...quality notion that accruals are estimates of future cash flow realizations, so that the quality of accruals and earnings is an inverse function of the precision of these estimates. Economic and structural factors can cause variation in the precision of accruals estimates (across accounts for a given firm, for a given firm over time, and across firms), regardless of the presence or absence of managerial interventions in the reporting process. In addition, managerial expertise will affect the precision of estimates, even if other factors that affect precision are held constant. As a result, a less-than-perfect mapping between accruals and cash flows in adjacent periods can reflect firms that report honestly but face uncertain economic environments, firms whose managers are less expert at estimation, and or firms whose managers intervene in the process to manipulate accruals. My discussion aims to shed light on the contribution of DD's paper by characterizing its innovation and limitations, and by putting it in the context of related literature. My discussion concludes with suggestions for future research on earnings quality.

H. DECHOW AND DICHEV'S DEFINITION OF EARNINGS QUALITY

The accounting literature includes several definitions of earnings quality. Some define earnings as high quality if earnings are persistent, an attribute based solely on the time-series properties of earnings. Some define earnings as high quality if earnings accurately represent the economic implications of underlying transactions and events. Some, and this includes DD, define earnings quality in terms of the relation between accruals and cash flows. DD's definition does not distinguish among the various factors that influence this relation--the uncertainty in the firm's environment, the ability of management, the extent to which accruals are manipulated--but some approaches to defining earnings quality do. (1)

DD characterize the linkage between current accruals and cash flows in the immediately adjacent periods. Recognizing that accruals may arise following some cash flows and in anticipation of others, they develop a model that reflects estimation error in anticipated cash flows. (2) They characterize aggregate accruals as the sum of opening and closing deferral and accrual entries. Specifically:

(DD4) [A.sub.t] = C[F.sub.t-1.sup.t] - (C[F.sub.t.sup.t+1] + C[F.sub.t.sup.t-1]) + C[F.sub.t+1.sup.t] + [[epsilon].sub.t+1.sup.t] - [[epsilon].sub.t.sup.t-1]

where:

[A.sub.t] = current accruals recognized in period t;

C[F.sub.t.sup.s] = cash from operations realized in period t and recognized in period s; and

[[epsilon].sub.t.sup.s] = estimation error associated with accruals recognized in period s and cash flows realized in period t.

The first and fourth terms reflect recognition of cash flows realized in t-1 and to be realized in t+1. The second term defers recognition of cash flows realized in t that are to be recognized in t+1, and the third term reflects cash flows realized in t that were recognized in t-1. The fifth and sixth terms reflect the estimation error in period t's opening accrual that will be realized in t+1 and the closing error for period t-1 realized in period t.

Estimation error is defined as the difference between the amount accrued and the amount realized. Therefore period t's earnings include the opening error that will be realized in t+1 when the related cash flows are realized and the reversing error from the cash flows realized in period t that differ from the amount accrued in period t-1. DD define the quality of accruals and earnings as the magnitude of these errors.

Cash flow realizations in periods prior to t-1 and subsequent to t+1 are assumed to be beyond the horizon reflected in current accruals. That is, the approach they take requires an estimated coefficient for every period in which there is a pertinent accrual. In a model of, say, deferred taxes or depreciation, this is a long series of leads/lags indeed, and the model is not operational. The approach requires that the key element of accruals/earnings quality is in the current accruals....

NOTE: All illustrations and photos have been removed from this article.



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