Accrual determinants, sales changes and their impact

on empirical accrual models

Nicholas Dopuch
Dopuch@wustl.edu

Raj Mashruwala
Mashruwala@wustl.edu

Chandra Seethamraju
Seethamraju@wustl.edu

Tzachi Zach
zach@wustl.edu




Washington University in St. Louis
Olin School of Business
Campus Box 1133
Saint Louis, MO, 63130






First draft: September 2005
This draft: September 2005

We thank participants in the workshop at Washington University in St. Louis for helpful comments and
suggestions.





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 studys logic and some of the results
also apply to the time-series version of the models.



1
1. Introduction
This paper investigates the important relation between accruals and changes in
sales as manifested in common empirical models of accruals. These models have gained
popularity in the accounting literature over the last two decades and have been used
mainly to address questions regarding managements accounting choices (see Kothari,
2001 and Fields, Lys and Vincent, 2001). More recently, the outputs of these models
discretionary or abnormal accruals have also been used as proxies for accrual or
earnings quality (e.g. Frankel, Johnson and Nelson, 2002, Francis, LaFond, Olsson and
Schipper, 2005).
The relation between accruals and sales changes is outlined by the popular accrual
models and is empirically summarized by a regression coefficient that is either firm- or
industry-specific (e.g. Jones, 1991 and modified Jones in Dechow, Sloan and Sweeney,
1995). Depending on the empirical estimation procedure, time-series or cross-sectional,
the assumption underlying the estimation procedure is that a firm either has a stable
accrual-generating process over time, or that a group of firms (typically a 2-digit SIC
code) has a common accrual-generating process.
In this paper, we argue that the relation between accruals and sales changes is
more complex than described by the common empirical models and depends on several
factors that are firm-specific such as credit and inventory policies. Using this intuition,
along with a theoretical model developed by Dechow, Kothari and Watts (1998), we
show that these firm-specific characteristics, labeled accrual determinants, exhibit a
large variation across time, and more importantly within an industry-group. Thus, we
2
argue that the accrual-generating process is not as homogeneous as implicitly assumed in
empirical applications of a Jones-type model.
The large variation in the accrual-generating process within an industry-group,
over which the cross-sectional version of the accrual models is estimated, has important
implications for the subsequent calculation of abnormal accruals.
1
We argue and show
that such large variation causes a measurement error in the Jones coefficients, i.e. a
disparity between the estimated coefficient of the Jones model and the true firm
coefficient that ought to be used to compute the residuals of the regression model, i.e. the
abnormal accruals. This measurement error in the coefficients directly translates to
measurement error, and in some instances bias, in the estimated abnormal accruals.
This paper makes several important contributions to the accounting literature.
First, while many papers discuss in length the potential biases that exist in measures of
discretionary accrual, in this paper we investigate a potential source of these biases.
Identifying the source of the bias is necessary if researchers are interested in eliminating
this bias. We believe that knowledge of the causes of measurement errors in the Jones
coefficients is critical in any attempt at reducing such measurement errors and
consequently reducing the bias in abnormal accruals.
Second, this paper furthers our understanding of the relation between sales
changes and accruals. While this relation is very intuitive and is discussed at length in
Dechow et al. (1998), it surprisingly has not as yet been utilized in the empirical
literature. In this paper, we attempt to fill this void. Finally, our results have important
implications for the interpretation of abnormal accrual measures and their use in the

1
Similar arguments could be made for the time-series version of the Jones-type models. We do not
explicitly discuss those for brevity.
3
extant literature. For example, we suggest caution in interpreting the absolute value of
abnormal accruals as a measure of earnings quality. We show that certain firms,
especially those that belong to industries with high-variation in accrual determinants,
have large measurement errors in their coefficients, leading to large errors in their
abnormal accruals.
Summary of the results. Our first set of results shows that the coefficients on
changes in sales (
1
) estimated from Jones-type models are associated with the four
accrual determinants that we investigate in this study. This implies that the Jones model
does, in fact, capture some of the interaction between sales and accruals. However, as our
next findings suggest, the Jones-type models only partially capture that relation.
When we examine whether the variation in the accrual-generating process within
an industry-group affects the accrual models, we find that the higher the variation in the
determinants related to accounts receivables and inventory, the lower is the likelihood
that the coefficients will be significant.
Finally, we look at the relation between the accrual determinants and abnormal
accruals. Using results in the accounting literature, we generate and test hypotheses about
the relation between the measurement errors of the Jones models coefficients and the
bias in abnormal accruals. In one of our tests, we correlate the measurement error in the
coefficients, which is the difference between the actual estimated coefficient and a
theoretical predicted coefficient, with factors associated with bias in abnormal accruals.
We compute the predicted measure using a formula developed in Dechow et al. (1998)
with firm-specific accrual determinants. We find that this measurement error is, in
general, associated with factors that have been associated with bias in abnormal accruals
4
such as extreme quartiles of book-to-market ratio. In a second set of tests, we correlate
the absolute value of abnormal accruals, which we argue contain a bias component, with
the measures we find to be associated with measurement error in Jones coefficients,
namely the degree of variation in the accrual-generating process. Again, we find that
higher variation in the accrual-generating process is associated, in most cases, with larger
absolute values of abnormal accruals.
Our study points at one source for the measurement error and bias in abnormal
accruals that arises from measurement error in the Jones coefficients. We acknowledge
that there could be other factors that could affect the measurement of abnormal accruals.
For example, miscalculation of the accrual variable itself (e.g Hribar and Collins, 2000
and Francis and Smith, 2005) could lead to estimation problems and erroneous abnormal
accruals. Another example, which stems from mismeasurement of the coefficients is
violation of the assumptions underlying the classical linear regression model.
The rest of the paper is organized as follows. In section 2 we develop our
hypothesis. In section 3 we describe our data and in section 4 we report the main results.
We discuss the implications of our results in section 5. Finally, we conclude in section 6.
2. Hypotheses development
2.1 The relation between sales changes and accruals
Modeling the accrual process is central to the accounting literature. The need for
aggregate accrual models arose when researchers realized that studies of discrete
accounting choices could only paint a partial picture because managers had a set of
accounting choices at their disposal (Fields, Lys and Vincent, 2001). Over the years, the
literature has evolved from using nave models as in Healy (1985) to the current industry-
5
standard: the Jones (1991) model, the modified-Jones model in Dechow et al. (1995)
and other variants (e.g. Dechow, Richardson and Tuna, 2003). The outcome of such
models, often referred to as discretionary or abnormal accruals, are typically used in
examining whether earnings management is present in a particular sample. More
recently, abnormal accruals and their variants, such as the absolute value of abnormal
accruals, have been used as proxies for earnings quality and as surrogate variables in
studying questions other than earnings management.
2

The Jones-type models structurally describe the behavior of accruals. The
original version of the Jones (1991) model described in equation (1) below is quite
parsimonious, relying on changes in sales and the level of property, plant and equipment
to explain total accruals:
1 2
_
i i
TA Ch Sales PPE
i i
= + + + (1)
The Jones-type models rely mainly on the shock to sales to describe the
generation of accruals. However, intuitively, it stands to reason that the creation of
accruals depends on more than just the shock to sales. In fact, there exist certain firm
specific characteristics that along with the shock to sales, determine the levels of
accruals. For example, consider two firms that are identical in all respects except for their
credit policies. Firm A does not grant any credit to its customers while firm B grants
credit. It is evident that for any given shock to sales, firm B will not generate any accruals
related to accounts receivables but firm B will. In addition to credit policies, other firm

