How Test Power Impacts Research Relevance: The Case of Earnings Management Research

47 Pages Posted: 8 Aug 2017

See all articles by Zhuoan Feng

Zhuoan Feng

The University of Waikato

Yaowen Shan

University of Technology Sydney; Financial Research Network (FIRN)

Stephen L. Taylor

University of Technology Sydney; Financial Research Network (FIRN)

Date Written: August 8, 2017

Abstract

We argue that the broader applicability of accounting research is often limited by the way accounting researchers typically place far greater weight on the relative cost of type I versus type II errors. To illustrate the extent of this problem, we examine the performance of simple financial ratio-type analysis for detecting earnings overstatements when the total misclassification costs are minimized subject to the relative cost of type I versus type II errors. We then contrast the likelihood of type I versus type II errors from this approach with those arising from several widely used measures of unexpected accruals. The results demonstrate how commonly-used unexpected accruals measures reduce the type I error rate by sacrificing the type II error rate. Given that accounting information users and auditors typically face much higher costs of type II errors, we explicitly identify why unexpected accruals models are likely far less useful in detecting earnings overstatements than a relatively simple approach using financial statement analysis red flags. Our results highlight the fundamentally contrasting incentives facing accounting researchers relative to those who might otherwise use the research in practice, and serve as a warning when the broader relevance of accounting research is increasingly under question.

Keywords: Research Relevance, Earnings Management, Test Power, Unexpected Accruals

JEL Classification: M41

Suggested Citation

Feng, Zhuoan and Shan, Yaowen and Taylor, Stephen L., How Test Power Impacts Research Relevance: The Case of Earnings Management Research (August 8, 2017). Available at SSRN: https://ssrn.com/abstract=3015043 or http://dx.doi.org/10.2139/ssrn.3015043

Zhuoan Feng

The University of Waikato ( email )

Hillcreset
Hamilton, Waikato 3216
New Zealand

Yaowen Shan

University of Technology Sydney ( email )

PO Box 123
Broadway, NSW 2007
Australia

HOME PAGE: http://profiles.uts.edu.au/Yaowen.Shan

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Stephen L. Taylor (Contact Author)

University of Technology Sydney ( email )

UTS Business School
PO Box 123 Broadway
Sydney, NSW 2007
Australia
61295143437 (Phone)
61295143513 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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