Errors in Estimating Accruals: Implications for Empirical Research

Abstract

This paper examines the impact of measuring accruals as the change in successive balance sheet accounts, as opposed to measuring accruals directly from the statement of cash flows. We demonstrate that the balance sheet approach to measuring accruals, which is the dominant method used in the literature to date, introduces significant measurement error into accruals estimates. Results show that the direction and magnitude of the bias in accruals estimates is related to the presence of mergers and acquisitions, discontinued operations, and to a lesser extent, foreign currency translations. Our primary finding is that studies using a balance sheet approach to test for earnings management are potentially contaminated. In particular, if the partitioning variable used to indicate the presence of earnings management is correlated with the occurrence of mergers and acquisitions or discontinued operations, researchers are likely to erroneously conclude that earnings management exists when there is none. Additional results show that the bias in balance sheet accruals estimation can confound regressions where discretionary and non-discretionary accruals are used as explanatory variables. Moreover, we demonstrate that tests of market mispricing of accruals will be understated due to erroneous classification of "extreme" accruals firms.

JEL Classification: M41, G14, G34