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Financial development, intangible investments, and the evolution of earnings quality
We contribute to the ongoing debate on the reason for the decline in earnings qual- ity (EQ) documented by prior literature. We argue that Srivastava (2014)’s explanation that “each new cohort of listed firms exhibits lower earnings quality than its predecessors, mainly because of higher intangible intensity” may not be satisfactory. Instead, we assert that the downward trend in the EQ measures of successive cohorts reflects a progressive decrease in newer firms’ business effectiveness, as measured by profitability, operational efficiency, and economic risk. This is a direct result of easier access to public funding brought about by the 1970s trend change in the state of development of the U.S. finan- cial sector (Rajan and Zingales, 2003). Our explanation strictly encompasses Srivastava (2014)’s. While for newcomers in specific industries lower business effectiveness is as- sociated with higher intangible intensity, the lack of fit of most of the new listings is not explained by their investments in intangibles. They are simply weaker, riskier firms and have lower EQ as a result.
Why have measures of earnings quality changed over time? A competing narrative
We contribute to the debate on the reason for the decline in earnings quality (EQ) documented by prior literature. We dissent from Srivastava (2014)’s conclusion that “each new cohort of listed firms exhibits lower earnings quality than its predecessors, mainly because of higher intangible intensity”. Instead, we argue that the downward trend in EQ measures is explained by changes in firms’ economic risk and operational efficiency associated with “broadening of the kinds of firms publicly traded” (Fama and French (2004)). The association of intangible intensity to EQ measures is spurious and disappears when controlling for the mentioned firm’s characteristics.