Errors in Estimating Accruals: Implications for Empirical Research

Abstract

This paper examines the impact of measuring accruals as the change in successive balance sheet accounts, as opposed to measuring accruals directly from the statement of cash flows. Our primary finding is that studies using a balance sheet approach to test for earnings management are potentially contaminated by measurement error in accruals estimates. In particular, if the partitioning variable used to indicate the presence of earnings management is correlated with the occurrence of mergers and acquisitions or discontinued operations, tests are biased and researchers are likely to erroneously conclude that earnings management exists when there is none. Additional results show that the errors in balance sheet accruals estimation can confound returns regressions where discretionary and non‐discretionary accruals are used as explanatory variables. Moreover, we demonstrate that tests of market mispricing of accruals will be understated due to erroneous classification of “extreme” accruals firms.