2
For example, in the literature that examines the relation between auditor independence and accounting
choices, Frankel, Johnson and Nelson (2003) use the absolute value of abnormal accruals as their main
measure of earnings quality. Other examples include Klein (2002), Ashbaugh, LaFond and Mayhew
(2003), Myers, Myers and Omer (2003), Larcker and Richardson (2004) and Francis, LaFond, Olsson and
Schipper (2005).
6
characteristics, such as inventory policies and credit terms granted by the firms
suppliers, interact with the shock to sales in affecting accruals.
The intuition of the effect of firm characteristics on accruals is modeled explicitly
in Dechow, Kothari and Watts (1998) (hereinafter, DKW). They develop a theoretical
algebraic model that describes the behavior of accruals absent any managerial
intervention. In the DKW model each of the accrual characteristics is summarized by a
parameter in the model. We label these parameters the accrual determinants. The DKW
model describes how accruals are generated as a function of sales and the accrual
determinants.
In this paper, we investigate the circumstances under which the lack of explicit
specification in the Jones-type models of the interactions between sales changes, the
accrual determinants and accruals, has an impact on the outcomes of the accrual models.
To measure these accrual determinants we rely on Dechow et al. (1998). They make
several assumptions about the sales process and obtain the following equation describing
working capital accruals:
1 2 1 2
[ (1 ) (1 )] (1 )[ (1 )] (1 )
t t t
WCA
1 t


= + + (2)
where WCA= working capital accruals; is the proportion of a firms sales that
remain uncollected at the end of the period; is the proportion of the firms purchases
that remain unpaid at the end of the period; is the net profit margin on sales;
1
is target
inventory as a percentage of next periods forecasted cost of sales;
2
is a constant that
captures the speed with which a firms adjusts its inventory to the target level.
7
Unlike the Jones models parsimonious representation of the interaction between
changes in sales and accruals, the DKW model describes a relation that is far more
complex.
Our first objective is to examine whether there is any link between the accrual
determinants such as those suggested by the DKW model and the estimated coefficient
(
1
) in the Jones model. In essence, the impact on accruals of all the accrual determinants,
through their interaction with the shock to sales, is collapsed in the empirical Jones-type
models into a single quantity,
1,
the estimated coefficient on changes in sales. Thus, it is
important to understand what affects the estimation of
1
because any factors affecting its
estimation will directly influence the outcomes of the model, i.e. the estimates of
abnormal accruals. We argue that if the Jones models estimation is meaningful, at a
minimum such a link should be observed.
More formally,
H1: Accrual determinants , (),
1
and are positively (negatively) associated
with the estimated coefficient on sales changes
1
.

2.2 What impacts the Jones coefficient on changes in sales?
One important element that affects the estimated coefficient
1
is the way in
which the Jones accrual model is estimated. Researchers would like to estimate the model
in a sample that is relatively homogeneous with respect to the accrual generating process.
This would increase the probability that the Jones model would adequately capture the
accrual-generating process and ensure that
1
will be estimated with precision and with
sufficient power. The relation between the accrual determinants and the Jones model
directs us to the kind of homogeneity researchers would like to identify. In particular,
8
since
1
collapses the impact of accrual determinants on the relation between sales
changes and accruals, researchers are interested in homogeneity in the accrual
determinants or, more broadly, homogeneity in the accrual-generating process.
Originally, the Jones-type models were estimated separately for each firm,
utilizing a time-series of observations for that particular firm. Underlying this
implementation is the notion that a particular firms accrual-generating process is stable
over time. The disadvantage of this approach is that many firms are dropped from the
sample because they do not have a sufficiently large time-series to warrant a meaningful
estimation (Subramanyam, 1996). As a result, researchers, beginning with DeFond and
Jiambalvo (1994) turned to a cross-sectional version of the model by estimating it
separately for each industry group defined by a common two-digit SIC code. The
assumption underlying this estimation procedure is that each 2-digit SIC code industry
group is homogeneous in its accrual-generating process (see pages 427-428 in Bartov,
Gul and Tsui, 2001).
One limitation of the cross-sectional estimation is that it implicitly assumes a
uniform accrual-generating process within the industry group. That is, the relation
between sales changes and accruals is identical for all firms that comprise a two-digit SIC
code group. If that assumption is violated, then the estimated coefficients could be biased
in unpredictable directions. For example, Bernard and Skinner (1996) note that a single
industry group may contain very different firms. They mention that the makers of heavy
equipment for the oil and gas industry, video games, lawn mowers and personal
computers all belong to the same two-digit SIC code.
9
We hypothesize that the degree of precision with which
1
is estimated depends
on the degree of homogeneity in the accrual-generating process within an industry group.
To operationalize the homogeneity of an industry with respect to the accrual-generating
process, we examine the coefficient of variation of each accrual determinant within the
industry.
H2: The frequency with which
1
is statistically significant is related to the
within-industry variation in the accrual determinants.

