Modeling Total Accruals in an International Environment: The Impact of Alternative Measures of PPE

Jane Culvenor Jayne M. Godfrey Graeme Byrne

The role of accounting regulation hinges upon whether, how, and why managers manage earnings in the absence of regulatory constraints. Determining whether managers engage in earnings management to transfer wealth away from its most economic or socially effective/ efcient distribution requires the researcher to rst model predicted earnings, or accruals, so that unexpected variations are appropriately classed as earnings management. In this study, we examine whether rening the property, plant and equipment (PPE) variable in the Jones (1991) model of total accruals by excluding assets not subject to depreciation or amortization, and including intangibles that are subject to amortization improves the models explanatory power. Results indicate that progressively rening the PPE variable improves the explanatory power of the total accruals model. The improvement in explanatory power is modest, however, and statistically signicant only when the renement is to use gross, rather than net, measures, and only when extreme observations remain in the sample. Therefore, the practical signicance of this result for researchers is that written-down asset measures can be substituted for the more difcult-to-collect gross measures, particularly when extreme observations are removed from the sample. Adjustments for the effects of upward asset revaluations do not improve the models explanatory power. 1999 Elsevier Science Inc. All rights reserved. Key Words: Accruals Modeling; Explanatory Power; Asset Revaluation; International Accounting Differences

Jayne M. Godfrey Department of Accounting and Finance, University of Tasmania, GPO Box 252 86, Hobart, Tasmania 7001, Australia; E-mail: jayne.godfrey@utas.edu.au. Journal of International Accounting, Auditing & Taxation, 8(2):289 313 ISSN: 1061-9518 Copyright 1999 by Elsevier Science Inc. All rights of reproduction in any form reserved.

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INTRODUCTION
Accounting standards have social and economic effects by virtue of their impact on stakeholders claims against rms. As such, the role of accounting regulation hinges upon whether, how, and why managers systematically manage earnings in the absence of regulatory constraints.1 While research indicates that U.S. managers manage earnings opportunistically in order to transfer wealth between various stakeholders,2 equivalent evidence is not available internationally. Furthermore, existing earnings management models use aggregated data that may introduce mismeasurement into their property, plant and equipment independent variable (PPE). This mismeasurement is likely to be exacerbated internationally because of differences in measurement systems and depreciation and amortization requirements. In this study, we use detailed data to examine the materiality of PPE mismeasurement in an international (Australian) context. Specically, we test for improvements in the explanatory power of the Jones (1991) total accruals model when more rened measures substitute for Joness PPE variable.3 We investigate the effect of using net, versus gross, measures of the tangible assets in property, plant and equipment. We then rene property, plant and equipment measures by excluding non-depreciable tangible assets and including amortizable intangible assets that are currently excluded from Joness PPE. In the nal stage of our analysis we investigate the impact of upward asset revaluations which are permitted in Australia. A worldwide trend towards the use of market value measurement means that the accruals effects of the resultant changes in asset measurement have international signicance. An additional contribution of the study is its extension of U.S.-based research to an international context, thereby testing whether existing models can be generalized beyond U.S. national boundaries. Overall, we establish that the explanatory power of the Jones (1991) model using Australian data can be improved by dening PPE to include the gross value of depreciable assets instead of their net value. We nd that the Jones (1991) model has high-explanatory power (up to 96 percent) in predicting depreciation and amortization expense, a phenomenon consistent with managers not altering depreciation and amortization expense on a periodic basis to manage prots. Measuring the PPE variable gross, rather than net, contributes to an improvement in the models ability to explain both depreciation and amortization expense, and working capital accruals. Although using gross PPE improves the explanatory power of depreciation and amortization expense signicantly when extreme observations are deleted from the sample, it makes no signicant improvement in the explanation of working capital and total accruals for such a smaller sample. This has practical signicance for researchers, because it implies that net PPE is generally an adequate substitute for gross PPE, especially when extreme observations are removed. Where the researcher lacks access to an electronic database

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and must hand-collect data, the easier-to-gather net PPE gure makes earnings management research considerably more feasible. The remainder of the paper is divided into four sections. The next section develops the hypotheses and is followed by a discussion of sample selection and variable measurement. The results of the regression analyses are then presented and are followed by the conclusions.

