Using the FASB's Qualitative Characteristics in Earnings Quality Measures

In this study, I develop a measure of earnings quality by using qualitative characteristics of financial statement information specified in the Statement of Financial Accounting Concepts (SFAC) No. 2 (FASB 1980). I derive a summary measure of earnings quality by applying factor analysis on fifteen variables representing different components of two primary dimensions of earnings quality: relevance and reliability. I then test the validity of the earnings quality construct by examining whether the construct reflects decision usefulness that is operationalized in two ways: value relevance and cost of capital analyses. I provide empirical evidence suggesting that the earnings quality construct reflects decision usefulness to investors, which is consistent with the FASB's assertion. Finally, I explore the relative desirability of each dimension in light of decision usefulness of earnings information, and find that investors, in general, prefer the relevance to the reliability dimension of earnings.