Operating asymmetries and non-linear spline correction in discretionary accrual models
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Earnings management research often uses discretionary accruals from Jones-type models. These models assume a linear relation between sales changes and accruals. However, we predict and find that sales changes have a non-linear asymmetric effect on accruals through managers’ operating decisions. By forcing a linear specification on this non-linear effect, the modified Jones model overestimates (underestimates) discretionary accruals for moderate (extreme) sales changes. This non-linear bias causes excessive type-I error in tests of positive (negative) discretionary accruals for subsamples with moderate (extreme) sales growth. The literature often controls for non-linearities using performance matching (Kothari et al. in J Account Econ 39(1):163–197, 2005). However, we show that this approach leads to false inferences due to matching on the dependent variable. We use a flexible non-linear spline specification to control for the non-linear operating effect of sales changes. Our method successfully mitigates the bias, improves type-I errors without sacrificing test power, and changes inferences about major prior findings.
KeywordsSales growth Non-linearity Performance matching Misspecification
JEL ClassificationC52 D21 D22 M40 M41
We thank Amy Hutton (discussant) and seminar participants at Temple University, JAAF Accounting Conference, Temple Accounting Conference, AAA annual meeting, FARS midyear meeting, and MAS midyear meeting for helpful comments and suggestions.
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