Earnings Quality and Future Returns:
The Relation between Accruals and the Probability of Earnings Manipulation
M. D. Beneish and D.C. Nichols
Indiana University
Current Draft: May 17, 2005
Corresponding Author
M
Indiana University Kelley School of Business 1309 E. 10 ^{t}^{h} Street Bloomington, Indiana 47405 dbeneish@indiana.edu
D.
Beneish
Earnings Quality and Future Returns:
The Relation between Accruals and the Probability of Earnings Manipulation
Abstract:
The paper examines the relation between the probability of manipulation, accruals, and future returns. We show that firms that have a high likelihood of earnings
manipulation (as measured by the Beneish (1999)’s MScore) experience lower future earnings, but that investors expect these firms to have higher future earnings. Indeed, we find that investors overestimate nextperiod return on assets by 490 to 690 basis points (this is significant as the median ROA in the sample 4.6%). We also show that the probability of manipulation is a correlated omitted variable for the earnings forecasting models used in prior research on accrual mispricing and that including the probability of manipulation greatly attenuates the mispricing of accrual persistence. Finally, we show that the probability of earnings manipulation predicts economically significant abnormal returns of approximately 15% per year after controlling for accruals and various controls for risk factors, including a factor compensating for earnings quality differences (Easley
and O’Hara (2004), Francis et al. (2005)).
ability of accruals for returns is greatly diminished in the presence of the MScore as indicating that accrual mispricing arises because investors are misled by managers’ opportunistic management of earnings.
We interpret our results that the predictive
Keywords: Earnings Manipulation; Accrual Mispricing; Future Returns. JEL Classification: M4, G11
1.
Introduction
In this paper, we investigate the relation between accruals and the probability of
earnings manipulation. Specifically, we rely on work by Beneish (1997, 1999) to estimate
the probability of manipulation and examine whether this assessment alters the persistence
and pricing implications of current earnings and its components. We conjecture that current
earnings that have a high likelihood of incomeincreasing manipulation lead to poor future
earnings and returns performance. Because the model for assessing the probability of
manipulation relies on publicly available information, and includes accruals as a predictive
variable, we assess (1) whether the likelihood of manipulation predicts future returns, and
(2) whether this relation is distinct from accrual mispricing.
Our paper has the potential to contribute to a large body of research that has
confirmed Sloan (1996)’s seminal findings and frequently proposed an earnings
management explanation for investors’ failure to recognize until later periods that
accruals are less persistent than operating cash flows. ^{1} We further examine the role of
earnings management in accrual mispricing by introducing a construct that ranks firms
according to the likelihood that they have manipulated earnings. This is important
because accruals and abnormal accruals measure earnings management with error, and
recent research suggests that the mispricing may be due to investors’ inability to forecast
the effects of growth rather than earnings management (Tarpley (2000) and Fairfield et
^{1} These studies provide (1) evidence of mispricing for alternative measurements of accruals, abnormal accruals, and components of accruals (Xie (2001); Collins and Hribar (2002); Hribar (2002); Thomas and Zhang (2002); Richardson et al. (2004)), (2) evidence that accrual mispricing appears to be distinct from postearnings announcement drift (Collins and Hribar (2001)), and from the tendency of stock prices to drift in the direction of analysts’ forecast revisions Barth and Hutton (2004); (3) evidence that sophisticated investors such as analysts, auditors, and institutional investors also fail to fully understand the implications of accruals for future earnings (Bradshaw et al. (2001); Collins et al. (2003), Barth and Hutton (2004), Lev and Nissim (2004); (4) evidence that top executives understand the implication of accruals for future earnings and trade their equity contingent wealth accordingly (Beneish and Vargus (2002)).
1
al. (2003)). ^{2} The MScore (Beneish (1997, 1999)) is a composite of eight ratios that, in
addition to total accruals, includes specific accruals intended to capture the financial
statement distortions that can result from earnings manipulation as well as incentives to
engage in earnings manipulation. Beneish (1997, 1999) validates the MScore as a
measure of earnings management by showing the MScore’s ability to identify firms
subject to SEC accounting enforcement actions. ^{3} As McNichols (2000, p. 335) suggests,
the MScore approach to exploiting information about specific accruals and allowing
variation in the exercise of discretion across accruals has the potential to lead to more
powerful methods of detecting earnings management.
Our findings include the following. First, we show that firms that have a high
likelihood of earnings manipulation experience lower future earnings. In contrast, we find
that the market acts as if it expects these firms to have higher future earnings. Consistent
with earnings manipulation misleading investors, we show that, for firms with a high
probability of manipulation, investors overestimate return on assets by 490 to 690 basis
points. Second, we show that the probability of manipulation is a correlated omitted
variable for the earnings forecasting models used in prior research on accrual mispricing.
We document that including the probability of manipulation greatly attenuates the
mispricing of accrual persistence. Third, we document that trading strategies based on M
Score rankings earn economically significant abnormal returns ranging from 20.1 percent
^{2} The former reflects not only the impact of deliberate earnings management, but also changes in firms’ economic performance, and the latter relies on accrual expectation models’ whose ability to disentangle the earnings management component in accruals from the performance component have been widely questioned (e.g., see McNichols (2000) and Beneish (2001) for reviews and evidence). ^{3} Specifically, Beneish (1997) shows that the MScore correctly classifies 41 out of 64 firms charged with GAAP violation whereas aggregate accrual models identify between 15 and 19 of the 64 firms. Beneish also shows in holdout sample tests that a strategy that sells short (buys) firms classified as violators (non violators) yields systematically higher returns for a classification based on the MScore rather than based on accruals.
2
(sizeadjusted) to 21.6 percent (FamaFrench threefactor model). These hedge returns
are 45 and 480 basis points higher than their accrual ranking counterparts (19.6 and 16.8
percent).
We conduct several tests to (1) distinguish the MScore from the accrual
strategy, ^{4} and (2) rule out omitted risk factors as an explanation for the evidence. ^{5}
Specifically, we show that the hedge returns for neither the accrual nor the MScore
rankings are simply manifestations of pricetobook, pricetoearnings, size, return
momentum, cash flow from operations to price, or earnings surprise effects. When we
consider the accrual and MScore strategies jointly, we find that the explanatory power of
accruals for future returns declines in the presence of the MScore alone, and that the
explanatory power disappears in the presence of the MScore and control variables. We
interpret these results as indicating that accrual mispricing arises because investors are
misled by managers’ opportunistic management of earnings.
Third, we consider whether augmenting the FamaFrench threefactor model with
a fourth factor proxying for the premium required by investors to hold stocks with greater
uncertainty about accruals/earnings persistence accounts for the abnormal returns we
