Discretionary Revenues as a Measure of Earnings

Management
Stephen R. Stubben
The University of North Carolina at Chapel Hill
July 2009

ABSTRACT: This study examines the ability of revenue and accrual models to detect simu-
lated and actual earnings management. The results indicate that revenue models are less
biased, better specified, and more powerful than commonly used accrual models. Using a
simulation procedure, I find that revenue models are more likely than accrual models to
detect a combina-tion of revenue and expense manipulation. Using a sample of firms subject
to SEC enforcement actions for a mix of revenue - and expense-related misstatements, I find
that, although revenue models detect manipulation, accrual models do not. These findings
provide support for using measures of discretionary revenues to study earnings management.

Keywords: Revenues; Earnings Management; Discretionary Accruals.

Data Availability: Data are available from public sources.

I. INTRODUCTION

This study examines the ability of revenue and accrual models to detect simulated and
ac-tual earnings management. Despite repeated criticisms of accrual models over the past 15
years (e.g., Dechow et al. 1995; Bernard and Skinner 1996; Guay et al. 1996; McNichols
2000; Tho-mas and Zhang 2000; Kothari et al. 2005), many studies have addressed and
continue to address earnings management using these models, presumably because few viable
alternatives exist.1 Accrual models have been criticized for providing biased and noisy
estimates of discretion, which calls into question the conclusions from studies that use them
(Bernard and Skinner 1996). The objective of this study is to evaluate a different measure of
earnings management— discretionary revenues—that permits more reliable and conclusive
inferences than existing mod-els.

The most common approaches to estimating earnings management (i.e., the extent man-
agement exercises discretion over reported earnings) use aggregate accruals. However,
several studies have suggested focusing on one component of earnings, which has the
potential to pro-vide more precise estimates of discretion (McNichols and Wilson 1988;
Bernard and Skinner 1996; Healy and Wahlen 1999; McNichols 2000). Modeling a single
earnings component per-mits incorporating key factors unique to that component, thereby
reducing measurement error. In addition, focusing on earnings components provides insights
into how earnings are managed. Revenues is an ideal component to examine as it is the
largest earnings component for most firms and is subject to discretion. Dechow and Schrand
(2004, 42) find that over 70 percent of SEC Accounting and Auditing Enforcement Releases
involve misstated revenues. Furthermore, revenues are the most common type of financial
restatement (Turner et al. 2001).

I model a common form of revenue manipulation—premature revenue recognition—and

its effect on the relation between revenues and accounts receivable. I define prematurely
recog-nized revenues as sales recognized before cash is collected using an aggressive or
incorrect ap-plication of Generally Accepted Accounting Principles. My revenue model is
similar to existing accrual models (Jones 1991; Dechow et al. 1995), but with three key
differences.

First, I model the receivables accrual, rather than aggregate accruals, as a function of the
change in revenues. Of the major accrual components, receivables have the strongest
empirical and most direct conceptual relation to revenues. Explaining other working capital
accruals by revenues alone contributes to the noise and bias that plague accrual models.
Because I model re-ceivables instead of aggregate accruals, the model is one of revenues
rather than earnings.

Second, I model the receivables accrual as a function of the change in reported revenues,
rather than the change in cash revenues (Dechow et al. 1995). Although this choice
systematical-ly understates estimates of discretion in revenues, it is less likely to overstate
estimates of discre-tion for firms whose revenues are less likely to be realized in cash by year
end (e.g., growth firms). The modified Jones model (Dechow et al. 1995) treats uncollected
credit sales as discre-tionary.

Third, I model the change in annual receivables as a linear function of two components
of the change in annual revenues: (1) change in revenues of the first three quarters and (2)
change in fourth-quarter revenues. Because revenues in the early part of the year are more
likely to be collected in cash by the end of the year, these have different implications for
year-end recei-vables than a change in fourth-quarter revenues. Revenue and accrual models
that fail to consider fourth-quarter revenues separately overstate (understate) discretion when
fourth-quarter revenues are relatively high (low).

I also estimate a version of the model that allows the relation between receivables and
annual revenues to vary depending on firms’ credit policies. Models that fail to incorporate
dif-ferences across firms in the relation between revenues and receivables (or accruals) will
misstate estimates of discretion.

Discretionary revenues is the difference between the actual change in receivables and the
predicted change in receivables based on the model. Abnormally high or low receivables
indicate revenue management. To benchmark against existing models, I compare the ability
of the reve-nue model and commonly used accrual models (Jones 1991; Dechow et al. 1995;
Dechow and Dichev 2002; Kothari et al. 2005) to detect combinations of revenue and
expense management.

