) + it ,
(8)
where E it is earnings for firm i in year t, TAit is total assets for firm i in
year t, and E Qit is the earnings-quality measure of firm i in year t. If β L , β C ,
or E Q 1 (the decile rank average of β L and β C ) proxies for E Qit , then the
earnings-quality estimation requires data for firm i from year t − 9 to t; if
γ L , γ C , or E Q 2 (the decile rank average of γ L and γ C ) proxies for it, then
the calculation uses data from year t and t − 1. In this regression, α 2 mea-
sures the persistence of earnings. Under the hypothesis that investment de-
cisions are informative about the quality of reported earnings, I expect the
coefficient on current earnings to be larger for firms with a higher associa-
tion between investment and earnings, which indicates that their earnings
are more persistent (α 3 > 0).
To assess the incremental information content of the investment-based
earnings-quality measures, the regression includes typical measures of earn-
ings quality and their interactions with E it . In the reported results, I use the
following control variables: earnings–returns association (β R ), the absolute
amount of accruals in current earnings (ABSACC), the Dechow and Dichev
[2002] measure of accruals quality (DD), and a dummy variable for current
dividend (DIV ) that equals one if a firm issues dividend and zero otherwise.
In untabulated results, I further control for the volatility of earnings, the
volatility of cash flows, the market-to-book ratio, and the e-loadings mea-
sure proposed by Ecker, Francis, and Kim [2006], because these variables
are also used as measures of earnings quality in the literature. These untab-
ulated results remain qualitatively similar to the reported results.9 All of the
regressions use the Fama and MacBeth [1973] approach with Newey–West
adjustment to standard errors.
Panel A of table 4 reports the results of estimating equation (8) with EQ
proxied by β L , β C , and their decile rank average (E Q 1 ). For my sample, the
9 I do not report the results with all the control variables because many of the variables are
highly correlated with each other. For instance, accruals volatility is highly correlated with the
Dechow and Dichev [2002] measure; including both variables in the regression makes it hard
to interpret the coefficients.
TABLE 4
Persistence as a Function of the Investment-Based Earnings-Quality Measures
(E it+1 /TAit−1 ) = α 0 + α 1 ×(E it /TAit−1 )+ α 2 × E Q it + α 3 × E Q it ×(E it /TAit−1 ) + α 4 × CON T ROL it + α 5 × CON T ROL it ×(E it /TAit−1 ) + ε it
Panel A: Earnings Quality Measured by Using the Regression Approach
(1) (2) (3) (4) (5) (6) (7) (8) (9)
EQ Proxied by
βC βL βC βL βC βL EQ 1 EQ 1
Intercept (α 0 ) 0.010 0.010 0.011 0.017 0.018 0.010 0.011 0.015 0.015
(5.55) (5.60) (4.70) (5.06) (4.82) (3.02) (3.07) (5.95) (3.82)
[0.002] [0.002] [0.002] [0.003] [0.004] [0.003] [0.004] [0.003] [0.004]
E (α 1 ) 1.027 1.003 1.003 0.870 0.867 0.953 0.951 0.951 0.906
(79.17) (90.27) (78.19) (25.39) (24.45) (28.27) (26.65) (106.04) (24.53)
[0.013] [0.011] [0.013] [0.034] [0.035] [0.034] [0.036] [0.009] [0.037]
EQ (α 2 ) −0.006 −0.046 −0.004 −0.042 −0.003 −0.053 −0.001 −0.001
(−3.50) (−4.16) (−2.88) (−5.63) (−2.33) (−4.17) (−2.94) (−3.32)
[0.002] [0.011] [0.001] [0.007] [0.001] [0.013] [0.000] [0.000]
E Q × E (α 3 ) 0.064 0.446 0.041 0.377 0.038 0.442 0.012 0.011
(5.06) (7.97) (3.66) (7.17) (3.28) (4.89) (4.91) (4.65)
[0.013] [0.056] [0.011] [0.053] [0.012] [0.090] [0.002] [0.002]
β R (α 4,1 ) −0.001 −0.001 −0.001 −0.001 −0.001
(−3.88) (−3.69) (−3.90) (−3.64) (−3.68)
[0.000] [0.000] [0.000] [0.000] [0.000]
β R × E (α 5,1 ) 0.006 0.006 0.006 0.006 0.006
(5.62) (5.70) (5.52) (5.42) (5.40)
[0.001] [0.001] [0.001] [0.001] [0.001]
(Continued)
15
16
T A B L E 4 — Continued
Panel A: Earnings Quality Measured by Using the Regression Approach
(1) (2) (3) (4) (5) (6) (7) (8) (9)
F. LI
EQ Proxied by
βC βL βC βL βC βL EQ 1 EQ 1
ABSACC (α 4,2 ) 0.074 0.074