observe. ^{6} We find that the returns to the trading strategies remain economically
^{4} These two strategies have substantial overlap. First, fifty percent of the low MScore decile firms also appear in the low accrual decile while 30 percent of the high MScore decile firms appear in the high accrual decile. Second, both partitions reveal a pattern of increasing earnings and decreasing cash flows.
^{5} Although prior research (cf. fn 1) has been careful to address riskbased explanations, recent studies have suggested that the accrual anomaly is subsumed by risk explanations based on growth and cashflowfrom operations to price, and information risk in earnings (Francis et al. (2003), Desai et al. (2004), Khan
(2005)).
^{6} The expanded return generating model is motivated by recent research developments. Specifically, analytical studies by Easley et al. (2002) and Easley and O’Hara (2004) show that uncertainty about
valuation parameters can affect firms’ costs of capital and, that such information uncertainty may be a non
diversifiable risk factor priced by investors.
appears in Francis et al. (2005) and Ecker et al. (2005) who show that a factor proxying for earnings quality explains variation in future stock returns incrementally to the threefactors proposed by Fama and French
(1992).
Empirically, evidence consistent with these predictions
3
significant when we use the expanded model proposed by Ecker et al. (2005). However,
we find that the long side of the hedge no longer yields a significant return, while the
returns to the short side of the hedge become larger in magnitude. Because short selling
strategies have high collateral transaction costs we conduct two additional analyses. We
show that limiting the trading strategy to either (1) firms with market capitalization
greater than $500 million, or (2) firms in which institutional investors take investment
positions, yields hedge returns that are similar to that of the whole sample. Indeed, we
show that institutional investors also appear to be misled by earnings management as, on
average, they increase their holdings independently of whether firms are in the high or
low manipulation decile.
We interpret our results that the predictive ability of accruals for returns is greatly
diminished in the presence of the MScore as indicating that accrual mispricing arises
because investors are misled by managers’ opportunistic management of earnings. Our
results also suggest that accrual mispricing and the relation between the MScore and
future returns both belong to the class of phenomena indicating that investors do not fully
exploit publicly available financial statement information (e.g., Ou and Penman (1989),
Bernard and Thomas (1989), Abarbanell and Bernard (1992), Lev and Thiagarajan
(1993), Abarbanell and Bushee (1997), Beneish (1997), Piotroski (2000), Beneish et al.
(2001)). Our results on the persistence of current earnings conditional on the probability
of earnings manipulation have the potential to be useful for academics and professionals
interested in forecasting future earnings.
We present the remainder of the paper in four parts. The next section discusses
the data and method. Section 3 presents the empirical results. Section 4 reports several
4
robustness checks, and Section 5 concludes.
2. Method
2.1. Sample
We select the initial sample from the Compustat Industrial, Research, and Full
Coverage files for the period 1993 to 2003. ^{7} We eliminate (1) financial services firms
(SIC codes 6000 – 6899), (2) firms with less than $100,000 in sales (Compustat #12) or
in total assets (Compustat #6), and (3) firms without sufficient data to compute accruals
and the MScore. To ensure that the trading strategies that we examine are
implementable, we (1) require all firms used in accruals and MScore rankings to have
stock return data available at the time rankings are made, and (2) use prior year cutoffs
to assign firms to accruals or MScore deciles in the current year. The final sample
consists of 25,285 firmyear observations from 1993 to 2003.
We winsorize financial statement variables at the 1% and 99% levels each year in
our sample period to control for the effect of potential outliers. Our trading strategy
return computations are based on taking positions at the beginning of the month
following the annual earnings announcement, and in case of delisting, we include
delisting returns in the buyand hold return. We next describe our partitioning variables
and the characteristics of our sample.
2.2. Partitioning Variables
2.2.1 Accruals
Following Collins and Hribar (2002), we measure accruals deflated by total assets as
follows:
Accruals
= − (∆AR + ∆INV + ∆AP + ∆TAX + ∆OTH + DEP)
(1)
^{7} Because the Beneish (1999) model was tested on data through 1992, we begin the sample period in 1993.
5
Current Accruals
= Accruals+DEP
(2)
In the Appendix, we discuss several measures of abnormal accruals derived from
aggregate accrual expectation models based on modifications of the Jones (1991) model.
As well, because recent work suggests that such constructs measure earnings management
with error (e.g., see McNichols (2000) among others), we follow Kothari et al. (2005) and
adjust both accruals and current accruals from such models by computing performance
matched abnormal accruals.
2.2.2 Beneish’s MScore
We use the MScore developed by Beneish (1999) to rank firms according to the
likelihood that they have manipulated earnings. The MScore is composed of eight ratios
that capture either financial statement distortions that can result from earnings
manipulation or indicate a predisposition to engage in earnings manipulation. Beneish
(1999) estimates the model using firms that admit to accounting manipulations and firms
targeted by the SEC for earnings manipulation.
There are two main differences between the MScore and accrualbased proxies
for earnings management. First, the MScore captures not only the possible financial
statement consequences of manipulation, but also incentives for manipulating earnings.
Second, in addition to considering the information in aggregate accruals, the MScore
exploits information about specific accruals. As McNichols (2000) points out, the M
Score approach to exploiting information about specific accruals and allowing variation
in the exercise of discretion across accruals has the potential to lead to more powerful
methods of detecting earnings management.
The MScore has been applied on a limited basis in the literature as it does not
measure the magnitude of earnings management. Beneish (1997) found this approach
6
performed better than abnormal accruals from aggregate accrual expectation models
based on Jones (1991) in distinguishing firms with financial statement fraud from firms
with extreme accruals. Teoh et al. (1998) applied the MScore as an alternative proxy for
the occurrence of earnings management in the context of initial public offerings. Both
studies documented that firms with higher probabilities of manipulation subsequently
experienced poor stock market performance. The model we use to estimate the
probability of earnings manipulation is:
M= 4.84+.920*DSR+.528*GMI+.404*AQI+.892*SGI+.115*DEPI
.172*SGAI)+4.679*ACCRUALS.327*LEVI
(3)
Where:
DSR = (Receivables _{t} [2]/Sales _{t} [12]/(Receivables _{t}_{}_{1} /Sales _{t}_{}_{1} )
GMI=
AQI=
SGI=
DEPI=
SGAI=
LEV=
Sales
Total Assets [6] Sales _{t} [12]/Sales _{t}_{}_{1}
t1
[12] Costs of Goods Sold
t1
[41]
1 −
Sales
t1
[12]
Current Assets [4]+ PPE [8]
tt
t
/
1−
/
Sales [12] Costs of Goods Sold [41]
t
t
Sales [12]
t
Current Assets
+ PPE
t1
t1
Total Assets
t 1
Depreciation
[14 less 65]
[8]
t1
Depreciation
t1 ^{+}
PPE
t1
Depreciation
t
/ Depreciation
t
^{+}
PPE
t
SGA Expense [189]
t
Sales [12]
t
/
SGA Expense
t1
Sales
t1
LTD [9]+ Current Liabilities [5] Total Assets [6]
t
t
t
/
LTD
+ Current Liabilities Total Assets
t1
t1
t1
ACCRUALS= (IBX [18]CFO[308])/ TA _{t} [6]
2.3 Sample Characteristics
In Table 1, we describe the characteristics of our sample. Accrual and MScore
decile ranks are highly correlated (correlation = 0.618, p < 0.001, untabulated), and we
