Earnings Management in the Context of Fair Value Accounting: Adjusting the Modified Jones Model to Fair Value Accounting

62 Pages Posted: 11 Feb 2013 Last revised: 3 May 2013

See all articles by Changling Chen

Changling Chen

University of Waterloo - School of Accounting and Finance

Corinna Ewelt-Knauer

University of Muenster

Date Written: May 2, 2013

Abstract

Since the late 1980s, the Financial Accounting Standards Board has implemented several new fair value accounting rules that have resulted in unrealized fair value gains or losses in net income. However, accrual-based earnings management models such as the Modified Jones Model (MJM) of Dechow, Sloan, and Sweeney (1995) and other accrual models in the literature do not consider the net income effects of fair value accounting. The fair value hierarchy of Statement of Financial Accounting Standard No. 157 implies that valuation of level 1 and level 2 instruments is subject to observable market inputs, whereas the valuation inputs of level 3 are unobservable. Therefore, with respect to earnings management, level 3 instruments are more likely to be manipulated relative to level 1 and level 2 instruments. In this paper, we adjust the MJM by adding level 1 and level 2 instruments as explanatory variables to nondiscretionary accruals; we classify net income effects of level 3 instruments as discretionary accruals in our Fair Value Adjusted Modified Jones Model (FVAMJM). We show that the FVAMJM is more powerful than the MJM in detecting earnings manipulation based on level 3 instruments and is equally good in detecting expense and revenue manipulations. In addition, the nondiscretionary accruals derived under FVAMJM have incremental explanatory power to firm market value beyond the accruals of the traditional MJM; the discretionary accruals derived under FVAMJM contribute to identifying companies meeting or beating earnings targets after controlling for MJM discretionary accruals.

Keywords: Earnings management, Fair value accounting, Modified Jones Model, Fair Value Adjusted Modified Jones Model

JEL Classification: M40, M41

Suggested Citation

Chen, Changling and Ewelt-Knauer, Corinna, Earnings Management in the Context of Fair Value Accounting: Adjusting the Modified Jones Model to Fair Value Accounting (May 2, 2013). Available at SSRN: https://ssrn.com/abstract=2214777 or http://dx.doi.org/10.2139/ssrn.2214777

Changling Chen

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

Corinna Ewelt-Knauer (Contact Author)

University of Muenster ( email )

Schlossplatz 2
Muenster, D-48149
Germany

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