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Edward Owens

Joanna Shuang Wu

Jerold Zimmerman

April 2016

Abstract

Economics challenge the specification of discretionary accrual models. Because rent-seeking

firms pursue differentiated business strategies, firms in the same industry experience

idiosyncratic shocks due to heterogeneous economic fundamentals and hence have different

accrual generating processes. We present evidence that idiosyncratic shocks are widespread,

propagate through multiple years of financial statements, and reduce accrual models goodness

of fit. This not only affects abnormal accrual estimates for the firm experiencing shocks, but also

affects measurement of abnormal accruals for other firms in the industry. We show that

idiosyncratic shocks not only adds noise to abnormal accruals, but can also exacerbate bias in

both unsigned and signed abnormal accruals. We propose ways to reduce accrual model

misspecification.

JEL Classification: G30, M41

We gratefully acknowledge the financial support provided by the Simon School at the University of

Rochester and the comments from Amy Hutton (editor), two referees, Dan Amiram, Dan Collins, Mark

Evans, Wayne Guay, Shane Heitzman, Jaewoo Kim, Mark Nelson, Robert Resutek, Robert Swieringa,

Jerry Warner, Charles Wasley, Paul Zarowin and seminar participants at the University of Chicago,

Columbia University, Cornell University, Dartmouth University, Kansas University, University of

Minnesota, NYU, University of Notre Dame, University of Rochester, University of Southern California,

MIT Asia Conference in Accounting, and Penn State Accounting Research Conference and Nordic

Accounting Conference.

Idiosyncratic Shocks to Firm Underlying Economics and Abnormal Accruals

Abstract

Economics challenge the specification of discretionary accrual models. Since rent-seeking firms

pursue differentiated business strategies, firms in the same industry experience idiosyncratic

shocks due to heterogeneous economic fundamentals and hence have different accrual generating

processes. We present evidence that idiosyncratic shocks are widespread, propagate through

multiple years of financial statements, and reduce accrual models goodness of fit. This not only

affects abnormal accrual estimates for the firm experiencing shocks, but also affects

measurement of abnormal accruals for other firms in the industry. We show that idiosyncratic

shocks not only adds noise to abnormal accruals, but can also exacerbate bias in both unsigned

and signed abnormal accruals. We propose ways to reduce accrual model misspecification.

I. INTRODUCTION

Since Healy (1985), the accounting literature has pursued an accruals-based measure of

accounting discretion. Despite significant effort seeking better specified accrual models, many

discretionary accruals, power, and bias remain (e.g., Dechow, Ge, and Schrand 2010).1 Several

authors encourage research to develop improved discretionary accrual models (e.g., Kaplan

1985; Holthausen, Larcker, and Sloan 1995; Guay, Kothari, and Watts 1996; Healy 1996;

Dechow et al. 2010). We offer more texture and economic intuition regarding the challenges

argue that economics challenge the fundamental assumptions underlying normal (non-

discretionary) accruals.2

One appeal of accrual models is their general applicability to large samples because

summary performance measures such as changes in sales or operating cash flows usually are

available. However, such generality comes at a price. Missing from accrual models are the

underlying economic circumstances that give rise to firm performance. These circumstances

often vary widely across firms and over time, resulting in different levels of expected accruals

that the accrual models, by construction, do not capture. For example, two firms may experience

similar increases in sales, but for one it may be due to higher customer demand, while for the

other it may be due to easier credit sales terms, resulting in different levels of accruals in the two

firms (below normal levels of inventory and higher accounts receivables, respectively). Or,

consider Amazon.com. Amazon started with few accounts receivables because customers paid

1

Also see Bernard and Skinner (1996), Dechow, Sloan, and Sweeney (1995), Subramanyam (1996), Guay et al.

(1996), Ball and Shivakumar (2008), Dechow, Hutton, Kim, and Sloan (2012), and Dichev, Graham, Harvey, and

Rajgopal (2013).

2

We rely on research from industrial organization, finance, and strategy. For parsimony, we refer to these literatures

broadly as economics.

1

with third-party credit cards, which amount to cash sales to Amazon. As it introduced its own

credit card and began selling services to other merchants, Amazons receivables increased,

affecting its operating cycle. Then, as Amazon entered the hardware business (Kindle devices),

inventory turnover slowed, impacting its operating cycle. Amazons working capital accruals

adjust to changes in the firms underlying business strategies, which a single summary

assumptions: firm stationarity (i.e., firms have reasonably stable accrual generating processes)

and intra-industry homogeneity (i.e., industry peers have similar accrual generating processes).3

Figure 1 illustrates two firms, Firms A and B, out of N firms in the same industry. Estimating a

cross-sectional accrual model for this industry assumes these two firms (and the other N-2 firms)

have similar accrual generating processes (i.e., intra-industry homogeneity exists). Firms A and

B each choose a strategy it believes maximizes its value given the economic environment.

Implementing these strategies (or business models) leads each firm to make investment and

financing decisions resulting in specific assets and liabilities structures. These actual assets and

liabilities then produce an operating cycle and accruals generating process for each firm. The

intra-industry homogeneity assumption presumes that firms A and B will choose similar

strategies in response to the common economic environment (or to changes in that environment).

However, a key economic principle dictates that a value maximizing manager seeks rents by

developing a unique, sustainable market niche that differentiates her business strategy from other

[ INSERT FIGURE 1 ]

3

Dopuch, Mashruwala, Seethamraju, and Zach (2011) conclude that substantial heterogeneity exists in accrual

generating processes in some industries and that this heterogeneity generates a large noise component in abnormal

accruals.

2

Although all firms in the industry face the same external environment, because they have

different business models, Firms A and B will react differently to technological innovations,

regulatory changes, and competition. In other words, Firms A and B will have different

idiosyncratic shocks to their business strategies, even though they face the same common shock.

For example, while all airlines are exposed to jet fuel price fluctuations, the same common shock

can affect airlines differently. Low cost airlines have different business models from hub-and-

spoke carriers causing airlines to adopt different fuel hedging strategies. Hereafter, we refer to

any such event that differentially alters a firm's underlying economics, whether own-firm-

frequent, are inconsistent with the firm stationarity assumption, and likewise decrease intra-

We examine the extent to which idiosyncratic shocks are associated with misspecification

of the accrual models and the residuals from these models, which often proxy for discretionary

accruals. To capture idiosyncratic shocks, and hence to operationalize the idea of heterogeneity

in firm underlying economics, we adopt Chun, Kim, Morck, and Yeungs (2008) measure of

firm-specific stock return heterogeneity. Specifically, Chun et al. (2008) regress each firms

monthly stock return on its monthly industry return and the monthly market index. They then

compute the standard deviation of the residuals from the regression. Firms with small standard

deviations have had few idiosyncratic shocks. These firms stock returns are mainly explained by

industry and market returns. As demonstrated by Chun et al. (2008), this measure captures the

forces of creative destruction. To validate that this measure captures idiosyncratic shocks, we

next identify firm-years with large acquisitions, four-digit SIC code changes, and large

restructuring charges or special items. Not surprisingly, the incidence of these firm-specific

3

events is statistically and economically associated with firm-specific heterogeneity. We also

show that the variability in firms cash operating cycles is positively correlated with

idiosyncratic shocks, which helps establish a causal link between the Chun et al. (2008)

heterogeneity measure and firms accruals generating processes. We conjecture that greater

heterogeneity in firm underlying economics (i.e., firms with large idiosyncratic shocks) is

we compute abnormal accruals using the Jones (1991) model via annual industry cross-sectional

estimation, along with modifications to the original Jones model suggested by Ball and

Shivakumar (2006) (hereafter referred to as the nonlinear model) and Kothari, Leone, and

Wasley (2005) (hereafter referred to as the performance model). Consistent with prior

literature, we find that for the median firm in our sample, the Jones model produces unsigned

discretionary accruals that are 67% of unsigned net income. Discretionary accruals of such

document that idiosyncratic shocks are positively correlated with large unsigned abnormal

accrual estimates from cross-sectional accrual model estimations. These results suggest that

unsigned abnormal accruals capture heterogeneity in firm underlying economics, and therefore

effect on a firms unsigned abnormal accruals from idiosyncratic shocks experienced by other

firms in the same industry year due to the effects of these shocks on the overall fit of the accrual

model.

conduct simulation tests. Our results suggest that when studying the relation between earnings

4

quality (proxied by unsigned abnormal accruals) and a partitioning variable, the null of no

relation between the two variables is over rejected even when modest correlation exists between

the partitioning variable and a firms idiosyncratic shock or the idiosyncratic shocks of other

firms in the same industry year. We find that including our proxy for the firms own

idiosyncratic shock in the second-stage regression reduces the over rejection, and additionally

including a proxy for shocks experienced by other firms in the industry year eliminates the over

rejection.

management using signed abnormal accruals. Our simulations show that idiosyncratic shocks

subsamples based on firm characteristics. 4 Simulation tests further show that including

observations with idiosyncratic shocks decreases the power to detect earnings management. We

later consider incorporating an instrument for idiosyncratic shocks in the accrual models but first

offer the following words of caution. Including shocks that occur in year t in estimating a cross-

sectional accrual model in year t only captures the average effect for all firms in the industry-

year t. Moreover, economic events may impact several years of operations as managers react by

modifying their extant strategies (e.g., Gerakos and Kovrijnykh 2013). Including an instrument

for idiosyncratic shocks likely fails to capture how the shock in year t affects accruals in years

t+n for all firms in the industry. For example, suppose a new technological innovation causes one

firm (either with a patent or complementary technology) to introduce a new product with a

different accrual generating process than its existing products (i.e., Amazon enters the e-reader

4

In our primary empirical specifications we estimate accrual models using total accruals, but our inferences remain

intact when using working capital accruals. Further, our results continue to hold when we exclude smaller firms (for

example, the bottom 10% of firms with market capitalization of less than $10 million, or the bottom 50% of firms

with market cap of less than $250 million, alternatively).

5

market with its Kindle). Unless the researcher can specify ex ante the evolution of this firms

accrual generating process, the time-series regression for this firms normal accruals fails to

correctly capture how the accrual generating process changes dynamically. Absent such

discretionary accruals.

With the above caveat in mind, we find that in all accrual models we consider, inclusion

of our proxy for the firms own idiosyncratic shock improves model performance, as reflected in

reduced over-rejection rates of the null of no earnings management while maintaining test power.

In other words, including controls for idiosyncratic shocks in the accrual models results in

improved Type I error rates without sacrificing Type II error performance. However, consistent

with idiosyncratic shocks having unpredictable directional effects on accruals, the addition of the

shock proxy to the accrual models does not fully resolve model misspecification arising from

underlying firm economic heterogeneity. Because idiosyncratic shocks tend to magnify any

existing bias, it is important to identify the source of the bias and correct the problem at its root.

Our paper makes several contributions. First, extant literature recognizes that normal

accruals and earnings quality depend on both fundamental performance and the accounting

system that measures that performance. Dechow et al. (2010, p. 345) conclude that we have

relatively little evidence about how fundamental performance affects earnings quality. Our

challenges facing accrual models due to the heterogeneity in firm underlying economics and how

this can affect measurement of abnormal accruals and those earnings quality proxies that rely on

reported earnings. We point out the econometric problems arising from the use of large-sample

first-stage accrual model regressions involving summary performance measures that leave un-

6

modeled the underlying economic events. Second, research offers several methods for improving

discretionary accrual models, such as using the cash flow statement to compute accruals (Collins

and Hribar 2002) and reducing other forms of model misspecification (e.g., Kothari et al. 2005;

Ball and Shivakumar 2006). Our analysis stresses the limitations of such attempts, in that they do

not adequately account for how idiosyncratic shocks drive the differences in accruals.

Finally, we offer suggestions for dealing with idiosyncratic shocks when using both

unsigned and signed abnormal accruals. We show that including both own-firm shocks and

shocks that relate to other firms in the second-stage regression can help mitigate biased

into the first-stage accrual models. However, such a control cannot fully resolve the underlying

misspecification problem because it does not capture the changing heterogeneity in economic

fundamentals or consistently predict the direction of accruals arising from idiosyncratic shocks.

A more complete solution for the misspecification requires modeling the changing firm

forces firms to modify their business strategies in response to entry and to adjustments in

business models by competitors (e.g., digital imaging destroying traditional photography). Chun

et al. (2008, p. 110) argue that information technology (IT) was one mechanism that induced

creative destruction across a wide swath of U.S. industries. New innovators, with

abnormally good performance, unpredictably and continually arose to dislodge

established firms, abnormally depressing their performance. This suggests intensified

7

creative destruction as a new explanation for the rising firm performance heterogeneity

among publicly traded firms in recent decades in the U.S.

Schumpeter (1942) himself writes (c)apitalism, then, is by nature a form or method of

economic change and not only never is but never can be stationary. Sutton (2007) argues that

business models are dynamic, and (i)t is also likely that even successful business models will at

some point need to be revamped, and possibly even abandoned (Teece 2010). Forces of creative

Porter (1979) describes various competitive forces that cause heterogeneous firm-specific

economics (e.g., threat of entry, bargaining power, and current contestants revising their

strategies). Changes in any of these competitive forces can generate shocks to firms extant

business strategies. Prahalad and Hamel (1990) argue that firms differentiate themselves by

developing and exploiting their unique core competencies. This literature predicts that firms

competing within the same product markets will exhibit heterogeneous firm economics, thereby

Several empirical regularities further challenge the validity of the firm stationarity and

industries in firm size, survival, entry and exit rates, and market structures (Berry and Reiss

2007; Schmalensee 1989; Srivastava 2014). As new markets develop, the number of firms tends

to rise and later falls and these trends vary widely across product markets (Sutton 2007). Further,

various operating characteristics of firms such as growth rates, idiosyncratic risk, and survival

rates of newly listed firms have changed over time (Comin and Mulani 2006; Fama and French

2004; Irvine and Pontiff 2009; Brown and Kapadia 2007). Fama and French (2004) report that

the ten-year survival rate for seasoned firms falls from 61% for the 1973 cohort to 47% for the

8

1991 cohort. Hence, firms do not appear very stationary, and firm stationarity has declined. This

decline in stationarity may lead to deterioration in the fit of the accrual models.5

Changes in the firms external environment affect its core competencies, asset base,

capital structure, operating cycle, accrual generating process, and accruals (see Figure 1). In fact,

Dichev et al. (2013) report that CFOs list their firms business model as being the most important

factor affecting their companys earnings quality. As a further illustration of the (lack of)

veracity of the firm stationarity and intra-industry homogeneity assumptions, Figure 2 plots the

annual operating cycles of seven major airlines (a relatively homogenous industry) over the

period 1990-2014. There is significant variation in operating cycles not only over time within a

single airline, but also in the industry cross-section. Specifically, the average pair-wise

correlation between any two airlines is only 0.22, and two of the fifteen pair-wise correlations

are negative.

