A Balance-Sheet-Based Measure of Accounting Quality

We develop and validate a balance sheet-based measure of accounting quality that quantifies the ability of accounting assets to measure firm-specific economic capital. The measure is based on economic theories linking a firm's economic capital (i.e., its productive capacity) to its intrinsic value. Taking the view that reported assets on a firm's balance sheet are the primary measure of firm-specific economic capital, we define balance sheet-based accounting quality as the degree to which accounting asset measurements reduce investors' uncertainty about firms' economic capital, relative to overall uncertainty. Our results suggest that accounting assets resolve a substantial portion of the uncertainty about economic capital and that our balance-sheet-based accounting quality measure is distinct from several earnings attributes sometimes associated with earnings quality. These findings support the view that it is important to assess the quality of accrual accounting by its ability to generate an informative measure of productive capacity, specifically, accounting assets