Discretionary Revenues as a Measure of Earnings

Management

Stephen R. Stubben*

The University of North Carolina at Chapel Hill

July 2009

ABSTRACT: This study examines the ability of revenue and accrual models to detect simu-
lated and actual earnings management. The results indicate that revenue models are less biased,
better specified, and more powerful than commonly used accrual models. Using a simulation
procedure, I find that revenue models are more likely than accrual models to detect a combina-
tion of revenue and expense manipulation. Using a sample of firms subject to SEC enforcement
actions for a mix of revenue- and expense-related misstatements, I find that, although revenue
models detect manipulation, accrual models do not. These findings provide support for using
measures of discretionary revenues to study earnings management.

Keywords: Revenues; Earnings Management; Discretionary Accruals.

Data Availability: Data are available from public sources.

* Email: stubben@unc.edu

This study is based on my dissertation titled “The Use of Discretionary Revenues to Meet Earnings and Revenue
Targets.” I thank my dissertation committee of Mary Barth (co-chair), Bill Beaver (co-chair), and Maureen McNi-
chols, as well as Steven Kachelmeier (the senior editor), Mark Trombley (the editor), two anonymous reviewers,
Yonca Ertimur, Fabrizio Ferri, Wayne Landsman, and workshop participants at Stanford University, UCLA, Uni-
versity of Chicago, MIT, Harvard Business School, The University of North Carolina at Chapel Hill, the 2005 Ac-
counting Research Symposium at Brigham Young University, and the 2006 EAA Doctoral Colloquium for invalua-
ble comments and suggestions.
 I. INTRODUCTION

This study examines the ability of revenue and accrual models to detect simulated and ac-

tual earnings management. Despite repeated criticisms of accrual models over the past 15 years

(e.g., Dechow et al. 1995; Bernard and Skinner 1996; Guay et al. 1996; McNichols 2000; Tho-

mas and Zhang 2000; Kothari et al. 2005), many studies have addressed and continue to address

earnings management using these models, presumably because few viable alternatives exist. 1

Accrual models have been criticized for providing biased and noisy estimates of discretion,

which calls into question the conclusions from studies that use them (Bernard and Skinner 1996).

The objective of this study is to evaluate a different measure of earnings management—

discretionary revenues—that permits more reliable and conclusive inferences than existing mod-

els.

The most common approaches to estimating earnings management (i.e., the extent man-

agement exercises discretion over reported earnings) use aggregate accruals. However, several

studies have suggested focusing on one component of earnings, which has the potential to pro-

vide more precise estimates of discretion (McNichols and Wilson 1988; Bernard and Skinner

1996; Healy and Wahlen 1999; McNichols 2000). Modeling a single earnings component per-

mits incorporating key factors unique to that component, thereby reducing measurement error. In

addition, focusing on earnings components provides insights into how earnings are managed.

Revenues is an ideal component to examine as it is the largest earnings component for most

firms and is subject to discretion. Dechow and Schrand (2004, 42) find that over 70 percent of

SEC Accounting and Auditing Enforcement Releases involve misstated revenues. Furthermore,

revenues are the most common type of financial restatement (Turner et al. 2001).

1
For example, between 2005 and 2008, The Accounting Review, Journal of Accounting and Economics, and Journal
of Accounting Research published at least 40 articles that use a measure of discretionary accruals.

1
 I model a common form of revenue manipulation—premature revenue recognition—and

its effect on the relation between revenues and accounts receivable. I define prematurely recog-

nized revenues as sales recognized before cash is collected using an aggressive or incorrect ap-

plication of Generally Accepted Accounting Principles. My revenue model is similar to existing

accrual models (Jones 1991; Dechow et al. 1995), but with three key differences.

First, I model the receivables accrual, rather than aggregate accruals, as a function of the

change in revenues. Of the major accrual components, receivables have the strongest empirical

and most direct conceptual relation to revenues. Explaining other working capital accruals by

revenues alone contributes to the noise and bias that plague accrual models. Because I model re-

ceivables instead of aggregate accruals, the model is one of revenues rather than earnings.

Second, I model the receivables accrual as a function of the change in reported revenues,

rather than the change in cash revenues (Dechow et al. 1995). Although this choice systematical-

ly understates estimates of discretion in revenues, it is less likely to overstate estimates of discre-

tion for firms whose revenues are less likely to be realized in cash by year end (e.g., growth

firms). The modified Jones model (Dechow et al. 1995) treats uncollected credit sales as discre-

tionary.

Third, I model the change in annual receivables as a linear function of two components of

the change in annual revenues: (1) change in revenues of the first three quarters and (2) change

in fourth-quarter revenues. Because revenues in the early part of the year are more likely to be

collected in cash by the end of the year, these have different implications for year-end recei-

vables than a change in fourth-quarter revenues. Revenue and accrual models that fail to consider

fourth-quarter revenues separately overstate (understate) discretion when fourth-quarter revenues

are relatively high (low).

2
 I also estimate a version of the model that allows the relation between receivables and

annual revenues to vary depending on firms’ credit policies. Models that fail to incorporate dif-

ferences across firms in the relation between revenues and receivables (or accruals) will misstate

estimates of discretion.

Discretionary revenues is the difference between the actual change in receivables and the

predicted change in receivables based on the model. Abnormally high or low receivables indicate

revenue management. To benchmark against existing models, I compare the ability of the reve-

nue model and commonly used accrual models (Jones 1991; Dechow et al. 1995; Dechow and

Dichev 2002; Kothari et al. 2005) to detect combinations of revenue and expense management.

Findings indicate that measures of discretionary revenues do in fact produce estimates

with substantially less bias and measurement error than those of accrual models. Using simulated

manipulation (Kothari et al. 2005), I find that the revenue model produces estimates of discretion

that are well specified for growth firms. Each of the accrual models tested exhibits substantial

misspecification. The results for growth firms indicate a bias of over two percent of total assets

for each of the accrual models.

The results indicate further that discretionary revenues can detect not only revenue man-

agement but also earnings management (via revenues), whereas accrual models do not. 2 Using a

sample of firms targeted by SEC enforcement actions, I find that the revenue model is able to

detect earnings manipulation, but accrual models are not. 3 The simulation analysis reveals that

the revenue model is more likely than accrual models to detect earnings management for equal

amounts of revenue and expense manipulation. These findings suggest that the revenue model is

2
Consistent with this idea, Stubben (2006) finds evidence of earnings management to meet several earnings targets
using estimates of discretionary revenues, despite the estimates of discretionary accruals being too noisy to produce
significant results.
3
Richardson et al. (2006) find a positive correlation between noncurrent operating accruals and SEC enforcement
actions. However, I limit my focus to the more commonly used accrual models.

3
less likely than accrual models to falsely indicate earnings management, and more likely than

accrual models to detect earnings management when it does occur.

Finally, the results have implications for studies that use accrual models. First, the Jones

model (Jones 1991) exhibits better specification than the modified Jones model (Dechow et al.

1995), which suggests including reported revenues, rather than cash revenues, in accrual mod-

els. 4 Second, the Dechow-Dichev model (Dechow and Dichev 2002; McNichols 2002), which

was originally developed to estimate earnings quality, exhibits greater misspecification than oth-

er accrual models when used to estimate discretionary accruals. I am unaware of any other study

that evaluates the ability of the Dechow-Dichev model to estimate discretionary accruals. Lastly,

the innovations I incorporate into the revenue model, including separating fourth-quarter reve-

nues and allowing the relation between revenues and accruals to vary across firms, could im-

prove the performance of accrual models.

II. MOTIVATION AND RELATED RESEARCH

Earnings Management

Earnings management has received significant attention in the popular press and academ-

ic accounting literature (McNichols 2000). Recently, various accounting scandals (e.g., Enron,

WorldCom, and Parmalat), and subsequent regulation (e.g., Sarbanes-Oxley) have fueled this

attention.

As Beneish (1999, 24) writes, “The extent to which earnings are manipulated has long

been of interest to analysts, regulators, researchers, and other investment professionals.” For

analysts and investors, understanding the extent to which managers exercise discretion in earn-

ings is important in assessing the quality of earnings. Understanding which firms manage earn-

4
Relatedly, Kothari et al. (2005) note the misspecification of the modified Jones model for firms with extreme
growth and caution its use unless the researcher is confident that credit sales represent accrual manipulation.

4
ings and how they do it is useful for standard setters and regulators. Frequent earnings manage-

ment warrants new standards or additional disclosures, and evidence on the specific accruals ma-

naged allows standard setters to narrow their focus in this regard. Understanding the motives for

earnings management allows the SEC to narrow its focus in enforcing standards. In each case, a

reliable measure of earnings management and the specific accruals used is required.

