Developing a Holistic Earnings Quality Model: A Joint Test of Agency and Signaling Theory

Financial sector plays a pivotal role in growth and development of non-financial sector. It strengthens the real economy and accelerates its growth. On the other hand, volatility of financial sector adversely affects investment and arrests the growth of the economy. Since the financial sector is more volatile than non-financial sector, it frequently causes fluctuations in the real sector of economy. The recent financial crisis 2007-08, emerging from USA housing market, has resulted in turmoil of financial environment over the globe. The banking industry has been a victim of the turmoil in debt markets due to crash of house bubble in mid-May 2007. Credit and earnings quality is one of the most crucial factors affecting the financial performance of the banks (Jin, Kanagaretnam and Lobo, 2011). Sixteen (16) of largest banks in USA faced increasing loan losses and bankruptcy risk and made the earnings of the banks suspicious and unreliable to investors1. Accordingly, many banks have faced pressure to achieve real growth in earnings and cash flows due to increasing number of defaults and non-performing loans.