2.3 The Bias in Abnormal Accruals
2.3.1 Background
Many studies argue that aggregate accrual models generate abnormal accruals that
are truly normal (e.g. McNichols (2000), Kothari (2001)). That is, these models are
misspecified and lead to erroneous detection of earnings management where in fact no
intentional intervention in the financial accounting process occurred. As such, all
earnings management tests are joint tests of the managerial intervention as well as the
models used to estimate abnormal accruals (Kothari et al., 2005).
The models misspecification, it is argued, stems from two correlated (but related)
omitted variables: past firm performance and expected firm performance. Dechow et al.
(1995) find that the Jones-type models reject the null hypothesis of no earnings
management at rates exceeding the specified levels when applied to samples of firms
with extreme financial performance. Kasznik (1999) shows that abnormal accruals are
associated with current ROA. In addition, Kothari et al. (2005) argue that if future firm
performance is serially correlated (either exhibits reversal or momentum) then expected
accruals will not be zero and will be related to past firm performance.
10
Expected future growth in firms operations leads to investments in current
accruals. McNichols (2000) shows that abnormal accruals from the Jones-type models are
associated not only with current and past performance, but also with analysts forecasts of
future expected growth.
Kothari et al. (2005) attempt to address the misspecification of the Jones-type
models by employing a control sample and isolating the portion of abnormal accruals that
may in fact be normal. Under the assumption that the models do in fact detect some
earnings management in their normal accruals, the control sample approach detects
abnormal earnings management. McNichols (2000) and Dechow et al. (2003) include a
measure of future sales growth (either forecasted growth by analysts in McNichols (2000)
or actual growth in sales in the following year in Dechow et al. (2003)) in their improved
Jones-type models. Larcker and Richardson (2004) add the book-to-market ratio and cash
flows from operations to the model.
While the studies mentioned above identify variables that may be correlated with
the bias in the models outcomes, none of the studies identifies the source of the
mismeasurement in the models that may lead to such bias. Kothari et al. (2005) provide
ample evidence that in random samples drawn from groups of firms with certain
characteristics, the null hypothesis of zero abnormal accruals is rejected too often. For
example, in their Table 3, the null hypothesis is rejected too frequently in favor of the
alternative of negative abnormal accruals in (i) both high and low quartiles of book-to-
market, (ii) the low quartile of sales growth, (iii) the low quartile of earnings-to-price
ratio, (iv) the quartile of smallest firms and (v) the low quartile of operating cash flows.
The null is rejected in favor of the alternative of positive abnormal accruals in (i) the
11
quartile of highest sales growth, (ii) high EP ratio, (iii) the quartile of largest firms and
(iv) the quartile of highest operating cash flows.
2.3.2 Measurement error test
Our next set of hypotheses attempts to evaluate the degree and source of bias that
potentially exist in abnormal accruals and that result from estimating the Jones-type
models. We use the results in Kothari et al. (2005) to generate the hypotheses. The goal is
to trace the sources of the documented biases. We argue that one source of the bias is
misestimated coefficients in the Jones model. If the estimation error in the coefficients is
related to the firm characteristics that are associated with abnormal accruals, then we can
conclude that this estimation error in the coefficients is responsible for the bias in
abnormal accruals. This is important, because such a finding will focus researchers
efforts on reducing the estimation error in the coefficients potentially leading to reduced
bias in abnormal accruals.
The direction of the bias in abnormal accruals for each firm will depend on the
direction of the estimation error in the coefficients as well as on the sign of the sales
change. This is true holding constant the effect of the intercept and other variables in the
Jones estimated regression model.
Estimation error in the coefficients. When the Jones-type model is estimated, the
resulting coefficient on sales change (
1
) could be biased with respect to the true
coefficient because of econometric problems such as the violation of classical
assumptions. In a cross-sectional application of the Jones model the true coefficient
could be viewed as an average coefficient for the industry. When discussing
mismeasurement of regression coefficients we do not refer to the econometric bias in the
12
coefficients, that is, the difference between the estimated industry coefficient and the true
industry coefficient. In other words, we assume that there are no econometric problems in
the estimation that that occur as a result of a violation of the three classical assumptions.
Instead, the mismeasurement of coefficients to which we refer in this paper is the
difference between the average estimated industry coefficients and the true firm-
specific coefficients. The latter, of course, are not observable by the researcher. However,
these are the coefficients we would like to have when estimating firm-specific abnormal
accruals. As Bartov et al. (2001) state: ifsample firms are not much different than
the average firm in their industry, the fact that the cross-sectional version forces the
coefficients to be the same for all firms in the industry should not represent a serious
problem. In other words, the average estimated industry coefficient will be closer to
each of the actual firm coefficients when the industry is more homogeneous with respect
to the accrual-generating process.
If the estimated cross-sectional industry coefficient (
1
EST
) is higher than the
firms actual predicted coefficient (
1
PRED
discussed below) and the sales change is
positive (negative) then the estimated normal accruals will be too high (low) and the
resulting abnormal accruals will be too low (high). We use this logic to generate
predictions about the direction of the estimation error in the coefficients and their relation
to several firm characteristics that are discussed in Kothari et al. (2005).
To evaluate any potential estimation error in the Jones coefficients, we require
some estimate of what the firm-specific coefficients would be absent any error (
1
PRED
).
To do so, we use the term developed in Dechow et al. (1998). In equation (2) the term
preceding the sales change (
t
) is
13
1 2
(1 ) (1 ) (1 )[ (1 )] + + (3)
which we label
1
PRED
. We calculate this term for each firm-year based on the five-year
averages of the firm-specific accrual determinants.
We summarize our predictions about the relation between the estimation error
(
1
EST
-
1
PRED
) and firm characteristics based on the results in Kothari et al. (2005). Such
predictions will help us: (1) corroborate Kothari et. als (2005) evidence using a different
methodology, (2) identify the source of the bias in discretionary accruals and (3) validate
a potentially better estimate for the coefficient on sales change which is an outcome of a
theoretical model and does not require a regression estimation.
Book-to-Market ratio. The results in Kothari et al. (2005) suggest that extreme
book-to-market quartiles exhibit high rejection rates of the null hypothesis of zero
discretionary accruals in favor of the alternative of negative discretionary accruals. This
means that in those quartiles estimated discretionary accruals are too low and estimated
normal accruals are too high. Thus, in those sets of firms (i) The absolute value of the
estimation error in the coefficient is expected to be positive, and (ii) the estimation error
in the coefficients (
1
EST
-
1
PRED
) is positive (negative) if changes in sales are positive
(negative). This translates into several predictions that we outline below.
P3a: When regressing the absolute value of the measurement error on a
continuous measure of the quartile of BM, the estimated coefficient cannot be
signed because the potential estimation error exists in both extreme quartiles.
P3b: When regressing the absolute value of the measurement error on an
indicator variable for extreme quartile of BM, the estimated coefficient will be
positive because in both quartiles we expect some estimation error in the
coefficient.
P3c: When regressing the measurement error on a continuous measure of the
quartile of BM, the estimated coefficient cannot be signed because the potential
estimation error exists in both extreme quartiles.
14
P3d: When regressing the measurement error on an indicator variable for extreme
quartile of BM, we differentiate between cases when the sales change is positive
or negative. If changes in sales are positive, then the relation between the
estimation error in the coefficient and the bias in abnormal accruals is positive.
Therefore, we expect the estimated coefficient on the indicator variable to be
positive. The relation flips when changes in sales are negative. In those cases, we
expect the coefficient to be negative.

Size. The results in Kothari et al. (2005) suggest that the quartiles of the smallest
firms exhibit high rejection rates of the null hypothesis of zero discretionary accruals in
favor of the alternative of negative discretionary accruals. This means that in those
quartiles estimated discretionary accruals are too low and estimated normal accruals are
too high. Thus, in those sets of firms the difference
1
EST
-
1
PRED
is positive (negative) if
sales changes are positive (negative).
The evidence in Kothari et al. (2005) regarding the quartile of the largest firms
suggests that there is excessive rejection of the null hypothesis in favor of an alternative
of positive discretionary accruals especially in the modified Jones model. Thus, in large
firms, abnormal accruals tend to be too high and normal accruals are too low. In those
sets of firms the measurement error is the difference
1
EST
-
1
PRED
and it is negative
(positive) if sales changes are positive (negative). We summarize the above logic in the
following predictions.
P4a: When regressing the absolute value of the measurement error on a
continuous measure of the quartile of size, the estimated coefficient cannot be
signed because the potential estimation error exists in both extreme quartiles.
P4b: When regressing the absolute value of the measurement error on an
indicator variable for extreme quartile of size, the estimated coefficient will be
positive because in both quartiles we expect some estimation error in the
coefficient.
P4c: When regressing the measurement error on a continuous measure of the
quartile of size, the estimated coefficient depends on the sign of sales changes. If
15
the sales changes are positive, then that implies a positive error in small firms and
negative error in large firms leading to an expected negative coefficient. When
sales changes are negative the expected sign flips and turns positive.
P4d: When regressing the measurement error on an indicator variable for extreme
quartile of size, we expect positive sign because the estimation error exists in both
small and large firms.

Sales Growth. The results in Kothari et al. (2005) suggest that the lowest (highest)
quartile of growth in sales exhibits high rejection rates of the null hypothesis of zero
discretionary accruals in favor of the alternative of negative (positive) discretionary
accruals. This means that in the lowest (highest) quartile estimated discretionary accruals
are too low (high) and estimated normal accruals are too high (low). Thus, in those sets of
firms (i) The absolute value of the estimation error in the coefficient is expected to be
positive and (ii) the estimation error in the coefficients (
1
EST
-
1
PRED
) is positive
(negative) if changes in sales are positive (negative). This translates into several
predictions that we outline below.
P4a: When regressing the absolute value of the measurement error on a
continuous measure of the quartile of sales change, the estimated coefficient
cannot be signed because the potential estimation error exists in both extreme
quartiles.
P4b: When regressing the absolute value of the measurement error on an
indicator variable for extreme quartile of size, the estimated coefficient will be
positive because in both quartiles we expect some estimation error in the
coefficient.
P4c: When regressing the measurement error on a continuous measure of the
quartile of sales changes, the estimated coefficient is expected to be positive
P4d: When regressing the measurement error on an indicator variable for extreme
quartile of sales change, we expect positive sign because the estimation error
exists in both extreme quartiles of sales change.

