Inference-in-residuals as an Estimation Method for Earnings Management

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Journal Article
Abacus, 2018, 54 (2), pp. 154 - 180
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© 2018 Accounting Foundation, The University of Sydney The paper tests the assumptions underlying the inference-in-residuals method as an estimation framework for detecting and classifying suspects of earnings management. We derive several systematic biases that are shown to confound inference-in-residuals and, depending on the data, could render the method a futile exercise. This is not a matter of model specification, but a limitation of the statistical method. Also, it is shown that the method of using estimated residuals in a second stage regression on economic determinants of earnings management suffers considerably, especially when residuals are estimated by industry classification in the first stage.
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