Findings indicate that measures of discretionary revenues do in fact produce estimates

with substantially less bias and measurement error than those of accrual models. Using
simulated manipulation (Kothari et al. 2005), I find that the revenue model produces
estimates of discretion that are well specified for growth firms. Each of the accrual models
tested exhibits substantial misspecification. The results for growth firms indicate a bias of
over two percent of total assets for each of the accrual models.

The results indicate further that discretionary revenues can detect not only revenue man-
agement but also earnings management (via revenues), whereas accrual models do not.2
Using a sample of firms targeted by SEC enforcement actions, I find that the revenue model
is able to detect earnings manipulation, but accrual models are not.3 The simulation analysis
reveals that the revenue model is more likely than accrual models to detect earnings
management for equal amounts of revenue and expense manipulation. These findings suggest
that the revenue model is less likely than accrual models to falsely indicate earnings
management, and more likely than accrual models to detect earnings management when it
does occur.

Finally, the results have implications for studies that use accrual models. First, the Jones
model (Jones 1991) exhibits better specification than the modified Jones model (Dechow et
al. 1995), which suggests including reported revenues, rather than cash revenues, in accrual
mod-els.4 Second, the Dechow-Dichev model (Dechow and Dichev 2002; McNichols 2002),
which was originally developed to estimate earnings quality, exhibits greater misspecification
than oth-er accrual models when used to estimate discretionary accruals. I am unaware of any
other study that evaluates the ability of the Dechow-Dichev model to estimate discretionary
accruals. Lastly, the innovations I incorporate into the revenue model, including separating
fourth-quarter reve-nues and allowing the relation between revenues and accruals to vary
across firms, could im-prove the performance of accrual models.

II. MOTIVATION AND RELATED RESEARCH

Earnings Management

Earnings management has received significant attention in the popular press and academ-
ic accounting literature (McNichols 2000). Recently, various accounting scandals (e.g.,
Enron, WorldCom, and Parmalat), and subsequent regulation (e.g., Sarbanes-Oxley) have
fueled this attention.

As Beneish (1999, 24) writes, “The extent to which earnings are manipulated has long
been of interest to analysts, regulators, researchers, and other investment professionals.” For
analysts and investors, understanding the extent to which managers exercise discretion in
earn-ings is important in assessing the quality of earnings. Understanding which firms
manage earn ings and how they do it is useful for standard setters and regulators. Frequent
earnings manage-ment warrants new standards or additional disclosures, and evidence on the
specific accruals ma-naged allows standard setters to narrow their focus in this regard.
Understanding the motives for earnings management allows the SEC to narrow its focus in
enforcing standards. In each case, a reliable measure of earnings management and the
specific accruals used is required.

Findings of Prior Literature

Accrual Models

Studies of earnings management around firm-specific events commonly use models of

aggregate accruals.5 A variety of accrual models have been used in recent years. Most
accrual models are some variation of the cross-sectional Jones model (Jones 1991; DeFond
and Jiambal-vo 1994). In these models, nondiscretionary, or normal, accruals are usually
estimated as a linear function of change in revenues and gross property, plant, and equipment.
The models are usually estimated by industry and year, and the residual is the discretionary
accruals estimate. The mod-ified Jones model (Dechow et al. 1995) uses change in cash
revenues rather than change in total revenues because some credit revenues may be
discretionary. Other models add additional condi-tioning variables, such as cash flows
(Dechow and Dichev 2002; McNichols 2002).

Despite the prevalence of these models, they have been criticized for providing biased
and noisy estimates of discretionary accruals (Dechow et al. 1995; Kang and
Sivaramakrishnan 1995; Bernard and Skinner 1996; Guay et al. 1996; Thomas and Zhang
2000). Dechow et al. (1995) find that discretionary accrual models generate tests of low
power for earnings manage-ment of economically plausible magnitudes and misspecified
tests of earnings management for firms with extreme financial performance, which is
frequently correlated with the earnings man agement incentive under investigation (e.g., IPOs
and SEOs). The results in Guay et al. (1996) are consistent with the modified Jones model
estimating discretionary accruals with considerable imprecision and/or misspecification.
Thomas and Zhang (2000) assert that the commonly used models “provide little ability to
predict accruals.”

Inferences relating to earnings management depend on the researcher’s ability to accu-

rately estimate discretionary accruals. As a consequence of accrual models’ poor
performance, studies using accrual models have often produced mixed results. Burgstahler
and Eames (2006) find that firms with small positive forecast errors have higher unexpected
accruals using the Jones (1991) model, in contrast to the absence of such an association in
Phillips et al. (2003), who employ the modified Jones model. Matsumoto (2002) finds
evidence of firms using discre-tionary accruals to meet earnings forecasts in one
specification, but not in another. Dechow et al. (2003) find similar magnitudes of
discretionary accruals for small loss and small profit firms and conclude that if firms
overstate earnings to report profits, their accrual model is not powerful enough to detect it.