16
2.3.3 Abnormal accruals test
To evaluate the sources of bias in abnormal accruals we also employ a second
test. In this test, we regress the absolute value of abnormal accruals on factors associated
with estimation error in the Jones coefficients. These factors are the coefficients of
variation in accrual determinants which capture the degree of homogeneity in the accrual-
generating process in a particular industry. We argue that industries with less
homogeneous accrual-generating processes will have firms with more biased abnormal
accruals.
The absolute value of abnormal accruals will include the true abnormal accruals
and the bias in abnormal accruals. By regressing both components, we hope to capture
the correlation of the bias component with the explanatory variables. This assumes that
the true component of abnormal accruals is not correlated with factors that are associated
with mismeasurement in the Jones coefficients.
Our prediction is that there will be a positive association between the coefficient
of variation of accrual determinants and the absolute value of abnormal accruals.
3. Data
We draw the accounting data necessary for our study from COMPUSTATs
primary, secondary and tertiary files. We include all firms with available data to estimate
the accrual models but exclude firms in the financial services industries (SIC codes 6000-
6999).
Accrual determinants. To calculate the accrual determinants we follow the
procedures outlined below. These procedures are similar to those used by Dechow et al.
(1998).
17



: AR= Accounts receivable (AR
t
+ AR
t-1
)/2*SALES
t

: AP = Accounts payable (AP
t
+ AP
t-1
)/2*SALES
t (1-)

1
: Target inventory g
1
/(1-) ; truncated above at 1 and below at -1
g
1
: Regression coefficient

INV
t
= g
1
*SALES
t
+ g
2
*SALES
t
+
t

: Profit Margin NI
t
/ SALES
t


For each firm, we then define the accrual determinant for year t as the 5-year
average of that determinant including the current year (t) and the previous 4 years. To
obtain industry-level statistics, at the 2-digit SIC code level, we calculate the average,
standard deviation and coefficient of variation based on each individual firms 5-year
averages and taking into account all firms belonging to an industry group for a particular
year.
Accrual models estimation. We estimate four versions of accrual models. The first
is the traditional Jones model
1 2
_
i i
TA Ch Sales PPE
i i
= + + + (4)
Where,
TA = total accruals calculated from the balance sheets as follows:
(Current Assets)- Cash- (Current Liabilities) + (current portion of LT debt)-
Depreciation and Amortization

Ch_Sales = the change in sales in year t (SALES
t
SALES
t-1
)/ASSETS
t-1
18
PPE = Property, Plant and Equipment.

We also estimate the modified-Jones model where we subtract the change in
receivables from the change in sales.
1 2
( _ _ )
i i i
TA Ch Sales Ch REC PPE
i i
= + + + (5)
Finally, we estimate a reduced form of the above models, wherein we only
include working capital accruals as the dependent variable, dropping PPE as an
explanatory variable. We do so because the accrual determinants from the Dechow at al.
(1998) model apply to working capital accruals (WCA).
1
_
i i
WCA Ch Sales
i
= + + (6),
1
( _ _ )
i i
WCA Ch Sales Ch REC
i i
= + + (7)

where,
WCA = working capital accruals calculated from the balance sheets as follows:
(Accounts receivables)- (inventories) (Accounts payable)

We exclude observations with the extreme 1% (from each side) of each variable
in models (4) through (7). In all these models,
1
, the coefficient on sales changes, is
assumed to capture the accrual-generating process.

19
4. Results
4.1 Summary statistics
Table 1 Panel A reports some descriptive statistics on the four main accrual
determinants. The summary statistics are calculated over all firm years in our sample and
are reported after eliminating the extreme 0.5% of observations on each side. The mean
(median) in our sample is 0.245 (0.167) which translates to an accounting receivable
cycle of about 89 (60) days. The mean (median) is 0.108 (0.078) which is equivalent to
39 (28) days in payables. The target inventorys mean (median) is 0.129 (0.110) which
translates to an inventory turnover of about 45 days. Finally, the median profit margin is
2.3%. The mean is affected by very extreme negative observations. In general, these
values (especially medians) are in line with those reported in Dechow et. al (1998). It is
worth noting that there is substantial variation in each of the parameters. For example,
s inter-quartile range is 0.114 to 0.242. All of the other accrual determinants in Panel A
display similar or greater levels of variation.
Panel B of Table 1 reports some correlations between the accrual determinants.
We note that and are positively correlated (0.37) and and are slightly negatively
correlated.
In Table 2 we provide additional summary statistics on the various accrual
determinants, broken down into different sub-groups. Note that some of the determinants
vary substantially across different quartiles. For example, 1s mean in the lowest book-
to-market quartile is 0.064 and it monotonically increases to 0.149 in the top quartile.
Similar variation appears in the ROA quartiles but not in the size quartiles.
20
4.2 The relation between accrual determinants and estimation of the Jones model
In this section we test our first hypothesis which examines the relation between
the empirical estimation of the Jones (1991) model and the accrual determinants. Recall
that
1
, the coefficient on the sales changes in the Jones model, can be viewed as a
parsimonious measure of the underlying accrual-generating process. In effect, the relation
between accruals and sales changes depends on a black box which consists of the
interactions between the accrual determinants and sales changes which, in turn, generate
accruals. In the Jones (1991) model, this black box is summarized by
1
.
To test H1, we regress the
1
industry-coefficients on the industry means of the
accrual determinants: , ,
1
and . The estimated
1
is derived from a cross-sectional
implementation of the Jones model within an industry group consisting of all firms
belonging to a common 2-digit SIC code group.
3
We average the accrual determinants
within those same industry groups to obtain the independent variables of our regression
model. We employ four regression models as described in section 3.
The results are reported in Table 3. Regardless of the type of model used for the
estimation (Jones or modified Jones, full or reduced), we find very strong evidence that
all four of the accrual determinants are significantly associated with
1
in the predicted
directions. The receivable policy (represented by ), the profit margin (represented by )
and the target inventory parameter (
1
) are positively and significantly associated with the
coefficient on sales. On the other hand , which represents credit policy granted by
suppliers, is significantly negatively associated with
1
, suggesting that the impact of this
determinant is to reduce overall accruals when sales increase.

3
In unreported results, we also regress
1
coefficients from a time-series version of the Jones model on
firm-specific accrual determinants. The conclusions are similar.
21
It is worth noting that the reduced-form models, which only involve working
capital accruals, have slightly higher explanatory power. This is expected because the
accrual determinants only pertain to working capital accruals.
In summary, the results in table 3 suggest that the Jones model does, in fact,
capture some of the relation between changes in sales and accruals, as reflected by the
accrual determinants. However, it is evident that this relation may be more complex than
what a simple parsimonious coefficient could capture. This complex interaction can best
be viewed in the more elaborate DKW model.
4.3 The significance of
1
and variation in accrual determinants within an
industry
In the previous section, we established a link between
1
and the accrual
determinants. Our second hypothesis argues that the quality of the empirical model
depends on the degree of variation in the accrual determinants within the group in which
the model is estimated. As a proxy for the quality of estimates of
1
we examine whether