[ INSERT FIGURE 2 ]

variant of the Jones (1991) model. While accrual models play an important role in earnings

management and earnings quality studies, accrual model misspecification remains a major

concern. Specifically, the magnitude of the accrual model residuals are implausibly large and

hence difficult to attribute solely, or even mostly, to management discretion (e.g., Ball and

Shivakumar 2008; Dopuch et al. 2011). Dechow et al. (1995) find excessive rejection rates in

favor of the existence of earnings management in firms with extreme financial performance.

5

In untabulated analysis we find a general declining time trend in the accrual model goodness-of-fit over our sample

period. The mean industry-year adjusted-R2 from estimating the Jones (1991) accrual model (i.e., our Eq. 6) is 0.101

and 0.078 during sample sub-periods 1989-1999 and 2000-2010, respectively. The correlation between the mean

industry-year adjusted-R2 and sample year is significantly negative (p-value 0.02).

9

Others conjecture that discretionary accruals are likely misspecified due to inadequate

growth and accounting fundamentals (Healy 1996; McNichols 2002). Similarly, Dechow et al.

(2010, p. 345) state (t)he literature often inadequately distinguishes the impact of fundamental

Kothari et al. (2005) incorporate the effects of firm fundamentals, in particular firm

performance, into the estimation of normal accruals. However, as recognized by the authors,

the success of their approach depends on the homogeneity in the relation between performance

and accruals for the matched and the sample firm. In other words, Kothari et al. (2005) employ

the standard assumption of intra-industry homogeneity to estimate normal accruals and to choose

their matched control firms. Collins, Pungaliya, and Vijh (2014) further match firms based on

sales growth in addition to return on assets. Zhang and Zhuang (2012) add current period signed

stock returns to the standard accrual models to capture anticipated future firm performance.

Again, these papers continue to rely on the standard accrual model assumptions of firm

stationarity and intra-industry homogeneity. Ball and Shivakumar (2006) introduce a nonlinear

accrual model to allow asymmetric associations of accruals with gains relative to losses. Their

accrual model explicitly accounts for one important aspect of firm performanceeconomic

gains versus losses. However, within the gains or losses subsamples their model still assumes

intra-industry homogeneity.

While the literatures efforts to incorporate fundamental performance into accrual models

have resulted in improved model specifications, the additional performance variables that are

introduced cannot account for the range of different business conditions and circumstances faced

by firms in studies employing large samples. Hence, adding performance controls and/or

10

performance interaction terms to accrual models has limited effectiveness, due to the potential

differences in firms accrual generating processes even when performance levels are similar.

The poor fit of accrual models likewise has implications for earnings quality research,

which relies on unsigned accrual model residuals. Hribar and Nichols (2007) point out that the

mean of unsigned abnormal accruals is positively correlated with the standard deviation of

signed residuals and operating volatility. They show that in tests of earnings quality based on

unsigned accrual model residuals, biased inferences result when the partitioning variable is

correlated with operating volatility. Similar problems of biased inferences also arise for signed

abnormal accruals. Kothari et al. (2005) and Collins et al. (2014) show that the null of no

earnings management is over-rejected in samples with extreme firm characteristics (i.e., market-

to-book, size, and sales growth). However, these studies ignore how underlying economic

Collins and Hribar (2002) provide evidence that accrual models are better specified using

data from the cash flow statement than from the balance sheet because of non-articulation events

(e.g., mergers and acquisitions). Many subsequent studies using cash flow statement data do not

exclude major events such as M&A because the common perception is that these events are

problematic only for balance sheet data.6,7 We find that major events remain problematic even

after using cash flow statement data to compute accrual models because heterogeneous

6

For example, papers that use the cash flow statement data and do not make adjustments for major events include

Dechow and Dichev (2002), Wysocki (2008), Ecker, Francis, Olsson, and Schipper (2013), and Dechow et al.

(2012).

7

McNichols (2002) uses the cash flow statement data and excludes M&A and discontinued operations because, as

she points out, accruals in one period and cash flows in another period may be for different economic entities. Ball

and Shivakumar (2006) use the cash flow statement data and exclude acquisitions.

11

III. EMPIRICAL PREDICTIONS

firm, j indexes industry, and t indexes year (subscripts suppressed for brevity in following

discussion):

N

TAijt 0 jt njt X nijt ijt (1)

n 1

TA is total accruals, Xn is the nth firm-specific variable thought to explain the accrual generating

process, and n is the estimated coefficient on the nth variable in industry j in year t. The signed

firm-specific residual (the prediction error), , is often used as a proxy for earnings management

We expect idiosyncratic shocks to firm underlying economics to negatively affect the fit

of the accrual models. First, idiosyncratic shocks are associated with changes in firm strategies,

operations, and accrual generating processes. These real changes cause firms to restructure their

balance sheets, which alter their operating cash flow cycles and generate large non-discretionary

abnormal accruals (NDA 0 in Eq. 2) as GAAP requires write-offs, and write-downs and write-

ups of deferred tax assets, for example.8 Second, if firms in the same industry have unique core

8

Strategy changes can take several years to implement. For example, some firms adapt to a shock by adding new

competencies via acquisitions. If the strategy fails, the acquirer may sell or close the business. Mitchell and Lehn

(1990) document that firms are more likely to become subsequent takeover targets if they made prior value-

destroying acquisitions. Later, these firms divested or restructured to thwart their own takeover.

12

competencies, each reacts to a similar exogenous event with a different strategy response. For

example, Ball (2013) argues that two firms experiencing similar negative demand shocks could

respond very differently with one firm seeing an increase in inventory and the other a decrease.

Thus, idiosyncratic shocks affect firms accrual generating processes in ways that are difficult to

model and control for ex ante, reducing the fit of the accrual regression.

Prediction 1: The unsigned residual in Eq. (1) for firm i in industry j in year t is

positively associated with idiosyncratic shocks of firm i.

Because idiosyncratic shocks experienced by a particular firm affect the overall fit of the

accrual model in the same and subsequent industry-years, from an econometrics perspective we

expect to observe an effect of a firms shocks on other firms accrual model residuals.

Prediction 2: The unsigned residual in Eq. (1) for firm i in industry j in year t is

positively associated with idiosyncratic shocks of firm i (i i) in industry j.

From Hribar and Nichols (2007) we know (i) the mean and variance of increase in the

variance of , and (ii) operating volatility is associated with the variance of . To the extent

idiosyncratic shocks in year t cause firms to change real investment and operating decisions in

years t through t+n (n>1), and these real changes result in large unsigned non-discretionary

accruals ( NDA ), then idiosyncratic shocks create bias in unsigned abnormal accruals ( ) as an

instrument for unsigned discretionary accruals ( DA ). Hribar and Nichols (2007) document that

in year t is correlated with the variances of cash flow from operations and revenue, where the

later variances are computed over years t-5 to t-1. While these variances capture some

idiosyncratic shocks, implicit in the Hribar and Nichols (2007) methodology is the assumption of

firm stationarity (past cash flow and revenue volatility predict future abnormal accrual

volatility). Since the likelihood of idiosyncratic shocks in period t is correlated with cash flow

13

and revenue volatilities from t-5 to t-1, idiosyncratic shocks in year t cause large unsigned non-

discretionary accruals ( NDA ) in years t through t+n. So, controlling for past cash flow and

revenue volatility in year t does not undo all the model misspecification caused by idiosyncratic

shocks that occur in years t-n through t that have not yet manifested in higher cash flow or

Idiosyncratic shocks likely increase NDA and due to the inability of the accrual

models to capture these shocks. In testing the effect of a partitioning variable on earnings

quality, false inferences will result if the partitioning variable is correlated with shocks.

partitioning variable are biased in favor of finding a positive relation between the two

variables when the partitioning variable is correlated with idiosyncratic shocks.

Because idiosyncratic shocks affect the overall fit of the accrual model, from an

econometrics perspective we predict a spillover effect among firms in the same industry-year.

partitioning variable are biased in favor of finding a positive relation between the two

variables when the partitioning variable is correlated with idiosyncratic shocks

experienced by firm i(i i) in industry j.

exhibit greater Type I and Type II errors in samples where idiosyncratic shocks are

present.

9

For example, suppose Firm A introduced a new product based on a patented technology that gains considerable

market acceptance, and this obsoletes Firm Bs business model. Further assume it takes several years before Bs

revenues are adversely affected. Bs stock price adjusts as the market (i) learns of As success on Bs value, and (ii)

how B changes its strategy in response to As success. Hence, idiosyncratic shocks to B (from A) in year t are not

captured by the volatility of Bs cash flow and revenue computed over t-5 to t-1.

10

Arif, Marshall, and Yohn (2015) find that business uncertainty is negatively associated with signed working

capital accruals, which suggests that idiosyncratic shocks can potentially cause biases in signed abnormal accruals.

14

IV. RESEARCH DESIGN AND EMPIRICAL FINDINGS

Our sample consists of the intersection of the annual Compustat file and the CRSP

monthly return file for fiscal years 1988 through 2014.11 For each fiscal year observation we

require non-missing industry identifiers and twelve non-missing CRSP monthly return

observations, along with non-missing observations for accruals, cash flows, sales, PP&E, return-

on-assets, and total assets. Next, because we estimate annual cross-sectional accrual models, we

[ INSERT TABLE 1 ]

Table 1 presents descriptive statistics of our variables. Notably, the median value of

unsigned abnormal accruals from the original Jones model, performance model, and nonlinear

model is 4.7%, 4.2%, and 3.9% of total assets, respectively. In untabulated analyses we note that

median unsigned abnormal accruals is roughly the same magnitude for both negative and

positive original Jones model accruals (4.8% and 4.6% of total assets, respectively). Some

studies attribute abnormal accruals specifically to earnings management.12 However, given the

large magnitude of the mean and median unsigned abnormal accruals, such earnings

management would be difficult to disguise from the external auditors (Ball and Shivakumar

2008), who must test the reasonableness of managerial estimates, and indicate a possible bias on

the part of the entity's management (AU Sections 312.37 and 9312A PCAOB). Auditors often

11

We begin the sample in 1988 because our analysis examines estimated abnormal accruals using data from the

statement of cash flows (unavailable until 1988) to avoid problems associated with the use of balance sheet data

(Collins and Hribar 2002).

12

For example, Cohen, Dey, and Lys (2008) use unsigned abnormal accruals to measure earnings management and

report median modified-Jones unsigned abnormal accruals of 6% of total assets over their sample period 1987-2005.

15

base their materiality assessment on a 5% of net income rule (Vorhies 2005).13 The median Jones

model abnormal accrual magnitude is 65% of unsigned net income. Assuming that auditors

detect and prevent material misstatements (including unreasonable management estimates) and

that they apply a 5% of net income materiality threshold, then a median abnormal accrual of 65%

of unsigned net income indicates that abnormal accruals as a proxy for earnings management

have a noise-to-signal ratio of roughly 13 (65%/5%). We note that not all managerial discretion

originates from motives to manage earnings. But even allowing for non-opportunistic application

of discretion, the magnitudes of the accrual model residuals are still implausibly large and hence

Table 2 presents correlations among the variables, with Pearson (Spearman) correlations

reported below (above) the diagonal. Consistent with Hribar and Nichols (2007), unsigned

abnormal accruals are positively correlated with both cash flow and revenue volatility, which

suggests the need to control for these variables in our analyses. We also note that firm-specific

stock return variation (IdioShock2), our measure of idiosyncratic shocks to firm underlying

economics, is negatively correlated with total accruals, size, and performance, and positively

correlated with cash flow and revenue volatility and unsigned abnormal accruals.

[ INSERT TABLE 2 ]

Chun et al. (2008) demonstrate that variation in firm idiosyncratic stock returns capture

the forces of creative destruction. They argue that creative destruction mechanically induces

13

In SAB 99 the SEC cautions auditors to avoid exclusive reliance on certain quantitative benchmarks to assess

materiality in preparing financial statements and performing audits. Moreover, the staff has no objection to such a

rule of thumb as an initial step in assessing materiality. The 5% net income rule of thumb (as opposed to

management discretions on the order of 65% of unsigned net income implied by the accrual model residuals) is in

line with Dichevs et al. (2013) finding that CFOs believe about 10% of earnings is managed for firms that manage

earnings.

16

high firm-specific performance heterogeneity in fundamentals and stock returns, as winner and

loser firms gradually emerge and are revealed. During this process, firm-level performance

necessarily deviates from industry- and economy-level performance (p. 114). Chun et al. (2008)

also point out that their findings support the conclusion in Wei and Zhang (2006) that any

explanation of rising firm-specific variation in stock returns must also permit a contemporaneous

rise in firm-specific fundamentals variation. Hence, Chuns et al. (2008) firm-specific stock

returns variation metric can represent variation in firm-specific economics that the accrual

We use Chuns et al. (2008) firm performance heterogeneity metric, i.e., firm-specific

Specifically, we estimate the following regression using 24 months of firm is return data (years t

and t-1) to reflect the fact that an idiosyncratic shock can ripple through multiple years of

accruals:

where ri,T is firm is monthly stock return, rj,T is the value-weighted monthly return for firm is

industry (excluding firm is return), and rm,T is the value-weighted monthly market return, where

T indexes the 24 months in years t and t-1. Our return-based idiosyncratic shock measure,

IdioShock2i,t, is the mean of the squared residuals from Eq. (3). IdioShock1i,t represents the

corresponding one-year firm-specific stock return variation from estimating Eq. (3) using the

We acknowledge that equity returns capture more than idiosyncratic shocks to firm

underlying economics (e.g., liquidity shocks, investor sentiment), which will add noise to any

17

return-based proxy (Savor 2012; Barberis, Shleifer, and Vishny 1998). To examine the

usefulness of firm-specific returns for capturing idiosyncratic shocks, we randomly sample 100

firm-years in the highest IdioShock2 decile, identify the month within that year with the largest

magnitude abnormal stock return, and read all the news stories on Factiva for that firm-month.

