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Feltham Olson Model

NP NB LA VL

= = = =

Market Model

CAPM

DISCRETIONARY ACCRUAL METHODMeasuring earnings

quality using discretionary accrual method The modified Jones model (Dechow, Sloan and Sweeney, 1995) is one of the models used todetermine quality of earnings (earnings management). Accounting fundamentals are used toseparate accruals into nondiscretionary (normal) and discretionary (abnormal) components.The absolute value of the abnormal

component determines the quality of earnings. Larger theabsolute value of discretionary accrual, lower the quality of earnings (Dechow et. al., 1995). Concepts:a.
Cross sectional

data on several companies for one particular year

ModifiedJones Modelb.

Time series

i,t

i,t

), and cash flow from operations ( CFO

i,t

)for company i and year t are calculated for 2008 financial year as shown below: TA
i,t

= (
CA

i,t

CL
i,t

CASH
i,t

+
STDEBT
i,t

DEPN
i,t

) TCA
i,t

= (
CA
i,t

CL
i,t

CASH
i,t

+
STDEBT
i,t

) CFO
i,t

= NIBE
i,t

TA where:

CA
i,t

= company i

t ,

CL

i,t

= company i

t ,

CASH
i,t

= company i

s change in cash in year

t ,

STDEB
i,t

= company i

s change in short
-term debt in year t

, DEPN
i,t

= company i

t , and NIBE
i,t

= company i

s net income before extraordinary items in year

t . Please note: to make it simple, total accruals can also be calculated by the following method: Net profit after tax (NPAT)

Net cash flow from operations (CFO) = Total Accruals (TA) Step 2 To estimate abnormal accruals ( AA
i,t

) for company i (your company) in year t (2009) , thefollowing cross-sectional regression is performed for the industry group (for your selectedAustralian company)

containing 10 companies [(other than your company), (at least 20companies normally)] in one year for 2009 financial year: TA
t it i

A REV A

(1)Where: TA
i,t

= total accruals in year t

for company i ;

REV
i,t

= revenues in year t less revenues in year t-1 for company i scaled by total assets at t-1

; PPE
i,t

= gross property, plant and equipment in year t for company i scaled by total assets at t-1 ; A
i,t

= total assets in year t-1

for company i ;

i,t

= the residual of company i for time t ; Suggestion: When selecting the 10 companies as a control, pick the top 10 companies by market capitalisation from

the same industry (or even subindustry; good matching will result in a better outcome). Step 3 The industry year (2009) specific parameter estimates from the above model is used toestimate company specific normal accruals ( NA
i,t

) for company i

in year t (2009) as a percentof lagged total assets; that is, ] / [PPE

] /AAR-[

] / 1[ /ANA
1,ti,t3,1-ti,ti,ti,t2,1, t11-ti,ti,
t it i

A REV A

(2)

Where: AR
i,t

= company i

s accounts receivables in year

t .Abnormal accruals ( AA
i,t

are:

) / () / (AA
1,ti,1,,ti,
t it it i

A NA ATA

AA
i,t

) is the measure of earnings quality with

lower values indicating higher earnings quality.

Step 4 Repeat step 3 for the 10 firms and calculate the abnormal accrual for the 10 firms Step 5 Calculate the mean and median abnormal accrual for 10 firms (industry control group,excluding your company) and compare the abnormal accrual of your firm with the industrymean and median.
Discretionary Accrual Method