Financial Accounting Research
Table of Contents
Week 1..................................................................................................................................................... 3
Lecture ................................................................................................................................................. 3
Dechow and Dichev (2002) – The quality of accruals and earnings: the role of accrual estimation
errors ............................................................................................................................................... 3
Tutorial ................................................................................................................................................ 6
McVay (2006) - Earnings Management Using Classification Shifting: An Examination of Core
Earnings and Special Items .............................................................................................................. 6
Amiram et al. (2015) - Financial statement errors: evidence from the distributional properties of
financial statement number ............................................................................................................ 9
Week 2................................................................................................................................................... 12
Lecture ............................................................................................................................................... 12
Nichols and Wahlen (2023 and 2004) ........................................................................................... 12
Tutorial .............................................................................................................................................. 17
Dechow (1994) - Accounting earnings and cash flows as measures of firm performance: The role
of accounting accruals ................................................................................................................... 17
Leung & Veenman (2018) – Non-GAAP earnings disclosure in loss firms ..................................... 21
Week 3................................................................................................................................................... 24
Lecture ............................................................................................................................................... 24
Sloan (1996) – Do stock prices fully reflect information in accruals and cash flows about future
earnings? ....................................................................................................................................... 24
Tutorial .............................................................................................................................................. 29
Shaffer & Wang (2024) – Scaling core earnings measurement with large language models ....... 30
Jung et al. (2018) – Do firms strategically disseminate? Evidence from corporate use of social
media ............................................................................................................................................. 33
Week 4................................................................................................................................................... 35
Lecture ............................................................................................................................................... 35
Frankel et al. (2016) – Using unstructured and qualitative disclosures to explain accruals ......... 37
Tutorial .............................................................................................................................................. 40
Brown et al. (2020) – What are you saying? Using topic to detect financial misreporting........... 40
Berk et al. (2024) – Firm-specific climate risk and market valuation ............................................ 44
Week 5................................................................................................................................................... 46
Lecture ............................................................................................................................................... 46
Chen et al. (2018) – The effect of mandatory CSR disclosure on firm profitability and social
externalities: evidence from China................................................................................................ 48
Page 1 of 58
,Tutorial .............................................................................................................................................. 51
Mittelback-Hörmanseder et al. (2020) – The information content of corporate social
responsibility in Europe: an institutional perspective ................................................................... 52
Thomas et al. (2022) – Meet, beat, and pollute ............................................................................ 55
Page 2 of 58
, Week 1
Lecture
The main theme of the course is to understand the economic role of accounting information to investors. This lecture
we’ll focus on the introduction to research in financial accounting and modelling financial reporting quality. After this
lecture you should be able to identify earnings management and financial reporting quality empirically.
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.; and (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 and 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.
• Aggressive recognition of revenues leads to increase in accruals and earnings, but does not change the
company’s cash flow. → This suggests that we can examine accruals to identify the possibility of earnings
management.
o An accrual that results from revenue recognition (increase in receivables) should lead to a future
cash inflow. But earnings management leads to (intentional) errors in these accruals because the
cash inflow is not realized. But accruals can also contain errors because the future is uncertain
(unintentional errors → focus of Dechow and Dichev (2002)).
Dechow and Dichev (2002) – The quality of accruals and earnings: the role of accrual
estimation errors
Paper objective: present a new measure for the quality of accruals and earnings.
• 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 accruals can vary 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 and Dichev argue that the quality of accruals and earnings is decreasing in the magnitude of estimation error
in accruals and derive an empirical measure of this concept of accrual quality.
When there is a timing difference between the
receipt/disbursement of the cash flow and the
recognition of the cash flow in earnings we
need an accruals adjustment. That is where
the discretion comes in, and therefore the
potential for error. Earnings will be combination
of all these cashflows, but the earnings
number is determined by the quality of these
estimates.
• Example of errors in accruals: Recording a receivable accelerates the recognition of future cash flows in
earnings, aligning the timing of accounting recognition with the economic benefits of a sale. However, this
process often relies on assumptions and estimations that may require corrections in future accruals and
earnings if they prove inaccurate. Such estimation errors and their subsequent adjustments introduce noise
into the system, diminishing the positive impact of accruals. → the bad debt write-off amount on uncollected
receivables in year t+1 is an accrual estimation error.
• Accrual estimation errors occur because (1) the future is uncertain → unintentional; and (2) management’s
self-interest → intentional.
