Behavior of Accrual Management and Performance of Discretionary Accrual Proxies

• In Event: Earnings Management and Discretionary Accrual Proxies

Abstract

In this study, we analyze how associations between accrual management and firm fundamentals affect the performance of commonly used discretionary accrual proxies (DAP). Using a self-collected sample, we identify directly the level of discretionary accruals from financial restatements, using the contrast between originally reported and restated numbers. Our analyses reveal two insights: First, discretionary accruals are associated with explanatory variables (i.e., sales growth and operating cash flows) in accrual models in the same direction as that of nondiscretionary accruals with similar magnitudes. This “mimicking” effect results in the exclusion of discretionary accruals from DAP of a similar degree to that of the exclusion of nondiscretionary accruals, causing failure in separating the two, even in comprehensive accrual models. Second, firms overstate accruals more when nondiscretionary accruals are lower. Such a negative relationship is particularly prominent among firms that report below-median accruals, whereby overstating firms’ reported accruals successfully “blend in” with those of the non-overstating population. Consequently, DAP are significant indicators of accrual overstatement only among firms that report above-median accruals. Our findings provide first evidence of the statistical behavior of accrual management and its significant impact on the performance of DAP.

Authors

• Wei Zhu, University of Illinois-Urbana-Champaign

• Yue Li, University of Illinois at Urbana-Champaign