Appendix A provides four such examples. We conclude that firms experience significant

business events during months with large abnormal returns, although it is often difficult to

pinpoint the exact date when the shock occurs. Business strategies evolve over time and shocks

get impounded into stock prices as tangible evidence, such as earnings, is released. While firm-

specific return heterogeneity captures some of these shocks, it does so with error. Further, large

unsigned abnormal accruals are not concentrated only in the year of the large abnormal returns.

Rather, idiosyncratic shocks tend to propagate through several years of abnormal accruals.

For additional validation, we examine the association between IdioShock2 and several

economic events (hereafter referred to as operational shocks) that are observable in financial

statements and relate to changing firm economics: (i) acquisitions, (ii) discontinued operations,

(iii) four-digit SIC industry changes, (iv) restructuring charges, and (v) special items. We create

indicator variables for each event, and also define an indicator OpShocki,t that equals one if at

least one of the five event indicators equals one (19.2% of sample).14

The following logit model is used to estimate the association between IdioShock2 and

operational shocks:

14

We create the following indicator variables: LargeMergAcqi,t equals one if Compustat footnote data item

sale_fn = "AB" (i.e., sales have been "restated for/reflects a major merger or reorganization resulting in the

formation of a new company") (0.1% of sample); LargeDiscOpsi,t equals one if the magnitude of the income effect

of discontinued operations is greater than five percent of sales (i.e., |do/sale| > 0.05) (3.1% of sample); IndChangei,t

equals one if firm is four digit SIC differs in years t-1 and t (3.8% of sample); LargeRestruci,t equals one if the

magnitude of restructuring charges is greater than five percent of sales (i.e., |rcp/sale| > 0.05) (1.5% of sample).

LargeSpecItemi,t equals one if the magnitude of special items is greater than five percent of sales (i.e., |spi/sale| >

0.05) (14.7% of sample). We note that these proxies unlikely capture all idiosyncratic shocks due to firm economic

heterogeneity.

18

1

Pr(OpShocki ,l 1) ; z 0 1IdioShock 2i ,t , (4)

1 e z

where variables are as defined above. Panel A of Table 3 presents the results of separately

estimating Eq. (4) for the five individual components of OpShock, and for the aggregate

OpShock indicator variable. The results are consistent with return-based idiosyncratic shocks

being associated with operational shock indicators disclosed in financial statements. We next

estimate a modified version of Eq. (4) where we replace IdioShock2 with contemporaneous and

lagged IdioShock1, and report results in Panel B. Consistent with Gerakos and Kovrijnykh

(2013) the statistically significant coefficients on lagged IdioShock1 indeed suggest that

idiosyncratic shocks can take multiple years to manifest in the financial statements.

[ INSERT TABLE 3 ]

Dechow, Kothari, and Watts (1998) develop a model of working capital accruals, where

the accrual is approximated by the product of a firms operating cycle and the sales shock. Their

model implies that a firms operating cycle affects the strength of the relation between accruals

and sales changes (assuming sales follow a random walk). Cross-sectional accrual models

impose the same slope coefficient (i.e., the same operating cycle) on all firm-year observations in

that regression. However, if operating cycles are affected by idiosyncratic shocks and vary by

firm and over time, such variation is one mechanism that leads to large absolute abnormal

where OpCycleVol is firm i's 4-quarter operating cycle volatility in year t (refer to Appendix C),

and all other variables are as previously defined. We also estimate a version of Eq. (5) after

19

replacing OpCycleVol with UOCVDiff, which measures the unsigned difference in firm is

operating cycle volatility relative to the industry average in year t. We report results from Eq. (5)

in Table 4. To summarize, results confirm that idiosyncratic shocks are associated with greater

operating cycle volatility, and with a greater difference in operating cycle volatility relative to

[ INSERT TABLE 4 ]

abnormal accrual estimation. For simplicity, we begin by estimating abnormal accruals using the

where TotalAccruals is taken from the statement of cash flows (Collins and Hribar 2002). As

mentioned earlier, our inferences are unchanged when using working capital accruals instead of

total accruals. SalesChange equals the change in sales from year t-1 to t, and PPE equals gross

property, plant and equipment. All variables are scaled by beginning-of-period total assets, and

Winsorized at the top and bottom one percent by two-digit SIC. As is standard, we define a

measure of signed abnormal accruals, AbAccruali,t, as the residual from Eq. (6). Further, we

(7)

6 ABNRETi ,t 7 DABNRETi ,t 8 DABNRET * ABNRETi ,t i ,t ,

where CF is operating cash flows scaled by average total assets, DCF is an indicator that equals

one if CF is less than zero and equals zero otherwise, ABNRET is firm i's abnormal stock return

during fiscal year t (based on the CRSP equal-weighted market index), DABNRET equals one if

20

ABNRET < 0 and zero otherwise, and all other variables are as defined above. We denote the

residual from Eq. (7) as AbAccrual_NL, and the corresponding unsigned residual as UAA_NL.

where ROA is calculated as net income divided by average total assets, and all other variables are

as previously defined. We denote the residual from Eq. (8) as AbAccrual_PF, and the

Figure 3 plots histograms of the R2 from the 1,006 industry-year estimations of Eqs. (6) -

(8). There is wide variation in the model fit across estimations. In the original Jones model, most

industry-years have R2s of less than 10%, suggesting that most industry-year models are

estimated relatively imprecisely. While model fit is substantially improved using both the

nonlinear and performance models, the sample mean and median values of the abnormal accruals

from these models are still relatively large (see Table 1).

[ INSERT FIGURE 3 ]

We first examine the relation between the magnitude of abnormal accrual estimates and

firm idiosyncratic shocks (Prediction 1), by estimating the following OLS model:

where UAA is unsigned Jones model abnormal accruals and IdioShock2 is as previously defined.

CFO and REV capture operating volatility, measured as the standard deviation of cash flow

and sales, respectively, scaled by assets over the current and previous four years (Hribar and

Nichols 2007). We also estimate a logit specification that tests for a relation between firm

21

Pr( LUAAi ,t 1) f 0 1OpShocki ,t 2 IdioShock2i ,t 3 CFOi ,t 4 REVi ,t , (10)

where LUAA is an indicator that equals one if UAA is greater than the sample median

(approximately 5% of total assets) and equals zero otherwise. We also estimate Eqs. (9) and (10)

using both the nonlinear and performance models, and we estimate variants where we replace

Figure 4 presents time-series plots of mean IdioShock2 (indexed on the right axis), along

with the proportion of sample firms each year with operational shocks and large abnormal

accruals (indexed on the left axis). Forty percent of all firms consistently have unsigned

abnormal accruals in excess of 5% of total assets across all model specifications. Further, in

excess of 20% of firms have operational shocks in most years. Moreover, these variables are

strongly correlated through time, with each other and with firm-specific idiosyncratic shocks.

[ INSERT FIGURE 4 ]

Table 5 Panel A reports results from estimating Eqs. (9) and (10). In all three abnormal

accrual models, IdioShock2 is positively associated with the magnitude of unsigned abnormal

accruals and the presence of a large abnormal accrual, even after controlling for operational

shocks reflected in financial statements and operating volatility (Hribar and Nichols 2007). As

shown in Panel B, both contemporaneous and lagged IdioShock1 are positively associated with

both measures of abnormal accrual magnitude across all models, where the strength of the

association generally diminishes with the lag. This evidence is consistent with idiosyncratic

shocks rippling through multiple years of accruals. Because IdioShock2 more succinctly captures

this dynamic in a single variable, we limit our attention to its use in subsequent tests.

[ INSERT TABLE 5 ]

22

To test Prediction 2 on the econometric spillover effect from other firms' shocks in the

(11)

4 CFOi ,t 5 REVi ,t i ,t ,

where PeerIdioShock2 is the average IdioShock2 across all other firms in firm i's industry during

year t. The results are presented in Table 6. Consistent with Prediction 2, the coefficients on

PeerIdioShock2 across the three accrual models are uniformly positive and significant, indicating

an econometric effect from the idiosyncratic shocks experienced by other firms due to their

(holding all other variables at their mean values) leads to an increase in unsigned abnormal

accruals of approximately 1% of total assets (i.e., from 0.071 to 0.081). Likewise, a one standard

deviation increase in PeerIdioShock2 (holding all other variables at their mean values) leads to

an increase in unsigned abnormal accruals of approximately 0.5% of total assets (i.e., from 0.071

to 0.076). Accordingly, the effect of both own-firm and peer-firm idiosyncratic shocks are not

[ INSERT TABLE 6 ]

shocks affects accrual model estimation, using Eqs. (6) - (8). We begin with industry-year

estimations using only observations in the first decile of IdioShock2 (i.e., lowest idiosyncratic

shocks), again requiring at least 25 observations in each industry-year. The resulting subsample

consists of 4,650 observations. We iteratively repeat the estimations after adding increasing

IdioShock2 observations decile-by-decile, recording the average unsigned abnormal accrual and

the percent of observations with a large unsigned abnormal accrual in each iteration. For each

23

iteration, we also report these statistics separately for the original 4,650 Decile 1 observations to

document how these low-shock observations are affected by inclusion of observations with

[ INSERT TABLE 7]

Table 7 presents the results. Panel A reports the sample composition across the ten

iterations. Panel B tabulates the average unsigned abnormal accruals, percent of observations

with a large abnormal accrual, and mean industry-year R2 from the accrual model estimations for

Eq. (6). Since the results of all accrual models are inferentially equivalent, we narrate the results

only for the original Jones model. 15 Figure 5 presents associated results in graphical form.

Focusing on columns (2) and (3) in Table 7 Panel B, the IdioShock2 Decile 1 subsample has an

average UAA of 0.0249 (i.e., unsigned abnormal accrual of 2.5% of total assets), where 11% of

the observations have a large unsigned abnormal accrual. In contrast, estimation with the full

sample generates an average UAA of 0.0764 (i.e., 7.6% of total assets), where 48% of the sample

has a large abnormal accrual. These results are consistent with our expectation there is a

monotonically increasing pattern in both the average UAA and the percentage of observations

with a large abnormal accrual as observations with greater degrees of idiosyncratic shocks are

[ INSERT FIGURE 5 ]

Columns (4) and (5) of Panel B present the effect on the initial 4,650 Decile 1 subsample

of adding observations with higher levels of IdioShock2 to the accrual model estimation. The

Decile 1 subsample likewise exhibits a monotonic increase in both the average UAA and the

percent of observations with a large abnormal accrual as the iterations proceed. Thus, including

observations with large shocks in accrual model regressions likewise affects the efficiency with

15

We obtain identical inferences if we use the residual from Eq. (11) as a measure of abnormal accruals.

24

which these models are estimated for the low shock observations (Prediction 2). Whereas 11%

of the original Decile 1 observations have a large abnormal accrual when the Jones model is

estimated without inclusion of other observations, nearly 17% of those same firm-years have a

large abnormal accrual when the Jones model is estimated using the full sample. Column (1) of

Panel B in Table 7 reports the median industry-year R2 across iterations. There is a monotonic

decrease in industry-year R2 as the iterations progress, which reinforces the inference that

idiosyncratic shocks among sample firms reduce the fit of the accrual models.16

management/earnings quality measured using unsigned abnormal accruals (Predictions 3 and 4).

Following the methodology in Hribar and Nichols (2007), we construct a partitioning variable

(PART) as a weighted combination of IdioShock2 and a random variable. Beginning with PART

as a variable uncorrelated with shocks, we draw 1,000 random samples of 1,000 observations

each from our full sample and estimate the following regression for each random sample:

We record the number of times out of 1,000 that 1 is statistically positive at the 5% level (one-

tailed test). We repeat this process at nine levels of induced correlation between IdioShock2 and

PART (0.1, 0.2, 0.3, 0.4, 0.5, 0.6, 0.7, 0.8, and 0.9). Within these randomly selected samples, we

16

Untabulated analysis shows that when ROA is included in the accrual model, industry-year R2 increases slightly as

iterations progress. We suspect that this is caused by correlation between idiosyncratic shocks and ROA.

Nonetheless, even in this case, the average unsigned abnormal accrual and the proportion of observations with large

unsigned abnormal accruals increases as iterations progress.

25

We plot the rejection rates in Figure 6 Panel A, with the diamond-dotted line for models

with no control variables and the square-dotted line for models with the following own-firm

characteristic controls: LnSize, MktToBook, Leverage, CFO and REV. Focusing first on the

estimation with no controls, we find excessive rejection rates (i.e., > 5%) in all cases when there

is a positive correlation between IdioShock2 and PART. Adding controls substantially lowers the

rejection rates. However, the test still over-rejects the null even at modest levels of correlation

and after controlling for the Hribar and Nichols (2007) volatility measures. Finally, the cross-

marked line includes IdioShock2 in addition to the characteristic controls mentioned above,

which indicates a well-specified model across all levels of induced correlation. This result

accords with our intuition that controls can effectively be employed for idiosyncratic shocks in

tests involving unsigned abnormal accruals, as idiosyncratic shocks unambiguously increase the

magnitude of abnormal accruals (i.e., it is the direction of the effect that is unpredictable).