Findings of Prior Literature

Accrual Models

Studies of earnings management around firm-specific events commonly use models of

aggregate accruals. 5 A variety of accrual models have been used in recent years. Most accrual

models are some variation of the cross-sectional Jones model (Jones 1991; DeFond and Jiambal-

vo 1994). In these models, nondiscretionary, or normal, accruals are usually estimated as a linear

function of change in revenues and gross property, plant, and equipment. The models are usually

estimated by industry and year, and the residual is the discretionary accruals estimate. The mod-

ified Jones model (Dechow et al. 1995) uses change in cash revenues rather than change in total

revenues because some credit revenues may be discretionary. Other models add additional condi-

tioning variables, such as cash flows (Dechow and Dichev 2002; McNichols 2002).

Despite the prevalence of these models, they have been criticized for providing biased

and noisy estimates of discretionary accruals (Dechow et al. 1995; Kang and Sivaramakrishnan

1995; Bernard and Skinner 1996; Guay et al. 1996; Thomas and Zhang 2000). Dechow et al.

(1995) find that discretionary accrual models generate tests of low power for earnings manage-

ment of economically plausible magnitudes and misspecified tests of earnings management for

firms with extreme financial performance, which is frequently correlated with the earnings man-

5
Other approaches to identify earnings management include distributional tests (e.g., Burgstahler and Dichev 1997),
accounting procedure changes (Healy 1985; Healy and Palepu 1990; Sweeney 1994), and components of discretio-
nary cash flows (Dechow and Sloan 1991).

5
agement incentive under investigation (e.g., IPOs and SEOs). The results in Guay et al. (1996)

are consistent with the modified Jones model estimating discretionary accruals with considerable

imprecision and/or misspecification. Thomas and Zhang (2000) assert that the commonly used

models “provide little ability to predict accruals.”

Inferences relating to earnings management depend on the researcher’s ability to accu-

rately estimate discretionary accruals. As a consequence of accrual models’ poor performance,

studies using accrual models have often produced mixed results. Burgstahler and Eames (2006)

find that firms with small positive forecast errors have higher unexpected accruals using the

Jones (1991) model, in contrast to the absence of such an association in Phillips et al. (2003),

who employ the modified Jones model. Matsumoto (2002) finds evidence of firms using discre-

tionary accruals to meet earnings forecasts in one specification, but not in another. Dechow et al.

(2003) find similar magnitudes of discretionary accruals for small loss and small profit firms and

conclude that if firms overstate earnings to report profits, their accrual model is not powerful

enough to detect it.

Specific Accruals

A limitation of aggregate discretionary accrual measures is that they do not provide in-

formation as to which components of earnings firms manage. These models do not distinguish

discretionary increases in earnings through revenues or components of expenses. McNichols

(2000) suggests that future progress in the earnings management literature is more likely to come

from the examination of specific accruals (see also Bernard and Skinner 1996; Healy and Wah-

len 1999; and Beneish 2001). 6

6
Examples of specific accruals that have been modeled are the allowance for bad debt (McNichols and Wilson
1988), loan loss provisions in the banking industry (Beaver et al. 1989; Moyer 1990; Scholes et al. 1990; Wahlen
1994; Beatty et al. 1995; Collins et al. 1995; and Beaver and Engel 1996), loss reserves of property and casualty

6
 The advantage of using specific accruals, such as loan loss reserves, is that they are ma-

terial and a likely object of judgment and discretion. However, many accruals are industry spe-

cific (e.g., banking and insurance industries) and the analysis cannot be applied to firms outside

the industry. In contrast, McNichols and Wilson (1988) examine discretion in the allowance for

bad debts. This accrual is common across industries. However, bad debt expense is often only a

small portion of reported earnings, so only a relatively small portion of the total amount of a

firm’s discretion is likely to be captured. An ideal specific accrual for study is one that is (1)

common across industries, (2) subject to discretion, and (3) represents a large portion of the earn-

ings discretion available to firms. Based on these criteria, revenues is a natural candidate.

Revenues as a Means of Earnings Management

Three studies that examine revenue management are Plummer and Mest (2001), Mar-

quardt and Wiedman (2004), and Caylor (2009). Plummer and Mest (2001) study the discretion

in earnings components using distributional tests similar to those of Burgstahler and Dichev

(1997), finding evidence suggesting firms manage earnings upward to meet earnings forecasts by

overstating revenues and understating some operating expenses. They do not attempt to estimate

discretionary revenues.

Marquardt and Wiedman (2004) estimate the unexpected portions of several accrual

components, including receivables, to determine which components of earnings firms manipulate

in certain settings. They find evidence that firms with small earnings increases understate special

items but do not overstate revenues. It also finds evidence that firms use discretion in revenues to

increase (decrease) earnings prior to equity issuances (management buyouts). Caylor (2009) uses

discretionary revenues to test their use for avoiding reporting negative earnings surprises and

insurers (Petroni 1992; Beaver and McNichols 1998; Nelson 2000; Petroni et al. 2000), and tax expense (Phillips et
al. 2003; Dhaliwal et al. 2004).

7
finds evidence that managers use discretion in revenues that affects both accounts receivable and

deferred revenues to report positive earnings surprises. I seek to validate a measure of discretio-

nary revenues that can be used to test hypotheses in studies such as these. 7

III. RESEARCH DESIGN

Discretionary revenues take a number of forms. Some involve the manipulation of real

activities (e.g., sales discounts, relaxed credit requirements, channel stuffing, and bill and hold

sales), and others do not (e.g., revenues recognized using an aggressive or incorrect application

of Generally Accepted Accounting Principles (GAAP), fictitious revenues, and revenue defer-

rals). I model premature revenue recognition and its effect on the relation between revenues and

accounts receivable. Premature revenue recognition includes channel stuffing and bill and hold

sales, if customers do not pay cash for the inventory, and revenues recognized using an aggres-

sive or incorrect application of GAAP. 8

I focus on premature revenue recognition because evidence suggests that it is the most

common form of revenue management. 9 For example, Feroz et al. (1991) find that more than

half of SEC enforcement actions issued between 1982 and 1989 involved overstatements of ac-

counts receivable resulting from premature revenue recognition. Other forms of revenue manipu-

7
The model used in Caylor (2009) is similar to my revenue model but does not split fourth-quarter revenues and
includes the change in cash flows from the current to following year. Untabulated results reveal that the model used
by Caylor (2009) produces statistically indistinguishable results compared to my revenue model in the simulation
analyses but fails to detect revenue manipulation by SEC firms. In addition, my model has the advantage of not rely-
ing on future data; it can be applied in real time.
8
By focusing on premature revenue recognition, I will not capture discretionary cash revenues. These might include
not deferring enough revenue, or taking real actions that increase cash collected from revenues. In fact, to the extent
these cash-based discretionary revenues occur, the model will understate the amount of accrual-based discretionary
revenues. Caylor (2009) provides a model of deferred revenues. I focus on receivables into order to obtain a measure
that can be used broadly across many firms; most firms don’t report a significant amount of deferred revenues.
9
Because of a possible selection bias, the type of earnings manipulation that is most commonly detected is not nec-
essarily the most commonly employed. However, without a reliable measure of revenue manipulation (such as those
presented in this study), it is difficult to assess the extent of revenue versus expense manipulation in the general
population of firms.

8
lation, such as sales discounts, could be profit-maximizing business decisions and not merely

attempts manage revenues to meet a performance benchmark.

Model of Discretionary Revenues

Reported (i.e., managed) revenues (R) is the sum of nondiscretionary revenues (RUM) and

discretionary revenues (δ RM).10

Rit = RitUM + δitRM

A fraction, c, of nondiscretionary revenues remains uncollected at year end, and I assume there

are no cash collections of discretionary revenues. Thus, accounts receivable (AR) equals the sum

of uncollected nondiscretionary revenues (c × RUM) and discretionary revenues (δ RM). 11

ARit = c × RitUM + δitRM

Discretionary revenues increase accounts receivable and revenues by the same amount; discre-

tionary receivables equals discretionary revenues.

