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Review of Quantitative Finance and Accounting

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01-01-2014 | Original Research

Dissecting and connecting the growth and accounting distortion components of accruals

Author: Donglin Li

Published in: Review of Quantitative Finance and Accounting | Issue 1/2014

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Abstract

This study refines the accrual decomposition approach in Richardson et al. (Account Rev 81:713–743, 2006) and introduces a growth measure that is free from accounting distortions. My evidence indicates that the lower persistence of accruals extends to accruals that are unrelated to accounting distortions. I, however, find that the growth and accounting distortion components of accruals are not isolated. Growth may provide a context where firms have more incentives to manipulate earnings. I provide evidence that the persistence of both the growth and accounting distortion components of accruals is affected by firm growth and agency cost factors, such as free cash flows, leverage, and overvalued equity. I also document high accounting distortions for relatively high-growth firms that are close to reporting positive earnings, and negative accounting distortions for relatively low-growth firms that are far from the potential to report positive earnings.

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Note that firm overinvestment could be nested within the broad concept of diminishing marginal returns to increased investment.

I also introduce a transformation of the two components that obviates the need for an interaction term.

Christie and Zimmerman (1994) suggest that non-value-maximizing managers may mask non-optimal investment opportunities with accounting manipulations.

This is different from early studies on earning management that hypothesize that firms whose earnings fall in intervals immediately below zero had distorted earnings downward or did not manipulate earnings. I posit that these firms had incentives to distort earnings upward, but in the end, failed to reach the goal of reporting positive earnings. There is a boundary to earnings discretion. Burgstahler and Dichev (1997) document that the levels of other accruals are unusually high for firms with earnings immediately below zero. Their evidence is consistent with my explanation. I explore the depth of earnings management around zero earnings in a separate study.

In fact, RSST report in their test of SEC enforcement actions that the growth component has a more significant coefficient.

My conclusion is in the spirit of Beneish et al. (2012), who find that firm predisposition to earnings management is an important red flag for detecting earnings management. Gu et al. (2005) find that managers’ accounting discretion is related to growth.

Shin and Stulz (1996) use growth in sales as a proxy for growth opportunity. Skinner (1993) applies PPE/firm value to proxy for investment opportunity. Thus, it is possible that discretionary accruals actually capture discretionary investment. In addition, growth in inventory, the most important component of accruals responsible for the accrual anomaly, is also a measure of investment (Kashyap et al. 1994).

FWY also propose another possible explanation of biases in conservative accounting that tends to dampen profitability in early years but boosts firm profitability in the more distant future. I address this concern by applying a distributed lag model on the relationship between accruals and firm profitability in future years. I do not find any positive effects of accruals on long-term profitability. This is consistent with conclusions in RSST. For exposition simplicity, results are not reported.

I require the deflator to be positive. My empirical results are robust if I deflate by end-of-year NOA, average NOA, or average total assets.

The proof of the equation is straightforward following the proof in RSST.

For details, see the empirical results in Sect. 4.

Applying the free cash flow measure in the finance literature generates results in the direction of my predictions with stronger significance.

I require non-missing Compustat data items che, act, lct, at, sale, and lt in both the current and previous years and the data item oiadp in the current year in order to keep a firm-year observation in the sample. If data items dltt, ivao, or dlc are missing, I set them to zero rather than eliminating the observation. These data items represent balance sheet items that may not be relevant for some firms, so I set them to zero rather than needlessly discarding observations.

Inferences regarding the persistence of various components of accruals are qualitatively similar if I instead use bottom-line net income.

Unreported tests indicate that the coefficient on −ΔAT is significantly more negative than the coefficient on SG at the 0.01 level.

The sales growth and efficiency measures potentially contain measurement errors for firms engaging in a merger or acquisition during the sample year. As a robustness check, I eliminate all observations with an increase in goodwill from the previous year and reestimate the regressions. The results are qualitatively similar.

A 2-year lag is imposed to avoid a potential effect on the denominator of RNOA.

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Title: Dissecting and connecting the growth and accounting distortion components of accruals
Author: Donglin Li
Publication date: 01-01-2014
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 1/2014
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-012-0323-y

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