1
is statistically significant in a particular industry-year model. The dispersion in accrual
determinants in each industry group is measured by the coefficient of variation of each
accrual determinant.
Our first examination is univariate. We rank into quintiles all industry-years based
on their coefficients of variation of the accrual determinants, separately for each
determinant. Quintile 1 is the quintile with the least degree of variation in the accrual
determinant whereas quintile 5 is the one with the greatest degree of variation in the
accrual determinant. Table 4 reports the frequency with which
1
is significant in each
quintile of an accrual determinants variation.
22
Starting with the first accrual determinant, , we find an almost monotonous
decline in the significance frequency of
1
from quintile 1 to quintile 5 for the Jones
model. The significance frequency of
1
is 59.5% in quintile 1, and declines to only
39.1% in quintile 5. The results are similar for the other models as well. For too, there
is a pattern of decline in significance frequency as we move to higher variation quintiles,
although it is not as strong as in the case of . Again, the patterns are similar across all
accrual models.
Turning to
1
, the accrual determinant related to inventory, we observe a strong
monotonous decline in significance frequency as we move from low to high variation
quintiles. For example, in the regular Jones model, 68% of the specifications yield a
significant
1
in the lowest variation quintiles. This proportion drops to 34% in the
highest variation quintile.
In contrast, there is a negative relation between the incidence of statistical
significance of
1
and the degree of variation in , the net profit margin. For example, in
the modified Jones specification, the significance frequency increases from 69.3% in the
lowest quintile to 82% in the highest quintile.
The relation between
1
and the accrual determinants is examined further in a
multivariate logistic regression. The dependent variable is an indicator variable which
equals 1 if
1
is significant. We use explanatory variables which capture the within-
industry variation in the accrual determinants. Essentially, these are the variables by
which we rank the industry-years in the previous tables. We also include as an
explanatory variable the number of observations used in the cross-sectional accrual
models. Obviously, a larger number of observations will lead to a more accurate
23
estimation of
1
. We examine whether our results with respect to the variation in the
accrual determinants are robust to the number of observations included in the accrual
model.
The results presented in Table 5 are largely consistent with those in Table 4. First,
as expected, the number of observations in a regression is positively related to the
significance of
1
. Both alpha and gamma are negatively associated with the likelihood of

1
being significant. As for , the weaker results in the univariate analysis do not show up
in the multivariate logistic model. Thus, the within-industry variation in does not play
an important role in the estimation of
1
. Recall that the pattern for in the univariate
analysis was opposite to the pattern on the other accrual determinants. In the multivariate
setting, however, the variation in is not significant.
In summary, Tables 4 and 5 confirm that the accrual determinants are important in
analyzing the empirical results of the Jones model. We discover that assessing the degree
of homogeneity in the industry-group is important in evaluating the Jones models
results. While the effect of the degree of variation in an explanatory variable on the
coefficient is very intuitive, we identify the identity of the candidates for high variation.
Thus, in industry groups with low variation in accrual determinants, i.e. a relatively
homogenous accrual-generating process, we expect the Jones models to perform better.
It is important to note that the variation within an industry is with respect to the
accrual-generating process. Currently, the industry measure used in this literature, the 2-
digit SIC code, is weak on two dimensions. First, two firms with very different business
environments could still belong to the same group. For example, Bernard and Skinner
(1996) mention that the makers of heavy equipment for the oil and gas industry, video
24
games, lawn mowers and personal computers all belong to the same two-digit SIC code.
Second, it is possible that two firms which operate in the same business environment
have different accrual-generating processes as a result of pursuing different business
strategies.
To illustrate these differences, we plot in figures 1-3, the accrual determinants of
four firms that belong to a common 2-digit SIC code (53): Walmart, Target, Kohls and
Neiman Marcus. The variation of the accrual determinants of these firms across time as
well as across the industry is striking. For example, Targets has decreased from about
0.15 to about 0.07 over the past 25 years. Such dramatic change is also observed in
Neiman Marcus . More importantly, we observe a large variation of across the four
firms. Similar patterns emerge in the rest of the accrual determinants.
4.4 The bias in discretionary accruals
We now turn to examining the nature and sources of the bias in the outcomes of
the Jones model, i.e. abnormal accruals. Prior studies document that such bias exists in
specific sets of firms. For example, firms that exhibit high levels of growth and extreme
performance. Prior studies, however, do not point to the sources of such biases. The
purpose of our tests is to ascertain whether some of that bias can be traced to
mismeasurement in the Jones coefficients. Such finding will enable researchers to direct
efforts at minimizing the measurement error in the coefficients which will then lead to
reduction in the abnormal accruals bias.
Measurement error test. In our first set of predictions we attempt to relate the
estimation error in the
1
coefficients of the Jones model to the bias in abnormal accruals.
We argue that if the measurement error is in the
1
coefficients, then the degree of
25
measurement error will be systematically associated with firm characteristics that are
related to biases in abnormal accruals.
To assess the degree of measurement error in the
1
coefficients, we compute a
firm-specific predicted coefficient based on the DKW model. We then regress the
difference between the industry-specific estimated coefficient and the firm-specific
predicted coefficient (
1
EST
-
1
PRED
) on several firm characteristics. The results are
reported in table 6.
4

First, we examine the regressions whose dependent variable is the absolute value
of
1
EST
-
1
PRED
. The results of these regressions are reported on the right-hand side of
Table 6. We predict that since all extreme quartiles are associated with some bias in
abnormal accruals, based on the results in Kothari et al. (2005), there will be a positive
relation between
1
EST
-
1
PRED
and indicator variables for whether a firm belongs to an
extreme quartile of BM, Sales growth and Size (EXT_BM, EXT_SALES, and
EXT_SIZE). The estimation results are consistent with this prediction in the case of
EXT_BM. That is, the coefficient on EXT_BM is positive and statistically significant.
Contrary to our prediction, the coefficient on EXT_SALES is negative and statistically
significant while the EXT_SIZE coefficient is negative but statistically insignificant.
In the models whose independent variable is an ordered rank variable with values
ranging from 1 to 4, we are unable to make definitive predictions because it is unclear
whether the biases are stronger in the lower or higher quartiles. An exception is the
QSALES coefficient. From the results in Kothari et. al. (2005), it is evident based on
higher rejection rates, that the biases are larger for lower quartiles of Sales growth.

4
We report results based on estimation of the full form of the Jones model. The models reported in Table 6
are run separately for each set of independent variables. That is, all the models are univariate.
26
Therefore, we make a prediction that the coefficient on QSALES will be negative. The
results indicate that in all variables, there exists a strong negative association between the
absolute value of the bias and the ranks of firm characteristics. This means that the bias is
larger and more likely to occur in the lower quartiles of BM, sales changes and size.
Next, we examine the models whose dependent variable is
1
EST
-
1
PRED
. Recall,
that the predictions in these models depended on the signs of sales changes. Therefore,
we also run the models separately for firms that experienced increasing or decreasing
sales. Focusing first on the pooled models, under the heading All, we find that extreme
book-to-market quartiles tend to have an upward bias in the Jones coefficient (a positive
coefficient of 0.0405) and it seems that this bias is larger in lower quartiles, as evidenced
by the negative coefficients (-0.0403) on QBM. The predictions on these coefficients
were ambiguous. When we estimate the models separately based on the sign of changes
in sales, we can relate directly to P3d. For declining sales, the positive coefficient on
EXT_BM is inconsistent with our prediction. However, the positive coefficient on
EXT_BM when sales are increasing is consistent with P3d. This means that the positive
bias in the Jones coefficients appears in both extreme quartiles of book-to-market.
In the cases of sales and size, the results are similar. Some of the results appear
consistent with our predictions (e.g. the negative coefficient on EXT_SALES) while in
other cases the results are insignificant.
In summary, we find some support for our predictions, although not in all cases.
We conclude that there is some evidence that the bias in abnormal accruals is associated
with measurement error in the coefficient on sales in the Jones model. We emphasize that
the results in table 6 are contingent on a well-specified predicted coefficient. While there
27
is a theoretical foundation for the use of the predicted coefficient based on the DKW
model, it is unclear whether that coefficient is the correct one. Therefore, our results
depend on the validity of this measure.
Abnormal accruals test. In our second test to evaluate the sources of bias in
discretionary accruals, we regress the absolute value of abnormal accruals directly on
three sets of variables. Recall that in this specification we hope to capture the systematic
variation of the bias in abnormal accruals (which is a component of the dependent
variable) with factors associated with mismeasurement of the Jones coefficients. The first
set of independent variables is similar to that examined in Table 6 and includes indicators
for sets of firms that are known to be associated with biased abnormal accruals. The
second set includes firm-specific values of the accrual determinants. Finally, we include
the variable of interest that is supposed to capture factors associated with measurement
error in the Jones coefficients. This variable is the coefficient of variation of each
determinant in a specific industry-year and it is supposed to track the industry-level
heterogeneity of the accrual generating process.
We report the main results in model I in Table 7. Other models are reported to
help interpret some of the results in model I. In the first model, we find that the
dependent variable, the absolute value of abnormal accruals, is systematically associated
with firm-level accrual determinants. Although we have no expectations for these
coefficients, we find it interesting that the accrual determinants still have strong
association with abnormal accruals. Theoretically, all that variation should have been
captured by the Jones model. We believe that this is additional evidence for the
misspecification of the Jones model with respect to the accrual determinants.
28
In the next set of variables, we find that extreme BM and Sales growth quartiles
are more likely to have larger (in absolute value) abnormal accruals. Since the absolute
value of abnormal accruals contains a true component and a bias and to the extent
that the true component is not associated with these quartiles, we argue that this is
evidence that extreme quartiles are associated with more bias. For BM, these results are
consistent with Table 6. However, with respect to Sales growth these results are in
contrast with those in Table 6. As for Size, we observe that extreme size quartiles are
associated with lower abnormal accruals.
Our main interest, however, lies in our proxies for the degree of homogeneity in
the accrual process. Our prediction suggests that an increased variation in the accrual-
generating process, proxied by the coefficients of variation in each accrual determinant,
will lead to more measurement error in the Jones coefficients and thus to more bias in the
firm-specific abnormal accruals. In model I, we find that larger variation in and
1

