Modelling the accruals process and assessing unexpected accruals*

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eceivables to offset the positive normal accounts receivables. As normal receivables increase, more negative abnormal receivables are needed to offset this increase.) This inherent correlation violates the zero conditional assumption imposed by ordinary least squares (OLS) that the expected component is orthogonal to the disturbance term. As a result, the regression approach to extract abnormal accruals as the disturbance term is likely to be problematic. If accruals models are ill-specified, the omitted relevant variables will be captured by the disturbance term; and they are likely to further contaminate the resulting unexpected accruals. This is especially the case for the Jones model, which omits lagged revenue and next period‟s change in revenue from its explanatory variables that are intended to capture normal accruals. In addition to normal changes in underlying performance (as discovered in Dechow et al 1995), my paper shows that two other factors (or determinants) are likely to contaminate Jones-type measures of unexpected accruals. These are normal changes in accrual policy and normal deferred accruals. The modified-Jones model suffers from similar problems to the Jones model. Finally, since conditional conservatism is an accounting distortion, its incorporation into the Ball-Shivakumar model tends to further contaminate the measure of unexpected accruals by attributing abnormal accruals from conditional conservatism as expected accruals. The remainder of the paper continues as follows. Section 2 defines accruals and reconciles direct and indirect methods to calculate accruals. Section 3 explores the accrual process and models normal and abnormal accruals. Section 4 assesses determinants of the bias in unexpected in capturing abnormal accruals. Section 5 demonstrates the correlation between normal and abnormal accruals, while section 6 concludes. 6
2 Direct and indirect method to calculate accruals 2.1 Accounting identity To calculate comprehensive accruals and their decomposition, I first specify the stock and flows clean-surplus relations (or accounting identity) for total working capital assets, non-current operating assets, and financial liabilities. I start by modifying the basic accounting identity Asset t =Liability t +Equity t to reflect operating and financing activities as (the firm j subscript is omitted from the modeling process in this paper till section 4) CASH NOA NFO CSE t t t t (1) where CASH t is cash on hand, NOA is non-cash net operating assets that consists of total working capital assets (TWC) which arise from day-to-day operating activities and non-current operating assets (NCO) which arise as a result of capital expenditures, NFO is non-cash net financial obligations or liabilities, and CSE is common shareholders equity. The clean surplus relations or identities of these items are summarized in Table 1. These specifications are similar to those in Feltham and Ohlson (1995) and Penman (2009), who separate firms‟ activities into operating and financing. However, this paper further separates operating activities into short-term operating activities that affect day-to-day working capital and long-term operating activities that affect capital investment decisions. [Table 1 about here] 7
Page 1 and 2: Modelling the accruals process and
Page 3 and 4: insights into what unexpected accru
Page 5: attributed to the firm‟s biased a
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 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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