Errors in estimating unexpected accruals in the presence of large changes in net external financing

Publication Type:
Conference Proceeding
2009 AFAANZ Conference, 2009, pp. 1 - 54
Issue Date:
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We demonstrate that the articulation among accruals, cash flows and revenues which is typically assumed in tests of earnings management does not hold when large (positive or negative) external financing activities are present. Our study provides evidence that managers normal operating decisions associated with net external financing activities are likely to lead to economically and statistically significant measurement errors in unexpected accruals. This is a serious concern given the frequency with which the partitioning variable used to identify instances of alleged earnings management is correlated with significant movements in net external financing. Simulation tests show that even at modest levels of net external financing changes, rejection frequencies for the null hypothesis of no earnings management rise dramatically
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