(3.02) (3.02)
[0.025] [0.025]
ABSACC × E (α 5,2 ) −0.086 −0.099
(−0.55) (−0.63)
[0.156] [0.157]
DD (α 4,3 ) 0.326 0.340 0.338
(4.48) (4.34) (4.30)
[0.073] [0.078] [0.079]
DD × E (α 5,3 ) −2.271 −2.361 −2.428
(−3.64) (−3.68) (−3.73)
[0.624] [0.642] [0.651]
DIV (α 4,4 ) −0.010 −0.010 −0.008 −0.008 −0.008
(−4.38) (−4.24) (−3.42) (−3.23) (−3.32)
[0.002] [0.002] [0.002] [0.002] [0.002]
DI V × E (α 5,4 ) 0.135 0.133 0.106 0.103 0.105
(3.91) (3.88) (3.35) (3.21) (3.26)
[0.035] [0.034] [0.032] [0.032] [0.032]
Average adj. R-squared 0.695 0.740 0.740 0.756 0.756 0.757 0.758 0.741 0.758
Average N 1,610 820 820 679 679 679 679 820 679
No. of years 52 42 42 42 42 42 42 42 42
(Continued)
Panel B: Earnings Quality Measured by Using the Nonregression Approach
(1) (2) (3) (4) (5) (6) (7) (8)
EQ Proxied by
γC γL γC γL γC γL EQ 2 EQ 2
Intercept (α 0 ) 0.010 0.010 0.010 0.010 0.009 0.009 0.019 0.012
(5.16) (5.76) (3.71) (3.75) (2.84) (2.82) (7.72) (3.68)
[0.002] [0.002] [0.003] [0.003] [0.003] [0.003] [0.002] [0.003]
E (α 1 ) 1.023 1.022 1.035 1.037 0.963 0.961 0.888 0.890
(79.25) (80.18) (31.42) (32.82) (29.35) (28.77) (51.39) (25.37)
[0.013] [0.013] [0.033] [0.032] [0.033] [0.033] [0.017] [0.035]
EQ (α 2 ) −0.000 −0.005 −0.000 −0.004 0.001 −0.003 −0.001 −0.001
(−1.16) (−4.35) (−0.99) (−3.95) (0.19) (−1.61) (−5.67) (−1.32)
[0.000] [0.001] [0.000] [0.001] [0.005] [0.002] [0.000] [0.001]
E Q × E (α 3 ) 0.011 0.060 0.010 0.054 0.004 0.030 0.023 0.012
(3.12) (5.67) (2.94) (5.02) (1.05) (2.39) (11.72) (5.00)
[0.004] [0.011] [0.003] [0.011] [0.004] [0.013] [0.002] [0.002]
β R (α 4,1 ) −0.001 −0.001 −0.001
(−3.74) (−3.60) (−3.58)
[0.000] [0.000] [0.000]
β R × E (α 5,1 ) 0.006 0.006 0.006
(5.61) (5.42) (5.60)
[0.001] [0.001] [0.001]
ABSACC (α 4,2 ) 0.078 0.078
(5.33) (5.28)
[0.015] [0.015]
ABSACC × E (α 5,2 ) −0.234 −0.238
(−2.45) (−2.44)
[0.096] [0.098]
(Continued)
17
18
Panel B: Earnings Quality Measured by Using the Nonregression Approach

(1) (2) (3) (4) (5) (6) (7) (8)
EQ Proxied by
F. LI
γC γL γC γL γC γL EQ 2 EQ 2
DD (α 4,3 ) 0.331 0.327 0.324
(4.64) (4.54) (4.50)
[0.071] [0.072] [0.072]
DD × E (α 5,3 ) −2.233 −2.287 −2.261
(−3.86) (−3.78) (−3.79)
[0.578] [0.605] [0.597]
DIV (α 4,4 ) −0.008 −0.007 −0.008 −0.008 −0.008
(−4.59) (−4.38) (−3.38) (−3.37) (−3.47)
[0.002] [0.002] [0.002] [0.002] [0.002]
DI V × E (α 5,4 ) 0.020 0.017 0.105 0.107 0.105
(0.65) (0.56) (3.35) (3.36) (3.42)
[0.031] [0.030] [0.031] [0.032] [0.031]
Average adj. R-squared 0.697 0.696 0.704 0.703 0.757 0.758 0.699 0.759
Average N 1,593 1,610 1,589 1,610 678 679 1,610 679
No. of years 52 52 52 52 42 42 52 42
This table presents the Fama–MacBeth regressions that estimate earnings persistence as a function of the investment-based earnings quality. The dependent variable is
E it+1 /TAit−1 , next year’s earnings scaled by the lagged book value of assets. Fama–MacBeth t-statistics (standard errors) adjusted for Newey–West autocorrelation (lag = 3) are
in parentheses (brackets).
The independent variables are defined as follows. E is, E it /TAit−1 , current earnings scaled by the lagged book value of assets. The β C is estimated for every firm year as the slope
coefficient from the regression of change in capital and R&D expenditures (scaled by lagged book value of assets) on the change in reported earnings (adjusted for the impact of
current capital and R&D expenditures and scaled by lagged book value of assets) using data from the last 10 years. The β L is estimated for every firm year as the slope coefficient
from the regression of change in the number of employees (scaled by lagged book value of assets) on the change in reported earnings (scaled by lagged book value of assets) using
data from the last 10 years. For a firm year to have β C and β L , it must have nonmissing data for the last 10 years. EQ 1 is the average of the decile ranks of β C and β L .The γ C is the
change in capital expenditure divided by the change in reported earnings. The γ L is the change in the number of employees divided by the change in reported earnings. EQ 2 is
the average of the decile ranks of γ C and γ L . DD is the standard deviation of the Dechow and Dichev [2002] residuals from the regression of accruals on lagged CFO (operating
cash flows), current CFO, and next year’s CFO using the last 10 years of data. ABSACC is the absolute amount of accruals, scaled by the lagged book value of assets. β R is the slope
coefficient from the regression of stock returns on the change in reported earnings (scaled by lagged book value of assets) using data from the last 10 years. DIV is a dummy variable
that equals 1 if a firm pays dividend and 0 otherwise.
coefficient on earnings, when used alone to explain next year’s earnings,

