The Effects of Firm Growth and Model Specification Choices on Tests of Earnings Management in Quarterly Settings
Daniel W. Collins
University of Iowa - Department of Accounting
Raunaq S. Pungaliya
SKK Graduate School of Business
Anand M. Vijh
University of Iowa - Department of Finance
December 1, 2012
Commonly used Jones-type discretionary accrual models applied in quarterly settings do not adequately control for nondiscretionary working capital accruals that naturally occur due to firm growth. This biases tests of earnings management in many settings where the partitioning variable is correlated with firm growth (such as stock splits, SEOs, stock acquisitions, and stock-based compensation). We show that there is a severe problem of falsely rejecting the null hypothesis of no earnings management in samples over-represented by high growth or low growth firms when using performance-adjusted discretionary accruals. In contrast, discretionary accrual models that control for both performance and firm growth are well specified and do not sacrifice power. Including adjustments for accruals’ noise reduction and timely loss recognition roles further improves the model power.
Number of Pages in PDF File: 59
Keywords: Discretionary Accruals, Earnings Management, Performance Matching, Firm Growth
JEL Classification: M41, M43working papers series
Date posted: April 27, 2011 ; Last revised: January 17, 2013
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