report the descriptive statistics by both accrual decile (Panel A) and by MScore decile
(Panel B) to highlight similarities and differences across the rankings.
7
Both partitions reveal a pattern of increasing earnings and decreasing cash flows.
However, the accrual rankings generate larger spreads in earnings (Accruals: 0.177, M
Score: 0.074, which are significantly different at p < 0.001, untabulated), and cash flows
from operations (Accruals: 0.156, MScore: 0.140, which are significantly different at p <
0.001, untabulated). If the mapping between earnings and returns is linear, these
statistics suggest that we should observe larger returns to strategy based on accruals.
We also report descriptive statistics for other financial characteristics across
accrual and MScore deciles. Extreme accrual deciles do not significantly differ on price
tobook, while the extreme MScore deciles do not display significant differences with
respect to return volatility. However, the extreme deciles of both accruals and the M
Score significantly differ on other characteristics such as pricetoearnings, cash flowto
price, earnings surprises (measured as the change in the quarterly earnings for the quarter
of the annual earnings announcement, scaled by market value at the end of the month
before the annual earnings announcement), and size. Because prior research shows that
these characteristics are related to future returns, we control for these variables in
subsequent tests.
3. Empirical Results
3.1 Persistence and Valuation Tests
Following Sloan (1996), we use the framework proposed by Mishkin (1983) to
investigate whether the market rationally prices the implications for oneyearahead
earnings of the likelihood that current earnings are manipulated. We estimate the
following system
8
E
CSAR
t
t
+
+
1
1
= α
= φ
0
1
[
+ β
E
t
+
1
1
EPos
− α
0
t
+ β
2
ENeg
t
+ β
3
EPosM
t
− β′
1
EPos
t
− β′
2
ENeg
t
− β′
3
+ β
EPosM
4
ENegM
t
t
− β′
4
+ β
5
SMS
t
+ ε
t
+
1
ENegM
t
− β′
5
SMS
t
]
+ υ
t
+
1
(4)
E 
= (CFO + Acc); 
CFO 
= Cash flows from operations (#308) divided by average total assets; 
Acc 
= − (∆AR + ∆INV + ∆AP + ∆TAX + ∆OTH + DEP)/ average total assets ; 
CSAR 
= Twelvemonth buy and hold sizeadjusted return from the beginning of 
EPos 
the month following the annual earnings announcement; = E if E > 0; 0 otherwise; 
ENeg 
= E if E < 0; 0 otherwise; 
SMS 
= Scaled MScore. MScores are computed using the model in Beneish (1999). MScores are ranked annually using the prior year decile rank cutoffs. Ranked MScores are scaled to have a zero mean and range from  1 (lowest MScore) to +1 (highest MScore); 
EPosM 
=EPos*SMS; 
ENegM 
=ENeg*SMS. 
The first equation in this system estimates the forecasting coefficients (β _{i} ) of
earnings and the MScore for predicting oneyearahead earnings. We disaggregate
earnings into positive and negative because our predictions about persistence conditional
on the MScore differ according to the sign of earnings. Thus, we expect that positive
earnings associated with a high probability of manipulation will be less persistent (β _{3} <0)
and negative earnings associated with a high probability of manipulation will be more
persistent (β _{4} >0). With respect to the influence of the probability of manipulation on the
level of oneyearahead earnings, we test the hypothesis in the forecasting equation that
high probability of manipulation leads to lower earnings (β _{5} <0).
The second equation in this system estimates the valuation coefficients (β ^{’} _{i} ) that
the market assigns to earnings components and the MScore. The Mishkin framework
provides a statistical comparison between the forecasting coefficients (measures of the
predictive ability of current earnings and the MScore for oneyearahead earnings) and
the valuation coefficients (measures of the market’s pricing of current earnings and of the
MScore).
9
We implement the tests of rational pricing by estimating this system of equations
jointly using a twostage iterative generalized nonlinear least squares procedure. We first
estimate the unconstrained system without imposing any constraints on the coefficients.
In the second stage, we test whether the valuation coefficients differ from the forecasting
coefficients obtained in the first stage by imposing rational pricing constraints β ^{’} _{i} = β _{i} , for
all q). Under the null hypothesis that the market rationally prices current earnings and the
MScore with respect to their association with oneyearahead earnings, Mishkin shows
that the following likelihood ratio statistic is asymptotically χ ^{2} (q) distributed:
2 × N × Ln(SSR ^{c} /SSR ^{u} ),
where
q = the number of rational pricing constraints imposed; N = the number of observations in the sample; SSR ^{c} = the sum of squared residuals from the constrained regressions in the second stage; SSR ^{u} = the sum of squared residuals from the unconstrained regressions in the first stage.
We report the results of this analysis in Table 2, Panel A. The results for the
persistence tests from the forecasting equation are consistent with our predictions. The
estimate for EPosM is negative and significant (0.056, tstatistic=2.52) suggesting that
positive earnings are less persistent when the probability is high that these earnings are
managed. Second, the estimate for ENegM is positive and significant (0.097, t
statistic=10.01) suggesting that negative earnings are more persistent when the
probability is high that current earnings are managed. The estimate for SMS is negative
and significant (0.021, tstatistic= 9.57) suggesting that oneyearahead earnings are
lower when the probability is high that current earnings are managed.
10
Our tests of mispricing reveal, consistent with Sloan (1996), that the persistence
of earnings is not mispriced. However, the market perception of the effect of the
probability of manipulation of current earnings implicit in the pricing regression (0.048)
is significantly different from that implied by the earnings forecasting regression (0.021)
(likelihood ratio=38.97, pvalue<0.001). This result suggests that investors not only fail
to discount current earnings for the probability that such earnings have been manipulated,
but that on average they expect return on assets to be 690 basis points higher than that
implied by the forecasting equation. ^{8}
We next investigate the relation between accruals and the MScore, because the
partitions on these variables described in Table 1 display a similar (though not identical)
pattern. In Figure 1, we display the distribution of total accrual decile rankings for firms
in the highest and lowest probability of manipulation decile.
Over half the firms in the
lowest probability of manipulation decile (54 percent) are firms that are in the Low
accrual decile, and a further 21 percent are from the next lowest accrual decile (decile 2).
The rankings on the low end are thus similar, suggesting that firms with low probability
of manipulation have incomedecreasing accruals. This is consistent with the MScore
being derived from studying firms that overstate earnings. A different picture emerges in
the highest probability of manipulation decile. Only 30 percent of the firms in the highest
probability of manipulation decile are in the highest accrual decile and a further 14
percent are in next highest accrual decile (decile 9). These results suggest that the
rankings are not substitutes, and that their intersection is less pronounced on the short
side of the hedge.
^{8} This effect is economically significant. The median firm in the sample has ROA of 4.6 percent (460 basis points).
11
To investigate whether a relation exists between the MScore and the persistence
and valuation implication of accruals, we estimate three different versions of the
following system:
E
CSAR
t
t
+
+
1
1
= α
+ β
= φ
1
0
5
[
+ β
t
+
1
1
CFO
− α
0
t
+ β
− β′
t
t
1
2
CAccPos
+ β
CFO
− β′
6
6
Dep
t
t
2
t
7
7
3
CAccNeg
SMS
t
+ ε
t
+
t
− β′
3
+ υ
t
+
1
t
+ β
+ β
4
CAccPosM
t
− β′
t
CAccNegM
E
CAccNegM
+ β
1
CAccNeg
− β′
CAccPos
− β′
SMS
t
]
4
CAccPosM
− β′
5
Dep
t
(5)
where: 