[ INSERT FIGURE 6 ]

repeat the analysis after inducing correlation between PART and PeerIdioShock2 (rather than

IdioShock2), and plot the rejection rates in Panel B of Figure 6. Again, when no control variables

are included, the rejection rate is greater than 5% at 0.1 correlation and climbs quickly as the

correlation rises. With the own-firm characteristic controls, the test over rejects the null at very

modest levels of correlation and the rejection rates quickly become elevated, even when the

IdioShock2 control is included. Importantly, as shown in the cross-marked line, inclusion of the

PeerIdioShock2 control results in a well-specified model across all levels of induced correlation.

These results support the spillover effect in Prediction 4 and suggest a dimension of potentially

26

correlated omitted variables not considered in prior literatureidiosyncratic shocks experienced

by other firms i' (i' i) in an industry can bias inferences relating to the earnings quality of firm i.

Type I Errors

In this section, we examine how rejection rates for signed abnormal accruals estimated

using the original Jones model are affected by inclusion of observations with increasing levels of

idiosyncratic shocks. Following Kothari et al. (2005), we examine rejection rates in sample

quartiles based on several firm characteristics: size (Table 8 Panel A), market-to-book (Table 8

Panel B), and sales growth (Table 8 Panel C). We discuss only the size-based partitioning as

inferences using market-to-book and sales growth are similar. The nonlinear and performance

We conduct the Type I error analysis first for the IdioShock2 Quintile 1 subsample, then

iteratively add IdioShock2 sample quintiles. For each iteration, we estimate the Jones model, sort

sample observations into size quartiles by year, combine observations in each size quartile across

years and randomly select 200 firms without replacement from each quartile, then calculate the

mean and t-statistic of the signed abnormal accruals for the 200 randomly selected observations.

We repeat this process 1,000 times, and compute rejection rates for the null hypothesis of

AbAccrual = 0 for both alternative hypotheses (Ha) of AbAccrual < 0 and AbAccrual > 0 at the

5% level using one-sided tests. If each test is well-specified, we expect a 5% rejection rate,

where the 95% confidence interval for a rejection rate of 5% ranges from 2% to 8%. If the actual

rejection rate falls below (above) 2% (8%), the test is misspecified in favor of (against) the null

hypothesis.

[ INSERT TABLE 8 ]

27

Table 8 Panel A reports the results. The first column (All) reports the rejection

frequency when firms are selected from the relevant pooled IdioShock2 quintile(s) without size

stratification. The Quartile columns report rejection frequency within each size quartile, and

the Avg. 1-4 column reports the average rejection frequency across the four separate size

quartiles. Focusing on the first IdioShock2 quintile, average rejection rates across all size

quintiles (Avg. 1-4) are not statistically different from the 5% level that we would expect in a

well specified test. Tests remain well-specified as we add the second and third IdioShock2

quintiles to the analysis. However, there is evidence of misspecification when the fourth

IdioShock2 quintile is added, which worsens when moving to the full sample, consistent with our

Prediction 5. Specifically, in the full sample average rejection rates across the four separate size

quartile estimations are 0.238 and 0.135 for AbAccrual > 0 and AbAccrual < 0, respectively. We

also note that, similar to findings in Kothari et al. (2005), there is substantial over/under-rejection

in both extreme size quartiles (e.g., rejection rate of 0.625 in size Quartile 4 for AbAccrual > 0

The last row of each panel reports average rejection rates computed across all partitions

in the panel. This provides a summary statistic to assess relative misspecification in total across

the panels, where larger averages indicate a greater degree of misspecification. As reported, the

average rejection rate when using size partitions (Panel A), market-to-book partitions (Panel B)

and sales growth partitions (Panel C) are 0.086, 0.099, and 0.099, respectively.

Type II Errors

will not only lead to over-rejection of the null of no earnings management when not present, but

17

Inferences are unaltered if we analyze the average deviation from 0.05 across all cells rather than the average

rejection rates across all cells.

28

will also lead to diminished power of the test to detect earnings management when present.

(Prediction 5). To examine this prediction, we follow Kothari et al. (2005) and conduct

simulations wherein we seed various levels of earnings management into iterative subsamples

based on IdioShock2 sample quintiles, and compare the test power across the iterations. For each

iteration we randomly draw 200 observations and add various seed levels of positive earnings

management (1%, 2%, and 4% of total assets) to total accruals, then return those 200

observations to the sample and estimate the original Jones model. We repeat this process 1,000

times, and record the frequency the null of no earnings management is rejected for the 200

seeded observations across the 1,000 trials. General patterns are similar (untabulated) using the

Table 9 reports the simulation results for the alternative hypotheses of abnormal accruals

greater than and less than zero. The power of the test decreases monotonically in each level of

seeded earnings management when IdioShock2 quintiles are added, particularly for more

plausible levels of earnings management. We note that when no earnings management is seeded,

the test is well specified in all iterations (i.e., rejection rates of the null of no earnings

management are not different from five percent). When we seed earnings management, the

inferior power of the test in the subsamples with more shock observations becomes clear. For

example, when we seed in earnings management of one percent of total assets, the test detects

earnings management 83% of the time in the IdioShock2 Quintile 1 subsample, but only 35% of

[ INSERT TABLE 9 ]

The last column of Table 9 reports the average rejection rates computed across all seeded

partitions in the panel. This provides a summary statistic to assess relative misspecification

29

across different models, where smaller averages (i.e., averages farther away from 1.00) indicate a

greater degree of misspecification. As reported, the average rejection rate across all seeded

Because the directional effect of a particular shock on a given firms accruals is generally

will improve shock-based misspecification in tests involving signed abnormal accruals. For

example, using our analysis of the airline industry in Figure 2, we examine the MD&A and

adjustments on the cash flow statements in firm years with large accruals in that industry. As

summarized in Appendix B, a variety of idiosyncratic shocks causes the adjustments. The largest

shocks (as captured in total accruals) appear to not be common to other firms in the industry.

Moreover, the large accrual adjustments affect numerous working capital accounts. Appendix B

demonstrates that without a clear understanding of the underlying economic events experienced

by the different firms, it is difficult to model normal accruals. This highlights the challenges to

devising a solution that is predicated on adding controls to the first-stage accrual models.

In this section, we examine this issue empirically by repeating the above analysis of Type

I and Type II errors after including IdioShock2 as a control directly in the abnormal accrual

6 ABNRETi ,t 7 DABNRETi ,t 8 DABNRET * ABNRETi ,t (14)

9 IdioShock2i ,t i ,t

30

Tables 10 and 11 report the Type I and Type II error analyses, respectively. Comparing Tables

misspecification, on average. Focusing on Panel A (size partitioning), the average rejection rate

when IdioShock2 is included in the accrual model is 0.065, compared to 0.086 when IdioShock2

is not included (i.e., a 23.9% reduction). Similar results obtain with the nonlinear and

performance models (untabulated). Comparing Tables 11 and 9, the Type II error rates are not

materially affected by adding the IdioShock2 control (average rejection rates of 0.827 vs. 0.826).

Panel A of Table 12 summarizes the results from all configurations of the Type I error

analysis for all models we consider. Specifically, we report the average rejection rates across all

firm characteristic groupings, both for the baseline accrual models of Eqs. (6) - (8) and the

versions that include IdioShock2 as a control (Eqs. 13-15). As indicated, in every instance, the

addition of IdioShock2 lowers Type I error, where the reduction in rejection rates ranges from

4.8% (using the performance model with market-to-book partitioning) to 40.7% (using the

nonlinear model with size partitioning). Panel B summarizes results of the Type II error analyses.

While rejection rates decrease slightly across all models (a decrease in rejection rates here

indicates poorer model specification), the decreases are small, especially compared to the

[ INSERT TABLE 12 ]

We note that Kothari et al. (2005) examine a similar tradeoff in model performance from

their performance-matching, and find that while performance matching results in better Type I

error characteristics, it suffers from inferior Type II error characteristics. This leads them to

discuss a tradeoff (between better Type I error rates and poorer Type II error rates) that comes

31

from performance matching. Because adding the IdioShock2 unambiguously improves Type I

error rates with no meaningful deterioration in Type II error performance, we face no such

tradeoff. This enables us to unambiguously recommend that researchers add IdioShock2 to all

variants of signed abnormal accrual models, as doing so improves model specification. However,

adding this control is only a partial solution, as misspecification is still generally greater when

The previous sections demonstrated that idiosyncratic shocks can cloud inferences in

studies of earnings management using discretionary accruals. This section further illustrates this

issue using a highly-cited studyBergstresser and Philippon (2006) (BP, hereafter). BP predict

and find that when CEO compensation is more sensitive to stock price, unsigned abnormal

accruals are larger, leading BP to conclude that incentive compensation causes earnings

management. However, firms experiencing idiosyncratic shocks may use incentive compensation

more heavily, and CEOs may exercise more options in years experiencing positive idiosyncratic

idiosyncratic shocks. Of course, even in the face of idiosyncratic shocks, the earnings

firms experiencing shocks take advantage of the resulting uncertainty to manage earnings.

We first replicate the findings of BP, and then examine the results in subsamples of firm-

years with different levels of idiosyncratic shocks. Specifically, we predict that if BPs results are

driven by idiosyncratic shocks rather than earnings management, their results will be stronger

among firm-years with larger shocks. Following BP, we obtain accounting data from Compustat

32

and compensation data from Execucomp for a sample of firm-years spanning 1994-2000, and

[ INSERT TABLE 13 ]

Table 13 reports results from Eq. (16). Column (1) uses the full sample, and replicates the

BP findings (their Table 2 column 4) of a positive association between CEO incentive pay and

unsigned abnormal accruals (coeff. 0.012; t-stat 2.15). Columns (2)-(6) repeat the estimation

separately for IdioShock2 sample quintiles. As indicated, the coefficient estimate on IncentRatio

is negative and insignificant in the first three IdioShock2 quintiles, turns positive and marginally

significant in the fourth IdioShock2 quintile (coeff. 0.017; t-stat 1.62), and becomes positive and

strongly significant (coeff. 0.049; t-stat 2.76) in the fifth IdioShock2 quintile. Column (7) repeats

the analysis with the full sample using an interactive structure based on HighIdioShock2 (an

indicator that equals one if IdioShock2 is in the top two quintiles), and likewise documents that

the association of interest is insignificant in the bottom three IdioShock2 deciles (IncentRatio

coeff. 0.005; t-stat 1.09), and becomes significant in the top two IdioShock2 deciles

(interaction coeff. 0.036; t-stat 3.24). Column (8) repeats the full sample column (1) estimation

strongly significant, the coefficient on IncentRatio is not materially weakened. This illustrates

that, in a study where the relation between a variable of interest and discretionary accruals

obtains only where idiosyncratic shocks are high, an identification problem arises where it is

difficult to unambiguously attribute the observed effect to either the variable of interest or

idiosyncratic shocks.

33

V. CONCLUSION

Economics predict that accrual models are inherently misspecified because un-modeled

differentiated products and services. We provide evidence that idiosyncratic shocks to firm

underlying economics result in accrual model misspecification that can cause false inferences in

studies using either unsigned or signed abnormal accruals. Also, a firms abnormal accrual

estimates are affected econometrically not only by its own shocks, but also by the shocks of

other firms in the industry. We suggest including controls for both the firms own shocks and the

shocks of other firms in the industry to mitigate biased inferences in tests employing unsigned

abnormal accruals.

In tests employing signed abnormal accruals, we document greater Type I and Type II

errors in samples where idiosyncratic shocks are present. Directly controlling for idiosyncratic

shocks in accrual models results in better-specified tests involving signed abnormal accruals.

However, misspecification still increases with the presence of idiosyncratic shocks even after

adding such controls, because the direction of the effect of idiosyncratic shocks on accruals is

unpredictable without modeling the underlying economic events. While controlling for

idiosyncratic shocks improves accrual model specification, it is not a substitute for identifying

the source of the bias and correcting the problem at its root. In addition, the model that includes

shock controls have limited effectiveness in tests of earnings management related to shock

misspecifications and create inference problems when researchers use discretionary accruals as a

proxy for earnings management. However, we also recognize that idiosyncratic shocks can

34

provide both the opportunity and incentives for earnings management. Because both earnings

management and idiosyncratic shocks are measured with error, researchers face an identification

challenge.

While unsigned abnormal accruals have been used as a proxy for earnings management

in prior studies, we note that the literature has also recognized that the earnings quality measures

based on unsigned abnormal accruals can capture firm fundamentals (e.g., Dechow et al. 2010).

Within the framework of Dechow and Dichev (2002), larger unsigned abnormal accruals due to

idiosyncratic shocks can still indicate lower quality earnings because the accrual models ability

to capture the underlying economic events is arguably compromised in these circumstances. This

interpretation of large unsigned abnormal accruals is consistent with the premise of our paper.

has implications for interpreting earnings quality and its associations with other economic

constructs, such as the cost of capital. For example, our analysis suggests a potential alternative

interpretation of the literature that use unsigned abnormal accruals as a measure of information

risk. Our evidence suggests that firms face inherent risk in their businesses, and that many

measures of earnings quality likely proxy for this risk. In many accounting studies of earnings

quality, business risk is a correlated omitted variable and the various instruments for earnings

35

Appendix A

Examples of Firms with News Stories Related to Large Idiosyncratic Shocks (IdioShock2),

and the Lead, Lagged, and Contemporaneous Unsigned Abnormal Accruals

We started by taking firm-years in the highest idiosyncratic shock decile, and then computed monthly

abnormal (market-adjusted) returns during each two-year computation horizon. Next, we identified the

single firm-month with the highest magnitude abnormal return for each firm-year. We randomly selected

100 firm-year observations from this top decile. We searched all news stories on Factiva for the

corresponding month with the large unsigned monthly abnormal return. The following are four examples.

