The Impact of Earnings Quality on the Stock Returns of Listed Manufacturing Companies in the Colombo Stock Exchange

Abstract

The earnings of a company is a very important indicator of firm performance, since it communicates information about the value creating ability of the company to its stakeholders. It is also considered a determinant of the stock market performance of the company. However, the possibility for managers to manipulate the true earnings of a company erodes the importance of using recorded earnings information in financial statements for decision making. Earnings quality could be measured using different proxy measures, varying from traditional accrual based measures to recent real earnings based measures. The earnings quality literature contains a plethora of evidence on the impact of earnings quality measured through accrual based measures on stock returns but it does not have as much evidence on the same impact where earnings quality is measured through real earnings. Further, the literature does not have a comparative study on how different earnings quality measures provide different results in the estimation of the impact of earnings quality on stock returns. Empirical evidence on the same relationship using data from the Sri Lankan context is virtually absent in the extant literature. In this milieu, the present study examines the impact of earnings quality measured through both accrual based measures and real earnings measures on stock returns of listed manufacturing companies in Sri Lanka during the period of 2010 to 2015. The findings of the study reveal that there is no significant positive impact of earnings quality on stock returns of the firms selected for the study. This suggests that earnings quality information of the selected firms fails to win investor trust when investors make their decisions. Perhaps this may be due to the fact that earnings manipulation is evident in the Sri Lankan context. Further, the study reveals that there is no inconsistency when measuring earnings quality through competing measurements.