E 
= (CFO + CAcc + Dep); 
CSAR 
= Twelvemonth buy and hold sizeadjusted return from the beginning of the month following the annual earnings announcement. 
CFO 
= Cash flows from operations (#308) divided by average total assets; 
CAcc 
= − (∆AR + ∆INV + ∆AP + ∆TAX + ∆OTH)/ average total assets ; 
Dep 
= Depreciation and amortization (#125) divided by average total assets; 
CAccPos 
= CAcc if CAcc > 0; 0 otherwise; 
CAccNeg 
= CAcc if CAcc < 0; 0 otherwise; 
SMS 
= Scaled MScore. MScores are computed using the model in Beneish (1999). MScores are ranked annually using the prior year decile rank cutoffs. Ranked MScores are scaled to have a zero mean and range from  1 (lowest MScore) to +1 (highest MScore); 
CAccPosM 
= CAccPos x SMS; 
CAccNegM 
= CAccNeg x SMS. 
In Panel B, we reproduce Sloan’s test after disaggregating accruals into working
capital accruals and depreciation following evidence in prior work suggesting that the
accrual mispricing phenomenon is due to working capital accruals (Bradshaw et al. 2001;
Thomas and Zhang 2002). We also disaggregate current accruals into positive and
negative accruals because our later predictions about persistence conditional on the M
Score differ according to the sign of accruals. In general, our results are consistent with
Sloan as they suggest that accruals are mispriced.
12
In Panel C, we augment the specification by conditioning signed accruals on the
MScore. We expect that positive accruals associated with a high probability of
manipulation will be less persistent (β _{4} <0) and negative accruals associated with a high
probability of manipulation will be more persistent (β _{5} >0).
Our results of our persistence
tests from the forecasting equation are consistent with our predictions. The estimate for
CAccPosM is negative and significant (0.124, tstatistic=4.23) suggesting that positive
accruals are less persistent when the probability is high that current earnings are
managed. Second, the estimate for CAccNegM is positive and significant (0.225, t
statistic=7.95) suggesting that negative accruals are more persistent when the probability
is high that current earnings are managed. The pricing tests reveal substantial accrual
mispricing for AccPos (likelihood ratio = 5.58, p < 0.001), CAccNegM (likelihood ratio
= 7.71, p < 0.001), and CAccPos + CAccPosM (likelihood ratio = 21.89, p < 0.001).
Our final specification includes SMS as a standalone variable, and, similar to
Panel , we predict β _{7} <0. We find that the market overprices positive accruals (likelihood
ratio = 5.47, p < 0.05), but that the market does not appear to misprice CAccNegM or
(CAccPos + CAccPosM). As in Panel A, the market perception of the effect of the
probability of manipulation of current earnings implicit in the pricing regression (0.039)
is significantly greater than that implied by the earnings forecasting regression (0.010)
(likelihood ratio=24.64, pvalue<0.001). This result also suggests that investors not only
fail to discount current earnings for the probability that such earnings have been
manipulated, but that on average they expect return on assets to be 490 basis points
higher than that implied by the forecasting equation.
13
A striking picture emerges in comparing results across Panels B, C, and D. Panel
B reveals mispricing of positive accruals. In Panel C, we condition positive accruals on
the MScore, but omit SMS as a standalone variable. We find that the mispricing of the
positive accruals is concentrated in the interaction between positive accruals and the M
Score. In the final panel, we include SMS in the specification. Here we find that the
mispricing of the positive accruals conditioned on the MScore disappears and is replaced
by mispricing of the MScore. We interpret these findings to indicate that much of the
predictive content of accruals for future returns arises from the correlation of accruals
with the MScore. To the extent that the MScore captures earnings management, this
suggests that managers’ attempts to opportunistically manipulate earnings successfully
mislead investors.
The pricing tests reported in Table 2 are subject to several limitations. The
Mishkin test is a joint test of market rationality and the ability of our model to correctly
capture the market’s expectation of earnings. Thus, if the test rejects market rationality,
one interpretation is that the earnings expectation model is misspecified. The expectation
model is likely misspecified because it assumes that the ability to forecast oneyearahead
earnings is the only valuerelevant dimension of current earnings. To the extent that our
earnings expectation model is incomplete, the Mishkin (1983) framework assumes that
stock prices are efficient with respect to all omitted variables that are correlated with
earnings or with the MScore. To ensure that our market mispricing results are not due to
errors in model specification, we next investigate (1) whether investment strategies based
on accrual and MScore earn economically significant returns, and (2) the extent to which
the MScore and accruals measures capture the same underlying event.
14
3.2 Returns to Trading Strategies on Accruals and the MScore
We investigate the returns to investment strategies based on accruals as well as
the MScore in Table 3. ^{9} The table presents mean sizeadjusted returns for deciles
formed on accruals, current accruals and the MScore. The oneyear holding period
begins on the first day of the month following a firm’s annual earnings announcement.
Because fiscal year ends and earnings announcement dates vary across sample firms, we
assign firms into deciles based on the prior years’ decile cutoffs.
The return to the hedge portfolio formed by taking a long position in the lowest
accrual decile and a short position in the highest total accrual decile earns a hedge return
of 19.6 percent. This hedge return is higher than the 10.4 percent documented in Sloan
(1996, p. 307), a fact that we attribute to a combination of (1) taking an investment
position on average two months earlier (beginning of the month following the earnings
announcement rather than four months after the end of the fiscal year), (2) our use of
accruals measured using the statement of cash flows rather than the balance sheet
(Collins and Hribar (2002)), and (3) our more recent sample period (Lev and Nissim
(2004)). The partition based on the MScore rankings yields a hedge return of 20.1
percent that is similar (higher by 45 basis points) to the total accrual hedge. Figure 2
demonstrates the similarity in returns across the two strategies. This similarity leads us to
investigate the incremental returns to these strategies.
In addition to examining how the strategies perform in relation to each other, we
investigate whether the hedge returns to these strategies can be explained by omitted
variables associated with future returns. Specifically, we rely on prior research that has
shown that the following six characteristics are correlated with subsequent returns: (1) the
^{9} We reproduce these tests for abnormal accruals in the Appendix.
15
pricetobook ratio, following evidence in Chan et al. (1996), Davis (1994), and Haugen
and Baker (1996), who document that firms with high markettobook ratios (P/B)
subsequently earn lower returns; (2) returns in the prior year (RET _{t}_{}_{1} ), following evidence
in Jegadeesh (1990), and Jegadeesh and Titman (1993) that shortrun returns tend to
continue in the subsequent year; (3) pricetoearnings (P/E), following evidence that
firms with low P/E ratios outperform firms with high P/E ratios on a riskadjusted basis
(among others, Haugen and Baker 1996); (4) firm size (ln(MVE)), following evidence in,
among others, Fama and French (1992), that size explains future returns; (5) unexpected
earnings (UE), to capture the postannouncement drift documented by (among others)
Freeman and Tse (1989) and Bernard and Thomas (1989); and (6) cash flow from
operations to price (CFO/P) following evidence in Desai et al. (2004) that strategies
based on CFO/P explain away the returns to returns to accrualbased strategies. We
estimate several versions of the regression below for each year in our sample as well as
by pooling observations across years:
CSAR _{t}_{+}_{1} = a _{0} + a _{1} HEDGEMSCOR _{t} + a _{2} HEDGEACCR _{t} + a _{3} P/B _{t} + a _{4} P/E _{t} +a _{5} RET _{t}_{}_{1}
+ a _{6} ln(MVE _{t} ) + a _{7} UE _{t} + a _{8} CFO/P _{t} + e _{t}_{+}_{1}
(6)
where CSAR is the oneyear ahead sizeadjusted return from the beginning of the month
following the annual earnings announcement, HEDGEMSCOR and HEDGEACCR are
the scaled MScore and accrual ranks, and the control variables (described above) are
recast as deviations from the mean, scaled by the insample standard deviation of the
variable. Under the assumption of linearity in the relation between rankings and returns,
the coefficient on HEDGEMSCOR (HEDGEACCR) is the return to the MScore
(accrual) hedge portfolio after controlling for the effect of all the other variables.
16
Table 4 presents results of six different versions of equation (7), which we
estimate as a pooled crosssectional regression (Panel A) as well as yearbyyear (Panel
B). The first version we estimate only has HEDGEMSCOR as an explanatory variable
for returns, and the coefficient estimate is 0.159 (tstatistic 8.91). This suggests a 15.9
percent return to a hedge portfolio based on extreme MScore decile rankings, and is
lower than the 20.1 percent reported in Table 3. This is because the coefficient’s
interpretation as a hedge portfolio return depends on linearity, and Figure 2 reveals non
linearity in the relation between decile ranks and returns. The second version we
estimate only has HEDGEACCR as an explanatory variable for returns. The coefficient
estimate of 0.133 (tstatistic 7.40) suggests a 13.3 percent return to a hedge portfolio
based on extreme accrual decile rankings and is similarly lower than the 19.6 percent
reported in Table 3.
Indeed, the spread between estimates of hedge portfolio returns for