Month of large unsigned monthly abnormal return: 12/08

Lagged unsigned Jones-model abnormal accrual: 0.01

Contemporaneous unsigned Jones-model abnormal accrual: 0.08

Lead unsigned Jones-model abnormal accrual: 0.13

Various News stories (12/15/08): Visage Imaging Receives FDA 510(k) Clearance for its Latest Thin Client

(12/20/08) Mercury Computer Systems Inc., said this week its Visage unit received Food and Drug Administration

clearance to sell a medical- imaging unit. The Visage CS 3.1 performs a range of imaging functions, including CAT

scans and magnetic resonance imaging. In addition, the Chelmsford manufacturer of computer, signal, and image-

processing systems and software is launching the Echotek Series of Virtex digital receivers.

Abnormal returns: 16% (12/2/08), 11% (12/3/08), 13% (12/9/08), 20% (12/19/08)

Month of large unsigned monthly abnormal return: 1/02

Lagged unsigned Jones-model abnormal accrual: 0.07

Contemporaneous unsigned Jones-model abnormal accrual: 0.35

Lead unsigned Jones-model abnormal accrual: 0.24

News story (1/29/02): CompuCredit announced preliminary fourth quarter 2001 net income of $5.6 million, or

$0.12 per share. Wall Street analysts on average were expecting the Company to earn $0.28 per share in the same

period, according to Multex Global Estimates. The Company cited reduced loan growth and increased expenses as

the primary reasons for its expected earnings shortfall. The Company also announced that it has reduced its

workforce by approximately 70 employees. CompuCredit is a credit card company that uses analytical techniques,

including sophisticated computer models, to market general-purpose credit cards and related fee-based products and

services.

Month of large unsigned monthly abnormal return: 10/09

Lagged unsigned Jones-model abnormal accrual: 0.08

Contemporaneous unsigned Jones-model abnormal accrual: 0.27

Lead unsigned Jones-model abnormal accrual: 0.03

36

News story (10/16/09): The CEO stated, Essentially all of our distribution channels experienced sales increases in

Q3. Despite economic conditions, we feel that Joe's brand is in the best shape that it has been since inception."

Month of large unsigned monthly abnormal return: 10/09

Lagged unsigned Jones-model abnormal accrual: n/a

Contemporaneous unsigned Jones-model abnormal accrual: 0.17

Lead unsigned Jones-model abnormal accrual: 0.16

News story (10/03/09): Shares of EnteroMedics Inc lost more than three-quarters of their market value, after the

company said its device for treating obesity was not effective. On 10/27/09 EntermMedics announced that it has

implemented a plan to reduce its workforce and operating costs. The reduction in force will lower the number of

employees by 40%.... The Company expects to incur a charge of approximately $0.5 million related to the

workforce reduction in the fourth quarter of 2009.

Additional observations:

Very few stories corresponding to the large daily abnormal returns specifically mentioned that the firm

was revising its business strategy, although a few did. Many of the stories associated with large

magnitude idiosyncratic shocks involved earnings releases. Within these stories the firm offers more

texture about the success or failure of its current business model. For example, CompuCredit reported

lower earnings citing reduced loan growth, and announced layoffs. Its stock price fell 42% on that day.

Such a story provides the market with tangible information about the success (or failure in this case) of

the firms strategy. Interestingly, the current and following years unsigned abnormal accruals are 38%

and 24% of total assets, respectively. Other large monthly abnormal returns are associated with new

products, joint ventures, and FDA drug approvals. For example, Mercury Computers stock price rose

128% in December 2008. Various stories started to appear during December that the FDA approved the

sales of its medical imaging system. Mercurys lagged, contemporaneous, and lead abnormal accruals

were 1%, 8%, and 13% of total assets, respectively.

37

Appendix B

To better understand the cause of large absolute accruals, we examined all U.S. scheduled

passenger air carriers with at least ten years of total accruals between 1993 and 2010 (12 airlines). We

chose this industry because all the firms provide a relatively homogenous service, are subject to a

common set of regulations, and face the same factor input markets (jet fuel and labor). On the other hand,

these airlines employ a variety of business strategies. Some are low cost carriers (Southwest and Airtran),

some specialize by geography (Alaska Air, Frontier, and Hawaiian Air), some operate regional jets (Mesa

and SkyWest), and others are national carriers with large hub-and-spoke networks (United, Continental,

Delta, American, and US Air). All these firms have been subjected to common exogenous shocks (9/11,

fuel cost increases and decreases, and deregulation). All have dynamic business strategies. Some have

expanded, others filed for bankruptcy, and still others have merged.

For each airline we selected the year with the largest and smallest total accrual (scaled by lagged

total assets.) We analyze the total accruals for 24 firm years (two observations for 12 firms). Had we

sorted on abnormal accruals rather than total accruals, if there was a large common industry-wide shock

in a year, it would be captured in the accrual models intercept and not in the abnormal accrual.18 We read

the Managements Analysis and Discussion and examined that firm-years statement of cash flows and

the Notes to the Financial Statements to identify the largest adjustment(s) to net income in the cash

flow statement causing the smallest or largest accrual.

Table B1 details our findings. The largest and smallest accruals do not concentrate in any one

calendar year, but occur fairly randomly over our sample period. For example, 1999 and 2008 each have

3 large or small accruals, and 2001 only had 2 large/small accruals despite the effect of 9/11. Most years

have at least one observation. A wide variety of adjustments cause the small and large accruals. Often

more than one large adjustment is recorded in the same firm year. Some of the adjustments result from an

air plane crash and the subsequent accounting accruals caused by the crash. For example, after a crash of

an Airtran plane (previously flying as ValueJet), the company wrote down its deferred tax asset. In other

cases, previously written down deferred tax assets were written back up after the firm returned to

profitable operations (Frontier in 1999). Some firms took impairment charges when they cut routes to

save costs (American in 1999). Continental in 1997 took an impairment charge when it accelerated the

replacement of older air planes in order to expand (also Airtran in 1999). Some air carriers had to take

large adjustments (positive and negative) because of mark-to-market of their fuel hedges (American in

2008 and Frontier in 2006). Other large adjustments result when an airline expands and records large

deferred revenues (Air traffic liability) from tickets sold for future flights (Alaska in 2009 and Frontier

in 2009).

Next, we collected all the Adjustments listed in the last column of Table B1 from the cash flow

statements and grouped them based on the nature of the adjustment. For example, Goodwill

impairments, Restructuring charges, and Impairment losses were classified as Restructuring and

impairment charges. Across the 24 firm years, fifteen different types of Adjustments exist in Table B1.

Table B2 lists the frequencies of these 15 different adjustments. These 15 adjustments are referenced

34 times in the 24 firm years. The most frequent Adjustment is to Deferred income taxes (eight

references). Write downs or subsequent write ups of deferred tax assets generate many of the large

positive and negative deferred tax adjustments. Restructuring and impairment charges are the next

most frequent Adjustment (seven references).

Finally, using all U.S. passenger carrier firm years, including foreign carriers and those with

fewer than ten observations (445 observations), we find (untabulated) that the mean negative abnormal

accrual from the Jones Model is -0.64 and the mean positive abnormal accrual is 0.40. The equivalent

18

Total accruals are correlated with abnormal accruals at approximately 0.80.

38

means from the performance model are -0.058 and 0.039. Adjustments that reduce earnings are larger in

absolute value than adjustments that increase earnings.

Several inferences can be drawn from the data in Tables B1 and B2. First, a wide variety of

idiosyncratic events (expansion, contraction, bankruptcies, mergers, fuel price hedges) cause airlines to

record large (positive and negative) one-time Adjustments to net income to derive cash flow from

operations. Second, these events do not cluster in time, nor do they appear to reverse in the next year.

Third, write downs and subsequent write ups of deferred tax assets are the most common, but not the only

cause of large positive and negative accruals. Fourth, perhaps most surprising is that significant industry-

wide shocks such as 9/11 and fuel cost changes do not appear to cause more than a few airlines to record

large absolute accruals in the shock year. Fifth, the largest shocks to firms business models (as captured

in total accruals) appear to be idiosyncratic and not common to other firms in the industry. Without a

clear understanding of the underlying economic events experienced by the different firms, it is difficult to

model normal accruals. This exercise highlights the challenges of adding variables to the first-stage

accrual models to control for underlying firm economic heterogeneity.

39

Table B1

Analysis of Accruals in the U.S. Passenger Air Carrier Industry 1993 -2010

Airline Year Accrual Accrual Event Causing Large Accrual Statement

Airtran 1996 0.112 0.127 Due to the crash of an Airtran plane and subsequent "Deferred income tax" $12.2

suspension of operations deferred tax asset written down to million.

zero.

Airtran 1999 -0.465 -0.369 A strategy change caused it to reconfigure its fleet and this "Impairment loss" $148 million

caused a impairment loss because its existing planes would

be retired sooner than expected.

Alaska 1996 -0.141 -0.052 Substantial growth caused prepaid tickets to increase. "Increase in air traffic liability"

$15 million

Alaska 2009 -0.038 0.018 A change in its mileage program increased the revenue by "Decrease in deferred revenue

adding non-airline partners who purchased miles in and other-net" $63 million

advance.

American 1995 -0.102 -0.006 A new strategic plan in response to increased competition Provision for Restructuring

and lower fares, AMR incurred restructuring charges for Charges $533 million

employee termination and aircraft impairment and

retirement.

American 2008 -0.024 0.031 Rising fuel costs and deteriorating economy forced AMR to Restructuring and settlement

cut service and its fleet. Also, higher fuel prices, AMR's charges $1.3 billion and

fuel hedging program, and fair value accounting caused a "Increase in derivative collateral

large accrual. and unwound derivative

contracts" $940 million

Continental 1997 -0.110 -0.052 The company accelerated the replacement of 97 aircraft "Provision for aircraft and

causing an impairment. Based on improved operating facilities" $128 million and

performance the company could utilize additional NOLs. "Deferred income taxes" $212

million

Continental 2003 -0.007 0.066 Company sold a portion of its investments in Orbitz and "Gains on sale investments"

Hotwire resulting in a gain. $305 million

Delta 2003 -0.050 0.038 To reduce costs Delta converted its existing pension plan "Pension, postretirement and

for employees not covered by a collective bargaining postemployment expense in

agreement to a cash balance plan. Under the 2003 excess payments" $532 million

Emergency Wartime Supplemental Appropriations Act and Increase in short-term

Delta received $398 million. investments, net" $311 million

40

Delta 2004 -0.155 -0.072 A strategic review of its regional carrier (Comair) caused a "Deferred income taxes" $1.2

$1.9 billion write off of goodwill and caused an additional and "Asset and other

valuation allowance against its deferred tax asset. writedowns" $1.9 billion

Frontier 1999 -0.240 -0.089 Improved performance and the probable realization of its "Deferred income taxes" $5.5

remaining NOLs allowed Frontier to reverse a deferred tax million and "Air traffic liability

asset reserve. Increased ticket sales generated additional $15.6 million

deferred revenues.

Frontier 2006 -0.045 0.008 Mark-to-market fuel hedges decreased fuel expense. Mark-to-market derivative

(gains) losses, net $12,753,000

Hawaii 2005 -0.628 -0.328 The application of purchase accounting upon Hawaiians Deferred income taxes $25

emergence from bankruptcy resulted in fair value million and Amortization

adjustments to the book basis of Hawaiians assets and intangible assets $14 million

liabilities.

Hawaii 2009 -0.021 0.040 Management concluded that additional net deferred tax Deferred income taxes $25

asset would more likely than not be realized and reversed a million

portion of its valuation allowance.

Mesa 2001 -0.242 -0.141 The allowance for doubtful accounts was increased as a "Impairment and restructuring

result of the impact of the attacks on 9/11 and the impact charges" $81 million and

that the decline in passenger traffic have had on their code "Provision for doubtful

share partners ability to pay. The company intends to accounts" $14 million

dispose of 21 B1900 aircraft. It impaired unamortized

goodwill associated with certain B1900 route systems. The

Company discontinued operating from its Charlotte hub.

Mesa 2005 0.046 0.104 Regional jet fleet grew 12%. Cash and marketable securities "Deferred income taxes" $32

increased to fund regional jet deliveries. Depreciation million, "Net purchases

expense increased 57%, which impacted deferred taxes. investment securities" $70

million and "Prepaid expenses

and other assets" $59 million

SkyWest 1993 -0.212 -0.220 Revenues increased 15% and net income more than "Deferred income taxes" $5

doubled. million

SkyWest 2005 -0.057 0.147 SkyWest operates Delta Connection flights and United "Deferred aircraft credits, net

Express flights who pay on rental agreements. SkyWest accretion" $25 million and

purchased ASA for $372 million paid for from current "Increase in other current assets

assets. $214.2 million was invested in flight equipment and and prepaid aircraft rents" $49

$101.4 million in deposits for aircraft. Aircraft million

manufacturers provide credits for leased aircraft and owned

41

aircraft that may be used to purchase spare parts and pay for

training and other expenses.

So.West 2007 -0.163 -0.049 Operating cash flows were significantly impacted by "Accounts payable and accrued

fluctuations in counterparty deposits associated with the liabilities" $1.6 billion

Companys fuel hedging program (counterparty deposits are

reflected as an increase to Cash and a corresponding

increase to Accrued liabilities).

So.West 2008 0.101 0.159 Oil prices rose 40%. The value of SWs fuel derivative "Accounts payable and accrued

instruments was positive, resulting in SW holding liabilities" ($1.9) billion

counterparty cash deposits, which are reflected as an

increase to Cash and a corresponding increase to Accrued

liabilities. In the Statement of Cash Flows, increases and/or

decreases to these cash deposits are reflected in operating

cash flows within the changes to Accounts payable and

accrued liabilities line item.

United 1999 -0.064 0.020 United sold part of its investments in Galileo for $539 "Gain on sale of investments"

million in cash and Equant for $828 million of cash. ($738 million)

United 2008 -0.170 -0.110 In 2006 United emerged from bankruptcy and adopted "Goodwill impairment" $2.3

fresh-start reporting, which resulted in goodwill being billion

recorded. During 2008, the Company wrote off its entire

goodwill balance.

US Air 2001 -0.191 -0.109 9/11 forced a restructuring plan whereby US Air replaced "Non-cash special charges"

old aircraft with more efficient planes, which resulted in $927 million

aircraft impairments and related charges.