Specific Accruals

A limitation of aggregate discretionary accrual measures is that they do not provide in-
formation as to which components of earnings firms manage. These models do not
distinguish discretionary increases in earnings through revenues or components of expenses.
McNichols (2000) suggests that future progress in the earnings management literature is more
likely to come from the examination of specific accruals (see also Bernard and Skinner 1996;
Healy and Wah-len 1999; and Beneish 2001).

The advantage of using specific accruals, such as loan loss reserves, is that they are ma-
terial and a likely object of judgment and discretion. However, many accruals are industry
spe-cific (e.g., banking and insurance industries) and the analysis cannot be applied to firms
outside the industry. In contrast, McNichols and Wilson (1988) examine discretion in the
allowance for bad debts. This accrual is common across industries. However, bad debt
expense is often only a small portion of reported earnings, so only a relatively small portion
of the total amount of a firm’s discretion is likely to be captured. An ideal specific accrual for
study is one that is (1) common across industries, (2) subject to discretion, and (3) represents
a large portion of the earn-ings discretion available to firms. Based on these criteria, revenues
is a natural candidate.

Revenues as a Means of Earnings Management

Three studies that examine revenue management are Plummer and Mest (2001), Mar-
quardt and Wiedman (2004), and Caylor (2009). Plummer and Mest (2001) study the
discretion in earnings components using distributional tests similar to those of Burgstahler
and Dichev (1997), finding evidence suggesting firms manage earnings upward to meet
earnings forecasts by overstating revenues and understating some operating expenses. They
do not attempt to estimate discretionary revenues.

Marquardt and Wiedman (2004) estimate the unexpected portions of several accrual
components, including receivables, to determine which components of earnings firms
manipulate in certain settings. They find evidence that firms with small earnings increases
understate special items but do not overstate revenues. It also finds evidence that firms use
discretion in revenues to increase (decrease) earnings prior to equity issuances (management
buyouts). Caylor (2009) uses discretionary revenues to test their use for avoiding reporting
negative earnings surprises and finds evidence that managers use discretion in revenues that
affects both accounts receivable and deferred revenues to report positive earnings surprises. I
seek to validate a measure of discretio-nary revenues that can be used to test hypotheses in
studies such as these.
 III. RESEARCH DESIGN

Discretionary revenues take a number of forms. Some involve the manipulation of real
activities (e.g., sales discounts, relaxed credit requirements, channel stuffing, and bill and
hold sales), and others do not (e.g., revenues recognized using an aggressive or incorrect
application of Generally Accepted Accounting Principles (GAAP), fictitious revenues, and
revenue defer-rals). I model premature revenue recognition and its effect on the relation
between revenues and accounts receivable. Premature revenue recognition includes channel
stuffing and bill and hold sales, if customers do not pay cash for the inventory, and revenues
recognized using an aggres-sive or incorrect application of GAAP.

I focus on premature revenue recognition because evidence suggests that it is the most
common form of revenue management.9 For example, Feroz et al. (1991) find that more than
half of SEC enforcement actions issued between 1982 and 1989 involved overstatements of
ac-counts receivable resulting from premature revenue recognition. Other forms of revenue
manipu lation, such as sales discounts, could be profit-maximizing business decisions and not
merely attempts manage revenues to meet a performance benchmark.

Model of Discretionary Revenues

Reported (i.e., managed) revenues (R) is the sum of nondiscretionary revenues (RUM)

and discretionary revenues (δ RM).

Rit = RitUM + δitRM

A fraction, c, of nondiscretionary revenues remains uncollected at year end, and I assume

there are no cash collections of discretionary revenues. Thus, accounts receivable (AR) equals

the sum of uncollected nondiscretionary revenues (c × RUM) and discretionary revenues (δ

RM
).

ARit = c × RitUM + δitRM

Discretionary revenues increase accounts receivable and revenues by the same amount;

discre-tionary receivables equals discretionary revenues.

 Because nondiscretionary revenues are not observable, I rearrange terms and express

end-ing receivables in terms of reported revenues. I then take first differences to arrive at the

follow-ing expression for the receivables accrual.