the MScore of 4.2 percent (0.2010.159) is lower than the corresponding measure for
accruals (6.3 percent or 0.1960.133), and we interpret the lower spread as an indication
that MScore rankings better delineate oneyearahead returns.
The third estimation includes both HEDGEMSCOR and HEDGEACCR and
reveals statistically positive coefficients of 0.124 and 0.059, respectively. These results
suggest commonality in the two investment strategies: using both strategies yields lower
hedge returns than using each strategy separately. Though both strategies in combination
yield significant returns, the effect of controlling for the other strategy is less pronounced
for the MScore. That is, controlling for accrual decile rankings, the hedge return to M
Score rankings is 12.4 percent (or 350 basis points lower than previously reported), but
17
controlling for MScore decile rankings, the hedge return to accrual rankings is 5.9
percent (or 740 basis points lower than previously reported).
The remaining estimations reproduce the results above while incorporating the
control variables that have been documented in prior work to be correlated with future
returns. ^{1}^{0} When we incorporate these controls for the MScore and the accruals strategies
separately, we obtain qualitatively similar results, suggesting that controlling for market
tobook ratio, prior year returns, earnings yield, firm size, earnings surprise, and cash
flow from operations to price does not diminish the profitability of hedge strategies based
on MScore and accruals. However, in the full model that includes both the MScore and
the accrual strategies, we only obtain an economically and statistically significant return
on the MScore hedge. These results are corroborated by the yearbyyear estimations in
Panel B.
In sum, our results suggest that the probability of manipulation is useful in
predicting future returns and that it acts as a correlated omitted variable in that it greatly
attenuates the predictive ability of accruals for future returns. We conjecture that the
incremental predictive ability of the MScore stems from using incentive variables in
addition to accruals and that the MScore provides an index of how reliable earnings
are. ^{1}^{1} We thus present tests based the FamaFrench three factors, and on the augmented
version that incorporates a factor capturing the compensation for earnings uncertainty
(Ecker et al. (2005)).
3.3 Asset pricing tests
^{1}^{0} We do not include both earnings and cash flow yield variables in regressions that also include accruals. ^{1}^{1} In fact, our finding that the MScore rankings generate a lower spread in terms of earnings components than accrual rankings, suggests that the spread in accruals is not the sole source of predictive ability for future returns.
18
In this section, we report results of asset pricing tests for portfolio returns formed
on accrual deciles and MScore deciles. These tests provide additional evidence on the
extent to which the returns we report in previous tables reflect mispricing or risk. We
estimate the following model for each of the ten decile portfolios for both the accrual
strategy and the MScore strategy:
( R
i,t
− R
f )
t
where
R i,t
= α
i
+ β
i
(
R
M,t
− R
f )
t
+ s SMB + h HML
i
t
i
t
denotes the return to decile i for month t,
+ e EQF
i
t
+ ε
i,t
(7)
f
R
t
denotes the return on the 30day
Tbill for month t,
R M,t
denotes the return on the valueweighted CRSP index for month
t, SMB denotes the FamaFrench size factor mimicking portfolio, HML denotes the
FamaFrench booktomarket factor mimicking portfolio, and EQF denotes the Ecker et
al. (2005) earnings quality factor mimicking portfolio.
Francis et al. (2005) and a companion paper by Ecker et al. (2005) identify EQF
as an important determinant of returns. These papers argue that EQF factor loadings, or
“eloadings,” capture a firm’s sensitivity to poor earnings quality. Neither paper provides
intuition for what shocks to the EQF represent, but the theoretical motivation for the EQF
might shed light on this issue. Easley and O’Hara (2004) argue that investors who are at
an information disadvantage face an adverse selection problem in trading securities in the
capital market. The greater the information asymmetry the greater is the adverse selection
problem and hence the greater is the premium these uninformed investors demand to hold
securities. High information quality “levels the playing field” by reducing information
asymmetry. As a result, high earnings quality can reduce the adverse selection problem
and the premium required by investors to hold securities.
19
Under this line of thought, shocks to the EQF reflect whether the amount of
private information that arrives to sophisticated or “informed” investors is greater than or
less than expected. When relatively less (more) private information arrives, the EQF is
relatively high (low) because the adverse selection costs faced by uninformed investors
are relatively low (high). The eloadings that Francis et al. (2005) and Ecker et al. (2005)
argue as capturing firms’ exposure to poor earnings quality reflect firms’ sensitivities to
shocks to the adverse selection costs associated with the arrival of private information.
Whether this, or an alternative, interpretation of the EQF and the eloadings is
valid can only be resolved by additional research. However, we include the EQF in our
regressions for two related reasons. First, Francis et al. (2005) document that EQF
provides incremental explanatory power relative to the FamaFrench factors in firm
specific regressions and Francis et al. (2005) and Ecker et al. (2005) document that e
loadings are correlated with widelyused measures of earnings quality. Second, earnings
quality could differ across portfolios of stocks sorted on accruals and the MScore. By
controlling for the differential asset pricing implications of earnings quality across the
two strategies, we can more crisply compare any remaining abnormal returns.
We generally follow the procedures in Ecker et al. (2005) for constructing the
EQF. First, we estimate the following model for every industryyear (using Fama and
French (1997) industry definitions) for which we have a minimum of 20 observations in
Compustat:
Acc
t
= α
0
+ α CFO
1
t
−
1
+ α CFO + α CFO
2
t
3
t
+
1
+ α ∆ Re v
4
t
+ α PPE
5
t
+ ε
t
,
(8)
where Acc =(CHGAR [#302]+ CHGINV [#303]+ CHGAP [#304]+ CHGTAX [#305]
+ CHGOTH [#307]+ DEP [#125]) / average total assets;
20
CFO = Cash from operations (#308) / average total assets;
∆Rev = Change in Sales (#12) from t1 to t / average total assets;
PPE = Property, plant, and equipment, gross (#7) / average total assets.
This estimation results in firmyearspecific residuals. For each firmyear, we
estimate the standard deviation of these residual accruals (
σ RA
) using the residuals for the
past five years. We then sort firms into deciles at the beginning of each month based on
the firms’ most recent
σ RA
. We compute the average returns for each decilemonth, and
form the EQF by taking a long position in the highest
σ RA
decile and a short position in
the lowest
σ RA
decile each month. The EQF averages 1.7% per month over the sample
period, which is similar to the average EQF reported by Ecker et al. (2005).
We report the results for accrualsbased rankings in Table 5. In Panel A, we report
the results for the FamaFrench three factor model. The alpha for the lowest accrual
decile is 1% per month, while the alpha for the highest decile is 0.4% per month. Thus,
the hedge portfolio generates a 1.4% abnormal return per month, or a 16.8% annualized
riskadjusted return. The top and bottom deciles do not significantly differ along
dimensions of risk captured by the market, SMB, and HML factors.
Panel B reports the results from augmenting the FamaFrench model with the
EQF. The EQF loads with a positive coefficient in all deciles. The eloading is largest for
the top and bottom deciles, forming a Upattern across the portfolios. This finding
indicates that firms with extreme accruals have poor earnings quality. Also consistent
with Francis et al. (2005), we find that the abnormal returns to the accrual strategy are
largely unaffected by inclusion of EQF. However, we do find that including EQF reduces
the abnormal returns across all the portfolios. While the spread declines slightly to 1.3%
21
per month, the majority of those returns are generated by the short side (–2.0% per
month) of the strategy – where transactions costs and limits to arbitrage are likely most
severe.
The results for the MScore portfolios are reported in Table 6. Panel A reports the
results of regressing the portfolio excess returns on the FamaFrench factors. The results
indicate that, while the FamaFrench factors explain a significant proportion of the
variation in each of the decile portfolios, the strategy nevertheless generates significant
positive abnormal returns. The hedge portfolio generates a 1.8% return per month, or an
annualized 21.6% riskadjusted return. The difference between the MScore hedge
portfolio and the accrual hedge portfolio, depicted in Figure 3, is 480 basis points on an
annualized basis and is statistically significant (p < 0.001 , not tabulated).
In Panel B, we report results from including EQF in the asset pricing regressions.
As for the accrual strategy, the EQF loads with a significant positive coefficient for each
decile and the eloadings exhibit a Upattern. Unlike the accrual strategy, the risk
adjusted returns for the MScore actually increase when including the EQF in the
regressions. The abnormal returns to the strategy rise to 2.1% per month for an
annualized riskadjusted return of 25.2%. The returns to the MScore strategy are
significantly greater than the returns to the accrual strategy (p < 0.001, not tabulated), as
depicted in Figure 4.
3.4 Sensitivity Analyses
3.4.1 Transaction Costs
We measure hedge returns before transaction costs, yet a large portion of the
hedge return arises from the short side of the hedge. While collateral transaction costs
22
seem unlikely to explain the large returns to our short position, we are not able to