US Air 2004 -0.067 0.003 US Airways filed for bankruptcy in 2004. Accounts payable Decrease in accrued

were accelerated and a new pilot agreement was executed, compensation and vacation

which generated an accrual for compensation and vacation benefits $18 million and

benefits. Decrease in accounts payable

$35 million

42

Table B2

Number of

Adjustments in Statements of Cash Flow Occurrences

payments

Total 34

43

Appendix C - Variable Definitions

CFOi,t Standard deviation of cash flow from operations (Compustat oancf) deflated

by total assets (Compustat at) over the current and prior four years

REVi,t Standard deviation of sales (Compustat sale) deflated by total assets

(Compustat at) over the current and prior four years

AbAccruali,t Firm i's year t abnormal accrual, estimated as the residual from the estimation

of the cross-sectional version of the original Jones model by industry-year.

AbAccrual_NLi,t Firm i's year t abnormal accrual, estimated as the residual from the estimation

of the cross-sectional version of the nonlinear model (Ball and Shivakumar

2006) by industry-year.

AbAccrual_PFi,t Firm i's year t abnormal accrual, estimated as the residual from the estimation

of the cross-sectional version of the accrual model with ROA performance

control (Kothari et al. 2005) by industry-year.

ABNRETi,t Firm i's cumulative abnormal stock return during fiscal year t (using the CRSP

monthly returns file), where expected return is measured by the equal-

weighted CRSP index.

CFi,t Firm i's cash flow from operations (Compustat oancf) in year t, scaled by

average total assets.

DAi,t Firm is year t abnormal accrual, estimated (following the approach in

Bergstresser and Philippon 2006) as the residual from estimation of the

original Jones model in one pooled estimation using firm-year Compustat data

spanning 1988-2000.

DABNRETi,t An indicator variable that equals one if ABNRET < 0, and equals zero

otherwise.

DCFi,t An indicator variable that equals one if CF < 0, and equals zero otherwise.

FirmAgei,t As of year t, the number of years that firm i has appeared in the Compustat

annual file.

HighIdioShock2i,t An indicator variable that equals one if IdioShock2i,t is in the top two sample

quintiles, and equals zero otherwise.

IdioShock1i,t A stock return-based idiosyncratic shock measure, defined as the firm-specific

stock return variation for firm i in year t, computed as the mean squared error

of the residuals from a regression of monthly firm returns on monthly industry

and market returns, using one year of monthly data (year t).

IdioShock2i,t A stock return-based idiosyncratic shock measure, defined as the firm-specific

stock return variation for firm i in years t and t-1, computed as the mean

squared error of the residuals from a regression of monthly firm returns on

monthly industry and market returns using two years of monthly data (years t

and t-1).

IncentRatioi,t A measure of the intensity of CEO incentive pay for firm i in year t.

Calculated (following Bergstresser and Philippon 2006, using Execucomp

data) as [OnePcti,t/(OnePcti,t+Salaryi,t+Bonusi,t)]. OnePcti,t = 0.01 x Pricei,t x

(Sharesi,t + Optionsi,t), where Price is year-end price per share, and Shares

(Options) is the number of shares (options) held by the CEO.

IndChangei,t An indicator that equals one if firm i changed four digit sic industries from

year t-1 to year t, and equals zero otherwise.

LUAAi,t An indicator that equals one if firm i in year t has an original Jones model

abnormal accrual with magnitude greater than 5% of total assets (UAA >

0.05), and equals zero otherwise.

LUAA_NLi,t An indicator that equals one if firm i in year t has a nonlinear model abnormal

accrual with magnitude greater than 5% of total assets (UAA_NL > 0.05), and

equals zero otherwise.

44

LUAA_PFi,t An indicator that equals one if firm i in year t has a performance model

abnormal accrual with magnitude greater than 5% of total assets (UAA_PF >

0.05), and equals zero otherwise.

LargeDiscOpsi,t An indicator that equals one if firm i has discontinued operations (Compustat

do) greater than five percent of sales in year t, and equals zero otherwise.

LargeMergAcqi,t An indicator that equals one if firm i in year t engaged in a large

merger/acquisition (as indicated by Compustat sales footnote code "AB"), and

equals zero otherwise.

LargeRestruci,t An indicator that equals one if firm i has restructuring charges (Compustat

rcp) greater than five percent of sales in year t, and equals zero otherwise.

LargeSpecItemi,t An indicator that equals one if firm i has special items (Compustat spi) greater

than five percent of sales in year t, and equals zero otherwise.

Leveragei,t Firm i's year t leverage, measured as total liabilities (Compustat lt) divided by

total assets (Compustat at).

LnAssetsi,t The natural log of firm i's year t ending total assets (Compustat at).

LnSizei,t The natural log of firm i's year t ending market value of common equity

(Compustat prcc_c*csho).

MktToBooki,t Firm i's market-to-book ratio at the end of year t (Compustat

[prcc_c*csho]/ceq)

OpCycleVoli,t Firm i's year t four-quarter operating cycle volatility (i.e., std. deviation). We

measure quarterly operating cycle as "days sales outstanding"

(90/(saleq/avg_rectq)) + "days inventory outstanding" (90/(cogsq/avg_invtq))

- "days payables outstanding" (90/(cogsq/avg_apq)).

OpShocki,t An indicator variable that equals one if firm i in year t experiences at least one

of five specifically identified operational shocks (from financial statements),

and equals zero otherwise; specifically, this variable equals one if at least one

of the following variables equals one: IndChange, LargeDiscOps,

LargeMergAcq, LargeRestruc, LargeSpecItem.

PeerIdioShock2i,t A measure of average firm-specific stock return variations for all other firms

in firm is industry in years t and t-1, computed as the average IdioShock2 of

all other firms in the industry.

PPEi,t Firm i's year t gross property, plant and equipment balance, scaled by

beginning-of-period total assets.

ROAi,t Firm i's year t return on assets, computed as net income divided by average

total assets.

SalesChangei,t Firm i's change in sales from year t-1 to t, scaled by year t-1 total assets.

TotalAccrualsi,t Firm i's year t total accruals, taken from the statement of cash flows.

UAAi,t Firm i's year t unsigned abnormal accrual, calculated as |AbAccrual|.

UAA_NLi,t Firm i's year t unsigned abnormal accrual, calculated as |AbAccrual_NL|.

UAA_PFi,t Firm i's year t unsigned abnormal accrual, calculated as |AbAccrual_PF|.

UOCVDiffi,t The unsigned simple difference between firm is operating cycle

(OpCycleVol) and the industry average operating cycle in year t.

45

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Figure 1 Idiosyncratic shocks, firm underlying economics and the accruals generating

process

48

Figure 2 - Variation in airline industry operating cycle

Figure 2 presents a time-series plot of the time-series and cross-sectional variation in the operating cycles of several

major airline companies.

40

30

American

20

10

Alaska

0 US Air

American

-10 Delta

Southwest

-20 United

-30

-40 Delta

-50

49

Figure 3 - Histogram of R2 from estimation of cross-sectional industry-year accrual models

Figure 3 presents frequency histograms of the estimated R2s from the 1,006 industry-year estimations within our

sample.

Industry-year R2 Frequency

200

180

160

140

120

100

80

60

40

20

50

Figure 4 - Time-series plots of mean IdioShock2 and large unsigned abnormal accruals

Figure 4 presents time-series plots of the annual sample average IdioShock2, the proportion of the firms in each year

that experience large operational shocks (i.e., OpShock = 1), large unsigned abnormal accruals from the original

Jones model (i.e., LUAA = 1), large unsigned abnormal accruals from the nonlinear model (i.e., LUAA_NL = 1), and

large unsigned abnormal accruals from a Jones model that includes ROA (i.e., LUAA_PF = 1). IdioShock2 is firm-

specific stock return variation for firm i in years t and t-1. All variables are further defined in Appendix C.

60 0.045

0.04

50

0.035

40 0.03

Mean IdioShock2

Percentage

0.025

30

0.02

20 0.015

0.01

10

0.005

0 0

51

Figure 5 Effects of increasing idiosyncratic shocks on unsigned abnormal accruals

Figure 5 presents plots of average unsigned abnormal accruals (Mean UAA) across ten estimations that iteratively

add sample deciles with increasing values of IdioShock2 (corresponding to the numerical data presented in Panel B

of Table 7). IdioShock2 is firm-specific stock return variation for firm i in years t and t-1. Each graph presents

results from the original Jones model, the nonlinear model, and the performance model. All Observations present

the associated statistics for all sample observations included in each estimation. IdioShock2 Decile 1 show the

effects of increasing sample size on the observations in the first sample decile of IdioShock2.

0.09

0.08

0.07

0.06

0.05

0.04

0.03

0.02

0.01

0.00

1 2 3 4 5 6 7 8 9 10

Iteration

0.035

0.030

0.025

0.020

0.015

0.010

1 2 3 4 5 6 7 8 9 10

Iteration

52

Figure 6 - Rejection rate frequencies

Figure 6 presents the frequency of rejecting (at the 5% level) the null hypothesis of no relation between absolute

discretionary Jones model accruals and a partitioning variable that is correlated with idiosyncratic shocks, using Eq.

(12), which includes the following controls: LnSize, MktToBook, Leverage, CFO, and REV. In Panel A, the

correlation is with a firm's own shocks (IdioShock2). IdioShock2 is firm-specific stock return variation for firm i in

years t and t-1. In Panel B, the correlation is with shocks to other industry firms during year t (PeerIdioShock2).

Results are based on 1,000 trials using a sample size of 1,000 randomly drawn observations.

100%

90%

80%

70%

Rejection Rate Frequency

60%

50%

40%

30%

20%

10%

0%

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Correlation between partition variable and IdioShock2

100%

90%

80%

70%

Rejection Rate Frequency

60%

50%

40%

30%

20%

10%

0%

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Correlation between partition variable and PeerIdioShock2

Firm Char. Controls + IdioShock2 Firm Char. Controls + IdioShock2 + PeerIdioShock2

53

Table 1 - Descriptive statistics

Table 1 presents descriptive statistics for key variables used in our analyses. UAA is the unsigned abnormal accrual

from estimating the original Jones model by industry-year (i.e., the absolute value of the residual from Eq. 6).

UAA_NL is the unsigned abnormal accrual from estimating the nonlinear model by industry-year (i.e., the absolute

value of the residual from Eq. 7). UAA_PF is the unsigned abnormal accrual from estimating the Jones model with

inclusion of ROA by industry-year (i.e., the absolute value of the residual from Eq. 8). IdioShock2 is firm-specific

stock return variation for firm i in years t and t-1. All variables are further defined in Appendix C.

TotalAccruals 101,847 -0.068 0.128 -0.610 -0.110 -0.054 -0.011 0.311

SalesChange 101,847 0.102 0.310 -0.789 -0.020 0.053 0.186 1.499

PPE 101,847 0.564 0.461 0.000 0.204 0.447 0.826 2.204

ROA 101,847 -0.032 0.223 -1.102 -0.045 0.029 0.074 0.298

CF 101,847 0.038 0.178 -0.781 0.002 0.070 0.129 0.371

MktToBook 101,642 2.775 4.222 -10.672 1.062 1.817 3.240 27.229

Leverage 101,649 0.507 0.260 0.044 0.307 0.501 0.673 1.381

LnSize 101,679 5.439 2.343 0.428 3.708 5.369 7.077 11.023

CFO 75,403 0.076 0.087 0.005 0.027 0.049 0.088 0.536

REV 76,331 0.172 0.169 0.005 0.062 0.120 0.221 0.959

IdioShock2 101,847 0.024 0.035 0.001 0.005 0.012 0.027 0.225

UAA 101,847 0.076 0.090 0.001 0.021 0.047 0.095 0.472

UAA_PF 101,847 0.066 0.074 0.001 0.018 0.042 0.086 0.358

UAA_NL 101,847 0.065 0.080 0.001 0.016 0.039 0.081 0.418

54

Table 2 - Correlation matrix

Table 2 presents Spearman (Pearson) correlations above (below) the diagonal among key variables we use in our analyses. Variables are defined in Appendix C.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)

TotalAccruals (1) 0.140 -0.144 0.493 -0.073 -0.037 -0.126 0.086 -0.139 -0.051 -0.173 -0.323 -0.130 -0.310

SalesChange (2) 0.149 0.059 0.208 0.110 0.116 -0.038 0.083 -0.001 0.131 -0.027 0.078 0.112 0.053

PPE (3) -0.193 0.077 0.121 0.219 -0.040 0.110 0.098 -0.172 -0.114 -0.095 -0.093 -0.101 -0.093

ROA (4) 0.341 0.366 0.115 0.783 -0.075 -0.133 0.326 -0.527 -0.137 -0.402 -0.421 -0.304 -0.439

CF (5) -0.306 0.196 0.275 0.659 -0.077 -0.048 0.310 -0.535 -0.121 -0.356 -0.289 -0.281 -0.306

MktToBook (6) 0.006 0.259 0.001 0.246 0.173 -0.066 0.161 0.150 0.038 0.083 0.083 0.119 0.111

Leverage (7) -0.079 -0.050 0.127 -0.184 -0.082 -0.086 0.064 -0.071 0.040 0.006 0.041 -0.018 0.005

LnSize (8) 0.051 0.131 0.107 0.375 0.360 0.371 0.094 -0.343 -0.301 -0.383 -0.243 -0.225 -0.228

CFO (9) -0.084 0.004 -0.185 -0.234 -0.247 0.053 -0.212 -0.463 0.347 0.399 0.405 0.455 0.395

REV (10) -0.045 0.125 -0.071 -0.071 -0.086 0.022 -0.035 -0.336 0.488 0.251 0.233 0.226 0.214

IdioShock2 (11) -0.142 -0.035 -0.167 -0.401 -0.360 -0.052 -0.101 -0.567 0.557 0.388 0.296 0.270 0.307

UAA (12) 0.006 0.022 -0.123 -0.155 -0.238 0.024 -0.052 -0.260 0.371 0.233 0.330 0.782 0.842

UAA_PF (13) -0.059 0.060 -0.124 -0.135 -0.148 0.069 -0.082 -0.250 0.421 0.238 0.330 0.684 0.668

UAA_NL (14) -0.048 0.007 -0.124 -0.179 -0.215 0.062 -0.100 -0.249 0.367 0.227 0.353 0.636 0.483

55

Table 3 - Operational shocks and stock return-based idiosyncratic shocks

Panel A of Table 3 presents results from estimating the logit specification of Eq (4). OpShocki,t is an indicator that equals one if firm i has an observed

operational shock in year t, and equals zero otherwise. IdioShock2 is firm-specific stock return variation for firm i in years t and t-1. All variables are further

defined in Appendix C. Robust t-statistics clustered by both firm and year are reported in parentheses. *, **, and *** indicate significance (two-sided) at the

10%, 5% and 1% levels, respectively.

