Modeling Discretionary Accrual Reversal and the Balance Sheet as an Earnings Management Constraint

Abstract

This study presents conceptual and empirical analyses of discretionary accrual reversal in the earnings management context. We specifically focus on the extent that income-increasing (decreasing) discretionary accruals initiated in a prior period reverse to become income-decreasing (increasing) accruals in the current period. The analysis suggests that the extent that such reversals constrain the ability to manage toward earnings objectives depends on both the magnitude of past accrual-based earnings management and the reversal speed of past discretionary accruals. To demonstrate the empirical implications of the analysis, we consider discretionary accrual reversal speed as an additional determinant of the balance sheet constraint on earnings management (Barton and Simko 2002). We show that, conditional on the magnitude of net operating asset overstatement, the probability of achieving quarterly earnings forecasts varies inversely with reversal speed.

The Debt-Contracting Value of Accounting Numbers, Renegotiation, and Investment Efficiency

“…Li (2010Li ( , 2011 closely examines the same agreements sample as I use in this study and finds that the most frequently excluded terms in net income are extraordinary items (23%), and that the most frequently excluded accrual items are long-term accruals (80% in the interest coverage sample, 89% in the fixed charge coverage sample, and 96% in the debtto-earnings sample). Therefore, I use earnings before extraordinary items, depreciation, and amortization in the regression.…”

“…Generally, the prior literature claims that a higher quality of accounting numbers mitigates moral hazard and adverse selection problems, thus enhancing investment efficiency (Kanodia and Lee 1998;Bens and Monahan 2004;Biddle and Hilary 2006;Hope and Thomas 2008;McNichols and Stubben 2008;Biddle 6 See Barton and Simko (2002) and Baber et al (2011) for situations where earnings management is very costly. et al 2009;Beatty et al 2010a;Chen et al 2011b).…”

Earnings Distribution Discontinuity from a Continuous Model of Earnings Management

“…Repeating the model for multiple periods does not give a truly dynamic model. In a dynamic model, care must be taken to consider the accumulation of past earnings manipulations in the total assets (see, e.g., Barton &Simko 2002 andBaber et al 2011), which might enhance the auditor's incentive to require an adjustment in the future. Owing to the limited space here, the analysis of a truly dynamic version of the model is left for future research.…”

Business cycles and earnings management.

“…The study by Baber, Kang, and Li (2011) to as 'net' discretionary accruals, and Baber et al, (2011) propose that these are the true indicators for determining companies' levels of earnings management.…”

“…An opportunity for future research would be a study of economic cycles and discretionary accruals among firms using the 'reversals' development in discretionary accruals by Baber et al, 2011 andDechow et al, 2012. 51…”