Dechow and Dichev focus on errors that are both intentional and unintentional. They focus on (variation in) the quality
of financial reporting more generally, not just low quality caused by earnings management. → “we argue that even in
Page 3 of 58
, the absence of intentional earnings management, accrual quality will be systematically related to firm and industry
characteristics”
Dechow and Dichev build an empirical model to quantify accrual estimation errors. They focus on (short-term) working
capital accruals because cash flow realizations related to working capital typically occur within one year. Their main
intuition is that earnings in the current period are the sum of all cash flows from periods 𝑡−1, 𝑡, and 𝑡+1 that are
recognized in the current period 𝑡, plus adjustments for: errors in current period accruals that will be realized in the
next period (𝜀𝑡+1
𝑡
) and corrections of errors in accruals recognized in the previous period and realized in the current
period (𝜀𝑡 ) → 𝐸𝑡 = 𝐶𝐹𝑡−1
𝑡−1 𝑡
+ 𝐶𝐹𝑡𝑡 + 𝐶𝐹𝑡+1𝑡 𝑡
+ 𝜀𝑡+1 − 𝜀𝑡𝑡−1 .
• We can see that, in theory, current-period accruals are positively related to cash flows in the previous (𝑡−1)
and next (𝑡+1) period, and negatively related to cash flows in the current (𝑡) period. We can test this
empirically using operating cash flows (𝐶𝐹𝑂) as measure of 𝐶𝐹: ∆𝑊𝐶𝑡 = 𝑏0 + 𝑏1 ∗ 𝐶𝐹𝑂𝑡−1 + 𝑏2 ∗
𝐶𝐹𝑂𝑡 + 𝑏3 ∗ 𝐶𝐹𝑂𝑡+1 + 𝜀𝑡 . Dechow and Dichev predict:
o 𝑏1 > 0: positive correlation between current accruals and last year’s cash flows
▪ Example: Deferred Revenue. If Deferred Revenue ↑ (positive) in the current year, the
company received CFO ↑ (positive) in last year, and recognizes the revenue in the current
year, as the good or service is delivered.
o 𝑏2 < 0: negative correlation between current accruals and current cash flows
▪ Example: Inventory (INV). If INV ↑ (positive) in the current year, the company disburses CFO
↓ (negative) in the current year, to pay for the INV
▪ Note: 𝑏2 < 0 is the main result from Dechow (1994) in Week 2
o 𝑏3 > 0: positive correlation between current accruals and next year’s cash flows
▪ Example: Accounts receivables (AR). If AR ↑ (positive) in the current year, the company
receives CFO ↑ (positive) next year, as the AR is repaid
• The regression residual 𝜀𝑡 is used as an estimate of the accrual estimation error. The error term represents
the portion of accruals that is not explained by cash flow realizations. It represents the estimation errors in
the accruals. A smaller error suggests a better match between accruals and cash flows, indicating higher
quality. The magnitude and variability of 𝜀𝑡 (𝜎(𝜀𝑡 ))is used as a measure of “accrual quality”. We can also
measure accrual quality as the absolute value of the residual: |𝜀𝑡 |. Intuition of using |𝜀𝑡 |: the better the
relation between working-capital accruals (∆𝑊𝐶) and the operating cash flows in the previous, current, and
next year, the smaller the error (𝜀𝑡 ) and the higher the quality of the accruals.
o Smaller |𝜀𝑡 | or 𝜎(𝜀𝑡 ) indicates higher quality accruals that are better estimations of cash flows
o The average firm is represented by the regression line.
Table 3 is the results of the accrual model estimation, estimated separately by (A) the company → looks at abnormal
accrual levels within 1 firm over time, (B) the industry → expect lower t-stat due to more correlated obs, and (C) all
companies → higher t-stat due to industry differences. Dechow and Dichev looked at these estimation to show the
validity of their findings. Regardless of how you estimate this regression the predicted signs all come true.
Next, Dechow and Dichev use the estimates of 𝜀𝑡 from (A) to create a measure of accrual quality for each of the 1725
companies based on the variability of 𝜀𝑡 : 𝜎(𝜀𝑡 ). If we can use observable company characteristics to predict accrual
instead of the 𝜀𝑡 , that means that company characteristics affect the quality of accruals, and not just managers’
intent → When you go into the field you can look for certain observable company characteristics that predict low-
quality accruals.
• Table 4, Panel B, shows the correlations of accrual quality with company characteristics. The results reveal
that companies with low-quality accruals…
o … have longer operating cycles
o … are smaller
o … have more volatility in their revenues, cash flows, accruals, and earnings
o … more frequently report losses
o … and have larger absolute working-capital accruals.
If this is a good measure of accrual quality then it should be related to the very thing that investors are interested in:
earnings persistence. The previous equations revealed that earnings are likely less persistent when accrual errors are
larger. Hence, Dechow and Dichev expect that firms with low accrual quality also have low earnings persistence.