indeed exhibit a positive and statistically significant association with abnormal accruals.
Interestingly, and contrary to our expectations, we find that greater variation in is
associated with lower absolute value of abnormal accruals. However, since our prediction
is univariate, we would like to assess whether this negative relation holds when only
CV_ is included in the model. According to results from estimating model IV, it seems
that high variation in is positively associated with the absolute value of abnormal
accruals. When all industry-specific variables are included in the model, such as in
models I and III, the sign on CV_ flips. It is worth mentioning that conceptually, the
variation in the accrual-generating process that we would like to capture is a combined
29
variation of all accrual determinants. However, since we do not have a proxy for this
combination, we use the variation in each individual accrual determinant.
Collectively, the results in Tables 6 suggest that the bias in discretionary accruals
can be traced, in part, to the estimation of the Jones model. In particular, there is evidence
that the estimation error in the coefficients that results from heterogeneity in the accrual-
generating process in a 2-digit SIC group is associated with larger biases in abnormal
accruals.
5. Implications of the results
This papers results are important to a large strand of the accounting literature.
Any researcher that uses abnormal accruals would be interested in understanding the
effect of our results on popular abnormal accrual measures. We believe that the
implications of these results are different for two groups of studies: (1) studies that use
the absolute value of abnormal accruals and (2) studies that use the signed values of
abnormal accruals.
Absolute value of abnormal accruals. This papers results highlight the relation
between the industry group under which the Jones-type models are estimated and the
outcome of the models. Abnormal accruals that are a result of coefficient
mismeasurement will be present in industry groups that have a large variation in their
accrual-generating process. This bias in abnormal accruals will directly affect any study
that investigates the absolute value of abnormal accruals or uses it to investigate a
separate issue. Thus, to understand whether a particular study is exposed to such bias,
researchers need to ask whether the study draws on firms from industries with high
variation in the accrual-generating process represented by the accrual determinants. The
30
inclusion of such firms in samples will tend to bias upward the average measures of
absolute value of abnormal accruals.
Suppose researchers are interested in the relation between X and accrual quality
represented by the absolute value of abnormal accruals. The existence of such a relation
will lead researchers to a conclusion. In light of our evidence, the absolute value of
abnormal accruals is correlated with certain industries. If those industries are related to Y,
a set of characteristic variables, and there is a relation between Y and X, then any
conclusion about the relation between X and accrual quality may be premature.
Signed abnormal accruals. The effect of the bias in abnormal accruals that stems
from the inclusion of firms from high-variation industries in the sample on tests that use
signed abnormal accruals is more subtle. Again, suppose researchers use the correlation
between the average abnormal accruals in the sample and some variable, X. In typical
earnings managements studies this is also referred to as the partitioning variable (e.g.
McNichols and Wilson, 1988). In this study, we show that abnormal accruals are
correlated with industries that have a high variation in the accrual-generating process.
One also needs to show that the partitioning variable, X, is correlated with the firms in
these industries that are likely to have positive (or negative) abnormal accruals. However,
we have yet to outline what factors are associated with such firms, or what factors
determine whether biased abnormal accruals will be positive or negative. We will
investigate these issues in future research.
6. Conclusion
In this paper, we investigate the circumstances under which, the lack of explicit
specification in the Jones-type models of the interactions between sales changes, the
31
accrual determinants and accruals, has an impact on the reliability of the accrual models.
This endeavor is especially important, since the residuals from the Jones-type models are
used extensively in the literature to make inferences about earnings management or as
proxies for earnings quality.
We initially explore the relationship between these Jones-type models and various
fundamental accrual determinants related to accounts receivable, accounts payable,
inventory and profit margins. We document that the coefficient on sales changes derived
from the Jones-type models does in fact capture some of the relationship between sales
changes and accrual determinants. The four accrual determinants in our study are
associated with
1
(the coefficient on sales changes) from the Jones-type models in the
predicted direction. However, we argue that the relationship between sales changes and
accruals is more complex.
Next, we examine the impact of the degree of homogeneity in accrual
determinants in a given industry on the estimation quality of the Jones-type models.
Using univariate and multivariate tests we find that the degree of homogeneity in accrual
determinants and the significance of
1
in the Jones-type models are related. The within-
industry variation in the accounts receivable parameter and the inventory parameter are
negatively associated with the likelihood that
1
will be significant. Therefore, we
conclude that assessing the within-industry variation in the accrual determinants is
important when evaluating results from the Jones-type models. We expect that in
industries with low variation in accrual determinants, the Jones-type models will perform
better than in industries with high variation.
32
Finally, we attempt to identify the source of the bias in abnormal accruals. We
find the measurement error in the Jones coefficient on sales changes is related to various
factors shown in prior literature to be associated with bias in abnormal accruals. We also
find that the absolute value of abnormal accruals, which includes a bias component, is
associated with the degree of within-industry homogeneity in the accrual determinants.
In summary, we conclude that the measurement of abnormal accruals is
significantly affected by measurement error in the coefficient on sales changes in the
Jones model. This measurement error stems from heterogeneity in the accrual-generating
process of firms that are grouped together for the regression estimations. We believe that
to reduce biases in abnormal accruals, researchers should focus on estimating the Jones-
type models in groups that are as homogeneous as possible with respect to their accrual-
generating process. We show that the implied assumption that 2-digit SIC codes represent
such homogeneity may not be descriptive.
We do not comment on other potential sources for bias or measurement errors in
abnormal accruals. These include mis-calculation of the accrual variable itself (e.g Hribar
and Collins, 2000 and Francis and Smith, 2005) or econometric biases that affect the
estimated coefficients and result from violation of the classical assumptions.
Our study has implications for the findings of most studies that use a measure of
abnormal accruals computed using a Jones-type model. While we do not explicitly
recommend an alternate model for eliminating the bias in abnormal accruals, our study
provides a better understanding of the sources of the bias which creates a strong
foundation for building a more appropriate model for estimating abnormal accruals.
33
7. References
Ashbaugh, H., LaFond, R., Mayhew, E., 2003, Do nonaudit services compromise auditor
independence? Further evidence, The Accounting Review 78(3), 611-639.
Bartov, E., Gul, F., Tsui, J., 2001, Discretionary-accruals models and audit qualifications,
Journal of Accounting & Economics 30, 421-452.
Bernard, V., Skinner, D., 1996, What motivates managers choice of discretionary
accruals?, Journal of Accounting & Economics 22, 313-325.
Dechow, P., Kothari, S.P., Watts, R., 1998, The relation between earnings and cash
flows, Journal of Accounting & Economics 25, 133-168.
Dechow, P., Richardson, S., Tuna, I., 2003, Why are earnings kinky? An examination of
the earnings management explanations, Review of Accounting Studies, 8, 355-
384.
Dechow, P., Sloan, R., Sweeney, A., 1995, Detecting earnings management, The
Accounting Review 70, 193-225.
DeFond, M., Jiambalvo, J., 1994, Debt covenant violation and manipulation of accruals:
Accounting choice in troubled companies, Journal of Accounting & Economics
17, 145-176.
Fields, T., Lys, T., Vincent, L., 2001, Empirical research on accounting choice, Journal of
Accounting & Economics 31, 255-307.
Francis, J., Smith, M., 2005, A reexamination of the persistence of accruals and cash
flows, Journal of Accounting Research 45(3), 413-451.
Frankel, R., Johnson, M., Nelson, K., 2002, The relation between auditors fees for non-
audit services and earnings management, The Accounting Review
77(supplement), 71-105.
Hribar, P., Collins, D., 2002, Errors in estimating accruals: Implications for empirical
research, Journal of Accounting Research 40(1), 105-134.
Kothari, S.P., 2001, Capital markets research in accounting, Journal of Accounting &
Economics 31, 105-231.
Kothari, S.P., Leone, A., Wasley C., 2005, Performance matched discretionary accruals
measures, Journal of Accounting & Economics 39(1), 163-197.
Larcker, D., Richardson, S., 2004, Fees paid to audit firms, accrual choices, and corporate
governance, Journal of Accounting Research, 42(3), 625-658.
34
Francis, J., LaFond, R., Olsson, P., Schipper, K., 2005, The market pricing of accrual
quality, Journal of Accounting & Economics 39, 295-327.
McNichols, M., 2000, Research design issues in earnings management studies, Journal of
Accounting and Public Policy 19, 313-345.
McNichols, M., Wilson, G. P., 1988, Evidence of earnings management from the
provision for bad debt, Journal of Accounting Research, 26 (Supplement), 131.
Myers, J., Myers, L., Omer, T., 2003, Exploring the term of the auditor-client relationship
and the quality of earnings: A case of mandatory auditor rotation?, The
Accounting Review 78(3), 779-799.
Subramanyam, K.R., 1996, The pricing of discretionary accruals, Journal of Accounting
& Economics 22, 249-281.

