Modelling the accruals process and assessing unexpected accruals*

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and where t a t d t m u, t PM t m t dm t d t dd u, t1 PM 1 t m u, t t m t dm t gm u, t1 , 2, t TWC TWC TWC 3, t TWC TWC TWC TWC , 4, t NCO 5, t NCO NCO NCO u, t1 REV u, t REV 3, , 3, 4, , 4, 5, , 5, t, j 0, t, j 0, t 1, t, j 1, t j 2, t, j 2, t j REV NCO NCO u, t 1 u, t 1 u, t t j t j t j t j t j t j ut , ut , PM represents the underlying pre-depreciation profit margin, represents the economic depreciation rate, and the j subscript represents individual observation. The parameters without the j subscript ( 0,t to 5,t ) are the regression parameters, while the parameters with the j subscript ( 0, t, j to 5, t, j (12) ) are the parameters of the individual observation. If this model is estimated using time-series observations of the same firm, then the estimated parameters will reflect the time-series averaged parameters. On the other hand, if this model is estimated using cross-sectional observations for a given year, then the estimated parameters will reflect the cross- sectional averaged parameters. 16 The implications of my analysis apply to both types of models, and I will refer to both of these time-series observations and cross-sectional observations as „benchmark firms‟. The encompassing model‟s disturbance term in expression (12) for a particular firm, firm j, is often referred to as the firm j‟s unexpected accruals. It is entirely attributed to the heterogeneity in the parameters (i.e., the deviation of firm j parameters from parameters of benchmark firms). This heterogeneity is shown to be due to deviations in accounting and operating policies between 16 The accruals model in Jones (1991) is originally applied in a time-series fashion. However, the cross-sectional estimation accruals model seems to be common (in Kothari, Leone, Wasley 2004 for instance). This is probably due to the superiority of the cross-section model over the time-series model (see Bartov, Gui, and Tsui 2000). 24
firm j and the benchmark firms. These accounting policies include accounting for working capital accruals ( m and dm ) and accounting for depreciation expense ( m , t NCO t TWC t TWC gm ). Alternatively, these operating policies include accrual policy ( a and ut , 1 policy ( d and dd ), and policies that drive profit margin ( PM , t TWC t TWC ut , ut , 1 economic depreciation rate ( and ). t TWC t NCO t dmNCO 25 and t da TWC ), deferral ut , PM , and ut , 1 PM ), Since the heterogeneity in the parameters of the encompassing model is due to both the normal accruals parameters and abnormal accruals parameters, one can express the disturbance term as AbACC AbACC NACC NACC (13) t, j j j where NACC ( AbACC j ) represents the normal (abnormal) accruals based on observation j specific parameters and NACC ( AbACC ) represents the normal (abnormal) accruals based on the regression parameters. For the unexpected accruals to fully capture abnormal accruals (i.e., AbACC ), there are two conditions which the encompassing model has to satisfy. The t, j j first condition is that the income of the benchmark firm is neutral (i.e., AbACC 0 ) and the second condition is that there is no deviation in operating policies between firm j and the benchmark firms (i.e. NACC NACC 0 ). Otherwise, the firm j‟s unexpected accruals j extracted from the encompassing model will be biased by one or both of these two factors as shown in Table 4. 17 17 If one holds the view that earnings management includes real activities or real earnings management (Roychowdhury 2006), the deviation in underlying operating policies can be seen as capturing real activities management. Moreover, my analysis shows that one cannot really disentangle the effect of earnings management via accruals and earnings management via real activities because they are both captured by unexpected accruals in the encompassing model. However, as argued in section 3.3.1, this paper holds the view that real activities management
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 and 16: period of income recognition and ca
Page 17 and 18: expenses or receive less revenue in
Page 19 and 20: any accounting distortions (conserv
Page 21 and 22: this paper). Combining the normal a
Page 23: 4 Assessing unexpected accruals mea
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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