. Data and Econometric Specification
Assume that firms make earnings management decisions in the following order. First, they use discretionary
accruals, which (because they have no cash flow implications) are considered to be less costly than discretionary
expenditures. Next, they decide on discretionary expenditures. From an earnings management perspective, we
expect a negative relationship between discretionary accruals and discretionary expenditures.
Our financial data is derived from Compustat Global for all U.S., Canadian, Hong Kong, Korean, Japanese, and
Taiwanese firms from 1990-2007. We first estimate each firm’s DACC (discretionary accruals), using the Jones
model, modified by Kothari et al. (2005). Abnormal accruals are the residuals from modified Jones model
regressions including ROA as shown in the following equation:
TAit = α0 + α1 /ΑSSETSit-1 + α2 Δ(SALESit-ΑR) + α3PPEit + α4ROAit + εit (3)
TAit = as the change in non-cash current assets minus the change in current liabilities excluding the current portion
of long-term debt minus depreciation and amortization, deflated by the beginning-of-year total assets;
ΑSSETSit-1 = the total assets at the beginning of fiscal year t;
Δ(SALESit – ΑRit) = the change in sales, adjusted for the change in accounts receivable from fiscal years t-1 to t,
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deflated by the beginning-of-year total assets;
PPEit = the gross property, plant and equipment at the end of fiscal year t, deflated by the beginning-of-year
total assets, and
ROAit = income before tax divided by lagged total assets of fiscal year t.
COMPUSTAT Global data items for (3) are shown in Appendix 1.
To develop our proxies for real earnings management, we follow the method used by Roychowdhury (2006). We
estimate normal discretionary expenses which include advertising expense, research and development, and SG&A
expenses using the following equation:
DEit = β0 + β1 /ΑSSETSit-1 + β2 SALESit-1/ ΑSSETSit-1 + εit , (4)
DEit = the sum of R&D expenses and Selling, General and Administrative expenses, deflated by the
beginning-of-year total assets;
ΑSSETSit-1 = the total assets at the beginning of fiscal year t, and
SALESit-1/ΑSSETSit-1 = the sales of fiscal year t-1, deflated by the beginning-of-year total assets.
Compustat data definitions for the above model are shown in Appendix 1. We next estimate abnormal discretionary
accruals as actual accruals minus discretionary accruals from