is 1.027 (column (1)). Consistent with the prediction, the coefficient on
the interaction of EQ and E it is reliably positive, implying that earnings are
more persistent for firms with a higher association between investment and
reported earnings. For instance, in column (2), the α 3 is 0.064 (t = 5.06).
The R-squared in column (2) is 0.74 and the R-squared in column (1) is
0.70, which suggests that adding β C incrementally explains 4% more of the
variation in next year’s earnings.
When I control for the earnings–returns association, the absolute
amount of accruals, the Dechow–Dichev measure, and the dividend
dummy, then the size of the α 3 coefficient is smaller, but it remains eco-
nomically and statistically significant. For example, in column (6), the co-
efficient on the interaction of β C and E it is 0.038 (t = 3.28). This effect is
also robust to using the rank specification of the earnings-quality measures.
In column (9), when E Q 1 represents investment-based earnings quality,
then the α 3 is estimated at 0.011 (t = 4.65). This result implies a sub-
stantial economic magnitude—increasing E Q 1 from decile 1 to decile 10
means that earnings persistence increases by about 0.10. As a benchmark,
the results in table 4 show that, after controlling for other variables, mov-
ing DD from the bottom decile (i.e., 5th percentile = 0.006) to the top
decile (i.e., 95th percentile = 0.055) reduces the earnings persistence by
0.11 (=(0.055−0.006)×(−2.3)).
Panel B of table 4 presents the evidence based on γ L and γ C . The results
paint the same picture as those from panel A. Throughout different spec-
ifications, the interaction terms of the investment-based earnings-quality
measure and current earnings appear positive and statistically significant,
with only the exception of column (5), where α 3 is 0.004 and insignificant
(t = 1.05). The economic magnitude is comparable to that of panel A. The
results in column (9) of panel B indicate that moving from decile 1 to decile
10 of E Q 2 , the decile rank average of γ L and γ C , increases earnings persis-
tence by about 0.10, even after controlling for the effects of other earnings-
quality measures.
A very interesting finding is that the main effects of the investment-based
earnings-quality measures on future earnings (i.e., the coefficients on E Q ,
α 2 ) are generally negative.10 One possible explanation for this finding is
that the mechanical impact of investment on reported earnings through
expensing leads to a negative bias that cannot be completely accounted
for by adding back an estimate of the expensing in equation (3). However,
10 In a multivariate regression with interaction terms, the coefficient on the main term (EQ )
is not its marginal effect. The marginal effect of EQ on next year’s earnings is determined by
both the main effect and the interaction effect (conditional on the level of current earnings).
For instance, in column (9) of panel A of table 4, the interactive effect (E Q × E ) coefficient
is 0.011 and the main effect of EQ is −0.001; unreported results show that the mean value of
current earnings (EARN ) is 0.12. Therefore, for an average firm, the marginal effect of EQ on
future earnings is positive (i.e., −0.001 + 0.011 × 0.12 > 0).
20 F. LI
other reasons likely exist for this result because similar relations can be
observed for β R , the earnings–returns association. In all of the tests, β R
× E is positively associated with earnings persistence, yet the main effect
of β R on future earnings is always negative and significant. To make sure
that it is not the main effect that drives the interaction effect, I repeat all
the empirical tests without including the main effect in the regression, and
the unreported results show that the coefficients on the interaction term
E Q × E remain positive and significant.
4.2 OVERINVESTMENT AND THE INVESTMENT- BASED EARNINGS QUALITY
This subsection explores the implications of the nonoptimal investment
decision making for the investment-based earnings-quality measures devel-
oped in this paper. The motivation comes from prior studies that demon-
strate rather pervasive evidence of overinvestment for a large sample of
firms over an extended period of time (Richardson [2006]).
Panel A of table 5 presents the association of E Q 1 and E Q 2 with earn-
ings persistence for firms with low and high free cash flows, respectively.
I follow Richardson [2006] and calculate free cash flow as cash flow gen-
erated from assets in place minus expected new investment; I then define
firms in the top tercile of free cash flows as high overinvestment tendency
firms. The evidence in panel A of table 5 is consistent with the ex ante pre-
diction that overinvesting firms tend to have less informative investment-
based earnings-quality measures. For instance, the coefficient on E Q 1 ×
E is 0.012 (t = 2.77) for firms in the bottom tercile of free cash flows and
0.003 (t = 0.62) for those in the top tercile; the difference is also statistically
significant at the 10% level.
Panel B of table 5 measures the overinvestment tendency by using the
sensitivity of investment to the amount of free cash flows measured for each
firm year using data from the last 10 years. Based on the findings in Richard-
son [2006], firms that tend to overinvest have higher investment–cash flow
sensitivity.11 Results in panel B of table 5 are largely consistent with this
reasoning. The coefficient on E Q 2 × E is 0.015 (t = 3.32) for the low
investment–cash flow sensitivity firms, much higher than that for firms with
high investment–cash flow sensitivity (0.008 with t = 1.40). For E Q 1 × E ,
this difference is also positive (0.008 vs. 0.006), although it is smaller and
statistically insignificant.
In Panel C of table 5, I rely directly on the overinvestment measure
constructed by Richardson [2006] for the cross-sectional tests. Because
this measure directly relates to capital expenditure, I focus on the capital
investment-based earnings-quality measures. I calculate overinvestment as
the residual from a regression of new capital investment on growth oppor-
tunities, leverage, cash, firm age, size, stock returns, lagged investment, year
11 The finance literature has argued that firms with higher investment–cash flow sensitivity
tend to have more severe financing constraint. Nevertheless, this interpretation also leads to
a prediction of suboptimal investment for firms with higher investment–cash flow sensitivity.
TABLE 5
Overinvestment and the Information Content of the Investment-Based Earnings-Quality Measures
(E it+1 /TAit−1 ) = α 0 + α 1 ×(E it /TAit−1 ) + α 2 × E Q it + α 3 × E Q it ×(E it /TAit−1 ) + α 4 × CON T ROL it + α 5 × CON T ROL it ×(E it /TAit−1 ) + ε it
Panel A: Cross-sectional Variations in the Information Content of the Investment-Based Earnings-Quality Measures as a Function of the Amount of Free Cash
Flows
EQ Proxied by EQ 1 EQ Proxied by EQ 2
Low Free High Free Low High Significance of
Cash Flow Cash Flow Significance of the Free Free the Difference
Firms Firms Difference in Coeff. Cash Flow Firms Cash Flow Firms in Coeff.
Intercept (α 0 ) 0.026 0.007 S 0.021 0.012 S
(3.76) (0.81) (3.90) (1.59)
[0.007] [0.009] [0.005] [0.008]
E (α 1 ) 0.769 0.927 S 0.730 0.885 S
(16.59) (11.37) (12.61) (12.80)
[0.046] [0.082] [0.058] [0.069]
EQ (α 2 ) −0.001 0.000 S −0.000 −0.000 NS
(−3.50) (0.21) (−0.05) (−0.27)
[0.000] [0.000] [0.000] [0.000]
E Q × E (α 3 ) 0.012 0.003 S 0.014 0.008 S
(2.77) (0.62) (2.43) (1.29)
[0.004] [0.005] [0.006] [0.006]
Average N 231 236 231 236
(Continued)
21
22
F. LI
Panel B: Cross-Sectional Variations in the Information Content of the Investment-Based Earnings-Quality Measures as a Function of the Level of
Investment–Cash Flow Sensitivities
EQ Proxied by EQ 1 EQ Proxied by EQ 2
Low investment– High Investment– Significance of Low Investment– High Investment– Significance of
Cash Flow Cash Flow the Difference Cash Flow Cash Flow the Difference
Sensitivity Firms Sensitivity Firms in Coefficient Sensitivity Firms Sensitivity Firms in Coefficient
Intercept (α 0 ) 0.010 0.014 NS 0.010 0.005 S
(2.02) (2.08) (2.68) (0.51)
[0.005] [0.007] [0.004] [0.010]
E (α 1 ) 0.896 0.897 NS 0.851 0.889 NS
(17.71) (18.63) (16.21) (15.68)
[0.051] [0.048] [0.052 [0.057]
EQ (α 2 ) −0.001 −0.000 NS −0.001 −0.000 NS
(−1.98) (−0.51) (−1.27) (−0.25)
[0.001] [0.000] [0.001] [0.000]
E Q × E (α 3 ) 0.008 0.006 NS 0.015 0.008 S
(2.12) (1.36) (3.32) (1.40)
[0.004] [0.004] [0.005] [0.006]
Average N 211 215 211 215
(Continued)
Panel C: Cross-Sectional Variations in the Information Content of the Investment-Based Earnings-Quality Measures as a Function of Overinvestment
EQ proxied by EQ 1 EQ proxied by EQ 2
Firms with Firms with Significance of Firms with Firms with Significance of
Less More the Difference Less More the Difference
Overinvestment Overinvestment in Coefficient Overinvestment Overinvestment in Coefficient
Intercept (α 0 ) 0.019 0.016 NS 0.016 0.016 NS
(1.94) (2.95) (2.26) (3.03)
[0.010] [0.005] [0.007] [0.005]
E (α 1 ) 0.790 0.908 S 0.783 0.907 S
(6.97) (16.36) (10.10) (16.31)
[0.113] [0.056] [0.078] [0.056]
EQ (α 2 ) −0.001 −0.000 NS −0.001 −0.000 NS
(−0.93) (−0.63) (−0.79) (−0.80)
[0.001] [0.000] [0.001] [0.000]
E Q × E (α 3 ) 0.012 0.003 S 0.018 0.005 S
(2.69) (0.76) (3.23) (0.91)
[0.004] [0.004] [0.006] [0.005]
Average N 233 235 233 235
This table presents the Fama–MacBeth regressions that estimate earnings persistence as a function of the investment-based earnings quality for two samples: firms with more
of an overinvestment tendency and firms with less of an overinvestment tendency. In panel A, the overinvestment tendency is proxied by the amount of free cash flows; firms with
high (low) free cash flows are those in the top tercile (bottom tercile) of the free cash flows. In panel B, the overinvestment tendency is proxied by the sensitivity of investment to
cash flows; firms with high (low) investment–cash flow sensitivity are those in the top tercile (bottom tercile) of the investment–cash flow sensitivity. In panel C, the overinvestment
tendency is proxied by the amount of overinvestment following Richardson [2006]. Firms with more (less) overinvestment are those in the top tercile (bottom tercile) of the excess
investment based on Richardson [2006]. The dependent variable is E it+1 /TAit−1 , next year’s earnings scaled by the lagged book value of assets. Fama–MacBeth t-statistics (standard
errors) adjusted for Newey–West autocorrelation (lag = 3) are in parentheses (brackets). The “NS” (“S”) indicates that the coefficients are statistically nonsignificant (significant)
between the two samples at the 10% level.
The independent variables are defined as follows. E is E it /TAit−1 , current earnings scaled by the lagged book value of assets. The β C is estimated for every firm year as the slope
coefficient from the regression of change in capital and R&D expenditures (scaled by lagged book value of assets) on the change in reported earnings (adjusted for the impact of
current capital and R&D expenditures and scaled by lagged book value of assets) using data from the last 10 years. The β L is estimated for every firm year as the slope coefficient
from the regression of change in the number of employees (scaled by lagged book value of assets) on the change in reported earnings (scaled by lagged book value of assets) using
data from the last 10 years. For a firm year to have β C and β L , it must have nonmissing data for the last 10 years. EQ 1 is the average of the decile ranks of β C and β L The γ C is the
change in capital expenditure divided by the change in reported earnings. The γ L is the change in the number of employees divided by the change in reported earnings. EQ 2 is the
average of the decile ranks of γ C and γ L . The following variables and their interactions with E are included in the regressions but are not reported. DD is the standard deviation of
the Dechow and Dichev [2002] residuals from the regression of accruals on lagged CFO (operating cash flows), current CFO, and next year’s CFO using the last 10 years of data.
23
ABSACC is the absolute amount of accruals, scaled by the lagged book value of assets. β R is the slope coefficient from the regression of stock returns on the change in reported
earnings (scaled by lagged book value of assets) using data from the last 10 years. DIV is a dummy variable that equals 1 if a firm pays dividend and 0 otherwise.
24 F. LI
fixed effects, and the Fama–French 43 industry fixed effects. I then divide
the sample into firms with more overinvestment and less overinvestment
groups. The results indicate that, consistent with the hypothesis, for firms
with less overinvestment problems, the interaction of E Q 1 with earnings
has a coefficient of 0.012 (t = 2.69) and that for firms with more overin-
vestment problems is 0.003 (t = 0.76), and the difference is statistically sig-
nificant. Similarly, the coefficient on E Q 2 × E is higher for firms with less
overinvestment. Overall, the evidence is largely consistent with the hypoth-
esis that investment-based earnings-quality measures are more informative
for firms with less of an overinvestment tendency.
4.3 ADDITIONAL TESTS

