Estimating Discretionary Accruals in the Cross-Section of Firms: A Reinterpretation of the Jones Model and its Variants

Abstract

The (modified) Jones model neglects prior information on the cross-sectional distribution of "true" profitability. This explains why the model's estimates of discretionary accruals tend to be positively related to earnings and negatively related to cash flows in the cross-section of firms. Including the neglected information in a Bayesian model provides a theoretical basis for various versions of the Jones model. Which version is appropriate depends on the sampling of firms suspected of earnings management. We provide practical guidelines for determining the relevant setting in earnings management studies.

Keywords: Earnings management, Discretionary accruals, Normal accruals, Bayesian analysis, Performance adjustment

JEL Classification: M41, G17