Detecting Earnings Management Patricia M. Dechow; Richard G, Sloan; Amy P. Sweeney The Accounting Review, Vol. 70, No. 2 (Apr., 1995), 193-225. Stable URL: Itty linksstor.orgsici?sici=0001-4826%28 19950452970%3A2%3C 193% 3ADEM%3E2.0.CO@IB2-Y The Accounting Review is curently published by American Accounting Association. Your use of the ISTOR archive indicates your acceptance of ISTOR's Terms and Conditions of Use, available at flip: feworwjtor org/aboutterms.htmal. ISTOR's Terms and Conditions of Use provides, in par, that unless you fave obtained pcior permission, you may not dowaload an cnt isus of @ journal or multiple copies of articles, and you may use content inthe ISTOR archive only for your personal, non-commercial uss. Please contact the publisher cegarding any further use of this work. Publisher contact information may be obtained at bupsterww.jstoc.org/joumals/axasoc hur. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transtnission. ISTOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding ISTOR, please contact support @jstor.org- up:therwwjstororgy ‘Thu May 20 06:09:40 2004nescence Bae? Ses. Detecting Earnings Management Patricia M. Dechow Richard G. Sloan University of Pennsylvania Amy P. Sweeney Harvard University ABSTRACT: This paper evaluates alternative accrual-based models for detecting ‘eamings management. The evaluation compares the specification and power of commonly used test statistics across the measures of discretionary accruals generated by the models and provides the following major insights. First, all of the models appear well specified when applied to a random sample of firm-years. Second, the models all generate tests of low power for earnings management of economically plausible magnitudes (2.g., one to five percent of total assets). Third, all models reject the null hypothesis of no earnings management at rates exceeding the specified testlevels when applied to samples of firms with extreme financial performance. This result highlights the Importance of controling for financial performance when investigating earnings management stimuli that are correlated With financial performance. Finally, a modified version of the model developed by Jones (1991) exhibits the most power in detecting earnings management. Key Words: Eamings management, Discretionary accruals, Models selection, SEC. Data Availability: Data used in this study are publicly available from the sources ‘identified in the paper. A listing of the firms investigated by the ‘SEC is available from the authors. We apeeciate the inpotof workshop panicipans ake Univertiy of Ariza, Harvard Univesicy (1994 ican Decision aed Control Seruvas), Michigan Stat University, New York Univetsiey, the University ef Peansjlvaia, Pennsyvania State Univers, Purdue University the Univer of Rochester, Rutgers iver, Stanford Unversity (1993 summer cap), Tempe Univesity, Teras Chistian University andthe 1994 AAA annval meetings, We are ppaiculaly grateful forthe suggestions of eb HolRausen and two efezees. Submsed February 1994, ‘Accepted December 1984 193194 ‘The Accounting Review, April 1995 L INTRODUCTION ‘NALYSIS of eamnings managementoften focuseson management’ suseof discretionary accruals.‘ Such research requires a model that estimates the discretionary companent(s) cof reported income. Existing models range {rom simple madels in which disecetionary accruals are measured as otal accruals, to more sophisticated models that akempt to separate cotal accruals into discretionary and nondiscretionary components. There is, hawever, no systematic evidence bearing on the celative performance of these alternative models at devecting earnings management We evaluate the relative performance of the competing models by comparing the specifica tion and power of commonly used test statistics. The specification ofthe test statistics isevaluated by examining the frequency with which they generate type Lettors. Type Lerrors arise when the ull hypothesis thatearnings are not systematically managed in response to the stimulus identified by the researcher is rejected when the aull is true. We generate type [ errors for both a andom sample of firm-years and for samples of firm-years with extreme financial performance. We focus on samples with extreme financial performance because the stimuli investigated in previous research are frequently coreelated with financial performance. Thus, our findings shed light on the specification of test statistics in cases where the stimulus deatified by the researcher does nat cause earnings to be managed, but is correlated with firm performance. ‘The power of the test statistics is evaluated by examining the frequency with which they generate type Il errors. Type II errors arise when the null bypathesis that earnings are nor systematically managed in response to the stimulus identified by the researcher is nav rejected when it is false, We generate type Il errors in cwo ways. Fitst, we measure rejection frequencies for samples of firm-ycars in which we have acificially added a fixed and knowa amount of accruals to each firm-year. ‘These simulations ace similar to those performed by Brown and ‘Warner (1980, 1985) in evaluating alternative models for detecting abnormal stock price performance. However, our simulations differ in several respects. In particular, we must make ‘explicit assumptions conceming the components of accruals that are managed and the timing of the accrual reversals. To the extent that our assumptions are not representative of the circum= stances of actual earnings management, our results lack external validity, To circumvent this problem, we generate type II errors fora second set of firms, for wich we have strong priors that earnings fave been managed * This sample consists of firms that have been targeted by the Secutities and Exchange Commission (SEC) for allegedly overstating annual eamings. The external validity of these results rests on the assumptioa that the SEC has correctly identified firm= years in which earnings have been managed. This assumption seems eeasonable, since the SEC (1992) indicates that out of the large aumber of cases that are brought to its attention, it oaly ppursues cases involving the most significant and blatant incidences of earnings manipulation. ‘The empirical analysis generates the follawing major insights. First, all of the models appear ‘well specified when applied (o a candom sample of firm-years. Second, the models all generate ests of low power for earnings management of economically plausible magnitudes (c-g., one to five percent of total assets). Third, all models reject the null hypathesis of no earnings " See, fo example, Healy (1985), DeAngelo (1986) and Jones (1991), er consiuct that have Been wae to detect. carnings management include accountrg rocedure changes (Healy 1985: Healy aad Palepu 1990 Sweeney 1994), ‘specfte components of dseraionay actuals (MeNictole ard Wilson 1984; DeAngelo era. 1994) and components Of aiseraionary cash Fiows (Dechow and Sloan (991), + Schigpe (1989) dines earings eanagerert as purposeful intervention inthe extral financial reporting process ‘with the intent of obtaining some private gain (opposed co, sey. merely failtating the neutal operation of the process) Tethe spe of Schipper defistion, our pracedure assumes tha epored stn nthe fr eres areted by tn SEC ore higher than they would bave bees under the nent applicaton of GAAP