The Effect of Accounting Method Choice on Earnings Quality: A Study of Analysts Forecasts of Earnings and Book Value

Whether the quality of a firms reported earnings affects investors ability to predictfuture earnings and stock returns is still a subject of much debate among accounting researchers.Lev (1989) suggests that low quality earnings may be causing the relatively low correlationbetween reported earnings and stock returns (or the markets evaluation of future earnings). Thisdissertation used the valuation model described in Ohlson (1995) and Feltham and Ohlson(1995) to explore the possible links between accounting method choices and the ability ofinvestors to use reported earnings to predict future earnings. The results demonstrate that priorresearchers' assumptions regarding which accounting methods are generally conservative orliberal are reasonably accurate over large numbers of firms. The results also show that onegroup of analysts (Value Line Investment Survey) is able to predict future earnings moreaccurately over medium-term and long-term forecast horizons for firms using generallyconservative accounting methods than those firms employing generally liberal accountingmethods.This research adds to the prior "quality of earnings" research by showing that analystscan predict earnings more accurately for certain classes of firms (i.e., firms using conservativeaccounting methods), thus increasing our knowledge of what constitutes high-quality earnings.The research also explores the effects of growth on the quality of earnings question, the effectsof firm size, leverage, and industry membership on the relationship, and the robustness of theFeltham and Ohlson Model to alternative definitions of key components of the model.