HLSEVIER Journal of Accounting and Economics 30 (2001) 421-492, ‘wawelseviercomMocatelecontase Discretionary-accruals models and audit qualifications ™ Eli Bartov", Ferdinand A, Gul”, Judy S.L, Tsui "Zeanard N. Storm School of Rusinss. Now York Unioesity 0 W. duh St. Suite 423 New York, NY 10012, USA Deparment of Aeconnuanes, Chy University of Hong Kong, 83 Tas Chee Avenue, ‘Kowloon Tony, Hong Kong % Abstract ‘The primary goal of this study isto evaluate the ability of the Cross-sectional Jones Model und the Cross-sectional Modified Jones Model (o detect earnings management visi-vis their time-series counterparts by examining the association between disere- tionary accruals and audit qualifications. These two cross-sectional models have not been formally evaluated by prior research, and their use may offer certain advantages to investors and researchers over their time-series counterpuris. A sample af 178 distinct firms with qualified audit reports and a matched-pair control sample with clean audit reports are used. Only the two cross-sectional models are consistently able to detect crnings management. One limitation ofthis study is that its findings merely indicate the superiority of the cross-sectional models vis@-vis their time-series counterparts in an audit qualification getting, not valcate either the former ar the latter © 01 Elsevier Science RLV. All rights reserved JEL Classficanon: Mit; B21; Keywords: Discretionary-aceruals models; Eamings management, Audit qualifca Big Sic auditors ‘We acknowledge comments from workshop participants at Penn State the University of acheter, nthe Ninth Annual Conference en Francia! Eoonomice an Aremintng. at wel at from Jery Zimmerman (the editor), Mark DeFond, Kimberly Duna, Charis Les, Dan Simm, KR. Subramanyam, Ross Watls, Colin Ferguson and Don Stokes. *Corroponding author. Tel: +852 2798 7022; fan: +852 2788 7002, E-mail address: acv@cityweduhk (ISL. Ts. (0165-4101/01/5-sce front matter «© 2001 Chsevier Science BV. All rights reserve. PESO 169-4101 (01}0001 9-9422 E, Bartow et al | Journal of Accounting and Beanamics 30 (2001) 421-482 Introduction Many earnings management studies examine managers’ use of discretionary accruals to shift reported income among fiscal periods, which entails sperification of a model to estimate discretionary accruals. The movols range frou dhe simple, in which the change in (otal actuals iy used ay a measure OF discretionary aceruals to the relatively sophisticated, which decompose accrualy into discretionary and nondiscretionary components using regression analysis. The most popular six models are the DeAngelo (1986) Model, the Healy (1985) Model, the Jones (1991) Model, he Modified Jones Model (Dechow et al, 1995), the Industry Madel (Dechow et al, 1998), and the Cross-sectional Jones Model (DeFond und Jiambulvo, 1994), Dechow et al, (1999) evaluate the relative pertormance ot tive of these models in detecting earnings management by comparing the specification and power of commonly used tests across discretionary accruals generated by the models. They evaluate the specification of the test statisties by examining the frequency with which the statistics generate type 1 errors and the power of the tests by examining the frequency with which the statistics generate type IL errors. Using various samples and assumptions, they demonstrate that all models appear well specified for random samples, generate tests of low power for earnings management, and reject the null hypothesis of no earnings ‘management at rates exceeding the specified test-levels when applied to samples of firms with extreme financial performance. Additionally. they show that the Modified Jones Model provides the most powerful test of earnings manage ment, Guay et al. (1996) argue that comparisons of diseretionary-accruals models in Dechow et al. (1995) critically hinge on such important (implicit) assumptions as the behavior of earnings absent discretion and how manage ment exercises discretion over accruals conditional on nondiscretionary Evaluations of timesericy discictionatysaverualy niotety using stock returns depend, additionally, on assumptions about the relation between accounting numbers and stock prices (e.g., market efficieney with respect to earnings information, and stock prices lead earnings). Guay et al, also show that attempts to increase statistical power by using non-random samples (e.. firms with extreme financial performance as in Dechow et al. (1995)) cloud the findings, as they increase the likelihood that correlated omitted variables confound the results. Iheir hndmgs thus cast doubts on the abihty of various time series models to separate accruals into discretionary and nondiseretionary ‘components. Healy (1996), however, points out that the study of Guay et al relies on strong assumptions such as strong form stock market efficiency, and that its tests examine the ageresate relation between stock returns, diseretionary accruals, and nondiseretionary carnings, rather than relations for a specific sample where earnings management 1s expected. ‘Thus, whetherE, Bartoe eta | Journal of Accounting and Beanomies 30 (2001) 21-482 493 these discretionary-accruals models are able to separate accruals into discretionary and nondiscretionary components and thereby detect earnings management is still an open empirical question. ‘The primary goal of this study is to evaluate empisieally the ability of the ‘eross.cectional version of two diseretionary-accrnals model, the Cross-sectional Joney Model and the Cross-sectional Modified Joney Model, to detect earnings management vis-i-vis their time series counterparts. We are motivated to undertake this evaluation for wo reasons, First, the Ovo cross-sectional models have not heen evaluated hy prior research. Second, each type relies an a different set of assumptions and i€ is an empirical question which set is snore descriptively valid. For completeness, we utilize our research method to alsa evaluate three other models used by prior studies: the Industry Model, the ‘DeAngelo Model, and the Healy Model Prior earnings management studies (see, e-g., Healy 1985; DeAngelo, 1986; Jones, 1991) have found that high discretionary accruals indicate earnings manipulations. Thus, high diseretionary accruals should be associated with audit qualifications. However. there are other factors that can lead to audit qualifications. Prior research has identified a number of such variables covering operational complexity and various types of risks. We incorporate the implications of these studies’ findings into our rescarch design in two ways. First we use a matched-pair design in which we evaluate the ability of each model to distinguish between 173 distinet firms with qualified audit opinions and 173 matched-pair firms with clean reports. Second. we perform sensitivity tests to evaluate the effects of buok-to-matket ratios, leverage, profitability, firm size, total aceruals, and mergers and acquisitions on our findings. A distinguishing feature of our research method is our simultancous effort to maximize power (by selecting a sample where earnings management is expected) while minimizing potential biases arising from using a non-random sample that may lead to erroneous inferences (hy adding controls. for confyuning variables). Por example, Dechow ct al. (1995, pp. 208-209) Teport that for firms experiencing extreme financial performance, the discretionary-accruals models they evaluate are unable to completely extract, the low (high) non-discretionary accruals associated with the low (high) earnings performance. We thus evaluate the association between discretionary accruals and audit qualifications after controlling for earnings performance and total accruals, Contingency-table tests for the assoctation between high discretionary accruals and audit qualifications show significant results for the Modified Jones Models, and the two cross-sectional models. Ihe contingency table results for the other four models are not significant. Univariate logistic regression tests show a significant relation between discretionary accruals and the likelihood of receiving qualified reports for all models, exeept the DeAngelo Model. Thus, ‘our univariate tests’ results show that the Cross-sectional Jones Model and the