Because nondiscretionary revenues are not observable, I rearrange terms and express end-

ing receivables in terms of reported revenues. I then take first differences to arrive at the follow-

ing expression for the receivables accrual. 12

∆ARit = c × ∆Rit + (1 − c) × ∆ δitRM

The estimate of a firm’s discretionary revenues is the residual from the following equation:

∆ARit = α + β ∆Rit +ε it

10
If revenues are managed each year, δ RM could be interpreted as net revenue management (i.e., revenue manage-
ment net of reversals from the prior period).
11
I assume that receivables are collected within one year. I address the impact of this assumption in untabulated
tests by adding additional lags of sales to the model. Qualitative results are unchanged.
12
The advantage of modeling receivables as opposed to accruals is that they are directly related to revenues—the
relation is not as clear with other current accruals (Kang and Sivaramakrishnan 1995). Accounts payable relates to
purchases, and inventory relates to forecasted revenues for the next period, not current revenues (Dechow et al.
1998). Forecasted revenues equals current revenues if revenues follow a random walk, but this is not true for grow-
ing firms. The relation between other accruals and change in revenues is unclear. Because revenues alone do not
explain payables, inventory, and other accruals, accrual models produce noisy estimates of discretionary accruals.
The estimates are also biased, for example, for growth firms if the noise is correlated with growth.

9
 Because reported revenues include discretionary revenues, the amount of revenue man-

agement estimated by the revenue model will be understated by a factor of 1 – c (see footnote 31

of Jones 1991). The modified Jones model (Dechow et al. 1995) conditions on the change in cash

revenues rather than total revenues, which avoids systematically understating the amount of

earnings management. However, this approach introduces another problem: uncollected credit

revenues are treated as discretionary. Firms with a higher than average portion of nondiscretio-

nary revenues that are credit will have higher estimates of discretionary accruals. I condition on

total revenues because this understates estimated earnings management, which biases against

finding in favor of typical alternative hypotheses.

One limitation of accrual models is that by conditioning on annual revenues they treat

revenues from early in the year the same as revenues from later in the year. Current accruals are

generally resolved within one year. Thus, sales made late in the year are more likely to remain on

account at year end. Therefore, the revenue model I estimate allows the estimated portion of rev-

enues that are uncollected at year end to vary in the fourth quarter.

∆ARit = α + β1 ∆R1_3it + β2 ∆R4it +ε it (1)

In Eq. (1), R1_3 is revenues in the first three quarters, and R4 is revenues in the fourth

quarter. Even though Eq. (1) incorporates quarterly revenues, I estimate discretion on an annual

level. 13 Any revenue management in early quarters that reverses by year end will not be cap-

tured.

13
I focus on annual accruals because most studies using discretionary accruals do so at the annual level. Stubben
(2006) develops models of revenues and accruals at the quarterly level. Similar to the findings of this study, the
quarterly revenue model is more powerful and better specified than quarterly accrual models.

10
 Another limitation of accrual models is that cross-sectional estimation implicitly assumes

that firms in the same industry have a common accrual-generating process. Dopuch et al. (2005)

show that the relation between accruals and revenue changes depends on firm-specific factors

such as credit and inventory policies. In cross-sectional estimation, deviations from the industry

average credit policy, for example, would lead to non-zero estimated unexpected accruals.

Therefore, to control for these deviations, I also estimate a version of the revenue model that al-

lows the coefficient on revenues to vary with firms’ credit policies. 14

Petersen and Rajan (1997) review theories of trade credit and the determinants of ac-

counts receivable. I use the implementation of the Petersen and Rajan (1997) credit policy model

described in Callen et al. (2008). A firm’s investment in receivables is a function of its financial

strength, operational performance relative to industry competitors, and stage in the business

cycle. Firm size, measured as the natural log of total assets (SIZE), is a proxy for financial

strength. Firm size and firm age (AGE), measured as the natural log of the firm’s age in years,

are proxies for the firm’s stage in the business cycle. Following Petersen and Rajan (1997), I also

include the square of firm age (AGE_SQ) to allow for a nonlinear relation between age and credit

policy. As proxies for the operational performance of the firm relative to industry competitors, I

use the industry-median-adjusted growth rate in revenues (GRR_P if positive, GRR_N if nega-

tive) and the industry-median-adjusted gross margin (GRM) and its square (GRM_SQ).

I refer to the following model as the conditional revenue model, as it is a cross-sectional

conditional estimation of the revenue coefficient:

14
The relation between receivables and revenues is also affected by economic events such as factoring accounts
receivable (McNichols 2000). Regarding factoring, Sopranzetti (1998) searches a database of over 4,000 publicly
traded firms from 1972–1993 and finds only 269 reports of factored accounts receivable by 98 firms. Nearly half of
the firms (47) were from the Textile and Apparel industries, and no other industry had more than 7 firms. To control
for the potential effects of factored receivables, I repeat my tests after excluding firms from the Textile and Apparel
industries and find similar results.

11
 ∆ARit = α + β1 ∆Rit + β2 ∆Rit×SIZEit + β3 ∆Rit×AGE it (2)
+ β4 ∆Rit×AGE_SQ it + β5 ∆Rit×GRR_Pit
+ β6 ∆Rit×GRR_Nit + β7 ∆Rit×GRMit + β8 ∆Rit×GRM_SQit +ε it

As a benchmark for the revenue models, I estimate discretionary accruals using four

common approaches: the Jones model (Equation 3 below; Jones 1991), the modified Jones model

(Equation 4 below; Dechow et al. 1995), the Dechow-Dichev model (Equation 5 below; Dechow

and Dichev 2002; McNichols 2002), and performance-matched estimates from the modified

Jones model (Kothari et al. 2005). The appendix summarizes the discretionary revenue and ac-

crual estimates I use in this study.

ACit = α + β1 ∆Rit + β2 PPEit +ε it (3)

ACit = α + β1 (∆Rit – ∆ΑRit) + β2 PPEit +ε it (4)

ACit = α + β1 ∆Rit + β2 PPEit + β3 ∆Rit×CFO i,t-1 + β4 CFOit + β5 CFOi,t+1 +ε it (5)

Data and Descriptive Statistics

The sample period begins in 1988 because prior to that date cash flow from operations

disclosed under Statement of Financial Accounting Standards No. 95 (FASB 1987) is unavaila-

ble. The sample period ends in 2003 but uses 2004 data for cash from operations. I exclude firms

in regulated industries (financial, insurance, and utilities) because their revenues and accruals

likely differ from those of other firms.

I obtain financial data from Compustat. I calculate accruals as earnings before extraordi-

nary items less cash flow from operations. 15 I obtain cash flow from operations and the change

in receivables from the cash flow statement (Hribar and Collins 2002). Revenues of the first

three quarters is the difference between annual revenues and fourth-quarter revenues. I deflate all
15
Because the statement in cash flows presents the change in net receivables, discretionary revenues include any
discretion in the allowance for doubtful accounts. McNichols and Wilson (1988) find evidence of earnings manage-
ment using the allowance for doubtful accounts for firms with unusually high or low earnings.

12
revenue and accrual variables by average total assets. Annual earnings growth is the annual

change in income before extraordinary items, deflated by average total assets. Revenue growth is

the ratio of current to prior-year revenues. Gross margin percentage equals revenues less cost of

revenues, divided by revenues. Firm age is the number of years since the firm’s initial appear-

ance in the Compustat annual file with nonmissing financial information. Industries are as de-

fined in Barth et al. (2005). I winsorize at one percent each model input variable by industry and

year.

Following Kothari et al. (2005), I estimate nondiscretionary accruals with scaled and un-

scaled intercepts (by assets), to control for scale differences among firms (Barth and Kallapur

1996). I exclude firms suspected of manipulation (e.g., firms targeted by the SEC) when estimat-

ing the model coefficients. I use the estimated coefficients to calculate discretionary revenues of

suspected firms.

[INSERT TABLE 1 ABOUT HERE]

Table 1 presents summary statistics. Panel A indicates that mean (median) accruals are –8

(–6) percent of average assets. The mean and median change in receivables is 1 percent of aver-

age assets. Panel A also indicates that the mean (median) change in revenues is 9 (7) percent of

average assets. On average, the revenue change is approximately evenly distributed across quar-

ters. The median change in revenues of the first three quarters is 5 percent of average assets (ap-

proximately 2 percent per quarter), and the median change in fourth-quarter revenues is 2 percent

of average assets.

Panel B of Table 1 presents correlations. Because the Pearson and Spearman correlations

are similar, I focus on the Pearson correlations. All correlations are significantly different from

13
zero. 16 Change in receivables is positively correlated with accruals (0.35), largely by construc-

tion because change in receivables is typically a large component of current accruals. However,

the correlation between annual revenue change and change in receivables (0.48) is larger than the

0.21 correlation between annual revenue change and accruals. Additionally, change in recei-

vables is more highly correlated with change in fourth-quarter revenues than with the change in

revenues of the first three quarters (0.49 versus 0.38) or even change in annual revenues (0.49

versus 0.48). Taken together, these correlations suggest that estimates from models of recei-

vables are less noisy than estimates from accrual models, and that using quarterly data to disag-

gregate annual change in revenues might lead to better specified models. However, I base my

inferences on the tests presented in the next section.

