One of the most critical aspects in the preparation of financial statements is the potential for manipulation through accrual-based earnings management (AEM) because reported earnings can be managed through the interpretation of generally accepted accounting principles (GAAP).
The traditional detection of earnings management (EM) through the use of total accruals leads to confusing the effect of accounting policies choices (AEM) with the consequences of real actions (REM) by managers to achieve a specific reported earnings objective.
To properly detect whether earnings are manipulated through GAAP (thus, through AEM), this paper directly isolates the subjective component of accruals attributable to internal estimates in the income statement.
It was found that there is a very significant negative correlation between subjective adjusting entry values and unadjusted transactional income.
Therefore, the “accrual anomaly” may already be explained in AEM. Similar to a “damper”, adjusting entries appear to absorb earnings in higher unadjusted income companies and release earnings in lower unadjusted income cases. Therefore, lower income seems to be also related to an increase in its subjectivity obtained by estimated values.
The accrual anomaly: The dampening effect of adjusting entries