estimate them, and we thus do not know whether these returns are sufficient to
compensate investors for the costs and risks associated with short sales. To assess the
reasonableness of these seemingly large hedge returns, we examine the hedge returns that
would obtain to limiting the investment strategy to larger firms. Specifically, because
transaction costs are lower for larger firms, and short sellers typically focus on such firms
to reduce the risk that a lender demands the return of a stock (Staley 1997), we focus on
firms with market capitalization greater than $500 million. As we describe in Table 7,
approximately one quarter of the firms in the extreme probability of manipulation decile
have market capitalization greater than this cutoff. Although this potentially limits the
number of firms over which the strategy can be implemented, the hedge return of 18.4
percent seems unlikely to be explained away by collateral transaction costs on the short
side. In addition, the short side of the hedge is similar for each of the sizebased sub
samples (9.77 v. 9.04 percent).
3.4.2 Institutional Investors
Sophisticated investors are a priori less likely to be misled by managers’ exercise
of accounting discretion and potentially better able to effect (at lower cost) a short selling
transaction. As a result, we examine changes in institutional holdings in the quarters
surrounding the earnings announcement (quarter 0) that results in the firms being ranked
in the extreme deciles. Table 7 reports that institutional investors hold 70 and 73 percent
of the firms in the Low and High MScore decile rankings. If we limit the trading
strategy to those firms, we obtain a hedge return (21.88 percent) similar to that observed
for the sample as a whole. We also document that the percentage of shares held by
23
institutions display a similar pattern of increases whether the firms are on the long or
short side of the hedge. Indeed, the increases in the percentage of shares held by
institutions in quarters 0 and +1 are greater for firms in the high probability of
manipulation decile (1.71% and 4.03%) than in the low probability of manipulation
decile (0.67% and 2.92%). This preliminary evidence suggests that institutional investors
are also misled by managers’ discretionary accounting actions.
4. Conclusion
In this paper, we investigate the relation between accruals and the probability of
earnings manipulation and document the following results. First, we provide evidence
that firms that have a high likelihood of earnings manipulation experience lower future
earnings, but that investors expect these firms to have higher future earnings, consistent
with earnings manipulation misleading investors. Second, we show that the probability
of manipulation is a correlated omitted variable in earnings forecasting models as
including the probability of manipulation greatly attenuates the mispricing of accrual
persistence. Third, we show that trading strategies based on MScore rankings earn
economically significant abnormal returns that are 45 basis points higher (sizeadjusted
returns) and 480 basis points higher (FamaFrench threefactor model) than their accrual
ranking counterparts.
Fourth, we show that the hedge returns for either the accrual or the
MScore rankings are not simply manifestations of markettobook, earnings yield, size,
price momentum, cash flow yield (cash flow from operations to price), or earnings
surprise effects. Fifth, when we consider the accrual and MScore strategies jointly, we
find that the explanatory power of accruals for future returns declines in the presence of
the MScore; the explanatory power disappears in the presence of the MScore and
24
control variables. Sixth, we show that economically significant returns remain when we
allow the returngenerating model to include a factor that proxies for the compensation
demanded by investors for uncertainty about the quality of earnings.
We interpret these results as indicating that accrual mispricing arises because
investors are misled by managers’ opportunistic management of earnings. In addition,
our results suggest that accrual mispricing and the relation between the MScore and
future returns both belong to the same class of phenomena characterized by investors’
failure to fully exploit publicly available financial statement information. Our evidence
on the persistence of current earnings conditioned on the probability of earnings
manipulation has the potential to be useful for academics and professionals interested in
forecasting future earnings.
25
Appendix
Abnormal Accruals and PerformanceMatched Abnormal Accruals
We consider several alternative proxies for earnings management based on measures of abnormal accruals and performancematched abnormal accruals (e.g., Healy, 1985, Jones 1991, Dechow et al. 1995, Beneish 1997, 1998,, and Kothari et al. 2005).
We estimate normal or expected accruals using the Jones (1991) model and two of its variants. The model proposed by Jones follows Kaplan's (1985) suggestion that accruals likely result from the exercise of managerial discretion and from changes in the firm's economic conditions. Jones’ model relates total accruals (Accruals) to the change in sales (ДSales) and the level of gross property, plant and equipment (PPE): ^{1}^{2}
Accruals _{i}_{t} = a _{1}_{i} + b _{1}_{i} ДSales
_{}
_{i}_{t} + c _{1}_{i} PPE _{i}_{t} + u _{1}_{i}_{t}
(A.1)
The second version uses current accruals (CAcc=Accruals +DEP) as the dependent variable and only the change in sales as an explanatory variable:
CAcc _{i}_{t} = a _{2}_{i} + b _{2}_{i} ДSales _{i}_{t} + u _{2}_{i}_{t}
(A.2)
The first modification we consider is the modification attributed to Dechow et al. (1995). The modification only pertains to the computation of predicted accruals. That is, Dechow et al. (1995) use the Jones model in the estimation period, and make a receivable adjustment in the prediction period to recognize that sales growth may be partly due to management exercising discretion over sales. Thus, for example, predicted total accruals under the Dechow et al. (1995) modification are given by:
ˆ
Predicted Accruals _{i}_{t} = ậ _{1}_{i} + b _{1}_{i} (ДSales _{i}_{t} ДReceivables _{i}_{t} ) + cˆ _{1}_{i} PPE _{i}_{t} + u _{3}_{i}
(A.3)
The second modification attributed to Beneish (1998) replaces change in sales by change in cash sales. Cash sales growth is an alternative construct that deals with the endogeneity problem and plays the same role as sales growth in explaining changes in
working capital accounts.
In their total accrual form, the models are given by:
Accruals _{i}_{t} = a _{2}_{i} + b _{2}_{i} ДCash Sales _{i}_{t} + c _{2}_{i} PPEit + u _{3}_{i}_{t}
(A.4)
We estimate these models in crosssection, using all firms in a given twodigit industry and year. Crosssectional estimation has the advantage of not restricting the
analysis only to firms with long time series of data.
make oneyearahead forecasts of expected accruals which, subtracted from the dependent variable, yield abnormal accruals.
Each yearestimation is used to
Recent work examining the properties of abnormal accruals generated with models
^{1}^{2} The model is based on two assumptions. First, working capital accruals resulting from changes in the firm's economic environment are related to changes in sales, or sales growth, since equation (1) is typically estimated with all variables deflated by either lagged assets or lagged sales. Second, gross property, plant and equipment controls for the portion of total accruals related to nondiscretionary depreciation expense.
26
based on Jones (1991) concludes that such proxies measure earnings management with error (e.g., see McNichols (2000) among others). As a result, we follow Kothari et al. (2005) and adjust both accruals and abnormal accruals from the above three models by computing performancematched abnormal accruals. Specifically, for each sample firm, we identify a performancematched firm based on industry membership, period, and lagged ROA. We estimate performancematched abnormal accruals as the difference between various accrual metrics for treatment and control firms.
We report in Table A.1 hedge returns that are comparable to those in Table 3. Two features are noteworthy. We find that the hedge returns for abnormal total accruals and abnormal current accruals are in line with their raw total and current accruals counterparts.
For example, the hedge return for abnormal total accruals using the DSS and Beneish modifications of the Jones’ model are 17.2 percent of 18.2 percent while the total
accruals hedge in Table 3 (19.6 percent).
similar rankings as these variables are highly correlated in our sample, and suggest that
little is gained from partitioning on abnormal accruals. Second, we find that performancematched accruals generate hedge returns that are systematically lower than
their raw total and current accruals counterparts. For example, _{t}_{h}_{e} _{h}_{e}_{d}_{g}_{e} _{r}_{e}_{t}_{u}_{r}_{n} _{f}_{o}_{r}
performancematched total accruals of 13.0 percent is lower than the total accruals hedge in Table 3 (19.6 percent). A decrease is apparent on both sides of the hedge: the long position yields oneyear ahead abnormal returns of 7.9 percent (vs. 10.2 percent for total accruals) and the short position yields oneyear ahead abnormal returns of 5.1 percent (vs. 9.4 for total accruals). These findings are subject to two possible interpretations. One possibility is that the abnormal accruals measures do not yield more precise estimates of earnings management than raw accruals. Alternatively, the abnormal accruals are a more precise measure of earnings management, and these results suggest that earnings management is a partial explanation for the accruals anomaly.
The similarity in hedge returns likely reflects
27
TABLE A.1 Average OneYearAhead SizeAdjusted Returns for Portfolios of Firms Ranked by Decile Based on Abnormal Accruals 25,283 Firmyears between 1993 and 2003.
Panel A: Abnormal Accruals (Total)
Perf. Matched 
Perf. Matched 