IV. RESULTS

Estimation of the Models

[INSERT TABLE 2 ABOUT HERE]

Table 2 presents results from the estimation of the revenue and accrual models. Panel A

presents summary results of the revenue models. In revenue model (1), the coefficient on change

in fourth-quarter revenues (0.21) is over four times higher than that of the change in revenues of

the first three quarters (0.05), although both are significantly positive. 17 In contrast, when condi-

tioning on annual revenue change, the average coefficient is 0.08 and the adjusted R-squared de-

creases from 0.28 to 0.21. The coefficient on revenues in model (2) varies significantly with size

(SIZE), age (AGE), industry-adjusted revenue growth (GRR_P and GRR_N), and gross margin

16
I use the term significance to denote statistical significance at less than the 0.05 level, based on a one-sided test
when I have signed predictions and a two-sided test otherwise.
17
Untabulated results reveal that, as expected, the higher fourth-quarter coefficient is attributable the fourth quarter
being closer in time to the fiscal year end rather than an inherent difference in fourth quarter accruals due to factors
such as audit requirements. I find similar coefficient magnitudes using alternative annual aggregations of quarterly
sales and accruals, ending at the first, second, or third quarter (see Jacob and Jorgensen 2007).

14
(GRM). The adjusted R-squared increases from 0.21 to 0.28 over the model that does not allow

for variations in credit policy.

Panel B presents summary results of the accrual models. The coefficient on revenue

change in the Jones model (3) is 0.10, as compared to 0.06 for the modified Jones model (4). In

addition, the adjusted R-squared of the modified Jones model is lower (0.09) than that of the

Jones model (0.12). In the Dechow-Dichev model (5), the coefficients on past and future cash

flows (0.27 and 0.14, respectively) and the coefficient on current cash flows (–0.46) are each

significantly related to accruals. The adjusted R-squared increases to 0.30 when adding cash

flows to the Jones model.

Untabulated results reveal that, when estimating the Jones model after excluding recei-

vables from accruals, the resulting coefficient on revenue change is 0.01 and is significantly

positive in only 66 out of 285 industry-year groups. This finding indicates that the change in re-

ceivables drives much of the correlation between accruals and change in revenues. As expected,

the relation between other accruals and revenue change is weaker than that of the receivables ac-

crual and revenue change, leading to noisier estimates of discretion for accrual models. 18

Evaluation of the Models

I evaluate estimates of discretion from the various models by assessing the models’ abili-

ties to detect simulated revenue and expense manipulation and by relying on actual earnings and

revenue manipulation in a sample of firms known to have misstated their financial results.

Detection of Simulated Revenue Manipulation

Similar to Dechow et al. (1995) and Kothari et al. (2005, hereafter KLW), I use simula-

tions to test the power and specification of discretionary accrual models in the presence of ex-

18
Finding little or no relation between aggregate accruals other than receivables and change in sales does not imply
that there is no relation between change in sales and individual accrual components. However, it does support mod-
eling specific accruals, such as receivables, rather than aggregate accruals.

15
treme performance. By comparing estimates of discretionary revenues and expenses against a

known quantity of manipulation, I am able to obtain evidence of the bias, specification, and

power of competing models. I measure the bias of each model as the difference between the

mean estimate of discretion and the amount of manipulation I induce. If the model is unbiased,

then the difference will equal zero. I evaluate the specification of the models by computing how

often tests reject the null hypothesis of no manipulation for samples with no manipulation in-

duced. Finally, I evaluate the power of the models by computing how often tests detect induced

manipulation.

I perform this simulation first using subsamples from the entire set of firms and then on

subsamples of firms known to produce biased estimates of discretion—i.e., subsamples with high

growth (McNichols 2000; Kothari et al. 2005). With the simulation on all firms, I compare the

revenue and accrual models’ power in detecting combinations of revenue and expense manipula-

tion. With the simulation on growth firms, I compare the specification of the revenue and accrual

models in the presence of extreme performance.

I repeat the following steps 250 times (either drawing firms from the entire population or

from the set of firms in each industry-year’s highest quartile of earnings growth):

(1) Draw a random subsample of 100 firm-year observations without replacement.

(2) Simulate revenue manipulation by adding one percent of average total assets to the

change in revenues, the change in fourth-quarter revenues, and the receivables ac-

crual, and one percent times the gross margin percentage to current accruals of these

100 firm-years; or simulate expense manipulation by adding one percent to current

accruals.

(3) Estimate the models using all observations except the 100 subsample firm-years.

16
 (4) Use each model’s coefficient estimates to calculate estimates of discretion for the 100

subsample firm-years.

(5) Calculate the mean estimate of discretion from each model and test whether the mean

is significantly greater than zero.

Statistics from the 250 subsamples form the basis of the tests. I report the mean and stan-

dard error of the 250 estimates of discretion, as well as the percent of the 250 times that the mod-

el rejects the null hypothesis of no manipulation. A rejection rate of 5 percent is expected when

manipulation is not introduced, and based on the 95 percent confidence interval, an actual rejec-

tion rate below 2 percent or above 8 percent indicates the test is misspecified. When manipula-

tion is introduced, however, the rejection rate should be 100 percent.

My procedure differs from that of KLW in three ways. First, I simulate combinations of

revenue and expense manipulation to evaluate the models under different forms of earnings

management. Second, I calculate accruals using items from the statement of cash flows rather

than the balance sheet. Hribar and Collins (2002) find that the error in the balance sheet approach

of estimating accruals is correlated with firms’ economic characteristics. As KLW note, this er-

ror not only reduces the models’ power to detect earnings management, but also has the potential

to generate incorrect inferences about earnings management. Finally, I winsorize variables be-

fore, rather than after, estimating the models. This ensures that each model’s mean estimate of

discretion is zero.

[INSERT TABLE 3 ABOUT HERE]

Table 3, Panel A, presents descriptive statistics from the simulation on subsamples drawn

from the entire sample of firms. The table presents estimates of discretionary revenues and ac-

cruals based on four combinations of induced manipulation: no manipulation, revenue manipula-

17
tion of one percent of assets, expense manipulation of one percent of assets, and both revenue

and expense manipulation of one percent of assets.

Because mean discretionary revenues and accruals in the entire sample are zero by con-

struction, the mean bias of each of the models should approximate zero. Table 3, Panel A, con-

firms this expectation. Table 3, Panel A, also presents standard errors. The standard errors from

the revenue models are about one-third those of the accrual models. A model that produces esti-

mates with lower standard errors is more likely to detect manipulation when it occurs.

The first column of Table 3, Panel B, reports results on the specification of the models

under the null hypothesis of no discretion. None of the models over-rejects the null hypothesis;

however, the revenue models under-reject. Rejection rates for the revenue and conditional reve-

nue models are 0.8 and 1.2 percent. Rejection rates for the Jones, modified Jones, Dechow-

Dichev (DD), and performance-matched modified Jones (PM) models are 5.6, 5.2, 7.6, and 4.4

percent.

The next three columns of Panel B present evidence on the power of the models. The

revenue and conditional revenue models detect revenue manipulation of one percent in 23.6 and

24.0 percent of samples. The rejection rates for the Jones, modified Jones, DD, and PM models

are a substantially lower 6.8, 7.2, 8.8, and 6.0 percent, respectively. By construction, the revenue

models do not detect expense manipulation. The Jones, modified Jones, DD, and PM models

detect expense manipulation of one percent in 13.6, 13.2, 18.8, and 9.2 percent of samples. The

revenue and conditional revenue models detect a combination of revenue and expense manipula-

tion in 23.6 and 24.0 percent of samples. The Jones, modified Jones, DD, and PM models detect

the same combination of manipulation in only 11.6, 14.0, 19.2, and 11.2 percent of samples. The

18
low rejection rates of the PM model relative to the modified Jones model indicate that perfor-

mance matching reduces the power of accrual models.

[INSERT TABLE 4 ABOUT HERE]

Table 4 presents results from the simulation on firms in the highest quartile of earnings

growth. Panel A of Table 4 reveals that each of the six models produces a positive estimate of

discretion for growth firms with zero induced manipulation, which indicates a positive bias for

growth firms. However, the bias is smaller for the revenue models than for the accrual models.

The revenue and conditional revenue model estimates are 0.41 and 0.40 percent of assets, respec-

tively; accrual model estimates are 2.39, 2.75, 3.71, and 2.07 percent of assets for the Jones,

modified Jones, DD, and PM models, respectively. The larger estimates for the accrual models

are consistent with accruals other than receivables not being explained by the change in revenues

alone, and the factors omitted from the models being correlated with growth. For example, it is

likely that growth firms invest in inventory beyond what would be predicted by the change in

current revenues alone.

