In this essay, I argue that external financial reporting quality (EFRQ) has at best a second-order effect on firm value of U.S. publicly traded companies, and that attempts to improve a firm's external reporting quality have a third-order effect on these firms' value. Recognizing that EFRQ is at best a second-order effect on firm value imposes an important external validity test on accounting research. If the economic magnitude of the study's proxy for quality on firm value is “too large,” then the researcher should question the research design strategy and whether correlated omitted variables, endogeneity, or sample selection bias are corrupting the study's inferences.
Dechow et al. (2010, 344) define “high quality earnings” as providing “more information about the features of a firm's financial performance that are relevant to a specific decision made by a specific decision-maker.” They review and discuss several mechanisms by which “earnings quality” affects firm...
