The Effects of Firm Growth and Model Specification Choices on Tests of Earnings Management
Daniel W. Collins
University of Iowa - Department of Accounting
Raunaq S. Pungaliya
Sungkyunkwan University (SKK) Graduate School of Business
Anand M. Vijh
University of Iowa - Department of Finance
June 1, 2014
Commonly used Jones-type discretionary accrual models applied in quarterly settings do not adequately control for nondiscretionary accruals that naturally occur due to firm growth. We show that the relation between firm growth and quarterly accruals is nonlinear and this nonlinear relation extends to other firm characteristics related to accruals. This also holds true for annual data. We propose refinements to Jones-type models that deal with this non-linearity and show that the expanded models are well specified and exhibit high power in quarterly and annual settings where one is interested in testing for earnings management. The proposed refinements are sufficiently general to accommodate multiple firm characteristics that may be related to nondiscretionary accruals. As an important by-product of our analysis, we derive an analytical algorithm for determining Type I error rates and power (1-Type II error) of alternative discretionary accrual model specifications. Our findings have important implications for earnings management research.
Number of Pages in PDF File: 67
Keywords: Discretionary Accruals, Earnings Management, Performance Matching, Firm Growth
JEL Classification: M41, M43
Date posted: April 27, 2011 ; Last revised: June 23, 2015
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