Perf. Matched 
Abnormal Total 
Abnormal Total 
Abnormal Total 
Abnormal Total 

Decile 
N 
Total Accruals 
N 
Accruals (DSS) 
N 
Accruals (DSS) 
N 
Accruals (B) 
N 
Accruals (B) 
Low 
2537 
7.88% 
2601 
10.04% 
2592 
8.83% 
2559 
10.39% 
2594 
8.31% 
2 2493 
2.17% 
2459 
5.77% 
2542 
2.16% 
2491 
4.95% 
2517 
2.95% 

3 2537 
1.32% 
2532 
2.83% 
2537 
1.14% 
2494 
2.72% 
2516 
1.19% 

4 2481 
3.19% 
2471 
3.03% 
2459 
3.90% 
2526 
2.27% 
2505 
2.06% 

5 2537 
0.46% 
2482 
2.25% 
2483 
1.67% 
2491 
1.44% 
2419 
2.60% 

6 2480 
2.38% 
2487 
0.44% 
2445 
1.37% 
2421 
1.56% 
2517 
0.14% 

7 2592 
3.65% 
2488 
0.10% 
2576 
1.22% 
2463 
1.39% 
2537 
3.15% 

8 2509 
1.63% 
2489 
1.17% 
2510 
0.22% 
2552 
2.32% 
2529 
1.13% 

9 2540 
5.05% 
2580 
2.43% 
2522 
2.78% 
2560 
1.47% 
2561 
3.24% 

High 
2579 
5.14% 
2696 
7.15% 
2619 
5.28% 
2728 
7.83% 
2590 
5.57% 
Hedge 
13.02% 
17.19% 
14.11% 
18.22% 
13.87% 
Panel B: Abnormal Accruals (Current)
Perf. Matched 
Perf. Matched 

Perf. Matched 
N 
Abnormal Curr. 
Abnormal Curr. 
Abnormal Curr. 
Abnormal curr. 