35
Figure 1. Accrual determinants of four firms in the retail industry (SIC code=53).
Alpha - Accounts receivables
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
Walmart
Target
Kohl's
Neiman Marcus


Beta - Accounts Payable
0
0.02
0.04
0.06
0.08
0.1
0.12
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
Walmart
Target
Kohl's
Neiman Marcus

Gamma1 - Inventory
0
0.05
0.1
0.15
0.2
0.25
0.3
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
Walmart
Target
Kohl's
Neiman Marcus


36

Table 1. Summary Statistics and Correlations. This table presents summary statistics
of and correlations between the accrual determinants. For each year, we calculate and
report the 5-year averages of each determinant. If the firm does not have a 5-year history,
we use the maximum number of past years for which there is data as of year t. The
variables are calculated as follows. = (AR
t
+ AR
t-1
)/2*SALES
t
;

=(AP
t
+ AP
t-
1
)/2*SALES
t (1-)
; 1= g
1
/(1-) truncated above at 1 and below at -1; g1 is obtained from
the following regression INV
t
= g
1
*SALES
t
+ g
2
*SALES
t
+
t
; = NI
t
/ SALES
t


Panel A
var mean std max q3 median q1 min
0.245 0.439 8.150 0.242 0.167 0.114 0.003
0.108 0.125 1.838 0.117 0.078 0.053 0.000

1
0.129 0.118 0.828 0.196 0.110 0.028 -0.009
-0.682 4.383 0.503 0.060 0.023 -0.040 -82.237

Panel B

1


0.3667***

1
-0.0006 -0.0006
-0.0405*** -0.0003 0.0042*



37
Table 2. Summary Statistics. This table presents medians of the accrual determinants calculated
separately for quartiles of book-to-market, market capitalization, return on assets, changes in sales and
price-to-earnings ratio. For each year, we calculate and report the 5-year averages of each determinant. If
the firm does not have a 5-year history, we use the maximum number of past years for which there is data
as of year t. The variables are calculated as follows. = (AR
t
+ AR
t-1
)/2*SALES
t
;

=(AP
t
+ AP
t-
1
)/2*SALES
t (1-)
; = ; 1= g
1
/(1-) truncated above at 1 and below at -1; 2=-g
2
/g
1
; g1 and g2 are
obtained from the following regression INV
t
= g
1
*SALES
t
+ g
2
*SALES
t
+
t
; = NI
t
/ SALES
t


1 2 3 4
Panel A: Book-to-Market ratio
0.199 0.176 0.163 0.157
0.090 0.078 0.075 0.072

1
0.064 0.114 0.128 0.149
-0.052 0.040 0.035 0.020
Panel B: Market Capitalization
0.177 0.179 0.173 0.159
0.083 0.076 0.073 0.078

1
0.118 0.126 0.117 0.109
-0.014 0.018 0.035 0.054
Panel C: Return on Assets
0.212 0.165 0.150 0.158
0.095 0.081 0.075 0.066

1
0.066 0.115 0.120 0.133
-0.164 0.018 0.042 0.061
Panel D: Changes in Sales
0.180 0.164 0.166 0.159
0.083 0.083 0.074 0.076

1
0.108 0.078 0.126 0.119
-0.003 0.039 0.035 0.026
Panel E: Price-to-Earnings ratio
0.213 0.148 0.157 0.183
0.093 0.073 0.070 0.077

1
0.072 0.135 0.133 0.119
-0.109 0.034 0.050 0.043

38
Table 3. The relation between Jones coefficients and accrual determinants.
The table reports regression results of the actual coefficient on changes in sales (1)
estimated using a Jones/Modified Jones models or the reduced form of each of them.
Each observation is an industry-year. Industry is a 2-digit SIC code. T-stats are reported
in parentheses. , ,
1
and are the accrual determinants described in Dechow et al.
(1998). For each industry-year, the independent variables are the average , ,
1
and
for that industry-year.