4.3.1. Frequency of Earnings Increases and the Investment-Based Earnings Qual-
ity. The accounting literature has documented the different implications of
losses for earnings properties (e.g., Hayn [1995]). In this subsection, I sys-
tematically examine the relation between losses and the frequency of earn-
ings increases versus decreases and the investment-based earnings-quality
measures.
First, to the extent that losses and earnings decreases are more likely to be
temporary (Hayn [1995]), β C and β L should be lower for firms with more
losses or higher frequency of earnings decreases. For instance, because of
the abandonment option, earnings decreases and losses are temporary and,
as a result, I expect that investment decisions respond less to earnings de-
creases or losses and hence the association between earnings and invest-
ment is less positive. The results in panel A of table 6 strongly support this
argument: β C and β L both increase in the percentage of earnings increases
and decrease in the percentage of reported losses in the estimation window
(last 10 years).
Second, I examine whether the association between investment-based
earnings-quality measures and earnings persistence is more significant if
I only include the positive β C and β L in the analysis. For instance, the statis-
tics in table 1 show that more than 25% of the estimated β C ’s are negative.
These negative β C estimates can be due to losses or earnings decreases as
discussed in the previous paragraph. Panel B of table 6 presents the results
when the tests exclude firms with negative estimates of β L and β C . Com-
pared with the results in table 4, the results are stronger in economic mag-
nitude. For instance, the coefficient on β C × E is 0.057 (t = 4.30), much
larger than that of 0.041 (t = 3.66) documented in table 4.
Also, I partition firm years into those that experienced few earnings in-
creases in the last 10 years (our estimation window for β C and β L ) and
those with more earnings increases. The prediction here is that for firms
with many earnings decreases, the investment-based earnings-quality mea-
sures (β C and β L ) are less informative compared with those with mostly
earnings increases in the estimation period. The results in panel C of table
6 are consistent with this hypothesis: the coefficient on E Q × E is positive
and significant for firms with high frequency of earnings increases and is
insignificant for those with a high frequency of earnings decreases.
TABLE 6
Losses, Earnings Decreases, and the Investment-Based Earnings Quality
Panel A: Regressions of Investment-Based Earnings-Quality Measure on the Frequency of Earnings Increases Versus Decreases and Profits Versus Losses
EQ Proxied by β C EQ Proxied by β L
Percentage of earnings increases 0.570 0.067
(16.34) (6.21)
[0.035] [0.011]
Rank of percentage of earnings increases 0.080 0.010
(15.06) (4.33)
[0.005] [0.002]
Percentage of losses −0.632 −0.092
(−8.56) (−4.41)
[0.074] [0.021]
Rank of percentage losses −0.080 −0.009
(−12.44) (−5.34)
[0.006] [0.002]
Average adj. R-squared 0.030 0.027 0.007 0.010 0.033 0.030 0.007 0.008
Average N 822 822 822 822 822 822 822 822
(Continued)
25
26
F. LI
Panel B: Regressions of Earnings Persistence as a Function of Investment-Based Earnings-Quality Measures (Firms with Positive EQ )
(E it+1 /TAit−1 ) = α 0 + α 1 ×(E it /TAit−1 ) + α 2 × E Q it + α 3 × E Q it ×(E it /TAit−1 ) + α 4 × CON T ROL it + α 5 × CON T ROLit ×(E it /TAit−1 ) + ε it
EQ Proxied by
βC βL EQ 1
Intercept (α 0 ) 0.017 0.019 0.023
(6.17) (5.88) (6.22)
[0.003] [0.003] [0.004]
E (α 1 ) 0.892 0.854 0.831
(32.06) (25.78) (22.79)
[0.028] [0.033] [0.036]
EQ (α 2 ) −0.007 −0.068 −0.001
(−3.36) (−4.77) (−2.83)
[0.002] [0.014] [0.000]
E Q × E (α 3 ) 0.057 0.572 0.014
(4.30) (6.87) (3.56)
[0.013] [0.083] [0.004]
Average adj. R-squared 0.763 0.755 0.762
Average N 503 529 415
(Continued)
Panel C: Cross-sectional Variations in the Investment-Based Earnings-Quality Measures as a Function of the Frequency of Earnings Increases Versus Earnings
Decreases in the 10-Year Estimation Period
(E it+1 /TAit−1 ) = α 0 + α 1 ×(E it /TAit−1 ) + α 2 × E Q it + α 3 × E Q it ×(E it /TAit−1 ) + α 4 × CON T ROL it + α 5 × CON T ROLit ×(E it /TAit−1 ) + ε it
Firms with High Percentage of Earnings- Firms with Low Percentage of Earnings- Significance of the
Increase Years in the Last 10 Years Increase Years in the Last 10 Years Difference in Coefficient
Intercept (α 0 ) 0.021 −0.000 S
(4.23) (−0.46)
[0.005] [0.000]
E (α 1 ) 0.707 1.133 S
(11.29) (8.06)
[0.063] [0.141]
EQ (α 2 ) −0.001 −0.000 NS
(−1.71) (−0.04)
[0.001] [0.000]
E Q × E (α 3 ) 0.014 0.001 S
(2.01) (0.20)
[0.007] [0.005]
Average N 202 233
Average adj. R-squared 0.598 0.820
Panel A presents the Fama–MacBeth regressions of the regression-approach investment-based earnings-quality measures on the percentages of earnings increases and the per-
centage of losses reported by the firm in the last 10 years. Panel B presents the Fama–MacBeth regressions that estimate earnings persistence as a function of the regression-approach
investment-based earnings-quality measures (β C and β L ), using only firms that have positive β C and β L . Panel C presents the Fama–MacBeth regressions that estimate earnings
persistence as a function of the regression-approach investment-based earnings-quality measures for two samples: firms with high frequency of earnings increases in the last 10 years
(firms in the top tercile of the percentage of earnings increase years) and firms with low frequency of earnings increases in the last 10 years (firms in the bottom tercile of the
percentage of earnings increase years). In panel C, the “NS” (“S”) indicates that the coefficients are statistically nonsignificant (significant) between the two samples at the 10% level.
In panel A, the dependent variables are β C or β L . In panels B and C, the dependent variable is E it+1 /TAit−1 , next year’s earnings scaled by the lagged book value of assets. In
panels B and C, the independent variables are defined as follows. E is E it /TAit−1 , current earnings scaled by the lagged book value of assets. The β C is estimated for every firm year
as the slope coefficient from the regression of change in capital and R&D expenditures (scaled by lagged book value of assets) on the change in reported earnings (adjusted for the
impact of current capital and R&D expenditures and scaled by lagged book value of assets) using data from the last 10 years. The β L is estimated for every firm year as the slope
coefficient from the regression of change in the number of employees (scaled by lagged book value of assets) on the change in reported earnings (scaled by lagged book value of
assets) using data from the last 10 years. For a firm year to have β C and β L , it must have nonmissing data for the last 10 years. EQ 1 is the average of the decile ranks of β C and β L .
Fama-MacBeth t-statistics (standard errors) adjusted for Newey–West autocorrelation (lag = 3) are in parentheses (brackets).
The following variables and their interactions with E are included in panels B and C, but are not reported. DD is the standard deviation of the Dechow and Dichev [2002]
residuals from the regression of accruals on lagged CFO (operating cash flows), current CFO, and next year’s CFO using the last 10 years of data. ABSACC is the absolute amount of
27
accruals, scaled by the lagged book value of assets. β R is the slope coefficient from the regression of stock returns on the change in reported earnings (scaled by lagged book value
of assets) using data from the last 10 years. DIV is a dummy variable that equals 1 if a firm pays dividend and 0 otherwise.
28 F. LI
TABLE 7
Capital-Investment Intensity, Unionization Rate, and the Investment-Based Earnings-Quality Measures
(E it+1 /TAit−1 ) = α 0 + α 1 ×(E it /TAit−1 ) + α 2 × EQ it + α 3 × E Q it ×(E it /TAit−1 ) + α 4 ×
CON T ROL it + α 5 × CON T ROLit ×(E it /TAit−1 ) + ε it
Panel A: Cross-sectional Variations in the Investment-Based Earnings-Quality Measures as a
Function of Investment Intensity
EQ Proxied by β C EQ Proxied by γ C
Low High Significance Low High Significance
Investment Investment of the Investment Investment of the
Intensity Intensity Difference in Intensity Intensity Difference in
Firms Firms Coefficient Firms Firms Coefficient
Intercept (α 0 ) 0.015 0.019 NS 0.013 0.020 NS
(3.22) (4.19) (2.88) (3.81)
[0.005] [0.005] [0.005] [0.005]
E (α 1 ) 0.865 0.856 S 0.884 0.854 S
(10.34) (17.69) (10.93) (16.07)
[0.084] [0.048] [0.081] [0.053]
EQ (α 2 ) −0.005 −0.003 NS 0.001 0.001 NS
(−2.35) (−0.99) (0.85) (0.93)
[0.002] [0.003] [0.001] [0.001]
E Q × E (α 3 ) 0.030 0.040 S −0.013 0.003 S
(1.38) (2.98) (−1.84) (1.66)
[0.022] [0.013] [0.007] [0.002]
Average adj. 0.766 0.751 0.767 0.753
R-squared
Average N 212 232 212 232
Panel B: Cross-sectional Variations in the Investment-Based Earnings-Quality Measures as a
Function of Industry Unionization Rate
EQ Proxied by β L EQ Proxied by γ L
Unionization Unionization of the Unionization Unionization of the
Industry Industry Difference in Industry Industry Difference in
Intercept (α 0 ) 0.007 0.015 S 0.006 0.014 S
(5.30) (5.67) (3.85) (5.50)
[0.001] [0.003] [0.002] [0.003]
E (α 1 ) 0.938 0.866 S 0.942 0.875 S
(24.48) (22.53) (26.25) (22.40)
[0.038] [0.038] [0.036] [0.039]
EQ (α 2 ) −0.027 −0.068 S 0.004 −0.005 S
(−0.93) (−2.27) (1.50) (−1.94)
[0.029] [0.030] [0.003] [0.003]
E Q × E (α 3 ) 0.185 0.766 S −0.010 0.097 S
(0.96) (2.97) (−0.49) (3.35)
[0.193] [0.258] [0.020] [0.029]
(Continued)
4.3.2. Capital Investment Intensity and the Investment-Based Earnings Qual-