Decile 
N 
Curr. Accruals 
2559 
Accruals (DSS) 
N 
Accruals (DSS) 
N 
Accruals (B) 
N 
Accruals (B) 
Low 
2529 
6.89% 
2585 
7.22% 
2554 
6.71% 
2551 
7.85% 
2545 
5.79% 
2 2503 
3.61% 
2494 
9.11% 
2498 
3.16% 
2565 
5.72% 
2521 
2.73% 

3 2512 
1.82% 
2562 
0.66% 
2509 
2.15% 
2605 
0.00% 
2534 
1.51% 

4 2568 
0.41% 
2504 
1.29% 
2583 
2.03% 
2510 
0.05% 
2500 
1.61% 

5 2508 
0.91% 
2569 
3.16% 
2455 
0.45% 
2481 
0.17% 
2486 
0.99% 

6 2449 
0.71% 
2498 
0.02% 
2488 
1.03% 
2545 
2.97% 
2492 
2.55% 

7 2525 
3.73% 
2499 
3.27% 
2521 
3.13% 
2592 
2.80% 
2507 
2.70% 

8 2576 
1.30% 
2516 
0.49% 
2572 
1.67% 
2437 
1.68% 
2580 
2.51% 

9 2548 
3.37% 
2499 
3.66% 
2547 
2.46% 
2495 
4.22% 
2565 
3.32% 

High 
2567 
3.53% 
5.56% 
2558 
4.64% 
2504 
4.87% 
2555 
4.64% 

Hedge 
10.42% 
12.78% 
11.36% 
12.72% 
10.43% 

28 
HoldingPeriod:
The oneyear holding period begins on the first day of the month following a firm’s annual earnings announcement.
ends and earnings announcement dates vary across sample firms, we assign firms into deciles based on the prior years’ decile cutoffs.
Because fiscal year
Accruals:
We compute accruals as using COMPUSTAT data (numbers in parentheses) as Total Accruals =  (∆AR[#302] + ∆INV[#303]+ ∆AP[#304] + ∆TAX [#305] + ∆OTH [#307]+ DEP [#125])/Total Assets _{}_{1} [#6], and Current Accruals = Total Accruals + DEP[#125]/ Total Assets _{} _{1} [#6]. ,We use the difference between total accruals for a firm and total accruals for its closest laggedROAmatch from other firms in the same twodigit industry and time period as PerformanceMatched Total Accruals. We similarly compute PerformanceMatched Current Accruals.
Abnormal Accruals:
We estimate abnormal total and current accruals using three models:
1  The Jones (1991) model relates total accruals (defined above) to the change in sales (#12) and the level of gross property, plant and
equipment (#8) and is written as Total accrualsit = ai + bi ∆Salesit + ciPPEit + uit (all variables deflated by lagged total assets). We estimate the model crosssectionally using all firms in a given twodigit SIC code industry and year. We make oneyear ahead forecasts of
expected accruals as Expected accruals _{i}_{t}_{+}_{1} = α _{i} + β _{i} (∆Sales _{i}_{t}_{+}_{1} )+γ _{i} PPE _{i}_{t}_{+}_{1} , where the Greek letters reflect estimates of the model coefficients in the prior year. We estimate abnormal total accruals as the difference between total accruals and expected accruals. We estimate abnormal current accruals by estimating the model after dropping the PPE variable.
2  The DSS modification: Jones’ model as modified by Dechow, Sloan and Sweeney (1995) is the same as the Jones model in the estimation
period. The modification introduced by DSS is the subtraction of the change in receivables (#2) from the change in sales in the prediction
period so that expected accruals are given by: Expected accruals _{i}_{t}_{+}_{1} = α _{i} + β _{i} (∆Sales _{i}_{t}_{+}_{1}  ∆Receivables _{i}_{t}_{+}_{1} )+ γ _{i} PPE _{i}_{t}_{+}_{1} .
unexpected total accruals as the difference between total accruals and expected accruals, and use the difference between abnormal accruals for a firm and abnormal accruals for its closest lagged ROA match from other firms in the same twodigit industry and time period as
PerformanceMatched Abnormal Total Accruals. (DSS).
We estimate abnormal current accruals by estimating the model after dropping the
PPE variable.
3  The Beneish (1998) model relates total accruals (defined above) to the change in cash sales and the level of gross property, plant and
equipment (#8) and is written as Total accrualsit = ai + bi ∆CashSalesit + ciPPEit + uit (all variables deflated by lagged total assets). We estimate the model crosssectionally using all firms in a given twodigit SIC code industry and year. We make oneyear ahead forecasts of
expected accruals as Expected accruals _{i}_{t}_{+}_{1} = α _{i} + β _{i} (∆Cash Sales _{i}_{t}_{+}_{1} )+γ _{i} PPE _{i}_{t}_{+}_{1} ,
coefficients in the prior year. We estimate unexpected total accruals as the difference between total accruals and expected accruals, and use the difference between abnormal accruals for a firm and abnormal accruals for its closest lagged ROA match from other firms in the same
twodigit industry and time period as PerformanceMatched Abnormal Total Accruals. (B). estimating the model after dropping the PPE variable.
We estimate
where the Greek letters reflect estimates of the model
We estimate abnormal current accruals by
29
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60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Accrual Decile Ranks
Low probability of Manipulation
High Probability of Manipulation
34
Figure 2 Accrual and MScore Decile SizeAdjusted Portfolio Returns 1993  2003
Decile Rankings
35
Decile Rankings
36
Figure 4 Accrual and MScore Decile RiskAdjusted Portfolio Returns Risk Adjustment Based on FamaFrench and Earnings Quality Factors 1993  2003
Decile Rankings
37
TABLE 1 Mean (Median) Values of Selected Characteristics for Ten Portfolios of Firms Formed Annually by Assigning Firms To Deciles Based on Total Accruals and the MScore ^{a} Sample Consists of 25,285 Firmyears between 1993 and 2003
Panel A. Accrual Deciles
Lowest 
2 
3 
4 
5 
6 
7 
8 
9 
Highest 
Accruals 
Accruals 
N 
2515 
2501 
2543 
2536 
2506 
2638 
2534 
2483 
2555 
2474 

Earnings 
0.137 
0.001 
0.016 
0.023 
0.026 
0.027 
0.035 
0.035 
0.043 
0.040 
^{*}^{*}^{*} 
(0.045) 
(0.040) 
(0.043) 
(0.043) 
(0.044) 
(0.046) 
(0.051) 
(0.054) 
(0.060) 
(0.065) 

Accruals 
0.189 
0.096 
0.070 
0.051 
0.036 
0.022 
0.003 
0.021 
0.059 
0.169 
^{*}^{*}^{*} 
(0.156) 
(0.092) 
(0.067) 
(0.049) 
(0.034) 
(0.020) 
(0.001) 
(0.022) 
(0.057) 
(0.142) 

CFO 
0.057 
0.108 
0.097 
0.083 
0.074 
0.060 
0.050 
0.030 
0.001 
0.099 
^{*}^{*}^{*} 
(0.114) 
(0.136) 
(0.114) 
(0.097) 
(0.085) 
(0.073) 
(0.062) 
(0.043) 
(0.012) 
(0.067) 

MScore Rank 
3.006 
3.615 
4.149 
4.622 
5.112 
5.685 
6.246 
6.878 
7.655 
8.686 
^{*}^{*}^{*} 
(1.000) 
(3.000) 
(3.000) 
(4.000) 
(5.000) 
(5.000) 
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