Dep. Var.: LargeMergAcq IndChange LargeDiscOps LargeRestruc LargeSpecItem OpShock

Column: (1) (2) (3) (4) (5) (6)

Intercept -7.03*** -3.47*** -3.65*** -4.56*** -2.06*** -1.71***

(-29.08) (-43.02) (-76.05) (-18.03) (-43.96) (-48.88)

IdioShock2 7.02*** 6.66*** 7.14*** 10.53*** 10.04*** 10.06***

(3.70) (12.87) (18.47) (8.16) (16.37) (18.24)

N 101,847 101,847 101,847 101,847 101,847 101,847

Pseudo-R2 0.007 0.010 0.012 0.031 0.028 0.027

Dep. Var.: LargeMergAcq IndChange LargeDiscOps LargeRestruc LargeSpecItem OpShock

Column: (1) (2) (3) (4) (5) (6)

Intercept -7.04*** -3.48*** -3.67*** -4.58*** -2.08*** -1.73***

(-29.10) (-41.28) (-74.22) (-18.18) (-44.63) (-48.94)

IdioShock1t 5.44*** 5.22*** 6.35*** 9.01*** 8.26*** 8.48***

(2.66) (10.37) (13.42) (7.46) (13.52) (14.25)

IdioShock1t-1 3.59 3.32*** 3.16*** 4.54*** 4.96*** 4.58***

(1.48) (6.01) (5.13) (3.75) (10.61) (10.51)

N 101,365 101,365 101,365 101,365 101,365 101,365

Pseudo-R2 0.007 0.010 0.013 0.031 0.029 0.027

56

Table 4 - Idiosyncratic shocks and operating cycle volatility

Table 4 presents results from estimating Eq. (5). OpCycleVol is firm i's 4-quarter operating cycle volatility. To

calculate operating cycle volatility in year t, we first calculate the operating cycle for each quarter in year t as "days

sales outstanding" + "days inventory outstanding" - "days payables outstanding." We then take the standard

deviation of these four quarterly operating cycles as year t's operating cycle volatility. UOCVDiff is the unsigned

simple difference between firm is OpCycleVol and the industry average OpCycleVol in year t. IdioShock2 is firm-

specific stock return variation for firm i in years t and t-1. All variables are further defined in Appendix C. Robust t-

statistics clustered by both firm and year are reported in parentheses. *, **, and *** indicate significance (two-sided)

at the 10%, 5% and 1% levels, respectively.

Column: (1) (2) (3) (4)

Intercept 21.589*** 16.623*** 55.205*** 54.445***

(31.56) (13.36) (11.26) (9.00)

IdioShock2 323.957*** 141.843*** 260.425*** 87.702*

(14.22) (6.24) (5.93) (1.92)

CFO 236.769*** 242.765***

(14.34) (11.03)

REV -52.107*** -63.195***

(-9.34) (-5.75)

Adj.-R2 0.024 0.076 0.005 0.020

57

Table 5 Unsigned abnormal accruals and idiosyncratic shocks

Table 5 presents results from estimating Eqs. (9) and (10). OpShocki,t is an indicator that equals one if firm i has an

observed operational shock in year t, and equals zero otherwise. UAA (UAA_NL, UAA_PF) is firm i's year t

unsigned original Jones model (nonlinear model, performance model) abnormal accrual. LUAA (LUAA_NL,

LUAA_PF) is an indicator that equals one if UAA (UAA_NL, UAA_PF) is greater than 5% of total assets, and equals

zero otherwise. IdioShock2 is firm-specific stock return variation for firm i in years t and t-1. All variables are

further defined in Appendix C. R2 refers to adjusted-R2 (pseudo-R2) in columns (1)-(3) (columns 4-6). Robust t-

statistics clustered by both firm and year are reported in parentheses. *, **, and *** indicate significance (two-sided)

at the 10%, 5% and 1% levels, respectively.

Panel A IdioShock2

Model: OLS OLS OLS Logit Logit Logit

Dep. Var.: UAA UAA_NL UAA_PF LUAA LUAA_NL LUAA_PF

Column: (1) (2) (3) (4) (5) (6)

Intercept 0.028*** 0.023*** 0.026*** -1.002*** -1.370*** -1.263***

(27.13) (30.16) (37.22) (-20.37) (-34.34) (-35.53)

OpShockt 0.042*** 0.040*** 0.023*** 0.704*** 0.844*** 0.593***

(26.32) (27.60) (26.28) (36.99) (38.71) (29.11)

IdioShock2 0.308*** 0.313*** 0.189*** 5.909*** 7.186*** 4.894***

(11.66) (12.83) (10.21) (11.44) (13.40) (11.13)

CFO 0.291*** 0.252*** 0.307*** 5.220*** 5.649*** 7.433***

(29.48) (27.52) (44.68) (18.07) (23.66) (25.19)

REV 0.043*** 0.030*** 0.026*** 1.155*** 1.002*** 0.956***

(11.06) (10.06) (7.69) (13.38) (16.11) (12.32)

N 75,397 75,397 75,397 75,397 75,397 75,397

R2 0.227 0.225 0.237 0.076 0.095 0.093

Panel B IdioShock1

Model: OLS OLS OLS Logit Logit Logit

Dep. Var.: UAA UAA_NL UAA_PF LUAA LUAA_NL LUAA_PF

Column: (1) (2) (3) (4) (5) (6)

Intercept 0.027*** 0.022*** 0.026*** -1.010*** -1.379*** -1.269***

(26.88) (29.80) (36.70) (-20.54) (-34.69) (-35.66)

OpShockt 0.042*** 0.040*** 0.023*** 0.698*** 0.838*** 0.588***

(25.71) (26.93) (25.97) (36.15) (39.21) (28.88)

IdioShock1t 0.252*** 0.246*** 0.154*** 4.633*** 5.695*** 4.070***

(9.03) (10.20) (8.25) (8.83) (8.78) (10.64)

IdioShock1t-1 0.166*** 0.178*** 0.095*** 3.537*** 4.054*** 2.632***

(7.87) (9.66) (6.26) (6.84) (9.28) (6.83)

CFO 0.287*** 0.248*** 0.305*** 5.119*** 5.552*** 7.352***

(29.42) (27.30) (44.00) (17.93) (23.58) (25.42)

REV 0.042*** 0.029*** 0.026*** 1.141*** 0.987*** 0.948***

(10.94) (9.97) (7.66) (13.17) (16.14) (12.24)

N 75,364 75,364 75,364 75,364 75,364 75,364

R2 0.228 0.227 0.238 0.077 0.096 0.093

58

Table 6 - Other firms shocks

Table 6 presents results from estimating Eq. (11), along with a corresponding logit model. UAA (UAA_NL, UAA_PF) is firm i's year t unsigned original Jones

model (nonlinear model, performance model) abnormal accrual. IdioShock2 is firm-specific stock return variation for firm i in years t and t-1. All variables are

further defined in Appendix C. R2 refers to adjusted-R2 (pseudo-R2) in columns (1)-(3) (columns 4-6). Robust t-statistics clustered by both firm and year are

reported in parentheses. *, **, and *** indicate significance (two-sided) at the 10%, 5% and 1% levels, respectively.

Dep. Var.: UAA UAA_NL UAA_PF LUAA LUAA_NL LUAA_PF

Column: (1) (2) (3) (4) (5) (6)

Intercept 0.022*** 0.016*** 0.021*** -1.260*** -1.636*** -1.434***

(14.83) (11.94) (23.70) (-24.25) (-32.33) (-42.40)

OpShockt 0.041*** 0.040*** 0.023*** 0.682*** 0.823*** 0.576***

(25.77) (27.23) (26.22) (34.19) (34.92) (26.88)

IdioShock2 0.276*** 0.272*** 0.161*** 4.297*** 5.586*** 3.847***

(9.90) (11.01) (7.87) (8.08) (10.59) (8.33)

PeerIdioShock2 0.252*** 0.316*** 0.221*** 12.102*** 12.254*** 8.099***

(6.64) (9.83) (5.82) (11.61) (12.14) (8.09)

CFO 0.286*** 0.246*** 0.303*** 4.968*** 5.411*** 7.234***

(30.21) (27.71) (46.28) (17.76) (24.16) (25.64)

REV 0.042*** 0.028*** 0.025*** 1.108*** 0.956*** 0.924***

(10.63) (9.83) (7.39) (11.39) (14.07) (11.41)

N 75,397 75,397 75,397 75,397 75,397 75,397

R2 0.229 0.230 0.240 0.082 0.101 0.095

59

Table 7 - Effects of increasing the number of observations with idiosyncratic shocks

Table 7 presents results from iterative estimation of accrual models to show the effect of inclusion of observations

with increasing levels of IdioShock2 in the cross-sectional industry-year estimation on the incidence of large

unsigned absolute accruals and industry-year estimation R2s. IdioShock2 is firm-specific stock return variation for

firm i in years t and t-1. We begin by estimating the accrual models using only the first sample decile of IdioShock2

(i.e., observations that have experienced the least degree of shocks), then successively add the remaining IdioShock2

deciles to the estimation one at a time, and re-estimate the models. Panel A presents the sample characteristics of

each estimation iteration. Panel B reports the mean industry-year R2 from each estimation, mean unsigned abnormal

accruals (UAA), and the percentage of sample observations with a large unsigned abnormal accrual (LUAA = 1). All

variables are further defined in Appendix C.

Iteration IdioShock2 Deciles N Mean IdioShock2

1 1 4,650 0.0013

2 1-2 12,989 0.0022

3 1-3 22,894 0.0031

4 1-4 33,675 0.0041

5 1-5 45,515 0.0053

6 1-6 56,994 0.0068

7 1-7 68,609 0.0086

8 1-8 79,866 0.0109

9 1-9 90,927 0.0144

10 1-10 101,847 0.0238

All Obs. in Estimation 4,650 Decile 1 Obs.

Column: (1) (2) (3) (4) (5)

IdioShock2 Deciles Avg. I-Y R2 % LUAA Avg. UAA % LUAA Avg. UAA

1 0.1835 10.97 0.0249 10.97 0.0249

1-2 0.1807 17.82 0.0319 11.72 0.0258

1-3 0.1647 22.82 0.0371 12.02 0.0261

1-4 0.1537 27.05 0.0416 12.47 0.0264

1-5 0.1451 30.98 0.0465 12.65 0.0267

1-6 0.1378 34.38 0.0513 12.69 0.0271

1-7 0.1302 37.49 0.0561 12.99 0.0275

1-8 0.1287 40.72 0.0618 13.87 0.0283

1-9 0.1251 43.73 0.0678 14.49 0.0291

1-10 0.1217 47.77 0.0764 16.86 0.0306

60

Table 8 - Specification tests of signed abnormal accruals - Type I errors

Table 8 reports the proportion of 1,000 random samples of 200 firms each where the null hypothesis of zero

abnormal accruals is rejected at the 5% level using a one-tailed t-test, where abnormal accruals are estimated using

the original Jones model (AbAccrual). The samples are drawn at random within each sample quartile based on

several different variables: Size (Panel A), Market-to-book (Panel B), and Sales Growth (Panel C). Figures in bold

signify rejection rates that are significantly different from the 5% significance level of the test (two-tailed), where

proportions above (below) 0.05 indicate that tests are biased against (in favor) of accepting the null hypothesis of

zero abnormal accruals.

