The Effects of Firm Growth and Model Specification Choices on Tests of Earnings Management in Quarterly Settings

Abstract

Commonly used Jones-type discretionary accrual models applied in quarterly settings do not adequately control for nondiscretionary accruals that naturally occur due to firm growth. We show that the relation between quarterly accruals and backward-looking sales growth (measured over a rolling four-quarter window) and forward-looking firm growth (market-to-book ratio) is non-linear. Failure to control for the effects of firm growth and performance on innate accruals leads to excessive Type I error rates in tests of earnings management. We propose simple refinements to Jones-type models that deal with non-linear growth and performance effects and show that the expanded models are well-specified and exhibit high power in quarterly settings where one is testing for earnings management. The expanded models are able to identify the presence of earnings management in a sample of restatement firms. Our findings have important implications for the use of discretionary accrual models in earnings management research. JEL Classifications: C15; M40; M41.

Return predictability: The dual signaling hypothesis of stock splits

“…We also test the sensitivity of our results to alternative RAM mechanisms such as cutting discretionary expenses. Our results do not change when we use growth and performance‐adjusted discretionary accruals (Collins, Pungaliya, & Vijh, ). Last, our results are robust for value and glamour stocks, and for subgroups of firms with different splitting factors (splits with a 2:1 factor vs. other splits).…”

“…We argue that differentiating between these groups of splits cannot be performed solely by observing pre‐split discretionary accruals, which could be growth triggered (Collins et al., ) and/or associated with managerial optimism (Louis & Robinson, ). The use of RAM to complement accruals management might provide a differentiating factor between the abovementioned groups of stock splits.…”

Achieving Revenue Benchmarks Conditional on Growth Properties

“…In order to establish consistency over the analysis, we show the test results using both versions of the growth proxy. In order to rule out potential alternative explanations-e.g., a possible mechanical relation between the probability of meeting or beating analyst revenue forecasts and revenue manipulation of growth firms-using the Collins et al [8] model we rerun Equation (9). Untabulated results show no difference in statistical implication (we are indebted to one reviewer's insightful suggestion to rule out this alternative explanation using the Collins et al model).…”

“…First, after dividing the final full sample into three groups (high, medium, or low) based on the book-to-market ratio, the GROWTH variable equals 1 if a firm is included in the medium or low growth rate groups, and 0 if it is included in the high growth rate group (cf. Collins et al [8]). Second, we simply use the book-to-market ratio.…”

“…Using a book-to-market ratio as a growth proxy, we find that growth firms are more likely to meet or beat analyst revenue expectations versus value firms (cf. Collins et al [8]). …”