Results in Table 4, Panel A, indicate that the modified Jones model is more biased than

the Jones model. This finding is consistent with growth firms having more uncollected credit

sales, which are treated as discretionary in the modified Jones model. The DD model exhibits the

greatest bias of all models tested. Although performance-matching reduces the bias of the mod-

ified Jones model, the bias remains more than five times the amount from either of the revenue

models. Performance matching by income as suggested by KLW does not fully correct for

growth-related model bias.

Table 4, Panel A, also presents standard errors across models. The standard errors from

the revenue models are less than half those of the accrual models. Of the accrual models, the PM

19
model produces estimates with the largest standard errors. Thus, the reduction in bias accom-

plished by performance matching comes at a cost in efficiency.

The first column of Table 4, Panel B, reports results on the specification of the models

under the null hypothesis of no discretion. 19 Only the revenue models produce well-specified

tests of manipulation for growth firms. Rejection rates for the revenue and conditional revenue

models are 7.3 and 7.2 percent, respectively. Each of the four accrual models over-rejects the

null hypothesis of no manipulation. Rejection rates for the Jones, modified Jones, DD, and PM

models are 35.6, 43.6, 68.8, and 20.0 percent, respectively.

The next three columns of Panel B present evidence on the power of the models. The

revenue and conditional revenue models detect revenue manipulation of one percent in 44.4 and

41.2 percent of samples. The rejection rates for the Jones, modified Jones, and DD models are

31.2, 38.4, and 59.6 percent. However, these rejection rates largely reflect the general tendency

of biased models to over-reject even when no manipulation is induced. The PM model, which

exhibits the least misspecification of the accrual models, detects revenue manipulation in only

18.4 percent of samples. By construction, the revenue models do not detect expense manipula-

tion. The PM model detects expense manipulation of one percent in 37.2 percent of samples. The

revenue and conditional revenue models detect a combination of revenue and expense manipula-

tion in 44.4 and 41.2 percent of samples. The PM model detects the same combination of mani-

pulation in only 34.4 percent of samples.

In summary, simulation analysis on all firms indicates that the revenue models are more

likely than accrual models to detect an equal combination of revenue and expense manipulation.

19
This analysis assumes zero discretionary revenues and accruals on average for growth firms. This does not, how-
ever, assume no manipulation. Because models of discretion are estimated in cross section, estimated manipulation
is relative to the industry-year average. Therefore, the assumption of this analysis is that growth firms, on average,
do not manipulate more than other firms in the same industry and year. To the extent this is not true, I overstate the
bias and misspecification of the models.

20
The simulation analysis on growth firms indicates that, although performance matching improves

the specification of the accrual models, only the revenue models are well-specified with or with-

out performance matching. Again, the revenue models are more likely than the PM model to

detect an equal combination of revenue and expense manipulation.

Detection of Actual Revenue Manipulation

The second procedure I use to evaluate revenue and accrual models assesses the ability of

these models to detect revenue and expense manipulation in a sample of firms that are known to

have misstated their financial results. The known manipulators are a sample of 250 firm-years

that were investigated by the SEC for accounting irregularities between 1995 and 2003. 20

I divide sample firms into two groups: those that manipulated revenues and those that

manipulated expenses only. For each sample firm, I group observations into four time periods:

the manipulation period, the year before the manipulation, the year after the manipulation, and

all other years. I assume that sample firms overstate revenues and understate expenses during the

manipulation period. 21 If the models are powerful, mean discretionary revenue and accrual esti-

mates should be significantly positive during the manipulation period. Assuming no manipula-

tion took place the year prior to the manipulation period, if the models are correctly specified,

mean discretionary revenue and accrual estimates should not differ from zero. 22

When studying SEC enforcement actions, one concern is selection bias. For this reason, I

present results after adjusting discretionary revenues and accruals of the SEC sample firms by

those of control firms chosen from the same industry and year. In the first case, I choose a con-

20
The sample was obtained by searching the EDGAR database at www.sec.gov. The initial search led to enforce-
ment actions for 265 firms (after excluding firms with enforcement actions on separate occasions) with 250 firm-
years remaining after imposing data requirements. A similar attrition rate is found by Dechow et al. (1996).
21
Consistent with an overstatement on average, Dechow et al. (1996) find positive discretionary accruals during the
manipulation period by firms subject to SEC enforcement actions.
22
This test of specification does not provide conclusive evidence, because it is possible that the sample firms used
discretionary accruals or revenues before the manipulation period. However, I assume that if this discretion was suf-
ficiently large, the SEC would have included the prior year in the enforcement action.

21
trol firm for each sample firm from the same industry and year with the closest return on assets,

which is analogous to the performance matching approach suggested by KLW. In the second

case, I choose a control firm from the same industry and year with the closest revenue growth in

the prior year. Prior research documents that firms targeted by SEC enforcement actions tend to

be firms with high revenue growth (Beneish 1999).

[INSERT TABLE 5 ABOUT HERE]

Table 5, Panel A, displays the distribution of sample firms through event time. Revenues

were manipulated over 173 firm-years and expenses were manipulated over 77 firm-years, con-

sistent with revenue manipulation being the most common form of earnings management.

Panel B provides results based on the entire sample of both revenue and expense manipu-

lators. When choosing control firms based on profitability, evidence indicates that the Jones,

modified Jones, and DD models are misspecified for the sample of SEC firms. Discretionary ac-

cruals before the manipulation period are estimated to be higher than control firms by 6.30, 7.05,

and 5.49 percent of assets, respectively. If these discretionary accruals represented actual mani-

pulation, however, it is likely that they would have been included in the alleged manipulation

period. The evidence indicates the performance-matched revenue models are well specified.

The revenue and conditional revenue models detect discretion significantly higher than

that of control firms during the event period (1.80 and 1.63 percent of assets when matching on

profitability; 1.16 and 1.15 percent of assets when matching on growth). Each of the perfor-

mance-matched accrual models fails to detect discretion during the event period—discretionary

accruals are not significantly higher than those of control firms.

Panel C provides results based on the entire sample of firms that manipulated revenues

alone or revenues and expenses. Each of the performance-matched accrual models is misspeci-

22
fied. Before the manipulation period, the Jones, modified Jones, and DD models produce discre-

tionary accruals that are significantly higher than those of control firms by 9.07, 10.18, and 7.92

percent of assets when matching on profitability and by 6.86, 6.96, and 5.47 percent of assets

when matching on growth. The revenue models are well specified.

Only the revenue models detect manipulation during the event period. Discretionary rev-

enues from the revenue and conditional revenue models are significantly higher than those of

control firms by 2.19 and 1.82 percent of assets when matching on profitability and 1.56 and

1.43 percent of assets when matching on growth. The performance-matched accrual models fail

to detect manipulation.

Panel D provides results based on the sample of firms that manipulated expenses. As ex-

pected, the performance-matched revenue models do not detect discretion in the sample of firms

that did not manipulate revenues. However, neither do the accrual models. Discretionary accruals

during the manipulation period are not significantly different than those of control firms. Be-

cause the sample studied in Table 5, Panel D is restricted to expense manipulators, the accrual

models should be more powerful than the revenue models. However, neither the accrual nor rev-

enue models detect manipulation by this subset of SEC firms.

V. CONCLUSION

This study provides evidence on the reliability of discretionary revenues and various

measures of discretionary accruals by assessing their ability to detect both simulated and actual

manipulation. The results indicate that the revenue model is less biased and better specified than

accrual models, such that estimates from revenue models could be useful as a measure of reve-

nue management or as a proxy for earnings management.

23
 Although revenue models do not detect discretion in expenses, findings suggest that ac-

crual models have difficulty detecting discretion in expenses as well. The state-of-the-art per-

formance-matched modified Jones model (Kothari et al. 2005) detects simulated expense mani-

pulation in only 9.2 percent of samples of firms, and it fails to detect expense manipulation by

firms subject to expense-related SEC enforcement actions. Still, the success of the revenue mod-

el at detecting earnings management depends on the relative frequency of revenue vs. expense

manipulation. For equal amounts of simulated revenue and expense manipulation across the en-

tire sample, the revenue model outperforms each of the accrual models. The revenue model also

detects earnings management by firms subject to SEC enforcement actions, but the performance-

matched accrual models do not. Overall, the revenue model outperforms accrual models both in

detecting and failing to detect earnings management, as appropriate. Thus, revisiting research

settings with the revenue model could shed light on whether significant results were driven by

misspecification of accrual models or whether insignificant results were driven by the accrual

models’ lack of power.

