Discretionary Accruals: Earnings Management ... or Not?

This paper discusses some limitations of discretionary accruals measures. While discretionary accruals are acknowledged to be noisy proxies for earnings management, they are still widely used in the literature. This paper attempts to explain from basic econometrics how discretionary accruals are estimated, and in doing so why they are inappropriate measures for earnings management. It is shown that decisions of peer firms will influence the regression coefficients, and hence residuals, in accruals models, which may lead to false conclusions about earnings management in other firms. This point is emphasized using an artificially constructed firm with no changes in its fundamental performance, and hence no discretion in its accruals. I also note concerns about the inferences, which are commonly not acknowledged in research. Finally, using Accounting and Auditing Enforcement Releases and Enron as examples, I demonstrate how discretionary accruals do not capture what literature often claims.