Modelling the accruals process and assessing unexpected accruals*

“Earnings management occurs when managers use judgment in financial reporting and in
structuring transactions to alter financial reports to either mislead some stakeholders about the
underlying economic performance of the company, or to influence contractual outcomes that
depend on reported accounting numbers”
One of the keywords in their definition of earnings management is “alter financial reports to
mislead stakeholders”. Real activities or real earnings management involves the management of
real activities and it clearly does not alter financial reports. Second, Statement of Financial
Accounting Concepts No. 1 indicates that one of the main objectives of financial reporting is to
provide information about enterprise resources, claims to those resources, and changes in them.
If there are changes in real activities, financial reports and accounting figures are supposed to
reflect these changes. Hence, it is the role of financial reporting to reflect firms‟ underlying
fundamentals. The choice of transactions that determine such fundamentals is another issue
entirely.
3.3.2 Modelling earnings management
Since accruals are temporary adjustments, the initiation of an accrual item (normal and abnormal)
must be reversed at some stage. This implies that aggregated accruals over a firm‟s life-span (LP)
are zero and
LP LP
ti CNI CASH tiDti (6)
i0 i0
Aggregated accrued income is the same as aggregated cash income, which is in turn equal to
cash flow from non-equity sources ( titi 18
CASH D ). This relation is consistent with Statement
of Financial Accounting Concepts, No. 1, paragraph 46 and it applies to income reported with