Measures of discretionary revenues can also be useful by providing evidence on how

firms manage earnings or for studying revenue management. On the whole, relatively little re-

search has been conducted in the area of discretion in revenues. Although revenues is a logical

first step in examining individual components of earnings, future studies could model discretion

in various expense components of earnings.

Finally, this study has implications for studies that use accrual models. First, the Jones

model (Jones 1991) exhibits better specification than the modified Jones model (Dechow et al.

1995), which suggests including reported revenues, rather than cash revenues, in accrual models.

Second, the Dechow-Dichev model (Dechow and Dichev 2002; McNichols 2002), which was

24
originally developed to estimate earnings quality, exhibits greater misspecification than other

accrual models when used to estimate discretionary accruals. Lastly, separating fourth-quarter

revenues and allowing the relation between revenues and accruals to vary across firms could be

applied to accrual models to improve their performance.

25
REFERENCES

Barth, M., W. Beaver, J. Hand, and W. Landsman. 2005. Accruals, accounting-based valuation
models, and the prediction of equity values. Journal of Accounting, Auditing & Finance
20: 311–345.

--------, and S. Kallapur. 1996. The effects of cross-sectional scale differences on regression re-
sults in empirical accounting research. Contemporary Accounting Research 13: 527–567.

Beatty, A., S. Chamberlain, and J. Magliolo. 1995. Managing financial reports of commercial
banks: the influence of taxes, regulatory capital and earnings. Journal of Accounting Re-
search 33: 195–212.

Beaver, W., C. Eger, S. Ryan, and M. Wolfson. 1989. Financial reporting, supplemental disclo-
sures, and bank share prices. Journal of Accounting Research 27: 157–178.

--------, and E. Engel. 1996. Discretionary behavior with respect to allowances for loan losses
and the behavior of security prices. Journal of Accounting and Economics 22: 177–206.

--------, and M. McNichols. 1998. The characteristics and valuation of loss reserves of property
casualty insurers. Review of Accounting Studies 3: 73–95.

Beneish, M. 1999. The Detection of Earnings Manipulation. Financial Analysts Journal

(Sep/Oct), 24–36.

--------. 2001. Earnings management: a perspective. Managerial Finance 27: 3–17.

Bernard, V., and D. Skinner. 1996. What motivates managers’ choice of discretionary accruals?
Journal of Accounting and Economics 22: 313–325.

Burgstahler, D. and I. Dichev. 1997. Earnings management to avoid earnings decreases and
losses. Journal of Accounting and Economics 24: 99–126.

--------, and M. Eames. 2006. Management of earnings and analysts’ forecasts to achieve zero
and small positive earnings surprises. Journal of Business Finance & Accounting 33:
633–652.

Callen, J., S. Robb, and D. Segal. 2008. Revenue manipulation and restatements by loss firms.
Auditing: A Journal of Practice & Theory 27: 1–29.

Caylor, R. 2009. Strategic revenue recognition to achieve earnings benchmarks. Journal of Ac-
counting and Public Policy (forthcoming).

Collins, J., D. Shackelford, and J. Wahlen. 1995. Bank differences in the coordination of regula-
tory capital, earnings and taxes. Journal of Accounting Research 33: 263–291.

26
Dechow, P., S. P. Kothari, and R. Watts. 1998. The relation between earnings and cash flow.
Journal of Accounting and Economics 25: 131–168.

--------, S. Richardson, and I. Tuna. 2003. Why are earnings kinky? An examination of the earn-
ings management explanation. Review of Accounting Studies 8: 355–384.

--------, and C. Schrand. 2004. Earnings quality. The Research Foundation of CFA Institute.
Charlottesville, Virginia.

--------, and R. Sloan. 1991. Executive incentives and the horizon problem: An empirical investi-
gation. Journal of Accounting and Economics 14: 51–89.

--------, --------, and A. Sweeney. 1995. Detecting earnings management. The Accounting Review
70: 193–225.

--------, --------, and --------. 1996. Causes and consequences of earnings manipulation: An analy-
sis of firms subject to enforcement actions by the SEC. Contemporary Accounting Re-
search 13: 1–36.

DeFond, M., and J. Jiambalvo. 1994. Debt covenant violation and manipulation of accruals.
Journal of Accounting and Economics 17: 145–176.

Dhaliwal, D., C. Gleason, and L. Mills. 2004. Last change earnings management: Using the tax
expense to achieve earnings targets. Contemporary Accounting Research 21: 431–459.

Dopuch, N., R. Mashruwala, C. Seethamraju, and T. Zach. 2005. Accrual determinants, sales
changes and their impact on empirical accrual models. Working paper, Washington Uni-
versity in St. Louis.

Fama, E., and J. Macbeth. 1973. Risk, return and equilibrium: empirical tests. Journal of Politi-
cal Economy 81: 607–636.

Feroz, E., K. Park, and V. Pastena. 1991. The financial and market effects of the SEC’s account-
ing and auditing enforcement releases. Journal of Accounting Research 29 (Supplement):
107–142.

Financial Accounting Standards Board. 1987. Statement of Financial Accounting Standards No.
95, Statement of Cash Flows. Norwalk, CT.

Guay, W., S. P. Kothari, and R. Watts. 1996. A market-based evaluation of discretionary accrual
models. Journal of Accounting Research 34 (Supplement): 83–105.

Healy, P. 1985. The effect of bonus schemes on accounting decisions. Journal of Accounting and
Economics 7: 85–107.

27
--------, and K. Palepu. 1990. Effectiveness of accounting-based dividend covenants. Journal of
Accounting and Economics 12: 97–124.

--------, and J. Wahlen. 1999. A review of the earnings management literature and its implica-
tions for standard setting. Accounting Horizons 13: 365–383.

Hribar, P., and D. Collins. 2002. Errors in estimating accruals: Implications for empirical re-
search. Journal of Accounting Research 40: 105–135.

Jacob, J., and B. Jorgensen. 2007. Earnings management and accounting income aggregation.
Journal of Accounting and Economics 43: 369-390.

Jones, J. 1991. Earnings management during import relief investigations. Journal of Accounting
Research 29: 193–228.

Kang, S., and K. Sivaramakrishnan. 1995. Issues in testing earnings management and an instru-
mental variable approach. Journal of Accounting Research 33: 353–367.

Kothari, S. P., A. Leone, and C. Wasley. 2005. Performance matched discretionary accrual
measures. Journal of Accounting and Economics 39: 163–197.

Marquardt, C. and C. Wiedman. 2004. How are earnings managed? An examination of specific
accruals. Contemporary Accounting Research 21: 461–491.

Matsumoto, D. 2002. Management’s incentives to avoid earnings surprises. The Accounting Re-
view 77: 483–514.

McNichols, M. 2000. Research design issues in earnings management studies. Journal of Ac-
counting and Public Policy 19: 313–345.

--------, and P. Wilson. 1988. Evidence of earnings management from the provision for bad
debts. Journal of Accounting Research 26 (Supplement): 1–31.

Moyer, S. 1990. Capital adequacy ratio regulations and accounting choices in commercial banks.
Journal of Accounting and Economics 13: 123–154.

Nelson, K. 2000. Rate regulation, competition and loss reserve discounting by property-casualty
insurers. The Accounting Review 75: 115–138.

Petersen, M., and R. Rajan. 1997. Trade credit: Theories and evidence. Review of Financial Stu-
dies 10: 661–691.

Petroni, K. 1992. Optimistic reporting in the property-casualty insurance industry. Journal of Ac-
counting and Economics 15: 485–508.

28
--------, S. Ryan, and J. Wahlen. 2000. Discretionary and non-discretionary revisions of loss re-
serves by property-casualty insurers: Differential implications for future profitability, risk
and market value. Review of Accounting Studies 5: 95–125.

Phillips, J., M. Pincus, and S. Rego. 2003. Earnings management: New evidence based on de-
ferred tax expense. The Accounting Review 78: 491–521.

Plummer, E., and D. Mest. 2001. Evidence on the management of earnings components. Journal
of Accounting, Auditing & Finance 16: 301–323.

Richardson, S., R. Sloan, M. Soliman, and I. Tuna. 2006. The implications of accounting distor-
tions and growth for accruals and profitability. The Accounting Review 81: 713–743.

Scholes, M., G. Wilson, and M. Wolfson. 1990. Tax planning, regulatory capital planning, and
financial reporting strategy for commercial banks. Review of Financial Studies 3: 625–
650.

Sopranzetti, B. 1998. The economics of factoring accounts receivable. Journal of Economics and
Business 50: 339–359.