∆ARit = c × ∆Rit + (1 − c) × ∆ δitRM

The estimate of a firm’s discretionary revenues is the residual from the following equation:

∆ARit = α + β ∆Rit +ε it

Because reported revenues include discretionary revenues, the amount of revenue

man-agement estimated by the revenue model will be understated by a factor of 1 – c (see
footnote 31 of Jones 1991). The modified Jones model (Dechow et al. 1995) conditions on
the change in cash revenues rather than total revenues, which avoids systematically
understating the amount of earnings management. However, this approach introduces another
problem: uncollected credit revenues are treated as discretionary. Firms with a higher than
average portion of nondiscretio-nary revenues that are credit will have higher estimates of
discretionary accruals. I condition on total revenues because this understates estimated
earnings management, which biases against finding in favor of typical alternative hypotheses.

One limitation of accrual models is that by conditioning on annual revenues they treat
revenues from early in the year the same as revenues from later in the year. Current accruals
are generally resolved within one year. Thus, sales made late in the year are more likely to
remain on account at year end. Therefore, the revenue model I estimate allows the estimated
portion of rev-enues that are uncollected at year end to vary in the fourth quarter.

∆ARit = α + β1 ∆R1_3it + β2 ∆R4it +ε it (1)

In Eq. (1), R1_3 is revenues in the first three quarters, and R4 is revenues in the fourth

quarter. Even though Eq. (1) incorporates quarterly revenues, I estimate discretion on an

annual level.13 Any revenue management in early quarters that reverses by year end will not

be captured.

Another limitation of accrual models is that cross-sectional estimation implicitly

assumes that firms in the same industry have a common accrual-generating process. Dopuch
et al. (2005) show that the relation between accruals and revenue changes depends on firm-
specific factors such as credit and inventory policies. In cross-sectional estimation, deviations
from the industry average credit policy, for example, would lead to non-zero estimated
unexpected accruals. Therefore, to control for these deviations, I also estimate a version of
the revenue model that al-lows the coefficient on revenues to vary with firms’ credit policies.

Petersen and Rajan (1997) review theories of trade credit and the determinants of ac-
counts receivable. I use the implementation of the Petersen and Rajan (1997) credit policy
model described in Callen et al. (2008). A firm’s investment in receivables is a function of its
financial strength, operational performance relative to industry competitors, and stage in the
business cycle. Firm size, measured as the natural log of total assets (SIZE), is a proxy for
financial strength. Firm size and firm age (AGE), measured as the natural log of the firm’s
age in years, are proxies for the firm’s stage in the business cycle. Following Petersen and
Rajan (1997), I also include the square of firm age (AGE_SQ) to allow for a nonlinear
relation between age and credit policy. As proxies for the operational performance of the firm
relative to industry competitors, I use the industry-median-adjusted growth rate in revenues
(GRR_P if positive, GRR_N if nega-tive) and the industry-median-adjusted gross margin
(GRM) and its square (GRM_SQ).

I refer to the following model as the conditional revenue model, as it is a cross-

sectional conditional estimation of the revenue coefficient:

∆ARit = α + β1 ∆Rit + β2 ∆Rit×SIZEit + β3 ∆Rit×AGE it (2)

+ β4 ∆Rit×AGE_SQ it + β5 ∆Rit×GRR_Pit

+ β6 ∆Rit×GRR_Nit + β7 ∆Rit×GRMit + β8 ∆Rit×GRM_SQit +ε it

As a benchmark for the revenue models, I estimate discretionary accruals using four

common approaches: the Jones model (Equation 3 below; Jones 1991), the modified Jones

model (Equation 4 below; Dechow et al. 1995), the Dechow-Dichev model (Equation 5

below; Dechow and Dichev 2002; McNichols 2002), and performance-matched estimates

from the modified Jones model (Kothari et al. 2005). The appendix summarizes the

discretionary revenue and ac-crual estimates I use in this study.

 ACit = α + β1 ∆Rit + β2 PPEit +ε it (3)

ACit = α + β1 (∆Rit – ∆ΑRit) + β2 PPEit +ε it (4)

ACit = α + β1 ∆Rit + β2 PPEit + β3 ∆Rit×CFO i,t-1 + β4 CFOit + β5 CFOi,t+1 +ε it (5)

Data and Descriptive Statistics

The sample period begins in 1988 because prior to that date cash flow from operations
disclosed under Statement of Financial Accounting Standards No. 95 (FASB 1987) is
unavaila-ble. The sample period ends in 2003 but uses 2004 data for cash from operations. I
exclude firms in regulated industries (financial, insurance, and utilities) because their
revenues and accruals likely differ from those of other firms.

