The Effects of Firm Growth and Model Specification Choices on Tests of Earnings Management

Posted: 27 Apr 2011 Last revised: 9 Jul 2016

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

Date Written: July 7, 2016

Abstract

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 quarterly accruals and backward-looking sales growth (measured over a rolling four-quarter window) and forward-looking firm growth (market-to-book ratio) is non-linear. Failure to control for the effects of firm growth and performance on innate accruals leads to excessive Type-I error rates in tests of earnings management. We propose simple refinements to Jones-type models that deal with non-linear growth and performance effects and show that the expanded models are well specified and exhibit high power in quarterly settings where one is testing for earnings management. The expanded models are able to identify the presence of earnings management in a sample of restatement firms. Our findings have important implications for the use of discretionary accrual models in earnings management research.

Keywords: Discretionary Accruals, Earnings Management, Performance Matching, Firm Growth

JEL Classification: M41, M43

Suggested Citation

Collins, Daniel W. and Pungaliya, Raunaq S. and Vijh, Anand M., The Effects of Firm Growth and Model Specification Choices on Tests of Earnings Management (July 7, 2016). The Accounting Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1823835 or http://dx.doi.org/10.2139/ssrn.1823835

Daniel W. Collins (Contact Author)

University of Iowa - Department of Accounting ( email )

108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States
319-335-0912 (Phone)
319-335-1956 (Fax)

Raunaq S. Pungaliya

Sungkyunkwan University (SKK) Graduate School of Business ( email )

53 Myeongnyun-dong 3-ga Jongno-ju
Guro-gu
Seoul, 110-745
Korea, Republic of (South Korea)

Anand M. Vijh

University of Iowa - Department of Finance ( email )

Iowa City, IA 52242-1000
United States
319-335-0921 (Phone)
319-335-3609 (Fax)

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