Entropy-Balanced Discretionary Accruals

69 Pages Posted: 29 Jan 2015 Last revised: 5 Mar 2018

See all articles by Jeff L. McMullin

Jeff L. McMullin

Indiana University - Kelley School of Business - Department of Accounting

Bryce Schonberger

University of Rochester - Simon Business School

Date Written: Feb 27, 2018

Abstract

To estimate discretionary accruals, we employ a recently developed multivariate matching approach (entropy balancing) to adjust for underlying accrual determinants at the sample-level instead of relying on a first-stage linear determinants model. Entropy balancing identifies weights for each control sample observation to equalize the mean, variance, and skewness of underlying determinants across treatment and control samples. Addressing covariate imbalance using either propensity score matching (PSM) or entropy balancing significantly improves discretionary accrual model specification in samples of extreme financial performance. However, we find that entropy balancing enhances test power over PSM in simulations with seeded accrual management. To empirically validate these improvements, we examine the accruals of firms issuing new equity as a setting in which differences in growth and financial constraint across treated and control samples are particularly egregious. In contrast to existing discretionary accrual measures, we find that combining entropy-balanced discretionary accruals with tests for accrual reversals results in an inference of insignificant (significant upward) accrual earnings management in the year of an initial public (seasoned equity) offering, consistent with the stringent reporting requirements and investor scrutiny of initial public offerings limiting earnings management.

Keywords: discretionary accruals; entropy balancing; propensity score matching; covariate balance; initial public offerings; seasoned equity offerings

JEL Classification: M04

Suggested Citation

McMullin, Jeff L. and Schonberger, Bryce, Entropy-Balanced Discretionary Accruals (Feb 27, 2018). Kelley School of Business Research Paper No. 15-31; Simon Business School Working Paper No. FR 15-01. Available at SSRN: https://ssrn.com/abstract=2556389 or http://dx.doi.org/10.2139/ssrn.2556389

Jeff L. McMullin (Contact Author)

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States

Bryce Schonberger

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

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