HYPOTHESIS DEVELOPMENT: REFINING

THE

JONES MODEL

Earnings management detection requires predictions of total accruals that would be reported in the absence of purposeful intervention by management.4 Jones (1991) models total accruals as: TAtb1(1/At1)b2(Revt)b3(PPEt)et where: TAt total accruals for year t scaled by total assets at t 1 b1, b2, and bt are estimates of rm-specic parameters Revt revenues in year t less revenues in year t 1 scaled by total assets at t 1 PPEt gross property, plant and equipment in year t scaled by total assets at t 1 Att 1 total assets at t 1. Discretionary accruals, the measure of earnings management, at the end of period p are measured as the prediction error and dened as: (1)

p TAp(b1(1/Ap1)b2(Revp)b3(PPEp))
The total accruals explained in regression (1) are calculated as: TAt(CAtCLtCashtSTDtDEPAMORTt)/(At1) where: CAt change in current assets during period t CLt change in current liabilities during period t Casht change in cash and cash equivalents during period t STDt change in short term debt during period t5 DEPAMORTt depreciation and amortisation expense during period t At 1 total assets at t 1

(2)

(3)

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p year index for years included in the prediction period. Conceptually, total accruals represent the sum of all non-cash adjustments made to cash ows from operations during the calculation of reported earnings. They are dened as the sum of the change in working capital, and depreciation and amortization expense. This is not the difference between reported earnings and cash ows from operations, since earnings include other accruals, such as prots and losses on non-current asset disposals and gains or losses from nancial instrument-related activities. The above denition is consistent, however, with Dechow, Sloan, and Sweeney (1995) and is widely used in the literature. For consistency and comparability, we use the same denition. The Jones model is estimated using ordinary least squares (OLS) regression. Assuming no systematic earnings management during the estimation period, total accruals equal non-discretionary accruals. The model correctly separates nondiscretionary accruals and discretionary accruals for an event period if all the following conditions apply: (1) the true functional form is linear; (2) the usual assumptions of OLS regression hold;6 and (3) changes in revenues, and levels of gross property, plant and equipment are non-discretionary and explain all nondiscretionary accruals. The approach adopted in this paper is to rene the measurement of a key independent variable of the Jones model in order to improve the explanation of total accruals. We predict that rening PPE measurement to recognize the assumed linear relation between gross values and depreciation, as well as removing the effects of prior earnings management, increases the explanatory power of the Jones model. Table 1 summarizes prior evaluations of the performance of the Jones model and other models commonly used to detect earnings management. Evaluative studies show that, although the Jones and modied Jones models exhibit the greatest power in detecting earnings management, they have also been known to misclassify some non-discretionary accruals as discretionary accruals. This tends to overstate the incidence and degree of earnings management for rms with extreme operating cash ows and earnings (relative to other rms in the same industry). The evidence in recent studies prompted Bernard and Skinner (1996) to call for better specied models of the accruals process, closer analysis of accrual components, and a move away from the mechanical use of large-scale databases. This paper addresses their challenge. Accumulated Depreciation Jones (1991) denes PPE as the gross value of property, plant and equipment. In explaining depreciation, this measure is theoretically superior to a value of property, plant and equipment net of accumulated depreciation, because depreciation is usually calculated by multiplying the depreciation rate by the gross value of PPE.7 Also, if depreciation charges are managed from period to period,

