Cost Structure and the Usefulness of Earnings

Abstract

We investigate the relation between the usefulness of earnings and a firm’s cost structure. We document that firms with a greater proportion of fixed to variable costs, a higher degree of operating leverage, report more volatile earnings and are more likely to aggressively recognize revenue to meet earnings thresholds. We then show that the usefulness of earnings to external users decreases in the degree of operating leverage and that this decrease stems from the effect of cost structure on earnings volatility and aggressive revenue recognition. Our results illuminate how firm fundamentals influence a firm’s information environment and the usefulness of earnings to external users.

Keywords: Cost Structure, Degree of Operating Leverage, Earnings Properties, Earnings Usefulness, Reporting Incentives

JEL Classification: D24, G31, M41