Modelling the accruals process and assessing unexpected accruals*

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If cash flow recognition in income is accelerated and/or delayed, the resulting proportions will change from their underlying proportions. For instance, if more accrued income (i.e., the difference between accrued revenue and accrued expenses) is initiated than the underlying accrued income, the proportion of the initiated accrued component embedded in income will be t different from the underlying proportion (if at 1 is not equal to one). Hence, these four parameters can be seen as indirectly capturing the timing-recognition of accrued and deferred components. Expression (5) indicates that normal accruals consist of accrued (in the first line) and deferred components (in the second line). In particular, the accrued component is shown to be a function of growth in income and changes in accrual policy. It will be higher if there is more growth in income, holding the accrual policy constant. Even if there is no growth in income, firms can end up with more accrued component of accruals if there is a change in accrual policy to grant more credit sales to debtors or to decrease the proportion of outstanding expenses. 9 If income and the accrual policy are both constant, the accrued component of accruals will be zero as the reversed and initiated components will offset one another. In contrast, the deferred component of accruals is driven by forward income growth and changes in the deferral policy. Holding deferral policy constant, higher forward income growth will lead to a higher deferred component of accruals. When income growth is zero, firms can end up with more deferred component of accruals if there is a change in deferral policy to pre-pay more 9 Provided that the parameter a is positive, i.e. accrued revenue is greater than accrued expenses. 16
expenses or receive less revenue in advance. 10 If there is no growth in underlying income and no change in deferral policy, the deferred component will be zero, as its reversed component will offset the initiated component. In short, normal accruals, as the sum of accrued and deferred components, are driven by growth in income and changes in accrual and deferral policies. 3.3 Modelling abnormal accruals 3.3.1 Definition of abnormal accruals Abnormal accruals are the reported accruals that deviate from underlying accruals or accruals under a neutral accounting policy. They are accruals that distort the neutral accrual process, and they can be attributed to both intentional and/or unintentional measurement errors. Intentional measurement errors are also referred to as managerial discretion (i.e., managers use their discretion to intentionally impose errors in their accrual estimates by adopting certain accounting choices.) Since the intention of management is unobservable (Dechow and Dichev 2002), any attempts to separate intentional and unintentional measurement errors are likely to be superficial. As a result, this paper treats all measurement errors as undesirable and attributes them to earnings management. 11 While some argue that earnings can also be managed through real activities (Roychowdhury 2006), this paper assumes that the accruals attributed to real activities management do not constitute earnings management as long as they represent underlying fundamentals. Healy and Whalen (1999) define earnings management as follows: 10 Provided that the parameter d is negative, i.e. deferred revenue is less than deferred expenses. 11 While intentional and unintentional measurement errors have different contracting implications, the separation of the two is irrelevant when it comes to modeling the behavior of abnormal accruals, see Lai (2009). Also, whether intentional measurement errors or managerial discretion are efficient or opportunistic (see Watts and Zimmerman 1986) is not the focus of this paper which merely focuses on the identification of earnings management. 17
Page 1 and 2: Modelling the accruals process and
Page 3 and 4: insights into what unexpected accru
Page 5 and 6: attributed to the firm‟s biased a
Page 7 and 8: 2 Direct and indirect method to cal
Page 9 and 10: flow associated with income recogni
Page 11 and 12: change in net financial obligations
Page 13 and 14: t t TACC CNICFt T t t t titti CNI
Page 15: period of income recognition and ca
Page 19 and 20: any accounting distortions (conserv
Page 21 and 22: this paper). Combining the normal a
Page 23 and 24: 4 Assessing unexpected accruals mea
Page 25 and 26: firm j and the benchmark firms. The
Page 27 and 28: If there is no deviation in operati
Page 29 and 30: accruals is highly positive (negati
Page 31 and 32: These restrictions respectively imp
Page 33 and 34: The second source of contamination
Page 35 and 36: Even if the use of changes in cash
Page 37 and 38: The item m m CNI , 1 a a CNI
Page 39 and 40: Hence, to manage earnings downward
Page 41 and 42: 6 Conclusion My analysis reveals th
Page 43 and 44: References Ball, R., Shivakumar, L.
Page 45 and 46: Appendix 1: Derivation of Normal Ac
Page 47 and 48: accrued (initiated deferred) propor
Page 49 and 50: The portion of underlying income in
Page 51 and 52: Hence, the correlation between norm
Page 53 and 54: Table 2: Summary of Accruals Compon
Page 55 and 56: Table 4: Summary of the Bias in Une

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