Regular Reduced Form
Jones Modified Jones Jones Modified Jones
Intercept 0.0023
(0.22)
-0.0046
(-0.38)
0.0599***
(6.32)
0.0594***
(5.66)

0.4290***
(9.08)
0.3431***
(6.32)
0.6103***
(14.34)
0.4822***
(10.23)

-0.6941***
(-6.52)
-0.6996***
(-5.72)
-0.8736***
(-9.11)
-0.8631***
(-8.12)

1
0.5532***
(15.9)
0.5842***
(14.62)
0.4428***
(14.13)
0.4604***
(13.26)

0.0148*
(1.73)
0.0114
(1.16)
0.0246***
(3.20)
0.0246***
(2.89)

N 1,434 1,434 1,434 1,434
R
2
0.1990 0.1620 0.2305 0.1787

39
Table 3. The relation between Jones coefficients and accrual process parameters.

Fama-MacBeth estimation by year. (t-stats in parentheses)

Regular Reduced Form
Jones Modified Jones Jones Modified Jones
Intercept 0.0032
(0.27)
-0.0069
(-0.48)
0.0566***
(4.82)
0.0533***
(4.16)

0.4231***
(7.92)
0.3486***
(5.77)
0.6390***
(13.11)
0.5252***
(9.70)

-0.7283***
(-7.13)
-0.7335***
(-6.92)
-0.9152***
(-9.99)
-0.8948***
(-8.45)

1
0.5851***
(10.84)
0.6249***
(11.37)
0.4632***
(9.79)
0.4871***
(11.18)

0.0208
(1.00)
0.0447
(1.51)
0.0337
(1.27)
0.0698
(1.85)

N 28 28 28 28
R
2
0.2831 0.2434 0.3209 0.2616


40
Table 4. The table reports the frequencies with which
1
(the coefficient on change in
sales in the Jones-type models) is statistically significant separately for each quintile of
dispersion in the accrual parameters. We rank industry-years (where industries are
defined as two-digit SIC codes) to quintiles based on the coefficient of variation of each
accrual determinant. The accrual determinants are those described in Dechow et al.
(1998).

Regular Reduced Form
Jones Modified Jones Jones Modified Jones

Panel A:
Low 59.5% 81.9% 47.4% 70.1%
1 60.1% 78.7% 49.1% 71.7%
2 55.6% 78.1% 47.1% 69.4%
3 46.8% 73.6% 38.4% 62.3%
High 39.1% 62.1% 33.4% 53.6%

Panel B:
Low 50.9% 75.3% 44.2% 70.1%
1 60.1% 81.8% 49.5% 73.6%
2 51.5% 71.9% 44.5% 63.5%
3 52.4% 75.6% 40.8% 63.6%
High 46.3% 69.8% 36.2% 56.7%

Panel C:
1

Low 68.2% 85.0% 55.8% 78.3%
1 69.0% 84.2% 61.4% 77.9%
2 55.7% 75.5% 45.6% 67.4%
3 35.0% 63.8% 28.9% 49.8%
High 34.2% 66.4% 22.8% 52.5%

Panel D:
Low 41.1% 69.3% 35.0% 55.4%
1 43.6% 68.8% 32.8% 59.0%
2 48.3% 71.8% 39.0% 59.1%
3 64.3% 82.6% 53.4% 72.2%
High 64.0% 82.0% 49.7% 75.0%

41
Table 5. This table reports logit regressions. The dependent variable equals 1 if the
coefficient
1
for that industry-year is significant. The dependent variables are the
coefficient of variation of each accrual determinant in the specific industry-year. In
addition, the number of observations (Nobs) in each accrual regression model in each
industry-year is also included as an independent variable.

Regular Reduced Form
Jones Modified Jones Jones Modified Jones
Intercept 0.4078***
(0.1835)
0.2490
(0.1997)
0.6680***
(0.2136)
0.9612***
(0.2109)


CV_ -0.7101***
(0.1365)
-0.4107***
(0.1473)
-0.7815***
(0.1435)
-0.4826***
(0.1425)


CV_ 0.3428
(0.2520)
-0.1422
(0.2849)
-0.3322
(0.2566)
-0.3168
(0.2763)


CV_
1
-0.6395***
(0.0961)
-0.6441***
(0.1089)
-0.0216
(0.0355)
-0.5143***
(0.0951)

CV_ -0.0005
(0.0004)
-0.0005
(0.0005)
0.0006
(0.0007)
0.0019
(0.0012)

Nobs 0.0074***
(0.0074)
0.0055***
(0.0006)
0.0224***
(0.0020)
0.0109***
(0.0012)

N 1,662 1,435 1,662 1,435
Pseudo-R
2
0.1329 0.1066 0.1808 0.1354



42
Table 6. This table reports regressions of the bias in
1
on ranks of various variables. The dependent variable is the difference between the estimated 1 from
cross-sectional Jones models on an industry level to the predicted firm-level 1 calculated from the DKW formula as follows: *** GIVE the formula ** The
regression models are estimated separately for each year. The reported coefficients are averages of 32 annual coefficients and the t-statistics are based on
standard errors calculated from the time-series standard deviation. The independent variables are either (1) Quartiles of BM/Growth in sales or size (0,1,2,3)
calculates for each firm separately each year or (2) an indicator variable (EXT_BM) which equals 1 if the firm belongs to an extreme (either high or low)
quartile.

Dependent variable =
1
EST
-
1
PRED
Dependent variable =
ABS(
1
EST
-
1
PRED
)
All Ch_Sales<0 Ch_Sales>0 All

QBM ? -0.0403***
(-7.39)

? -0.0527***
(-6.65)
? -0.0356***
(-7.53)
? -0.0295***
(-7.33)

EXT_BM ? 0.0405***
(4.24)

- 0.0513***
(5.00)
+ 0.0429***
(4.30)
+ 0.0875***
(9.27)

QSALES + 0.0048
(1.72)
0.2846***
(7.84)

-0.0034
(-0.94)
- -0.0229***
(-9.78)

EXT_SALES - -0.0104*
(-1.91)

- -0.2846***
(-7.84)
- 0.0128***
(2.30)
+ -0.0116***
(-2.41)

QSIZE ? -0.0116***
(-2.70)

+ -0.0078
(-1.77)
- -0.0164***
(-3.27)
? -0.0578***
(-10.26)

EXT_SiZE + 0.0036
(0.69)

0.0089
(0.88)
0.0011
(0.17)
+ -0.0137
(-1.75)
43
Table 7. This table reports regressions results of models whose dependent variable is the absolute
value of abnormal accruals generated using the regular Jones model. The independent variables
are firm-sepecific accrual determinants: , , 1 and ; firm-specific indicator variables that equal
to 1 if the firm-year observations appears in one of the extreme quartile of the cross-sectional
distribution of book-to-market ratio (EXT_BM), market capitalization (EXT_SIZE) and annual
changes in sales (EXT_SALES); and industry-level measures of the coefficient of variation of
accrual determinants in a particular industry-year CV_, CV_, CV_1 and CV_. T-stats
appear in parentheses.

I II III IV V VI VII
Intercept -0.003*** 0.059*** 0.040*** 0.076*** 0.036*** 0.072*** 0.080***
(-2.20) (98.61) (32.86) (93.68) (31.77) (144.29) (244.90)

0.015*** 0.021***
(12.09) (17.24)

0.090*** 0.093***
(29.03) (29.47)

1
0.060*** 0.036***
(20.23) (12.71)

-0.004*** -0.004***
(-38.96) (-38.51)

EXT_BM 0.013***
(20.78)

EXT_SIZE -0.006***
(8.53)

EXT_Sales 0.041***
(65.02)

CV_ -0.007*** -0.008*** 0.004***
(-7.26) (-8.18) (4.65)

CV_ 0.052*** 0.062*** 0.061***
(30.02) (35.20) (39.62)

CV_
1
0.003*** 0.002*** 0.008***
(8.3) (4.43) (20.20)

CV_ -0.001 -0.001* -0.001***
(1.19) (-1.86) (-2.86)

N 154,313 176,923 176,923 176,923 176,923 176,923 176,923

R
2
0.0659 0.0272 0.0106 0.0001 0.0101 0.0026 0.0000