I obtain financial data from Compustat. I calculate accruals as earnings before

extraordi-nary items less cash flow from operations.15 I obtain cash flow from operations and
the change in receivables from the cash flow statement (Hribar and Collins 2002). Revenues
of the first three quarters is the difference between annual revenues and fourth-quarter
revenues. I deflate all revenue and accrual variables by average total assets. Annual earnings
growth is the annual change in income before extraordinary items, deflated by average total
assets. Revenue growth is the ratio of current to prior-year revenues. Gross margin
percentage equals revenues less cost of revenues, divided by revenues. Firm age is the
number of years since the firm’s initial appear-ance in the Compustat annual file with
nonmissing financial information. Industries are as de-fined in Barth et al. (2005). I winsorize
at one percent each model input variable by industry and year.

Following Kothari et al. (2005), I estimate nondiscretionary accruals with scaled and
un-scaled intercepts (by assets), to control for scale differences among firms (Barth and
Kallapur 1996). I exclude firms suspected of manipulation (e.g., firms targeted by the SEC)
when estimat-ing the model coefficients. I use the estimated coefficients to calculate
discretionary revenues of suspected firms. Table 1 presents summary statistics. Panel A
indicates that mean (median) accruals are –8 (–6) percent of average assets. The mean and
median change in receivables is 1 percent of aver-age assets. Panel A also indicates that the
mean (median) change in revenues is 9 (7) percent of average assets. On average, the revenue
change is approximately evenly distributed across quar-ters. The median change in revenues
of the first three quarters is 5 percent of average assets (ap-proximately 2 percent per quarter),
and the median change in fourth-quarter revenues is 2 percent of average assets.

Panel B of Table 1 presents correlations. Because the Pearson and Spearman

correlations are similar, I focus on the Pearson correlations. All correlations are significantly
different from zero. Change in receivables is positively correlated with accruals (0.35),
largely by construc-tion because change in receivables is typically a large component of
current accruals. However, the correlation between annual revenue change and change in
receivables (0.48) is larger than the 0.21 correlation between annual revenue change and
accruals. Additionally, change in recei-vables is more highly correlated with change in
fourth-quarter revenues than with the change in revenues of the first three quarters (0.49
versus 0.38) or even change in annual revenues (0.49 versus 0.48). Taken together, these
correlations suggest that estimates from models of recei-vables are less noisy than estimates
from accrual models, and that using quarterly data to disag-gregate annual change in revenues
might lead to better specified models. However, I base my inferences on the tests presented in
the next section.
 IV. RESULTS

Estimation of the Models

Table 2 presents results from the estimation of the revenue and accrual models. Panel
A presents summary results of the revenue models. In revenue model (1), the coefficient on
change in fourth-quarter revenues (0.21) is over four times higher than that of the change in
revenues of the first three quarters (0.05), although both are significantly positive.17 In
contrast, when condi-tioning on annual revenue change, the average coefficient is 0.08 and
the adjusted R-squared de-creases from 0.28 to 0.21. The coefficient on revenues in model
(2) varies significantly with size (SIZE), age (AGE), industry-adjusted revenue growth
(GRR_P and GRR_N), and gross margin (GRM). The adjusted R-squared increases from
0.21 to 0.28 over the model that does not allow for variations in credit policy.

Panel B presents summary results of the accrual models. The coefficient on revenue
change in the Jones model (3) is 0.10, as compared to 0.06 for the modified Jones model (4).
In addition, the adjusted R-squared of the modified Jones model is lower (0.09) than that of
the Jones model (0.12). In the Dechow-Dichev model (5), the coefficients on past and future
cash flows (0.27 and 0.14, respectively) and the coefficient on current cash flows (–0.46) are
each significantly related to accruals. The adjusted R-squared increases to 0.30 when adding
cash flows to the Jones model.

Untabulated results reveal that, when estimating the Jones model after excluding
recei-vables from accruals, the resulting coefficient on revenue change is 0.01 and is
significantly positive in only 66 out of 285 industry-year groups. This finding indicates that
the change in re-ceivables drives much of the correlation between accruals and change in
revenues. As expected, the relation between other accruals and revenue change is weaker
than that of the receivables ac-crual and revenue change, leading to noisier estimates of
discretion for accrual models.18

Evaluation of the Models

I evaluate estimates of discretion from the various models by assessing the models’
abili-ties to detect simulated revenue and expense manipulation and by relying on actual
earnings and revenue manipulation in a sample of firms known to have misstated their
financial results.
Detection of Simulated Revenue Manipulation

Similar to Dechow et al. (1995) and Kothari et al. (2005, hereafter KLW), I use
simula-tions to test the power and specification of discretionary accrual models in the
presence of ex treme performance. By comparing estimates of discretionary revenues and
expenses against a known quantity of manipulation, I am able to obtain evidence of the bias,
specification, and power of competing models. I measure the bias of each model as the
difference between the mean estimate of discretion and the amount of manipulation I induce.
If the model is unbiased, then the difference will equal zero. I evaluate the specification of the
models by computing how often tests reject the null hypothesis of no manipulation for
samples with no manipulation in-duced. Finally, I evaluate the power of the models by
computing how often tests detect induced manipulation.

