A Market-Based Evaluation of Discretionary Accrual Models

In order to evaluate five discretionary-accrual models, a simple earnings model is specified, managerial discretion hypotheses are presented from existing literature, and efficient markets are assumed. The five discretionary accrual models are the same as those evaluated in Dechow, Sloan, and Sweeney (1995). Three managerial discretion hypotheses are specified. First, under the performance measure hypothesis, discretionary accruals help managers produce a reliable and more timely measure of firm performance than using nondiscretionary accruals alone. Second, the opportunistic accrual management hypothesis is that discretionary accruals are employed to hide poor performance or postpone a portion of unusually good current earnings to future years. Finally, discretionary accruals are noise in earnings. This is the noise hypothesis. The joint hypotheses are made explicit and explicit predictions are generated about the relative variability of earnings components, the correlation between discretionary accruals and nondiscretionary earnings, and the relation between stock returns and earnings components.