Summary Financial Accounting Research
Lecture week 1 – Introduction to Research in Financial Accounting (Modelling Financial
Reporting Quality)
Introduction
This week’s objective: the quality of financial reporting: accruals quality, earnings management and
fraud detection. Identifying low quality earnings and financial reporting.
Three questions that you should be able to answer for each paper:
- What?
o What is the Research Question? This is about the topic: what am I learning from this
paper?
- How?
o How is the Research Question examined? This is about the methodology: how do the
researchers measure the data and which statistical model are they using?
- Why?
o Why is this paper relevant? This is about the contribution: why is this paper
important for me?
Example Under Armour
The paper is about the accounting issue at some organization (Under Armour). The sportwear maker
shifted sales from quarter to quarter to appear healthier, by recording revenue before it is earned or
defer the dating of expenses to make earnings appear stronger.
,Earnings management
Earnings management = managers’ intentional over- or understatement of earnings to achieve a
particular reporting objective and thereby influence users’ perceptions of company performance.
This can be achieved through:
1) Managing accruals: aggressive recognition of revenues, deferring or capitalizing costs,
understatement of liability reserves (e.g., warranty), etc.
2) Managing real activities: cutting R&D, using discounts to boost end-of-year sales etc.
Accruals-based earnings management is not necessarily fraud when it is done within the discretion
allowed under accounting rules.
- Dechow & Dichev (2002, p. 38): Accruals are temporary adjustments that shift the
recognition of cash flow over time. Accrual accounting relies on estimates and assumptions
made by managers.
Someone is actively doing something, he is either over- or understating earnings. He does this
because of specific reporting objectives. When is something intentional? What is over- or
understatement, and what are reporting objectives? Trying to pursue a number that is not the actual
number by under- or overstating.
Under Armour was accused of aggressively recognizing revenues to meet quarterly targets. This leads
to an increase in accruals and earnings, but does not change the company’s cash flows.
This suggests that we can examine accruals to identify the possibility of earnings management. An
accrual that results from revenue recognition (increase in receivables) should lead to a future cash
inflow. But earnings management leads to errors in these accruals because the cash inflow is not
realized. This I the focus of the Stubben (2010) paper: identifying intentional errors.
But accruals can also contain errors because the future is uncertain (unintentional errors). This is the
focus of Dechow & Dichev (2002).
Financial Accounting Research Objectives
We want to understand what has happened with Under Armour with respect to earnings
management. Accounting research: two general approaches.
- Case based approach: Case studies focus on bounded and particular organizations, events, or
phenomena, and scrutinize the activities and experiences of those involved, as well as the
context in which these activities and experiences occur → Qualitative research approach.
- Big Data approach: an approach to research methodology that seeks to generalize from
specific data through the arms-length testing of hypotheses as to stable causal laws →
Qualitative research approach.
,Big Data: learning how to solve problems using critical thinking & the scientific method
The goal of Financial Accounting Research (FAR)
FAR = positivistic approach (quantitative hypothesis-testing research). Why did things happen and
how do they happen? Positive research → all about generalizing.
Positive research: investigate elements of accounting practice that are generalizable (global) rather
than the unique configuration of common and non-common elements that occur in any single
instance (local). Luft & Shields (2014): empirically validating general causal explanations of
accounting related phenomena that apply to many instances of a given phenomenon.
Dechow & Dichev (2002) – The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors
We can very often not see inside the heads of people, so what we should do is let’s first model the
error in general, and once we understand this, it might help improve.
Measuring the quality of accruals and earnings
Paper objective: present a new measure for the quality of accruals and earnings.
Why? We know from Dechow (1994): the role of accruals is to shift or adjust the recognition of cash
flows over time so that the adjusted numbers (earnings) better measure firm performance. But as we
know from Sloan (1996), accruals can very in the extent to which they make earnings a better
, measure of performance, because accruals require assumptions and estimates of future cash flows.
→ greater uncertainty about the future likely reduces the quality of the accrual estimates.
Dechow & Dichev (2002) argue that the quality of accruals and earnings is decreasing in the
magnitude of estimation error in accruals. They derive an empirical measure of this concept of
accrual quality.
How do we know whether one firm is healthy compared to the other? Why is one firm healthy and
the other not healthy? We want a generalization. We need to create a measure for that health.
Dechow & Dichev come up with a measure for what we already know. The problem with accruals is
that they require estimates and estimates can also create worse measures of performance. The
paper wants to measure the quality of accruals, where high quality means that earnings are healthy.
The paper is therefore about creating a variable accrual quality that is going to help us to compare
firms.
Example of errors in accruals (Dechow & Dichev 2002): “For example, recording a receivable
accelerates the recognition of a future cash flow in earnings, and matches the timing of the
accounting recognition with the timing of the economic benefits from the sale. However, accruals are
frequently based on assumptions and estimates that, if wrong, must be corrected in future accruals
and earnings.”
Accounts receivable: you book already in the current year earnings that someone is going to repay
you next year. We do this because we want to match and time. This means that we have to have an
estimate of how much of those accounts receivables are going to be repaid. If the actual net
proceeds of the receivables are less than the original estimate, then we need a subsequent entry.
There is a timing difference between when we say we have earned something.
“For example, if the net proceeds from a receivable are less than the original estimate, then the
subsequent entry records both the cash collected and the correction of the estimation error. We
argue that estimation errors and their subsequent corrections are noise that reduces the beneficial
role of accruals.”
