Using the balance sheet to assess earnings quality

Purpose We discuss the importance of the Financial Accounting Standards Board’s (FASB) emphasis on balance sheet primacy and examine whether balance sheet quality is associated with earnings quality. Design/methodology/approach We confirm that a firm’s market-to-book ratio is associated with variables that capture unrecognized intangible assets and therefore serves as a valid proxy for balance sheet quality. Findings We find that the explanatory power of earnings for contemporaneous returns is 24–50% higher for firms with higher quality balance sheets relative to firms with lower quality balance sheets, suggesting that the balance sheet is associated with earnings quality. Practical implications We interpret these results as providing empirical support for standard setters’ decision to give primacy to assets and liabilities and reinforces the importance of proper recognition and measurement of intangible assets. Originality/value Although a plethora of metrics exist that are meant to capture earnings quality, no research to date has explicitly linked the quality of a firm’s balance sheet to the quality of its earnings, despite the theoretical primacy of assets and liabilities.