I perform this simulation first using subsamples from the entire set of firms and then
on subsamples of firms known to produce biased estimates of discretion—i.e., subsamples
with high growth (McNichols 2000; Kothari et al. 2005). With the simulation on all firms, I
compare the revenue and accrual models’ power in detecting combinations of revenue and
expense manipula-tion. With the simulation on growth firms, I compare the specification of
the revenue and accrual models in the presence of extreme performance.

I repeat the following steps 250 times (either drawing firms from the entire population
or from the set of firms in each industry-year’s highest quartile of earnings growth):

(1) Draw a random subsample of 100 firm-year observations without replacement.

(2) Simulate revenue manipulation by adding one percent of average total assets to the
change in revenues, the change in fourth-quarter revenues, and the receivables ac-crual,
and one percent times the gross margin percentage to current accruals of these 100 firm-
years; or simulate expense manipulation by adding one percent to current accruals.

(3) Estimate the models using all observations except the 100 subsample firm-years.

(4) Use each model’s coefficient estimates to calculate estimates of discretion for the 100
subsample firm-years.

(5) Calculate the mean estimate of discretion from each model and test whether the mean is
significantly greater than zero.
 Statistics from the 250 subsamples form the basis of the tests. I report the mean and
stan-dard error of the 250 estimates of discretion, as well as the percent of the 250 times that
the mod-el rejects the null hypothesis of no manipulation. A rejection rate of 5 percent is
expected when manipulation is not introduced, and based on the 95 percent confidence
interval, an actual rejec-tion rate below 2 percent or above 8 percent indicates the test is
misspecified. When manipula-tion is introduced, however, the rejection rate should be 100
percent.

My procedure differs from that of KLW in three ways. First, I simulate combinations
of revenue and expense manipulation to evaluate the models under different forms of
earnings management. Second, I calculate accruals using items from the statement of cash
flows rather than the balance sheet. Hribar and Collins (2002) find that the error in the
balance sheet approach of estimating accruals is correlated with firms’ economic
characteristics. As KLW note, this er-ror not only reduces the models’ power to detect
earnings management, but also has the potential to generate incorrect inferences about
earnings management. Finally, I winsorize variables be-fore, rather than after, estimating the
models. This ensures that each model’s mean estimate of discretion is zero.
 Table 3, Panel A, presents descriptive statistics from the simulation on subsamples
drawn from the entire sample of firms. The table presents estimates of discretionary revenues
and ac-cruals based on four combinations of induced manipulation: no manipulation, revenue
manipula tion of one percent of assets, expense manipulation of one percent of assets, and
both revenue and expense manipulation of one percent of assets.

Because mean discretionary revenues and accruals in the entire sample are zero by con-
struction, the mean bias of each of the models should approximate zero. Table 3, Panel A,
con-firms this expectation. Table 3, Panel A, also presents standard errors. The standard
errors from the revenue models are about one-third those of the accrual models. A model that
produces esti-mates with lower standard errors is more likely to detect manipulation when it
occurs.

The first column of Table 3, Panel B, reports results on the specification of the models
under the null hypothesis of no discretion. None of the models over-rejects the null
hypothesis; however, the revenue models under-reject. Rejection rates for the revenue and
conditional reve-nue models are 0.8 and 1.2 percent. Rejection rates for the Jones, modified
Jones, Dechow-Dichev (DD), and performance-matched modified Jones (PM) models are
5.6, 5.2, 7.6, and 4.4 percent.

The next three columns of Panel B present evidence on the power of the models. The
revenue and conditional revenue models detect revenue manipulation of one percent in 23.6
and 24.0 percent of samples. The rejection rates for the Jones, modified Jones, DD, and PM
models are a substantially lower 6.8, 7.2, 8.8, and 6.0 percent, respectively. By construction,
the revenue models do not detect expense manipulation. The Jones, modified Jones, DD, and
PM models detect expense manipulation of one percent in 13.6, 13.2, 18.8, and 9.2 percent of
samples. The revenue and conditional revenue models detect a combination of revenue and
expense manipula-tion in 23.6 and 24.0 percent of samples. The Jones, modified Jones, DD,
and PM models detect the same combination of manipulation in only 11.6, 14.0, 19.2, and
11.2 percent of samples. The low rejection rates of the PM model relative to the modified
Jones model indicate that perfor-mance matching reduces the power of accrual models.