Stubben, S. 2006. The use of discretionary revenues to meet earnings and revenue targets. Doc-
toral Dissertation, Stanford University.

Sweeney, A. 1994. Debt-covenant violations and managers’ accounting responses. Journal of

Accounting and Economics 17: 281–308.

Thomas, J., and X. J. Zhang. 2000. Identifying unexpected accruals: a comparison of current ap-
proaches. Journal of Accounting and Public Policy 19: 347–376.

Turner, L., J. R. Dietrich, K. Anderson, and A. Bailey. 2001. Accounting restatements. Working
paper, United States Securities and Exchange Commission, The Ohio State University,
Georgetown University, and University of Illinois at Urbana-Champaign.

Whalen, J. 1994. The nature of information in commercial bank loan loss disclosures. The Ac-
counting Review 69: 455–478.

29
 TABLE 1
Sample Summary Statistics (N = 70,580)

Panel A: Descriptive Statistics

Variable Mean Std. Dev. Q1 Median Q3

AC –0.08 0.17 –0.12 –0.06 –0.01
∆AR 0.01 0.07 –0.01 0.01 0.04
∆R 0.09 0.37 –0.04 0.07 0.22
∆R1_3 0.07 0.30 –0.03 0.05 0.17
∆R4 0.03 0.13 –0.02 0.02 0.07
PPE 0.30 0.24 0.11 0.24 0.44
CFO 0.03 0.19 –0.01 0.06 0.13

Panel B: Pearson (above), Spearman (below) Correlations

AC ∆AR ∆R ∆R1_3 ∆R4 PPE CFO

AC 0.35 0.21 0.18 0.19 –0.05 0.04
∆AR 0.40 0.48 0.38 0.49 –0.04 –0.07
∆R 0.26 0.50 0.94 0.67 0.02 0.09
∆R1_3 0.23 0.41 0.93 0.40 0.02 0.09
∆R4 0.24 0.54 0.72 0.50 0.01 0.05
PPE –0.14 –0.04 0.01 0.01 0.01 0.23
CFO –0.25 –0.06 0.14 0.14 0.10 0.28

AC = Annual current accruals = earnings before extraordinary items – cash from operations
AR = End of fiscal year accounts receivable
R = Annual revenues
R1_3 = Revenues of the first three quarters
R4 = Revenues of the fourth quarter
PPE = End of fiscal year gross property, plant, and equipment
CFO = Cash from operations
∆ denotes annual change

Variables are deflated by average total assets. All correlations in Panel B are significantly differ-
ent from zero (p < 0.01).

30
 TABLE 2
Estimation of Revenue and Accrual Models

Table 2 summarizes the results of separate estimations of revenue and accrual models for each of
285 industry-years. An intercept scaled by average total assets and an unscaled intercept are not
tabulated. FM t-stat is the Fama-Macbeth (1973) t-statistic. * (**) indicates the coefficient esti-
mate is significantly different from zero at the 0.05 (0.01) level, using a two-sided test.

Panel A: Estimation of Revenue Models

∆ARit = α + β1 ∆R1_3it + β2 ∆R4it +ε it (1)

∆ARit = α + β1 ∆Rit + β2 ∆Rit×SIZEit + β3 ∆Rit×AGE it (2)

+ β4 ∆Rit×AGE_SQ it + β5 ∆Rit×GRR_Pit
+ β6 ∆Rit×GRR_Nit + β7 ∆Rit×GRMit + β8 ∆Rit×GRM_SQit +ε it

(1) (2)
Mean FM Mean FM Mean FM
Variable Estimate t-stat Estimate t-stat Estimate t-stat
∆R 0.08 33.03** 0.19 9.84**
∆R1_3 0.05 22.86**
∆R4 0.21 30.00**
∆R × SIZE –0.01 –6.20**
∆R × AGE –0.04 –2.80**
∆R × AGE_SQ 0.01 2.07*
∆R × GRR_P –0.02 –5.12**
∆R × GRR_N 0.07 7.70**
∆R × GRM 0.04 3.83**
∆R × GRM_SQ 0.06 1.38

Adj. R2 0.28 0.21 0.28

31
 TABLE 2 (continued)

Panel B: Estimation of Accrual Models

ACit = α + β1 ∆Rit + β2 PPEit +ε it (3)

ACit = α + β1 (∆Rit – ∆ΑRit) + β2 PPEit +ε it (4)

ACit = α + β1 ∆Rit + β2 PPEit + β3 ∆Rit×CFO i,t-1 + β4 CFOit + β5 CFOi,t+1 +ε it (5)

(3) (4) (5)

Mean FM Mean FM Mean FM
Variable Estimate t-stat Estimate t-stat Estimate t-stat
∆R 0.10 22.29** 0.10 24.09**
∆R – ∆AR 0.06 15.73**
PPE –0.07 –15.55** –0.07 –15.03** –0.07 –18.07**
CFOt-1 0.27 23.62**
CFOt –0.46 –27.75**
CFOt+1 0.14 13.98**

Adj. R2 0.12 0.09 0.30

AR = End of fiscal year accounts receivable

AC = Annual current accruals = earnings before extraordinary items – cash from operations
R = Annual revenues
R1_3 = Revenues of the first three quarters
R4 = Revenues of the fourth quarter
PPE = End of fiscal year gross property, plant, and equipment
CFO = Cash from operations
SIZE = Natural log of total assets at end of fiscal year
AGE = Age of firm (years)
GRR_P = Industry-median-adjusted revenue growth (=0 if negative)
GRR_N = Industry-median-adjusted revenue growth (=0 if positive)
GRM = Industry-median-adjusted gross margin at end of fiscal year
_SQ = Square of variable
∆ denotes annual change

Variables are deflated by average total assets.

32
 TABLE 3
Bias, Specification, and Power of Revenue and Accrual Models Using Simulated Revenue
and Expense Manipulation on All Firms

Table 3 presents statistics on discretionary revenues and discretionary accruals from 250 random
samples of 100 firms. “%Manip” is the percent of revenue or expense manipulation induced in
each of 250 random samples of 100 firm-years—either 0% or 1% of average assets. Panel A
presents the mean (“Mean”) and standard deviation (“S.E.”) of the 250 sample mean discretio-
nary accrual or revenue estimates, expressed as a percent of average assets. Panel B presents re-
jection rates (“Rate”), which is the percent of the 250 sample means that are significantly greater
than zero (α = 0.05). * (**) indicates the rejection rate is significantly different from 5% at the
0.05 (0.01) level. The revenue models (Revenue and Conditional Revenue) and accrual models
(Jones, Modified Jones, Dechow-Dichev, and Performance-matched Modified Jones) are de-
scribed in the appendix.

Panel A: Mean Bias and Standard Error of Discretionary Revenue and Accrual Estimates

%Manip: (Rev,Exp) (0%,0%) (0%,0%)

Model Mean S.E.
Revenue (1) –0.05 0.55
Cond. Revenue (2) –0.06 0.64
Jones (3) 0.05 1.63
Mod. Jones (4) 0.03 1.63
DD (5) 0.21 1.66
PM Mod. Jones (6) 0.19 1.86

Panel B: Rejection Rates (Ha: Discretion > 0) for Combinations of Induced Revenue and
Expense Manipulation

%Manip: (Rev,Exp) (0%,0%) (1%,0%) (0%,1%) (1%,1%)

Model Rate Rate Rate Rate
Revenue (1) 0.8%** 23.6%** 0.8%** 23.6%**
Cond. Revenue (2) 1.2%** 24.0%** 1.2%** 24.0%**
Jones (3) 5.6% 6.8% 13.6%** 11.6%**
Mod. Jones (4) 5.2% 7.2% 13.2%** 14.0%**
DD (5) 7.6% 8.8%** 18.8%** 19.2%**
PM Mod. Jones (6) 4.4% 6.0% 9.2%** 11.2%**

33
 TABLE 4
Bias, Specification, and Power of Revenue and Accrual Models Using Simulated Revenue
and Expense Manipulation on Growth Firms

Table 4 presents statistics on discretionary revenues and discretionary accruals from 250 random
samples of 100 growth firms. Growth firms are those in the highest quartile of change in earn-
ings before extraordinary items deflated by average total assets, where quartiles are determined
by industry and year. “%Manip” is the percent of revenue or expense manipulation induced in
each of 250 random samples of 100 firm-years—either 0% or 1% of average assets. Panel A
presents the mean (“Mean”) and standard deviation (“S.E.”) of the 250 sample mean discretio-
nary accrual or revenue estimates, expressed as a percent of average assets. Panel B presents re-
jection rates (“Rate”), which is the percent of the 250 sample means that are significantly greater
than zero (α = 0.05). * (**) indicates the rejection rate is significantly different from 5% at the
0.05 (0.01) level. The revenue models (Revenue and Conditional Revenue) and accrual models
(Jones, Modified Jones, Dechow-Dichev, and Performance-matched Modified Jones) are de-
scribed in the appendix.