Modeling Total Accruals in an International Environment TABLE 1

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Summary of Key Prior Research Studies Evaluating the Performance of Discretionary Accruals Models
Study Dechow, Sloan, and Sweeney (1995) Models Evaluated Healy (1985) DeAngelo (1988) Jones (1991) Modied Jones (proposed in Dechow et al., 1995) Industry model (Dechow & Sloan, 1991) Method of Evaluation Comparison of the incidence of type I error rates (false nding of earnings management) for the models for a random sample of rm-year observations. Comparison of the incidence of type II error rates (false nding of no earnings management) for a sample of rm-year observations with induced earnings management, and for a sample of rmyear observations with known earnings management. Prediction and testing of the relationship between stock returns and discretionary and nondiscretionary accruals under alternative hypotheses (i) that discretionary accruals improve earnings as a performance measure, (ii) that discretionary accruals are opportunistic, and (iii) that discretionary accruals add noise to reported earnings. Conclusions All models appear well specied when applied to a random sample of rm years and generally detect low levels of earnings management. Models do not perform as well when rms are characterized by extreme performance (when levels of earnings or cash ow are compared to other rms in same industry). Modied Jones is the most powerful model, followed by the Jones model. Only the Jones and Modied Jones models yield components that have some characteristics consistent with the opportunism and performance measure hypotheses; the other models cannot distinguish between the three assumptions. Correlations of stock returns and accrual components provided by the Jones and Modied Jones models outperform the correlations when accruals are randomly decomposed. Similar conclusions to Dechow, Sloan, and Sweeney (1995): The Jones model outperforms the Healy model. Misclassication of nondiscretionary and discretionary accruals using the Jones model occurs when nondiscretionary accruals are negatively correlated with operating cash ows and negatively correlated with non-discretionary earnings (measured using Joness technique).

Guay, Kothari, and Watts (1996)

Healy (1985) DeAngelo (1988) Jones (1991) Modied Jones (proposed in Dechow et al., 1995) Industry model (Dechow & Sloan, 1991)

Dechow, Sabino, and Sloan (1997)

Healy (1985) Jones (1991)

Modelling of rm performance with no earnings management. Replication of the simulations in Dechow, Sloan, and Sweeney (1995) with data generated by the model of rm performance with no earnings management.

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the effects of prior period earnings management are removed from estimates of unmanaged accruals. Where data are hand collected due to the absence of a database like COMPUSTAT, however, the written-down value is more accessible to the researcher because it is reported on the balance sheet rather than in the notes to the accounts. Therefore, for contrasting theoretical and pragmatic research reasons, it is useful to assess whether the net measure provides a cost-efcient surrogate for the gross measure. We predict that:
H1: Gross measurement of property, plant and equipment included in PPE increases the explanatory power of the Jones model relative to net measurement.

Renements to Gross Property, Plant and Equipment Non-Depreciable Property, Plant and Equipment, and Other Assets. The PPE variable used in the Jones model is the gross value of property, plant and equipment. U.S. studies rely on the COMPUSTAT database to measure the variables in this model. COMPUSTATs property, plant and equipment item (#7) includes land held for the production of revenue and excludes intangibles (#33). Land, however, is generally not amortized unless it is being wasted, and total accruals includes amortization expense for intangibles (#14).8 In Australia and many other countries, assets commonly held as part of property, plant and equipment and which are not depreciated include land, assets under construction, exploration and evaluation expenditure carried forward for mining areas not yet in production, and forests and other regenerative resources. Non-depreciable assets reported as part of property, plant and equipment disturb the linear relation between gross PPE and depreciation and amortization expense as those holdings change. We therefore expect that excluding non-depreciable assets from PPE improves the performance of the Jones model. Non-current assets other than property, plant and equipment, or intangibles, are disclosed under Other Assets in the non-current assets section of the balance sheet. Since the depreciation and amortization expense in the prot-and-loss statement includes amortization of other assets, there is a relationship between the gross value of other amortizable assets and the expense. We expect that redening PPE to include the gross value of all amortizable assets improves the explanatory power of the Jones model. Institutional Differences: Intangible Assets. Although variations of the Jones model are used in earnings management studies there appears to be no systematic evidence about the impact of different national reporting requirements on the models power. Three important areas in which some national accounting regulations vary from those in the U.S. are (1) upward revaluation of non-current assets, (2) the goodwill amortization period, (3) and requirements to amortize identiable intangible assets. We use Australian data in this study and apply it to the benchmark Jones model. Therefore, the following discussion focuses on

