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14 views5 pages

Da 2

Uploaded by

mkhattakfocused
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DISCRETIONARY ACCRUALS

MODEL
Professor Brian Bushee

WHARTON ONLINE
Discretionary accruals

• Net Income = Cash Earnings + Non-cash Earnings


– Cash Flow from Operations is a measure of Cash Earnings
– Non-cash Earnings are “Accruals”
• e.g., sales made on account, depreciation expense, warranty expense
• In general, accruals improve the measurement of firm performance by tying
earnings to business activities, rather than to cash flows
• But, accruals are also the easiest portion of earnings to manipulate
because they are based on managerial judgment and estimates
• Revenue and expense ratios only detect big manipulations to those
accounts
– May also be easier for outsiders to detect
• What if managers make small manipulations to multiple accounts?
– Discretionary accruals models are designed to detect this

WHARTON ONLINE
Modified Jones Model of Discretionary Accruals

• Accruals should be a function of revenue growth and tangible assets


– Revenue growth -> growth in working capital -> increase in non-cash earnings
– High PP&E -> higher depreciation in non-cash earnings
• Accruals =  + *(Cash Revenue Growth)+ *PP&E + 
– Accruals = Net Income – Cash from Operations
– Cash revenue growth = Change in Revenue – Change in Accounts Receivable
– PP&E = Gross Property, Plant, and Equipment
• Accruals that fit this model are “normal accruals” that are explained by
normal business activities
• Accruals that do not fit this model are “discretionary accruals” and are
more likely to reflect earnings management
– Caveat: changes in the business, changes in the industry, or bad model fit could
also create “discretionary” accruals

WHARTON ONLINE
Estimation Approach

• Accruals =  + *(Cash Revenue Growth)+ *PP&E + 


– Scale all variables by prior total assets
• Removes a firm size effect
• Estimate a regression to get estimated parameters a, b, and c
– Time-series: use past history for company
• Cons: can’t do for younger firms, parameters change over time
– Cross-sectional: use industry at a point in time
• Cons: sensitive to definition of industry
– Assumes no manipulation on average in estimation sample
• Normal Accruals = a + b*(Cash Revenue Growth) + c*PPE
– Where a, b, and c are estimated regression coefficients
• Discretionary Accruals = Accruals – Normal Accruals

WHARTON ONLINE
WHARTON ONLINE

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