Researchers Offer Better Approach for Analyzing Discretionary Accruals
Accruals are to accounting what projected sales are to marketing. Rather than using actual cash flows to compose a financial portrait, managers can use accruals--projected receipts or payments within a given period--to present a more accurate picture of a company's financial performance. While accruals do, on average, help portray a more accurate financial picture, managers sometimes manipulate accruals opportunistically to boost their own performance evaluations.
Recently, a Simon School team consisting of Ph.D. student Wayne R. Guay, S. P. Kothari, professor of accounting, and Ross L. Watts, professor of accounting and finance and Rochester Telephone Corporation Professor, completed a paper entitled "A Market-Based Evaluation of Discretionary-Accrual Models," which challenges the methods and conclusions of past studies on the topic.
In their paper, the authors agree that their predecessors have been on the right track in attempting to distinguish between accruals over which managers have discretion ("discretionary accruals"), and non-discretionary earnings. However, they say, several of the major studies are wholly ineffective at making this distinction, and most of them rely on the questionable assumption that discretionary accruals are always used opportunistically by managers.
Guay, Kothari and Watts are in line with a number of colleagues who have begun doubting the effectiveness of past studies. They also explore the real possibility that discretionary accruals--rather than being opportunistic devices--may actually be used to improve the way in which earnings signal a company's true financial performance.
The Simon team makes three sets of explicit, comparative predictions about the relations between returns, accruals and earnings in order to test each of the following three hypotheses: a) discretionary accruals represent managerial opportunism; b) accruals make earnings a better performance indicator; and c) accruals are merely "noise" in reported earnings.
Without the gauge of these predictions, the authors say, no study can accurately demonstrate whether accruals are used opportunistically or to communicate a firm's true performance.
In their testing, Guay, Kothari and Watts looked at a sample of over 30,000 separate observations of stocks on the New York and American Stock Exchanges. Their results indicate that managers use discretionary accruals to "smooth" earnings, but the authors acknowledge that they cannot conclude whether managers do this for their own opportunistic reasons, for the benefit of the company, or both.
While the authors say more research is needed before final conclusions can be drawn regarding the true motives behind discretionary accruals, they warn that "caution should be exercised in interpreting the research of management's use of accruals motivated by opportunism."
Guay, Kothari and Watts say they hope their paper will be of interest to accountants and investors, and will help keep accounting regulators from rashly prohibiting the use of discretionary accruals. "The investment community is deeply interested in gaining a better understanding of what discretionary accruals are and how they are used by managers," says Kothari.
"Though our paper is technical," he continues, "the issue it examines--how managers use discretionary accruals--is of concern to a wide range of academics and practitioners. Our study is important precisely because regulation, which may limit or alter a manager's control over accruals, will be dependent, in part, on such research." (FR 96-01)
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