ity. To the extent that investment decisions are more important for capital-
intensive firms, their investment decisions are more informative about fu-
ture earnings. In this subsection, I examine this implication empirically.
Panel A of table 7 divides the sample into firms with very little capital in-
vestment (bottom tercile firms) and those with substantial investment (top
Panel B: Cross-sectional Variations in the Investment-Based Earnings-Quality Measures as a
Function of Industry Unionization Rate
EQ Proxied by β L EQ Proxied by γ L
Unionization Unionization of the Unionization Unionization of the
Industry Industry Difference in Industry Industry Difference in
Average adj. 0.758 0.719 0.759 0.719
R-squared
Average N 356 457 356 457
Panel A presents the Fama–MacBeth regressions that estimate earnings persistence as a function of
the capital investment-based earnings quality for two samples: firms with high capital investment intensity
(firms in the top tercile) and firms with less capital investment intensity (bottom tercile). Panel B presents
the Fama–MacBeth regressions that estimate earnings persistence as a function of the labor investment-
based earnings quality for two samples: firms in a high unionization rate industry (industries with a union-
ization rate above the median of all industries) and firms in a low unionization rate industry (industries
with a unionization rate below the median of all industries). In both panels, the dependent variable is
E it+1 /TAit−1 , next year’s earnings scaled by the lagged book value of assets. Fama–MacBeth t-statistics (stan-
dard errors) adjusted for Newey–West autocorrelation (lag = 3) are in parentheses (brackets). The “NS”
(“S”) indicates that the coefficients are statistically nonsignificant (significant) between the two samples at
the 10% level.
The independent variables are defined as follows. E is E it /TAit−1 , current earnings scaled by the lagged
book value of assets. The β C is estimated for every firm year as the slope coefficient from the regression of
change in capital and R&D expenditures (scaled by lagged book value of assets) on the change in reported
earnings (adjusted for the impact of current capital and R&D expenditures and scaled by lagged book value
of assets) using data from the last 10 years. The β L is estimated for every firm year as the slope coefficient
from the regression of change in the number of employees (scaled by lagged book value of assets) on the
change in reported earnings (scaled by lagged book value of assets) using data from the last 10 years. For
a firm year to have β C and β L , it must have nonmissing data for the last 10 years. EQ 1 is the average of the
decile ranks of β C and β L . The γ C is the change in capital expenditure divided by the change in reported
earnings. The γ L is the change in the number of employees divided by the change in reported earnings.
EQ 2 is the average of the decile ranks of γ C and γ L .
The following variables and their interactions with E are included in the regressions but are not re-
ported. DD is the standard deviation of the Dechow and Dichev [2002] residuals from the regression of
accruals on lagged CFO (operating cash flows), current CFO, and next year’s CFO using the last 10 years of
data. ABSACC is the absolute amount of accruals, scaled by the lagged book value of assets. β R is the slope
coefficients from the regression of stock returns on the change in reported earnings (scaled by lagged
book value of assets) using data from the last 10 years. DIV is a dummy variable that equals 1 if a firm pays
dividend and 0 otherwise.
tercile firms). Since capital expenditure is the basis for this construction
of subsamples, I focus on its implications for β C and γ C . The results in-
dicate that, as predicted, β C associates more with earnings persistence for
more capital-intensive firms. For firms with low (high) capital investment
intensity, the coefficient on β C × E is 0.030 (0.040) with a t-statistic of 1.38
(2.98); the difference between the two coefficients is also statistically signif-
icant. The coefficient γ C × E is insignificant for both firms with low capital
investment intensity (−0.013 with a t-value of −1.84) and those with high
investment intensity (0.003 with a t-value of 1.66), but the difference be-
tween them is statistically significant. Overall, the empirical results indicate
that investment-based earnings-quality measures are more likely to contain
future earnings information for capital-intensive firms.
4.3.3. Unionization Rate and the Investment-Based Earnings Quality. In this