Page 4 of 58
Table of Contents
Week 1..................................................................................................................................................... 3
Lecture ................................................................................................................................................. 3
Dechow and Dichev (2002) – The quality of accruals and earnings: the role of accrual estimation
errors ............................................................................................................................................... 3
Tutorial ................................................................................................................................................ 6
McVay (2006) - Earnings Management Using Classification Shifting: An Examination of Core
Earnings and Special Items .............................................................................................................. 6
Amiram et al. (2015) - Financial statement errors: evidence from the distributional properties of
financial statement number ............................................................................................................ 9
Week 2................................................................................................................................................... 12
Lecture ............................................................................................................................................... 12
Nichols and Wahlen (2023 and 2004) ........................................................................................... 12
Tutorial .............................................................................................................................................. 17
Dechow (1994) - Accounting earnings and cash flows as measures of firm performance: The role
of accounting accruals ................................................................................................................... 17
Leung & Veenman (2018) – Non-GAAP earnings disclosure in loss firms ..................................... 21
Week 3................................................................................................................................................... 24
Lecture ............................................................................................................................................... 24
Sloan (1996) – Do stock prices fully reflect information in accruals and cash flows about future
earnings? ....................................................................................................................................... 24
Tutorial .............................................................................................................................................. 29
Shaffer & Wang (2024) – Scaling core earnings measurement with large language models ....... 30
Jung et al. (2018) – Do firms strategically disseminate? Evidence from corporate use of social
media ............................................................................................................................................. 33
Week 4................................................................................................................................................... 35
Lecture ............................................................................................................................................... 35
Frankel et al. (2016) – Using unstructured and qualitative disclosures to explain accruals ......... 37
Tutorial .............................................................................................................................................. 40
Brown et al. (2020) – What are you saying? Using topic to detect financial misreporting........... 40
Berk et al. (2024) – Firm-specific climate risk and market valuation ............................................ 44
Week 5................................................................................................................................................... 46
Lecture ............................................................................................................................................... 46
Chen et al. (2018) – The effect of mandatory CSR disclosure on firm profitability and social
externalities: evidence from China................................................................................................ 48
Page 1 of 58
,Tutorial .............................................................................................................................................. 51
Mittelback-Hörmanseder et al. (2020) – The information content of corporate social
responsibility in Europe: an institutional perspective ................................................................... 52
Thomas et al. (2022) – Meet, beat, and pollute ............................................................................ 55
Page 2 of 58
, Week 1
Lecture
The main theme of the course is to understand the economic role of accounting information to investors. This lecture
we’ll focus on the introduction to research in financial accounting and modelling financial reporting quality. After this
lecture you should be able to identify earnings management and financial reporting quality empirically.
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.; and (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 and 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.
• Aggressive recognition of revenues leads to increase in accruals and earnings, but does not change the
company’s cash flow. → This suggests that we can examine accruals to identify the possibility of earnings
management.
o An accrual that results from revenue recognition (increase in receivables) should lead to a future
cash inflow. But earnings management leads to (intentional) errors in these accruals because the
cash inflow is not realized. But accruals can also contain errors because the future is uncertain
(unintentional errors → focus of Dechow and Dichev (2002)).
Dechow and Dichev (2002) – The quality of accruals and earnings: the role of accrual
estimation errors
Paper objective: present a new measure for the quality of accruals and earnings.
• 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 accruals can vary 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 and Dichev argue that the quality of accruals and earnings is decreasing in the magnitude of estimation error
in accruals and derive an empirical measure of this concept of accrual quality.
When there is a timing difference between the
receipt/disbursement of the cash flow and the
recognition of the cash flow in earnings we
need an accruals adjustment. That is where
the discretion comes in, and therefore the
potential for error. Earnings will be combination
of all these cashflows, but the earnings
number is determined by the quality of these
estimates.
• Example of errors in accruals: Recording a receivable accelerates the recognition of future cash flows in
earnings, aligning the timing of accounting recognition with the economic benefits of a sale. However, this
process often relies on assumptions and estimations that may require corrections in future accruals and
earnings if they prove inaccurate. Such estimation errors and their subsequent adjustments introduce noise
into the system, diminishing the positive impact of accruals. → the bad debt write-off amount on uncollected
receivables in year t+1 is an accrual estimation error.
• Accrual estimation errors occur because (1) the future is uncertain → unintentional; and (2) management’s
self-interest → intentional.
