Accrual Determinants, Sales Changes and Their Impact on Empirical Accrual Models

Abstract

In this paper we argue that the relationship between working capital accruals and changes in sales, extensively modeled in the accounting literature by the Jones-type models, is more complex than portrayed by these models. In addition to sales changes, accruals are also affected by accrual determinants such as firms' inventory and credit policies. In our first set of tests, we document that the coefficient on sales changes in Jones-type accrual models is related to the accrual determinants. Additionally, we find that the homogeneity in the accrual-generating process within a given industry, which is represented by the accrual determinants, affects the significance level of the coefficient on sales changes. Higher dispersion in accrual determinants is associated with lower levels of significance. We also identify one source of bias in abnormal accruals - measurement error in the coefficient of sales changes, which stems from heterogeneity in the accrual generating process. Our study has direct implications on studies that use the absolute value of abnormal accruals as a measure of accrual or earnings quality. Our results indicate that a high level of heterogeneity in the accrual-generating process within an industry leads to larger errors in abnormal accruals and thus, larger absolute values of abnormal accruals. The implication of our results on earnings management studies is more complex and requires knowledge of the correlation between the partitioning variables in those studies and industry classification. While our analysis focuses mostly on the more popular cross-sectional implementation of the Jones-model, the study's logic and some of the results also apply to the time-series version of the models.