subsection, I examine whether labor investment decisions have differ-
ent information content about earnings quality for industries with more
30 F. LI
unionization. Prior empirical work based on both survey and historical data
shows large wage differentials between union and nonunion workers with
similar measured personal skills (Duncan and Stafford [1980]). Therefore,
firms that hire more union employees likely pay a higher wage as compared
to nonunion firms, and union employees probably receive higher severance
pay and benefits after being laid off as compared to nonunion employees.
This reasoning suggests that changes in employment levels are more
costly for firms that are heavily unionized. As a result, these firms need
to be more certain that changes in demand are more permanent before
they make changes in employment levels. Consequently, changes in em-
ployment levels of heavily unionized firms are more informative about fu-
ture earnings prospects. I hypothesize that the labor-based earnings-quality
measures are more informative about the future earnings.
Following Chen Kacperczyk and Ortiz-Molina [2010], I obtain unioniza-
tion data for the period 1984-2004 from the Union Membership and Cover-
age Database at www.unionstats.com, which is maintained by Barry Hirsch
and David Macpherson. The data are compiled from the Current Popu-
lation Survey, based on the method used by the Bureau of Labor Statis-
tics. Hirsch and Macpherson [2003] provide details on the construction
of this unique and comprehensive data set. I follow previous work in la-
bor economics such as Connolly, Hirsch, and Hirschey [1986] and mea-
sure labor force unionization as the percentage of employed workers in a
firm’s primary Census Industry Classification (CIC) industry who are union
members.12 The data set comprises 188 CIC industries, which correspond
roughly to three-digit SIC industries.
I define high (low) unionization industry as those industries with labor
force unionization rates above (below) the median of all industries. The
empirical results (table 7, panel B) show that, consistent with the predic-
tion, the earnings-quality measure based on corporate labor investment
decisions is more informative for firms from highly unionized industries:
the coefficient on β L × E is 0.185 (t = 0.96) for firms in low unioniza-
tion rate industries and 0.766 (t = 2.97) for those in high unionization rate
industries and the difference is statistically significant. Similar results are
obtained for γ L .
4.3.4. Other Robustness Tests. One problem with using earnings persis-
tence to gauge earnings quality is that next year’s earnings is of a short-term
nature and captures the “permanent earnings” concept with error. To miti-
gate this concern, I adopt an alternative specification by using longer term
future cash flows as a measure of permanent earnings. Specifically, I sum
the cash flows from operations from year t + 1 to year t + 3 and regress this
sum on earnings in year t to measure earnings persistence. I then examine
12 I also carry out another test based on the percentage of employees covered by unions in
the collective bargaining with the employers for a given industry and the (unreported) results
are almost the same.
whether the investment-based earnings-quality measures have implications