Panel A: Mean Bias and Standard Error of Discretionary Revenue and Accrual Estimates

%Manip: (Rev,Exp) (0%,0%) (0%,0%)

Model Mean S.E.
Revenue (1) 0.41 0.64
Cond. Revenue (2) 0.40 0.70
Jones (3) 2.39 1.99
Mod. Jones (4) 2.75 2.07
DD (5) 3.71 1.56
PM Mod. Jones (6) 2.07 2.41

Panel B: Rejection Rates (Ha: Discretion > 0) for Combinations of Induced Revenue and
Expense Manipulation

%Manip: (Rev,Exp) (0%,0%) (1%,0%) (0%,1%) (1%,1%)

Model Rate Rate Rate Rate
Revenue (1) 7.3% 44.4%** 7.3% 44.4%**
Cond. Revenue (2) 7.2% 41.2%** 7.2% 41.2%**
Jones (3) 35.6%** 31.2%** 52.4%** 46.8%**
Mod. Jones (4) 43.6%** 38.4%** 58.0%** 52.0%**
DD (5) 68.8%** 59.6%** 84.4%** 76.4%**
PM Mod. Jones (6) 20.0%** 18.4%** 37.2%** 34.4%**

34
 TABLE 5
Detection of Revenue and Expense Manipulation by Firms Subject to SEC Enforcement
Actions

Table 5 presents mean discretionary revenue and accrual estimates before, during, and after SEC
enforcement actions. “Revenue Manipulation” indicates whether the alleged violations involved
a revenue misstatement. Event years include –1, the year preceding the first year of the manipu-
lation, 0, one or more years during the manipulation, and 1, the first year after the manipulation.
Panels B through D present mean (“Mean”) estimates of discretion from models described in the
appendix, expressed as a percent of average assets. Mean estimates presented under “Adjusted
for Control Firms (matched on profitability)” (“Adjusted for Control Firms (matched on
growth)”) use discretionary revenue and accrual estimates after adjusting for a control firm from
the same industry and year with the closest return on assets (revenue growth). The t-statistics
represent a paired t-test of discretionary revenues or accruals of sample firms versus control
firms. * (**) indicates a significant difference from zero at the 0.05 (0.01) level, using a one-
sided test in event year 0 and a two-sided test otherwise.

Panel A: Number of Sample Firm Observations through Event Time

Event Year No Revenue Manipulation Revenue Manipulation

–1 25 54
0 77 173
1 28 69
Total 130 296

Panel B: Mean Discretionary Revenues and Accruals by Event Year – All Firms

Event Year −1 Event Year 0 Event Year +1

Adjusted for Control Firms
(matched on profitability) Mean t-stat Mean t-stat Mean t-stat
Revenue (1) 0.86 0.90 1.80 2.99** –1.14 –1.10
Cond. Revenue (2) 1.71 1.72 1.63 2.93** –1.10 –1.02
Jones (3) 6.30 2.57* 0.89 0.70 –4.98 –2.32*
Mod. Jones (4) 7.05 2.89** 1.39 1.08 –5.07 –2.35*
DD (5) 5.49 2.40* 0.92 0.68 –3.85 –1.52

Adjusted for Control Firms

(matched on growth) Mean t-stat Mean t-stat Mean t-stat
Revenue (1) 0.36 0.35 1.16 2.02* –2.17 –2.36*
Cond. Revenue (2) 1.24 1.07 1.15 1.97* –2.10 –2.01*
Jones (3) 3.95 1.57 –0.20 –0.11 –8.43 –3.50**
Mod. Jones (4) 4.16 1.66 –0.43 –0.25 –8.94 –3.72**
DD (5) 2.61 0.95 –0.92 –0.59 –3.81 –1.57

35
 TABLE 5 (continued)

Panel C: Mean Discretionary Revenues and Accruals by Event Year – Revenue Manipula-
tors

Event Year −1 Event Year 0 Event Year +1

Adjusted for Control Firms
(matched on profitability) Mean t-stat Mean t-stat Mean t-stat
Revenue (1) 1.32 0.98 2.19 2.75** –2.04 –1.51
Cond. Revenue (2) 1.86 1.39 1.82 2.51** –1.95 –1.39
Jones (3) 9.07 2.85** 0.77 0.48 –5.37 –1.92
Mod. Jones (4) 10.18 3.21** 1.55 0.95 –5.50 –1.95
DD (5) 7.92 2.64* –0.02 –0.01 –3.68 –1.12

Adjusted for Control Firms

(matched on growth) Mean t-stat Mean t-stat Mean t-stat
Revenue (1) 0.06 0.05 1.56 2.14* –1.67 –1.58
Cond. Revenue (2) 0.11 0.08 1.43 1.89* –1.77 –1.45
Jones (3) 6.86 2.30* –1.11 –0.54 –9.05 –3.02**
Mod. Jones (4) 6.96 2.32* –1.33 –0.64 –9.53 –3.19**
DD (5) 5.47 1.78 –0.26 –0.13 –5.62 –1.78

Panel D: Mean Discretionary Revenues and Accruals by Event Year – Expense Manipula-
tors

Event Year −1 Event Year 0 Event Year +1

Adjusted for Control Firms
(matched on profitability) Mean t-stat Mean t-stat Mean t-stat
Revenue (1) 0.52 0.47 0.91 1.16 1.02 0.81
Cond. Revenue (2) 1.95 1.46 1.14 1.41 0.95 0.70
Jones (3) –0.66 –0.21 1.17 0.59 –4.02 –1.41
Mod. Jones (4) –0.80 –0.26 1.06 0.53 –4.00 –1.44
DD (5) –1.76 –0.72 2.73 1.59 –4.43 –1.24

Adjusted for Control Firms

(matched on growth) Mean t-stat Mean t-stat Mean t-stat
Revenue (1) 1.05 0.59 0.26 0.29 –3.41 –1.86
Cond. Revenue (2) 3.62 1.56 0.53 0.59 –2.95 –1.47
Jones (3) –2.43 –0.54 1.96 0.64 –6.88 –1.75
Mod. Jones (4) –2.01 –0.46 1.69 0.54 –7.46 –1.90
DD (5) –4.83 –0.89 –2.23 –0.99 0.61 0.20

36
 APPENDIX
Summary of Discretionary Revenue and Accrual Estimates

Revenue Model

Discretion = ∆ARit − α̂ − β̂1 ∆R1_3it− β̂ 2 ∆R4it

Conditional Revenue Model

Discretion = ∆ARit − α̂ − β̂1 ∆Rit − β̂2 ∆Rit×SIZEit − β̂3 ∆Rit×AGEit − β̂4 ∆Rit×AGE_SQit
− β̂5 ∆Rit×GRR_Pit − β̂6 ∆Rit×GRR_Nit − β̂7 ∆Rit×GRMit − β̂8 ∆Rit×GRM_SQit

Accrual Models:

Jones Model (Jones 1991)

Discretion = ACit − α̂ − β̂1 ∆Rit – β̂2 PPEit

Modified Jones Model (Dechow et al. 1995)

Discretion = ACit − α̂ − β̂1 (∆Rit −∆ARit) – β̂2 PPEit

Dichow-Dichev (DD) Model (Dechow and Dichev 2002; McNichols 2002)

Discretion = ACit − α̂ − β̂1 ∆Rit – β̂2 PPEit – β̂3 CFOi,t-1 – β̂4 CFOit – β̂5 CFOi,t+1

Performance-matched (PM) Modified Jones Model (Kothari et al. 2005)

Discretion = ACit − α̂ − β̂1 (∆Rit −∆ARit) – β̂2 PPEit, less the same measure for the firm
from the same industry and year with the closest return on assets.

where
AR = End of fiscal year accounts receivable
AC = Annual current accruals = earnings before extraordinary items – cash from operations
R = Annual revenues
R1_3 = Revenues of the first three quarters
R4 = Revenues of the fourth quarter
PPE = End of fiscal year gross property, plant, and equipment
CFO = Cash from operations
SIZE = Natural log of total assets at end of fiscal year
AGE = Age of firm (years)
GRR_P = Industry-median-adjusted revenue growth (=0 if negative)
GRR_N = Industry-median-adjusted revenue growth (=0 if positive)
GRM = Industry-median-adjusted gross margin at end of fiscal year
_SQ = Square of variable
∆ denotes annual change

37