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We demonstrate that the articulation among accruals, cash flows and revenues which is typically assumed in tests of earnings management does not hold when large (positive or negative) external financing activities are present. Our study provides evidence that managers’ “normal” operating decisions associated with net external financing activities are likely to lead to economically and statistically significant measurement errors in unexpected accruals. This is a serious concern given the frequency with which the partitioning variable used to identify instances of alleged earnings management is correlated with significant movements in net external financing. Simulation tests show that even at modest levels of net external financing changes, rejection frequencies for the null hypothesis of no earnings management rise dramatically. This result underscores the importance of additional specification tests being conducted to control for estimation biases in unexpected accruals associated with external financing. We suggest the use of a matched-firm approach using industry and external financing matches. Using this method, we demonstrate that prior conclusions about the existence of earnings management around open market repurchases (Gong et al. 2008) do not appear robust when attempts are made to control for the effect on unexpected accruals of large changes in net external financing.

Errors in Estimating Unexpected Accruals in the Presence of Large Changes in Net External Financing