for the association of current earnings with future cash flows. Unreported
results show that all the empirical results in the paper remain qualitatively
similar. The results are also robust to an alternative definition of earnings
and calculation of accruals and cash flows. For instance, the empirical re-
sults remain similar if net income, instead of operating income, is used in
the tests. The empirical results still hold if industry-level definitions of earn-
ings quality and earnings persistence are used.
5. Conclusion
In this study, I investigate a new approach to assess earnings quality,
based on the reasoning that firm labor- and capital-investment decisions
contain managers’ information about future profitability. I document that
there is a positive and significant relation between the investment-based
measures of earnings quality and earnings persistence. This effect holds
after controlling for other commonly used measures of earnings quality.
The information content in investment decisions with regard to future
earnings decreases with firms’ overinvestment tendency. The usefulness of
the investment-based earnings-quality measures also varies with the capital-
investment intensity, the unionization rate, and the frequency of earnings
increases versus decreases. Overall, the evidence from the paper suggests
that it is important to tap into the information set of managers to assess
earnings quality.
REFERENCES
BAKER, M. “Career Concerns and Staged Investment: Evidence from the Venture Capital In-
dustry,” Working paper. Harvard Business School, 2000.
BASU, S. “The Conservatism Principle and the Asymmetric Timeliness of Earnings.” Journal of
Accounting and Economics 24 (1997): 3–37.
BEAVER, W. H. Financial Reporting: An Accounting Revolution, Third edition. Englewood Cliffs:
Prentice Hall, 1998.
BERLE, A., AND G. MEANS. The Modern Corporation and Private Property. New York: Macmillan,
1932.
BERTRAND, M., AND S. MULLAINATHAN. “Enjoying the Quiet Life? Corporate Governance and
Managerial Preferences.” Journal of Political Economy 111 (2003): 1043–75.
BLACK, F. “The Magic in Earnings: Economic Earnings Versus Accounting Earnings.” Financial
Analysts Journal 36 (1980): 19–24.
BLANCHARD, O. J.; E. LOPEZ DE SILANES; AND A. SHLEIFER. “What Do Firms Do with Cash Wind-
falls.” Journal of Financial Economics 36 (1994): 337–60.
CHEN, J.; M. KACPERCZYK; and H. ORTIZ-MOLINA. “Labor Unions, Operating Flexibility, and
the Cost of Equity.” Journal of Financial and Quantitative Analysis (2010): Forthcoming.
COLLINS, D. W.; E. L. MAYDEW; and I. S. WEISS. “Changes in the Value-Relevance of Earnings
and Book Values over the Past Forty Years.” Journal of Accounting and Economics 24 (1999):
39–67.
CONNOLLY, R.; B. HIRSCH; AND M. HIRSCHEY. “Union Rent Seeking, Intangible Capital, and
Market Value of the Firm.” The Review of Economics and Statistics 68 (1986): 567–77.
DECHOW, P. M., AND I. D. DICHEV. “The Quality of Accruals and Earnings: The Role of Accrual
Estimation Errors.” Accounting Review 77 (2002): 35–59.
32 F. LI
DECHOW, P. M., AND C. M. SCHRAND. Earnings Quality, First edition. Virginia, Charlottesville:
Research Foundation of CFA Institute, 2004.
DICHEV, I., AND W. TANG. “Earnings Volatility and Earnings Predictability.” Journal of Accounting
and Economics 47 (2009): 160–81.
DONALDSON, G. Managing Corporate Wealth, New York: Praeger, 1984.
DUNCAN, G. J., AND F. P. STAFFORD. “Do Union Members Receive Compensating Wage Differ-
entials.” American Economic Review 70 (1980): 355–71.
ECKER, F.; J. FRANCIS; I. KIM; P. OLSSON; AND K. SCHIPPER. “A Returns-Based Representation of
Earnings Quality.” The Accounting Review 81 (2006): 749–80.
FAMA, E. F., AND J. MACBETH. “Risk, Return and Equilibrium: Empirical Tests.” Journal of Politi-
cal Economy 81 (1973): 607–36.
FRANCIS, J.; R. LAFOND; P. OLSSON; AND K. SCHIPPER. “The Market Pricing of Accruals Quality.”
Journal of Accounting and Economics 31 (2005): 295–327.
FRANCIS, J., AND K. SCHIPPER. “Have Financial Statements Lost Their Relevance?” Journal of
Accounting Research 37 (1999): 319–52.
HAYN, C. “Information Content of Losses.” Journal of Accounting and Economics 20 (1995):
125–53.
HEALY, P. M., AND J. M. WAHLEN. “A Review of the Earnings Management Literature and Its
Implications for Standard Setting.” Accounting Horizons 13 (1999): 365–83.
HIRSCH, B. T., AND D. A. MACPHERSON. “Union Membership and Coverage Database from the
Current Population Survey: Note.” Industrial and Labor Relations Review 56 (2003): 349–54.
JENSEN, M. C. “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers.” The Amer-
ican Economic Review 76 (1986): 323–29.
JENSEN, M. C., AND W. H. MECKLING. “Managerial Behavior, Agency Costs and Ownership Struc-
ture.” Journal of Financial Economics 3 (1976): 305–60.
LEV, B., AND T. SOUGIANNIS. “The Capitalization, Amortization and Value-Relevance of R&D.”
Journal of Accounting and Economics 21 (1996): 107–38.
LI, F. “Annual Report Readability, Current Earnings, and Earnings Persistence.” Journal of Ac-
counting and Economics 45 (2008): 221–47.
NEWEY, W. K., AND K. D. WEST. “Automatic Lag Selection in Covariance Matrix Estimation.”
Review of Economic Studies 61 (1994): 631–53.
OHLSON, J., AND X. ZHANG. “Earnings, Book Values, and Dividends in Equity Security Valua-
tion.” Journal of Accounting Research 36 (1998): 85–111.
RICHARDSON, S. “Over-Investment of Free Cash Flow.” Review of Accounting Studies 11 (2006):
159–89.
SKINNER, D. J., AND E. SOLTES. “What Do Dividends Tell Us About Earnings Quality.” Review of
Accounting Studies (2009): Forthcoming.
SLOAN, R. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future
Earnings?” Accounting Review 71 (1996): 289–15.
STEIN, J. C. “Agency, Information, and Corporate Investment,” in Handbook of the Economics
of Finance, edited by G. M. Constantinides, M. Harris, and R. Stulz. North Holland: B.V.
Elsevier, 2003: 111–65.
WILLIAMSON, O. E. The Economics of Discretionary Behavior: Managerial Objectives in a Theory of the
Firm. Englewood Cliffs, NJ: Prentice Hall, 1964.

