Operating Asymmetries and Propensity Score Matching in Discretionary Accrual Models

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1 Operating Asymmetries and Propensity Score Matching in Discretionary Accrual Models Rajiv D. Banker Dmitri Byzalov * Temple University Shunlan Fang Kent State University Byunghoon Jin Marist College June 10, 2016 ABSTRACT Earnings management research often uses discretionary accruals from Jones-type expectation models. These standard models assume a linear relation between sales changes and accruals. However, we predict and find that sales changes have an asymmetric effect on accruals through managers operating decisions. By forcing a linear functional form on this non-linear effect, the modified Jones model overestimates discretionary accruals for moderate sales changes and underestimates them for extreme sales changes. This non-linear bias causes excessive type-i error in tests of positive (negative) discretionary accruals for subsamples with moderate (extreme) sales growth. We generalize the performance matching approach of Kothari, Leone, and Wasley (2005) by using propensity score matching on multiple economic determinants of accruals. This modification improves type-i errors relative to standard performance matching on ROA and successfully mitigates the bias. We also show that propensity score matching changes inferences about some of the major findings in the literature. Keywords: discretionary accruals, sales growth, non-linearity, performance matching, propensity score * Corresponding Author. Department of Accounting, Fox School of Business and Management. Temple University, 1801 Liacouras Walk, Philadelphia, PA

2 EXTENDED ABSTRACT Earnings management research typically measures discretionary accruals against a benchmark of normal accruals, such as the modified Jones model (Dechow et al. 1995). 1 Ball (2013) questions this research, pointing to our limited understanding of normal accruals. We argue that managers operating decisions, such as adjustments to a firm s credit and inventory policies in response to demand changes, have an asymmetric effect on accruals. Because the modified Jones model ignores this asymmetry, it suffers from non-linear bias in discretionary accrual estimates. Ball and Shivakumar (2006) suggest that the modified Jones model is misspecified because it does not control for conditional conservatism (Basu 1997). However, we show that the bias in the modified Jones model is primarily attributable to managers operating decisions. These decisions vary with the direction of sales change and have an asymmetric effect on major accrual components such as accounts receivable, inventory, accounts payable, and depreciation. For example, when demand decreases, managers are likely to relax the credit policy to stimulate sales. When demand increases, they are unlikely to tighten the credit policy more than usual. Therefore, accounts receivable likely fall less during sales decreases than they rise during equivalent sales increases. When demand decreases, managers are unlikely to immediately dispose of all excess inventory (Bernard and Noel 1991). When demand increases, they need to quickly add the required inventory. Therefore, inventory is likely less sensitive to sales decreases than to sales increases. When demand decreases, managers in cash-constrained firms can postpone payments to suppliers. When demand increases, they are unlikely to pay the suppliers earlier than usual. Therefore, accounts payable likely fall less for sales decreases than they rise 1 During , the modified Jones model or its variants was used in 29 articles published in Journal of Accounting and Economics, Journal of Accounting Research and The Accounting Review (excluding review articles). Of these, 11 used the modified Jones model as the main specification, 7 used an extended model with ROA as an additional control, 5 used performance matching (Kothari et al. 2005), and 6 used other variants of the Jones model. Therefore, we use the modified Jones model as our main benchmark. 1

3 for sales increases. When demand decreases, managers are unlikely to quickly dispose of all unused equipment. When demand increases, they need to add the required equipment. Therefore, depreciation expense likely responds asymmetrically to sales changes (Banker et al. 2016). These operational predictions are distinct from, and likely co-exist with, conditional conservatism. If a sales decrease conveys relevant bad news for the assets, then it can trigger asset write-downs (i.e., negative accruals that reflect conservatism). In contrast, a sale increase normally cannot cause asset write-ups. Thus, if conservatism is the dominant source of accrual asymmetry, then inventory and receivables should be more sensitive to sales decreases than to sales increases. Total accruals incorporate change in current assets less change in current liabilities and depreciation. We conjecture that the asymmetric effect of current liabilities on accruals outweighs that of current assets. When sales decrease, the asymmetry in current liabilities conserves cash (through delayed payments to suppliers), while the asymmetry in current assets consumes cash (through outlays for additional inventory and receivables). Operating cash flow incorporates the net effect of these asymmetries. If managers prefer to avoid disproportionately large cash flow decreases during sales decreases, then they will likely place more emphasis on conserving cash, i.e., the asymmetry in current liabilities will be larger than that in current assets. Because current liabilities (and depreciation) enter total accruals with a negative sign, the predicted direction of asymmetry for total accruals is reversed, i.e., total accruals likely fall more for sales decreases than they rise for sales increases. We use annual Compustat data from 1988 to As predicted, we find that all of the major accrual components are significantly less sensitive to sales decreases than to sales increases. This asymmetry is larger for change in current liabilities than for change in current assets. This leads to an asymmetry of the opposite sign for total accruals, i.e., total accruals are more sensitive to 2

4 sales decreases than to sales increases, as expected. The asymmetry for total accruals is consistent with conservatism; however, the estimates for the individual accrual components differ from the predictions for conservatism and are consistent with asymmetry in operations. 2 Because the modified Jones model forces a linear specification on the non-linear relation between sales changes and accruals, it suffers from non-linear bias in discretionary accrual estimates. We predict and find that the modified Jones model systematically underestimates discretionary accruals for extreme sales changes and overestimates them for moderate sales changes. This non-linear bias leads to excessive type-i error in tests of negative discretionary accruals for the top and bottom sales growth deciles and in tests of positive discretionary accruals for the middle sales growth deciles, respectively. Thus, if a researcher s treatment sample is dominated by extreme (moderate) sales changes, then tests based on the modified Jones model will likely be biased in favor of finding income-decreasing (income-increasing) earnings management. Because the bias in the modified Jones model is non-linear, it cannot be eliminated by adding sales growth as a linear control. Further, to avoid distorted inferences due to functional form misspecification, the model must accurately capture the shape of the asymmetry. Therefore, we use performance matching (Kothari, Leone, and Wasley 2005) to flexibly control for nonlinearity. We find that propensity score matching on multiple economic correlates of accruals successfully mitigates the bias in the modified Jones model and might be preferred both theoretically and empirically to conventional performance matching on ROA. To illustrate how a researcher s use of propensity score matching can change inferences, we revisit two major findings from the literature. First, Teoh, Welch, and Wong (1998) and Rangan 2 This does not suggest that conservatism is irrelevant, only that it is not the dominant source of asymmetry for working capital accruals and depreciation. 3

5 (1998) report that firms engage in income-increasing accrual management during seasoned equity offerings (SEOs). However, the SEO firms are unlikely to be comparable, in terms of their observable characteristics, to an average firm in the full sample. When we use the propensity score approach, which matches the SEO firms with comparable non-seo firms, the estimated impact of SEO on discretionary accruals decreases by half and is no longer significant. Second, Dechow, Richardson, and Tuna (2003) report that discretionary accruals for small-profit firms are insignificantly different from those for small-loss firms, which suggests that the kink at zero in the earnings distribution (Burgstahler and Dichev 1997) should not be attributed to accrual management. We replicate these estimates in unmatched tests. However, when we use propensity score matching, discretionary accruals for small-profits firms are significantly higher than those for small-loss firms. This is consistent with accruals management at the zero earnings benchmark, alleviating the interpretation concerns raised by Dechow et al. (2003). 4

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