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U.S.-Australian institutional differences. These differences vary in their relevance to other countries, according to their national accounting regulations and practices. The Jones model does not include goodwill in PPE when predicting depreciation and amortization expense. This omission presumably results in less accurate estimates of non-discretionary accruals, because goodwill amortization is included in accruals. We predict that the Jones model will have more explanatory power when gross goodwill is included in PPE. Changes in accounting regulations can alter the nature of the relation between accruals and particular account balances. In the case of goodwill, the mandatory Australian accounting standard, AASB 1013, Accounting for Goodwill, applies to nancial periods ending on or after June 30, 1988. AASB 1013 requires amortization of purchased goodwill recognized as an asset over a period not exceeding 20 years. Before 1988, a professional (non-mandatory) accounting standard9 required the same thing, but there was considerable variation in goodwill accounting practices (Anderson & Zimmer, 1992; Wines & Ferguson, 1993). Compliance with the professional accounting standard on goodwill was seen as optional, as most company directors are not members of the professional accounting bodies and did not feel bound by their rules. The most common method of accounting for goodwill prior to 1988 (other than systematic amortization) was to write the asset off as an extraordinary item. This practice is not permitted under AASB 1013. A well-specied total accruals model should include a control for the introduction of an accounting standard, where the introduction of that standard affects the relationship between PPE and accruals. Before 1988, the relationship between PPE (including gross goodwill) and accruals was not affected by the write-off of goodwill, as the asset was removed from the balance sheet and there was no expense passing through the earnings. Those companies using the systematic-amortization-of-goodwill accounting method before 1988 continued to do so after that date. Therefore, there should be no need, generally, for the total accruals model to incorporate a control for the introduction of AASB 1013. Similarly, while the maximum amortization period for goodwill is 20 years in Australia and 40 years in the U.S., this difference should have no effect on the signicance of any association between gross goodwill balances and total accruals measures, since both associations should differ only in relation to the magnitude of the coefcient on goodwill. In the U.S., identiable intangible assets are amortized over a maximum of 40 years. In contrast, Australia has no requirement to amortize identiable intangible assets; they may, in fact, be revalued upwards in the same way as tangible non-current assets. Wines and Ferguson (1993) document a substitution effect whereby rms recognized more identiable intangible assets after the introduction of AASB 1013 and reduced their goodwill balances. In their sample, capitalized identiable intangible assets balances average three times the size of

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capitalized goodwill balances, so the effect on accruals could be material. It should not, however, disturb the relation between accruals and asset account balances. The Jones model does not incorporate identiable intangible assets. As total accruals includes amortization expense, including the gross value of identiable intangible assets in the model improves the explanation of total accruals if two problems are overcome. The rst is the confounding of results if managers alter the gross value of identiable intangible assets through revaluation. Revaluation of intangible assets has the same impact as revaluation of tangible assets, as discussed below. It is proposed, therefore, to treat identiable intangible asset revaluations the same as tangible asset revaluations. The second problem is that the lack of an enforceable standard on the issue permits management to keep from amortizing some identiable intangibles. It is therefore appropriate to specify PPE measurement as excluding the gross value of identiable intangible assets not subject to amortization. We expect that inclusion in PPE of the gross value of identiable intangible assets being amortized during the period increases the Jones models explanatory power, and predict that:
H2: Inclusion in PPE of the gross value of all amortized and depreciable noncurrent assets, and exclusion of all non-amortized and non-depreciated assets, improves the explanatory power of the Jones model.