Earnig Quality Based On Corporate Investment PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Earnig Quality Based On Corporate Investment PDF

Uploaded by

Copyright:

Available Formats

DOI: 10.1111/j.1475-679X.2010.00397.

Earnings Quality Based

Received 25 July 2007; accepted 20 September 2010

most important investment decisions managers make. I construct earnings-

2. Literature and Hypotheses Development

provide informative signals about earnings quality relative to the market-

change—can lead to excessive continuation of negative-NPV projects. In

3. Estimation of Earnings Quality Based on Investment Decisions

following two regressions using the data from year T − 9 to T :

6 This is especially true during recession years.

To summarize, β L , β C , and E Q 1 (i.e., the decile rank average of β L

3.2 SUMMARY STATISTICS

the slope coefficient in the regression of the change in capital investment

3.3 INVESTMENT- BASED EARNINGS QUALITY AND OTHER MEASURES

and 99% levels.

Table 2 shows a correlation between β L and β C with a Pearson correlation

T 1/4 , where T is the time-series length of the data.

ABSACC (α 4,2 ) 0.074 0.074

Panel B: Earnings Quality Measured by Using the Nonregression Approach

coefficient on earnings, when used alone to explain next year’s earnings,

4.3 ADDITIONAL TESTS

4.3.2. Capital Investment Intensity and the Investment-Based Earnings Qual-

4.3.3. Unionization Rate and the Investment-Based Earnings Quality. In this

whether the investment-based earnings-quality measures have implications

You might also like