Dechow and Dichev focus on errors that are both intentional and unintentional. They focus on (variation in) the quality
of financial reporting more generally, not just low quality caused by earnings management. → “we argue that even in
Page 3 of 58
, the absence of intentional earnings management, accrual quality will be systematically related to firm and industry
characteristics”
Dechow and Dichev build an empirical model to quantify accrual estimation errors. They focus on (short-term) working
capital accruals because cash flow realizations related to working capital typically occur within one year. Their main
intuition is that earnings in the current period are the sum of all cash flows from periods 𝑡−1, 𝑡, and 𝑡+1 that are
recognized in the current period 𝑡, plus adjustments for: errors in current period accruals that will be realized in the
next period (𝜀𝑡+1
𝑡
) and corrections of errors in accruals recognized in the previous period and realized in the current
period (𝜀𝑡 ) → 𝐸𝑡 = 𝐶𝐹𝑡−1
𝑡−1 𝑡
+ 𝐶𝐹𝑡𝑡 + 𝐶𝐹𝑡+1𝑡 𝑡
+ 𝜀𝑡+1 − 𝜀𝑡𝑡−1 .
• We can see that, in theory, current-period accruals are positively related to cash flows in the previous (𝑡−1)
and next (𝑡+1) period, and negatively related to cash flows in the current (𝑡) period. We can test this
empirically using operating cash flows (𝐶𝐹𝑂) as measure of 𝐶𝐹: ∆𝑊𝐶𝑡 = 𝑏0 + 𝑏1 ∗ 𝐶𝐹𝑂𝑡−1 + 𝑏2 ∗
𝐶𝐹𝑂𝑡 + 𝑏3 ∗ 𝐶𝐹𝑂𝑡+1 + 𝜀𝑡 . Dechow and Dichev predict:
o 𝑏1 > 0: positive correlation between current accruals and last year’s cash flows
▪ Example: Deferred Revenue. If Deferred Revenue ↑ (positive) in the current year, the
company received CFO ↑ (positive) in last year, and recognizes the revenue in the current
year, as the good or service is delivered.
o 𝑏2 < 0: negative correlation between current accruals and current cash flows
▪ Example: Inventory (INV). If INV ↑ (positive) in the current year, the company disburses CFO
↓ (negative) in the current year, to pay for the INV
▪ Note: 𝑏2 < 0 is the main result from Dechow (1994) in Week 2
o 𝑏3 > 0: positive correlation between current accruals and next year’s cash flows
▪ Example: Accounts receivables (AR). If AR ↑ (positive) in the current year, the company
receives CFO ↑ (positive) next year, as the AR is repaid
• The regression residual 𝜀𝑡 is used as an estimate of the accrual estimation error. The error term represents
the portion of accruals that is not explained by cash flow realizations. It represents the estimation errors in
the accruals. A smaller error suggests a better match between accruals and cash flows, indicating higher
quality. The magnitude and variability of 𝜀𝑡 (𝜎(𝜀𝑡 ))is used as a measure of “accrual quality”. We can also
measure accrual quality as the absolute value of the residual: |𝜀𝑡 |. Intuition of using |𝜀𝑡 |: the better the
relation between working-capital accruals (∆𝑊𝐶) and the operating cash flows in the previous, current, and
next year, the smaller the error (𝜀𝑡 ) and the higher the quality of the accruals.
o Smaller |𝜀𝑡 | or 𝜎(𝜀𝑡 ) indicates higher quality accruals that are better estimations of cash flows
o The average firm is represented by the regression line.
Table 3 is the results of the accrual model estimation, estimated separately by (A) the company → looks at abnormal
accrual levels within 1 firm over time, (B) the industry → expect lower t-stat due to more correlated obs, and (C) all
companies → higher t-stat due to industry differences. Dechow and Dichev looked at these estimation to show the
validity of their findings. Regardless of how you estimate this regression the predicted signs all come true.
Next, Dechow and Dichev use the estimates of 𝜀𝑡 from (A) to create a measure of accrual quality for each of the 1725
companies based on the variability of 𝜀𝑡 : 𝜎(𝜀𝑡 ). If we can use observable company characteristics to predict accrual
instead of the 𝜀𝑡 , that means that company characteristics affect the quality of accruals, and not just managers’
intent → When you go into the field you can look for certain observable company characteristics that predict low-
quality accruals.
• Table 4, Panel B, shows the correlations of accrual quality with company characteristics. The results reveal
that companies with low-quality accruals…
o … have longer operating cycles
o … are smaller
o … have more volatility in their revenues, cash flows, accruals, and earnings
o … more frequently report losses
o … and have larger absolute working-capital accruals.
If this is a good measure of accrual quality then it should be related to the very thing that investors are interested in:
earnings persistence. The previous equations revealed that earnings are likely less persistent when accrual errors are
larger. Hence, Dechow and Dichev expect that firms with low accrual quality also have low earnings persistence.
Page 4 of 58
