Inference‐in‐residuals as an Estimation Method for Earnings Management

Abstract

The paper tests the assumptions underlying the inference-in-residuals method as an estimation framework for detecting and classifying suspects of earnings management. We derive several systematic biases that are shown to confound inference-in-residuals and, depending on the data, could render the method a futile exercise. This is not a matter of model specification, but a limitation of the statistical method. Also, it is shown that the method of using estimated residuals in a second stage regression on economic determinants of earnings management suffers considerably, especially when residuals are estimated by industry classification in the first stage.

Research Design Issues in Studies Using Discretionary Accruals

“…() and Christodoulou et al . (). While it is not clear that these research design choices, individually or in aggregate, would change the inferences of Capalbo et al .…”

“…The ability to make strong inferences about earnings management in a single firm based on discretionary accruals is another challenge, which Christodoulou et al . () examine. Given the noise in discretionary accrual estimates, they are more likely to be useful in capturing the average extent of earnings management among a portfolio of firms rather than the exact amount of earnings management in any one particular firm.…”

“…Christodoulou et al . () derive propositions concerning measurement error in discretionary accrual proxies analytically. Their paper considers the case of ‘inference in residuals’, attempting to classify specific cases of earnings management for specific residuals.…”

“…In doing so, we first discuss the concerns about aggregate accrual models raised by Jackson () and Christodoulou et al . (), along with concerns raised in prior research. Next, we explore and discuss the advantages and disadvantages of alternatives to aggregate accrual models, including the models of receivables and deferred revenues presented by Zha Giedt ().…”

Equity Financial Assets: A Tool for Earnings Management—A Case Study of a Chinese Corporation

“…2) on earnings management, which features papers by Jones (), Jackson (), Christodoulou et al . (), Zha Geidt (2018), Capalbo et al . (), and McNichols and Stubben ().…”