A CFO Based Performance Control in Earnings Management Studies

Inspired by Kothari et al. (2005) and Dechow et al. (1995) we propose a single-step CFO (cash flows from operations) approach for classifying the research sample into equal-size portfolios at the estimation stage of discretionary accruals. Our results indicate that the CFO portfolio approach of estimation is an efficient approach, and yet controls performance more effectively and ensures more stable and consistent measures of discretionary accruals than the ROA approach suggested by Kothari et al. We document the following: First, the CFO portfolio approach significantly outperforms the industry approach for portfolio selection in terms of observed adjusted R2 values and the individual regressors’ coefficient consistency. Second, the models’ results are driven by the application of a better estimation approach. Third, the CFO approach of estimation properly controls performance and eliminates the over- or under-rejection tendency of type-I errors resulting from the industry approach. Fourth, based on a comparison of the statistical power of tests, the CFO approach always outperforms the industry approach across the models studied. Fifth, the between-model differences under the industry approach are eliminated when the CFO approach is used. Lastly, a combination of the YK model with the CFO approach significantly outperforms a combination of the modified Jones model with the industry approach of estimation.