Sample Utilized: All 1 2 3 4 Avg. 1-4

IdioShock2 Quintile 1 (N) 12,980 3,238 3,245 3,256 3,241

Ha : AbAccrual > 0 0.057 0.167 0.009 0.035 0.012 0.056

Ha : AbAccrual < 0 0.051 0.005 0.114 0.042 0.096 0.064

IdioShock2 Quintile 1-2 (N) 33,593 8,386 8,402 8,407 8,398

Ha : AbAccrual > 0 0.048 0.082 0.031 0.051 0.044 0.052

Ha : AbAccrual < 0 0.044 0.019 0.068 0.045 0.049 0.045

IdioShock2 Quintile 1-3 (N) 56,921 14,221 14,231 14,239 14,230

Ha : AbAccrual > 0 0.055 0.024 0.069 0.074 0.069 0.059

Ha : AbAccrual < 0 0.044 0.084 0.024 0.043 0.025 0.044

IdioShock2 Quintile 1-4 (N) 79,759 19,928 19,945 19,948 19,938

Ha : AbAccrual > 0 0.057 0.010 0.078 0.099 0.232 0.105

Ha : AbAccrual < 0 0.036 0.177 0.033 0.016 0.006 0.058

IdioShock2 Quintile 1-5 (N) 101,679 25,409 25,425 25,429 25,416

Ha : AbAccrual > 0 0.056 0.000 0.066 0.262 0.625 0.238

Ha : AbAccrual < 0 0.032 0.481 0.056 0.002 0.001 0.135

Average rejection rate-all quartile cuts 0.086

61

Panel B: Market-to-Book Quartile

Sample Utilized: Pooled 1 2 3 4 Sum 1-4

IdioShock2 Quintile 1 (N) 12,972 3,235 3,244 3,254 3,239

Ha : AbAccrual > 0 0.052 0.155 0.137 0.018 0.003 0.078

Ha : AbAccrual < 0 0.044 0.009 0.016 0.076 0.208 0.077

IdioShock2 Quintiles 1-2 (N) 33,556 8,378 8,393 8,400 8,385

Ha : AbAccrual > 0 0.055 0.076 0.176 0.058 0.012 0.081

Ha : AbAccrual < 0 0.048 0.025 0.017 0.043 0.176 0.065

IdioShock2 Quintiles 1-3 (N) 56,877 14,209 14,220 14,231 14,217

Ha : AbAccrual > 0 0.056 0.044 0.159 0.157 0.009 0.092

Ha : AbAccrual < 0 0.045 0.054 0.012 0.010 0.183 0.065

IdioShock2 Quintiles 1-4 (N) 79,705 19,916 19,931 19,934 19,924

Ha : AbAccrual > 0 0.050 0.013 0.217 0.257 0.010 0.124

Ha : AbAccrual < 0 0.031 0.118 0.003 0.013 0.177 0.078

IdioShock2 Quintiles 1-5 (N) 101,642 25,400 25,416 25,418 25,408

Ha : AbAccrual > 0 0.057 0.004 0.427 0.363 0.007 0.200

Ha : AbAccrual < 0 0.047 0.270 0.000 0.000 0.245 0.129

Average rejection rate-all quartile cuts 0.099

Sample Utilized: All 1 2 3 4 Sum 1-4

IdioShock2 Quintile 1 (N) 12,948 3,228 3,238 3,248 3,234

Ha : AbAccrual > 0 0.054 0.028 0.099 0.160 0.026 0.078

Ha : AbAccrual < 0 0.053 0.099 0.016 0.003 0.104 0.054

IdioShock2 Quintile 1-2 (N) 33,509 8,369 8,380 8,384 8,376

Ha : AbAccrual > 0 0.045 0.016 0.100 0.153 0.031 0.075

Ha : AbAccrual < 0 0.035 0.114 0.018 0.007 0.080 0.055

IdioShock2 Quintile 1-3 (N) 56,762 14,180 14,195 14,202 14,185

Ha : AbAccrual > 0 0.048 0.017 0.124 0.220 0.030 0.098

Ha : AbAccrual < 0 0.047 0.141 0.014 0.002 0.095 0.063

IdioShock2 Quintile 1-4 (N) 79,329 19,822 19,837 19,843 19,827

Ha : AbAccrual > 0 0.055 0.005 0.193 0.333 0.021 0.138

Ha : AbAccrual < 0 0.047 0.207 0.007 0.001 0.104 0.080

IdioShock2 Quintile 1-5 (N) 100,546 25,125 25,141 25,148 25,132

Ha : AbAccrual > 0 0.063 0.004 0.403 0.527 0.014 0.237

Ha : AbAccrual < 0 0.045 0.294 0.000 0.001 0.150 0.111

Average rejection rate-all quartile cuts 0.099

62

Table 9 - Specification tests of signed abnormal accruals - Type II errors

Table 9 presents a comparison of the power of the test to detect seeded earnings management after successively

adding IdioShock2 quintiles. IdioShock2 is firm-specific stock return variation for firm i in years t and t-1. The table

reports the percentage of 1,000 samples of 200 firms each where the null hypothesis of zero discretionary accruals is

rejected at the 5% level (one-tailed tests) based on estimation of the original Jones model.

Sample Observations (N): 12,989 33,675 56,994 79,866 101,847

HA: Abnormal accruals > 0

Seeded Abnormal Accrual (%) Rejection Rates Avg

0 0.050 0.056 0.060 0.061 0.048

1 0.832 0.683 0.577 0.418 0.352

2 1.000 0.980 0.952 0.865 0.765 0.828

4 1.000 1.000 1.000 1.000 0.996

HA: Abnormal accruals < 0

Seeded Abnormal Accrual (%) Rejection Rates Avg

0 0.055 0.045 0.048 0.042 0.054

-1 0.828 0.675 0.520 0.406 0.308

-2 0.999 0.997 0.967 0.895 0.787 0.825

-4 1.000 1.000 1.000 1.000 0.996

Average rejection rate-all seeded groups 0.827

63

Table 10 - Specification tests of signed abnormal accruals after controlling for idiosyncratic shocks

- Type I errors

Table 10 reports the proportion of 1,000 random samples of 200 firms each where the null hypothesis of zero

abnormal accruals is rejected at the 5% level using a one-tailed t-test, where abnormal accruals are estimated using

the original Jones model (AbAccrual) with the addition of a control for idiosyncratic shocks. The samples are drawn

at random within each sample quartile based on several different variables: Size (Panel A), Market-to-book (Panel

B), and Sales Growth (Panel C). Figures in bold signify rejection rates that are significantly different from the 5%

significance level of the test (two-tailed), where proportions above (below) 0.05 indicate that tests are biased against

(in favor) of accepting the null hypothesis of zero abnormal accruals.

Sample Utilized: 1 2 3 4 Avg. 1-4

IdioShock2 Quintile 1 (N) 3,238 3,245 3,256 3,241

Ha : AbAccrual > 0 0.265 0.013 0.024 0.007 0.077

Ha : AbAccrual < 0 0.004 0.101 0.051 0.158 0.079

IdioShock2 Quintile 1-2 (N) 8,386 8,402 8,407 8,398

Ha : AbAccrual > 0 0.130 0.046 0.040 0.017 0.058

Ha : AbAccrual < 0 0.015 0.046 0.057 0.123 0.060

IdioShock2 Quintile 1-3 (N) 14,221 14,231 14,239 14,230

Ha : AbAccrual > 0 0.064 0.111 0.048 0.010 0.058

Ha : AbAccrual < 0 0.039 0.012 0.047 0.139 0.059

IdioShock2 Quintile 1-4 (N) 19,928 19,945 19,948 19,938

Ha : AbAccrual > 0 0.038 0.115 0.080 0.013 0.062

Ha : AbAccrual < 0 0.057 0.017 0.036 0.134 0.061

IdioShock2 Quintile 1-5 (N) 25,409 25,425 25,429 25,416

Ha : AbAccrual > 0 0.010 0.084 0.128 0.126 0.087

Ha : AbAccrual < 0 0.142 0.024 0.020 0.016 0.051

Average rejection rate-all quartile cuts 0.065

64

Panel B: Market-to-Book Quartile

Sample Utilized: 1 2 3 4 Sum 1-4

IdioShock2 Quintile 1 (N) 3,235 3,244 3,254 3,239

Ha : AbAccrual > 0 0.177 0.133 0.021 0.006 0.084

Ha : AbAccrual < 0 0.006 0.018 0.100 0.181 0.076

IdioShock2 Quintiles 1-2 (N) 8,378 8,393 8,400 8,385

Ha : AbAccrual > 0 0.128 0.145 0.069 0.007 0.087

Ha : AbAccrual < 0 0.018 0.010 0.040 0.201 0.067

IdioShock2 Quintiles 1-3 (N) 14,209 14,220 14,231 14,217

Ha : AbAccrual > 0 0.073 0.154 0.117 0.004 0.087

Ha : AbAccrual < 0 0.034 0.005 0.016 0.232 0.072

IdioShock2 Quintiles 1-4 (N) 19,916 19,931 19,934 19,924

Ha : AbAccrual > 0 0.033 0.171 0.191 0.005 0.100

Ha : AbAccrual < 0 0.066 0.006 0.009 0.188 0.067

IdioShock2 Quintiles 1-5 (N) 25,400 25,416 25,418 25,408

Ha : AbAccrual > 0 0.013 0.316 0.285 0.012 0.157

Ha : AbAccrual < 0 0.165 0.004 0.002 0.190 0.090

Average rejection rate-all quartile cuts 0.089

Sample Utilized: 1 2 3 4 Sum 1-4

IdioShock2 Quintile 1 (N) 3,228 3,238 3,248 3,234

Ha : AbAccrual > 0 0.026 0.075 0.150 0.045 0.074

Ha : AbAccrual < 0 0.087 0.023 0.010 0.060 0.045

IdioShock2 Quintile 1-2 (N) 8,369 8,380 8,384 8,376

Ha : AbAccrual > 0 0.020 0.094 0.120 0.018 0.063

Ha : AbAccrual < 0 0.080 0.025 0.017 0.069 0.048

IdioShock2 Quintile 1-3 (N) 14,180 14,195 14,202 14,185

Ha : AbAccrual > 0 0.013 0.083 0.175 0.033 0.076

Ha : AbAccrual < 0 0.112 0.020 0.013 0.083 0.057

IdioShock2 Quintile 1-4 (N) 19,822 19,837 19,843 19,827

Ha : AbAccrual > 0 0.017 0.119 0.218 0.029 0.096

Ha : AbAccrual < 0 0.108 0.019 0.003 0.084 0.054

IdioShock2 Quintile 1-5 (N) 25,125 25,141 25,148 25,132

Ha : AbAccrual > 0 0.010 0.251 0.351 0.022 0.159

Ha : AbAccrual < 0 0.216 0.005 0.002 0.114 0.084

Average rejection rate-all quartile cuts 0.075

65

Table 11 - Specification tests of signed abnormal accruals after controlling for idiosyncratic shocks

- Type II errors

Table 11 presents a comparison of the power of the test to detect seeded earnings management after successively

adding IdioShock2 quintiles. IdioShock2 is firm-specific stock return variation for firm i in years t and t-1. The table

reports the percentage of 1,000 samples of 200 firms each where the null hypothesis of zero discretionary accruals is

rejected at the 5% level (one-tailed tests) based on estimation of the original Jones model with the addition of a

control for idiosyncratic shocks.

Sample Observations (N): 12,989 33,675 56,994 79,866 101,847

HA: Abnormal accruals > 0

Seeded Abnormal Accrual (%) Rejection Rates Avg

0 0.041 0.050 0.060 0.054 0.059

1 0.839 0.669 0.536 0.405 0.333

2 0.999 0.990 0.938 0.882 0.734 0.822

4 1.000 1.000 1.000 1.000 0.999

HA: Abnormal accruals < 0

Seeded Abnormal Accrual (%) Rejection Rates Avg

0 0.046 0.053 0.043 0.042 0.052

-1 0.862 0.680 0.525 0.425 0.317

-2 1.000 0.995 0.966 0.909 0.774 0.830

-4 1.000 1.000 1.000 1.000 0.999

Average rejection rate-all seeded groups 0.826

66

Table 12 - Specification tests of signed abnormal accruals Type I and II errors summary

Panel A of Table 12 presents average rejection rates for the null hypothesis of no earnings management across

various combinations of firm characteristic partitioning schemes and accrual models (Eqs. 6-8 and 13-15), where

analyses are conducted as described in Tables 8 and 10. Panel B of Table 12 presents average rejection rates for the

null hypothesis of no earnings management across various levels of seeded earnings management and accrual

models (Eqs. 6-8 and 13-15), where analyses are conducted as described in Tables 9 and 11. IdioShock2 is firm-

specific stock return variation for firm i in years t and t-1.

IdioShock2 Control Included

Model No Yes % Change

Size Partitioning

Jones 0.086 0.065 -23.9%

Nonlinear 0.120 0.071 -40.7%

Performance 0.175 0.153 -13.0%

Mkt-to-Book Partitioning

Jones 0.099 0.089 -10.3%

Nonlinear 0.144 0.131 -9.4%

Performance 0.176 0.167 -4.8%

Sales Growth Partitioning

Jones 0.099 0.075 -23.8%

Nonlinear 0.134 0.117 -12.9%

Performance 0.055 0.051 -8.1%

IdioShock2 Control Included

Model No Yes % Change

Jones 0.827 0.826 -0.09%

Nonlinear 0.867 0.865 -0.15%

Performance 0.860 0.858 -0.26%

67

Table 13 CEO incentive intensity, abnormal accruals, and idiosyncratic shocks

Table 13 presents results from estimation of Eq. (16) using firm-year observations spanning 1994-2000. DA is discretionary accruals from a pooled estimation of

the Jones model. IncentRatio is a measure of CEO incentive pay intensity. HighIdioShock2 is an indicator that equals one if IdioShock2 is in the top two sample

quintiles, where IdioShock2 is firm-specific stock return variation for firm i in years t and t-1. All variables are further defined in Appendix C. Fixed effects are

included but not tabulated (including the intercept), where I refers to two-digit SIC industry, and Y refers to fiscal year. Robust t-statistics clustered by firm are

reported in parentheses. *, **, and *** indicate significance (two-sided) at the 10%, 5% and 1% levels, respectively.

IdioShock2 Sample Quintile: Full Sample Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 Full Sample

Column: (1) (2) (3) (4) (5) (6) (7) (8)

(2.15) (-0.46) (-1.06) (-1.41) (1.62) (2.76) (-1.09) (2.04)

HighIdioShock2 0.002

(0.64)

IncentRatio*HighIdioShock2 0.036***

(3.24)

IdioShock2 1.426***

(8.03)

MktToBook 0.001*** 0.001 0.000 0.000 0.000 0.002*** 0.001*** 0.001***

(3.21) (1.55) (0.49) (0.64) (0.30) (3.13) (3.27) (3.36)

LnAssetst-1 -0.008*** -0.003** -0.000 -0.000 -0.007*** -0.021*** -0.007*** -0.004***

(-7.68) (-2.25) (-0.27) (-0.12) (-4.44) (-5.28) (-6.79) (-4.61)

Leveraget-1 0.003 -0.008 -0.028*** -0.012 0.001 0.057*** 0.002 -0.006

(0.49) (-0.72) (-3.94) (-1.51) (0.12) (3.52) (0.37) (-0.97)

FirmAge -0.000*** 0.000 -0.000 -0.000 -0.000 -0.000* -0.000 0.000

(-2.65) (0.85) (-0.04) (-0.46) (-1.52) (-1.74) (-1.58) (0.40)

N 8,977 1,797 1,796 1,795 1,795 1,794 8,977 8,977

Adj-R2 0.071 0.234 0.139 0.075 0.077 0.103 0.077 0.103

68

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