Table 4 presents results from the simulation on firms in the highest quartile of earnings
growth. Panel A of Table 4 reveals that each of the six models produces a positive estimate of
discretion for growth firms with zero induced manipulation, which indicates a positive bias
for growth firms. However, the bias is smaller for the revenue models than for the accrual
models. The revenue and conditional revenue model estimates are 0.41 and 0.40 percent of
assets, respec-tively; accrual model estimates are 2.39, 2.75, 3.71, and 2.07 percent of assets
for the Jones, modified Jones, DD, and PM models, respectively. The larger estimates for the
accrual models are consistent with accruals other than receivables not being explained by the
change in revenues alone, and the factors omitted from the models being correlated with
growth. For example, it is likely that growth firms invest in inventory beyond what would be
predicted by the change in current revenues alone.

Results in Table 4, Panel A, indicate that the modified Jones model is more biased than
the Jones model. This finding is consistent with growth firms having more uncollected credit
sales, which are treated as discretionary in the modified Jones model. The DD model exhibits
the greatest bias of all models tested. Although performance-matching reduces the bias of the
mod-ified Jones model, the bias remains more than five times the amount from either of the
revenue models. Performance matching by income as suggested by KLW does not fully
correct for growth-related model bias.

Table 4, Panel A, also presents standard errors across models. The standard errors from
the revenue models are less than half those of the accrual models. Of the accrual models, the
PM model produces estimates with the largest standard errors. Thus, the reduction in bias
accom-plished by performance matching comes at a cost in efficiency.

The first column of Table 4, Panel B, reports results on the specification of the models
under the null hypothesis of no discretion.19 Only the revenue models produce well-specified
tests of manipulation for growth firms. Rejection rates for the revenue and conditional
revenue models are 7.3 and 7.2 percent, respectively. Each of the four accrual models over-
rejects the null hypothesis of no manipulation. Rejection rates for the Jones, modified Jones,
DD, and PM models are 35.6, 43.6, 68.8, and 20.0 percent, respectively.

The next three columns of Panel B present evidence on the power of the models. The
revenue and conditional revenue models detect revenue manipulation of one percent in 44.4
and 41.2 percent of samples. The rejection rates for the Jones, modified Jones, and DD
models are
 31.2, 38.4, and 59.6 percent. However, these rejection rates largely reflect the general
tendency of biased models to over-reject even when no manipulation is induced. The PM
model, which exhibits the least misspecification of the accrual models, detects revenue
manipulation in only 18.4 percent of samples. By construction, the revenue models do not
detect expense manipula-tion. The PM model detects expense manipulation of one percent in
37.2 percent of samples. The revenue and conditional revenue models detect a combination
of revenue and expense manipula-tion in 44.4 and 41.2 percent of samples. The PM model
detects the same combination of mani-pulation in only 34.4 percent of samples.

In summary, simulation analysis on all firms indicates that the revenue models are more
likely than accrual models to detect an equal combination of revenue and expense
manipulation.

The simulation analysis on growth firms indicates that, although performance matching
improves the specification of the accrual models, only the revenue models are well-specified
with or with-out performance matching. Again, the revenue models are more likely than the
PM model to detect an equal combination of revenue and expense manipulation.

Detection of Actual Revenue Manipulation

The second procedure I use to evaluate revenue and accrual models assesses the ability
of these models to detect revenue and expense manipulation in a sample of firms that are
known to have misstated their financial results. The known manipulators are a sample of 250
firm-years that were investigated by the SEC for accounting irregularities between 1995 and
2003.

I divide sample firms into two groups: those that manipulated revenues and those that
manipulated expenses only. For each sample firm, I group observations into four time
periods: the manipulation period, the year before the manipulation, the year after the
manipulation, and all other years. I assume that sample firms overstate revenues and
understate expenses during the manipulation period.21 If the models are powerful, mean
discretionary revenue and accrual esti-mates should be significantly positive during the
manipulation period. Assuming no manipula-tion took place the year prior to the
manipulation period, if the models are correctly specified, mean discretionary revenue and
accrual estimates should not differ from zero.
 When studying SEC enforcement actions, one concern is selection bias. For this reason,
I present results after adjusting discretionary revenues and accruals of the SEC sample firms
by those of control firms chosen from the same industry and year. In the first case, I choose a
con trol firm for each sample firm from the same industry and year with the closest return on
assets, which is analogous to the performance matching approach suggested by KLW. In the
second case, I choose a control firm from the same industry and year with the closest revenue
growth in the prior year. Prior research documents that firms targeted by SEC enforcement
actions tend to be firms with high revenue growth (Beneish 1999).
 Table 5, Panel A, displays the distribution of sample firms through event time.
Revenues were manipulated over 173 firm-years and expenses were manipulated over 77
firm-years, con-sistent with revenue manipulation being the most common form of earnings
management.

