A New Approach to Performance Control in Earnings Management Studies

• In Event: Financial Accounting and Reporting III

Abstract

We propose a cash flows from operations (CFO) portfolio approach to the performance control issue in earnings management studies, which was initiated by Kothari et al.(2005). We argue that the CFO portfolio is less costly, and yet controls performance more properly and ensures more stable and consistent measures of discretionary accruals than the Kothari et al. approach. We address the issues of alternative models as well as estimation approaches to present a comprehensive study. We carry out diverse analyses and tests and document some important findings.
First, the new models proposed by Yoon et al.(2013) are statistically superior to the Jones and modified Jones models. Second, the industry approach results in unsigned or inconsistent regression coefficients across different industries. Third, the CFO portfolio approach significantly outperforms the industry approach, across competing models. Fourth, when the industry approach is used, significantly different mean nondiscretionary and discretionary accruals result between the different models. However, the between-model differences disappear when the CFO portfolio approach is used and we find that the application of a better estimation approach is more important than the choice of models. Fifth, the Jones models do not properly isolate discretionary accruals particularly when the industry approach is used. We find that the application of a better estimation approach is more important than the choice of models. Sixth, CFO levels and the estimation approach used matter in terms of type-1 errors. There are larger differences in the rejection rates between the estimation approaches than between the models. However, the rejection rates are mostly lower than the hypothesized rate for the middle CFO level firm-years. Seventh, there are risks of drawing incorrect inferences when the ROA control approach is used. Eighth, we document that a significant proportion of negative CFO firms employ income-increasing earnings management strategies to avoid reporting losses. We find that the number of big-bath firms is correlated with very low CFO levels. Lastly, discretionary accruals can be overestimated (underestimated) when CFO level is negative (positive) under the industry approach, indicating that use of the CFO control approach is more warranted.

Key Words: performance control, earnings management, discretionary accrual models, industry approach, CFO portfolio approach

Authors

• Soon Suk Yoon, Chonnam National University

• Hyo Jin Kim, Jeonju University

• Gregg S. Woodruff, Western Illinois University