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.