Lecture week 1 – Introduction to Research in Financial Accounting (Modelling Financial
Reporting Quality)
Introduction
This week’s objective: the quality of financial reporting: accruals quality, earnings management and
fraud detection. Identifying low quality earnings and financial reporting.
Three questions that you should be able to answer for each paper:
- What?
o What is the Research Question? This is about the topic: what am I learning from this
paper?
- How?
o How is the Research Question examined? This is about the methodology: how do the
researchers measure the data and which statistical model are they using?
- Why?
o Why is this paper relevant? This is about the contribution: why is this paper
important for me?
Example Under Armour
The paper is about the accounting issue at some organization (Under Armour). The sportwear maker
shifted sales from quarter to quarter to appear healthier, by recording revenue before it is earned or
defer the dating of expenses to make earnings appear stronger.
,Earnings management
Earnings management = managers’ intentional over- or understatement of earnings to achieve a
particular reporting objective and thereby influence users’ perceptions of company performance.
This can be achieved through:
1) Managing accruals: aggressive recognition of revenues, deferring or capitalizing costs,
understatement of liability reserves (e.g., warranty), etc.
2) Managing real activities: cutting R&D, using discounts to boost end-of-year sales etc.
Accruals-based earnings management is not necessarily fraud when it is done within the discretion
allowed under accounting rules.
- Dechow & Dichev (2002, p. 38): Accruals are temporary adjustments that shift the
recognition of cash flow over time. Accrual accounting relies on estimates and assumptions
made by managers.
Someone is actively doing something, he is either over- or understating earnings. He does this
because of specific reporting objectives. When is something intentional? What is over- or
understatement, and what are reporting objectives? Trying to pursue a number that is not the actual
number by under- or overstating.
Under Armour was accused of aggressively recognizing revenues to meet quarterly targets. This leads
to an increase in accruals and earnings, but does not change the company’s cash flows.
This suggests that we can examine accruals to identify the possibility of earnings management. An
accrual that results from revenue recognition (increase in receivables) should lead to a future cash
inflow. But earnings management leads to errors in these accruals because the cash inflow is not
realized. This I the focus of the Stubben (2010) paper: identifying intentional errors.
But accruals can also contain errors because the future is uncertain (unintentional errors). This is the
focus of Dechow & Dichev (2002).
Financial Accounting Research Objectives
We want to understand what has happened with Under Armour with respect to earnings
management. Accounting research: two general approaches.
- Case based approach: Case studies focus on bounded and particular organizations, events, or
phenomena, and scrutinize the activities and experiences of those involved, as well as the
context in which these activities and experiences occur → Qualitative research approach.
- Big Data approach: an approach to research methodology that seeks to generalize from
specific data through the arms-length testing of hypotheses as to stable causal laws →
Qualitative research approach.
,Big Data: learning how to solve problems using critical thinking & the scientific method
The goal of Financial Accounting Research (FAR)
FAR = positivistic approach (quantitative hypothesis-testing research). Why did things happen and
how do they happen? Positive research → all about generalizing.
Positive research: investigate elements of accounting practice that are generalizable (global) rather
than the unique configuration of common and non-common elements that occur in any single
instance (local). Luft & Shields (2014): empirically validating general causal explanations of
accounting related phenomena that apply to many instances of a given phenomenon.
Dechow & Dichev (2002) – The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors
We can very often not see inside the heads of people, so what we should do is let’s first model the
error in general, and once we understand this, it might help improve.
Measuring the quality of accruals and earnings
Paper objective: present a new measure for the quality of accruals and earnings.
Why? We know from Dechow (1994): the role of accruals is to shift or adjust the recognition of cash
flows over time so that the adjusted numbers (earnings) better measure firm performance. But as we
know from Sloan (1996), accruals can very in the extent to which they make earnings a better
, measure of performance, because accruals require assumptions and estimates of future cash flows.
→ greater uncertainty about the future likely reduces the quality of the accrual estimates.
Dechow & Dichev (2002) argue that the quality of accruals and earnings is decreasing in the
magnitude of estimation error in accruals. They derive an empirical measure of this concept of
accrual quality.
How do we know whether one firm is healthy compared to the other? Why is one firm healthy and
the other not healthy? We want a generalization. We need to create a measure for that health.
Dechow & Dichev come up with a measure for what we already know. The problem with accruals is
that they require estimates and estimates can also create worse measures of performance. The
paper wants to measure the quality of accruals, where high quality means that earnings are healthy.
The paper is therefore about creating a variable accrual quality that is going to help us to compare
firms.
Example of errors in accruals (Dechow & Dichev 2002): “For example, recording a receivable
accelerates the recognition of a future cash flow in earnings, and matches the timing of the
accounting recognition with the timing of the economic benefits from the sale. However, accruals are
frequently based on assumptions and estimates that, if wrong, must be corrected in future accruals
and earnings.”
Accounts receivable: you book already in the current year earnings that someone is going to repay
you next year. We do this because we want to match and time. This means that we have to have an
estimate of how much of those accounts receivables are going to be repaid. If the actual net
proceeds of the receivables are less than the original estimate, then we need a subsequent entry.
There is a timing difference between when we say we have earned something.
“For example, if the net proceeds from a receivable are less than the original estimate, then the
subsequent entry records both the cash collected and the correction of the estimation error. We
argue that estimation errors and their subsequent corrections are noise that reduces the beneficial
role of accruals.”