Panel B provides results based on the entire sample of both revenue and expense
manipu-lators. When choosing control firms based on profitability, evidence indicates that
the Jones, modified Jones, and DD models are misspecified for the sample of SEC firms.
Discretionary ac-cruals before the manipulation period are estimated to be higher than control
firms by 6.30, 7.05, and 5.49 percent of assets, respectively. If these discretionary accruals
represented actual mani-pulation, however, it is likely that they would have been included in
the alleged manipulation period. The evidence indicates the performance-matched revenue
models are well specified.

The revenue and conditional revenue models detect discretion significantly higher than
that of control firms during the event period (1.80 and 1.63 percent of assets when matching
on profitability; 1.16 and 1.15 percent of assets when matching on growth). Each of the
perfor-mance-matched accrual models fails to detect discretion during the event period—
discretionary accruals are not significantly higher than those of control firms.
 Panel C provides results based on the entire sample of firms that manipulated revenues
alone or revenues and expenses. Each of the performance-matched accrual models is
misspeci fied. Before the manipulation period, the Jones, modified Jones, and DD models
produce discre-tionary accruals that are significantly higher than those of control firms by
9.07, 10.18, and 7.92 percent of assets when matching on profitability and by 6.86, 6.96, and
5.47 percent of assets when matching on growth. The revenue models are well specified.

Only the revenue models detect manipulation during the event period. Discretionary
rev-enues from the revenue and conditional revenue models are significantly higher than
those of control firms by 2.19 and 1.82 percent of assets when matching on profitability and
1.56 and 1.43 percent of assets when matching on growth. The performance-matched accrual
models fail to detect manipulation.

Panel D provides results based on the sample of firms that manipulated expenses. As
ex-pected, the performance-matched revenue models do not detect discretion in the sample of
firms that did not manipulate revenues. However, neither do the accrual models.
Discretionary accruals during the manipulation period are not significantly different than
those of control firms. Be-cause the sample studied in Table 5, Panel D is restricted to
expense manipulators, the accrual models should be more powerful than the revenue models.
However, neither the accrual nor rev-enue models detect manipulation by this subset of SEC
firms.

V. CONCLUSION

This study provides evidence on the reliability of discretionary revenues and various
measures of discretionary accruals by assessing their ability to detect both simulated and
actual manipulation. The results indicate that the revenue model is less biased and better
specified than accrual models, such that estimates from revenue models could be useful as a
measure of reve-nue management or as a proxy for earnings management. Although revenue
models do not detect discretion in expenses, findings suggest that ac-crual models have
difficulty detecting discretion in expenses as well. The state-of-the-art per-formance-matched
modified Jones model (Kothari et al. 2005) detects simulated expense mani-pulation in only
9.2 percent of samples of firms, and it fails to detect expense manipulation by firms subject to
expense-related SEC enforcement actions. Still, the success of the revenue mod-el at
detecting earnings management depends on the relative frequency of revenue vs. expense
manipulation. For equal amounts of simulated revenue and expense manipulation across the
en-tire sample, the revenue model outperforms each of the accrual models. The revenue
model also detects earnings management by firms subject to SEC enforcement actions, but
the performance-matched accrual models do not. Overall, the revenue model outperforms
accrual models both in detecting and failing to detect earnings management, as appropriate.
Thus, revisiting research settings with the revenue model could shed light on whether
significant results were driven by misspecification of accrual models or whether insignificant
results were driven by the accrual models’ lack of power.

Measures of discretionary revenues can also be useful by providing evidence on how

firms manage earnings or for studying revenue management. On the whole, relatively little
re-search has been conducted in the area of discretion in revenues. Although revenues is a
logical first step in examining individual components of earnings, future studies could model
discretion in various expense components of earnings.

Finally, this study has implications for studies that use accrual models. First, the Jones
model (Jones 1991) exhibits better specification than the modified Jones model (Dechow et
al. 1995), which suggests including reported revenues, rather than cash revenues, in accrual
models. Second, the Dechow-Dichev model (Dechow and Dichev 2002; McNichols 2002),
which was originally developed to estimate earnings quality, exhibits greater misspecification
than other accrual models when used to estimate discretionary accruals. Lastly, separating
fourth-quarter revenues and allowing the relation between revenues and accruals to vary
across firms could be applied to accrual models to improve their performance.