Institutional Differences: Asset Revaluation. Unlike U.S. rms, Australian rms may recognize increases in non-current asset values in their accounts.10 The increment for an upward revaluation is the difference between the old written-down value of the asset and the new gross value, and depreciation charges subsequent to asset revaluations are based on the new value. The depreciation charge following an upward revaluation is almost always greater than charges prior to the revaluation. Norton (1995) provides evidence that the Form 20-F prot reconciliation lings by Australian rms listed on the U.S. stock exchanges show higher depreciation charges under Australian accounting regulations following upward asset revaluations than those occurring under U.S. accounting regulations. Easton, Eddey, and Harris (1993) provide evidence that the most common revaluation cycle (including both upward and downward revaluations) is triennial.11 Downward revaluations are mandatory when the carrying value of the asset exceeds the assets recoverable amount. Upward revaluations, however, are discretionary in both timing and amount, as long as the new carrying value of the asset does not exceed the assets recoverable amount. Evidence indicates that upward asset revaluations are used to alter debt-toequity ratios, thereby mitigating underinvestment problems induced by the presence of risky debt and exacerbated by the manner in which conventional borrow-

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ing limitations are written (Easton et al., 1993; Whittred & Chan, 1992). Although the primary objective of an asset revaluation appears to be to alter the balance sheet, there is an earnings effect from increased depreciation charges. As depreciation charges also rise following an upward asset revaluation, the practice of revaluing assets does not invalidate the Jones model. The majority of revaluations, however, are dated the last month, if not the last day, of the nancial period (Whittred & Chan, 1992). The depreciation expense for the year of revaluation is calculated on the basis of asset values for the time the assets are held at those values. As such, when revaluations are recognized at the end of the accounting period, the depreciation expense for the year is not related to the new gross value of the asset. What an upward asset revaluation implies for the Jones model is that the relationship is disrupted between the gross value of property, plant and equipment (PPE) at the end of the period and the depreciation expense for the period. Removing the effect of the upward asset revaluation from the gross PPE value at the end of the period restores the linear relationship between PPE and the depreciation expense. The relation between property, plant and equipment, and the other component of total accruals, change in working capital, also demands consideration. Increased economic activity is likely to be linked to increases in property, plant and equipment, as well as working capital for established rms. Established rms prove, through their survival, that they are protable in the long term. When such rms experience an increase in economic activity, measured as a growth in sales revenue, non-cash working capital increases due to the growth in debtors and stock trades exceeding the growth in trade creditors. Over time, growth also leads to expansion of property, plant and equipment as capacity increases. These changes are likely to be step changes, since property, plant and equipment generally cannot be acquired in easily divisible units. Upward revaluations of property, plant and equipment are more likely in times of economic growth, as growth tends to lead to increases in asset values. The timing of those revaluations, however, are discretionary and not necessarily related to the level of economic activity of the rm during the period. As such, the relation between the PPE level and the change in working capital in the period of the asset revaluation increment can differ from that of other periods. Based on the preceding analysis, we predict that:
H3: Removing the earnings effects of current period asset revaluations from gross PPE increases the explanatory power of the Jones model in relation to: (a) (b) (c) predictions of depreciation and amortisation expense, predictions of changes in working capital, and predictions of total accruals.

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SAMPLE
Sample

AND

VARIABLE MEASUREMENT

The sample comprises all industrial rms on the Australian Stock Exchange with annual reports available each year between 1984 and 1996, inclusive, other than nance industry and foreign rms and those reporting in foreign currency. Table 2 outlines the sample selection procedure. Excluded rms are those not listed on the Connect 4 database for 1996 or 1995 and which do not have annual reports available on the AGSM microche for the years not covered by Connect 412 in the libraries of either The University of Tasmania or The University of Melbourne. We also exclude rms if they are subject to a merger or takeover, are in receivership, or experience a change in their nancial period during the sample period. We exclude mining rms because their patterns of operations, earnings, and nancial positions follow less predictable patterns than industrial rms.13 For additional tests, we remove extreme observations. Extreme observations for the industrial rm sample are identied as those with increases or decreases in total assets or operating revenue exceeding 50 percent for any period. Firms with a one-period variation in total assets greater than 50 percent are assumed to have undergone a structural change, which violates the stationary-data assumption underlying accruals time-series analysis. Firms with more than 50 percent variation in operating revenue are not necessarily undergoing structural change, since the variation could be explained by changes in activity levels. In these cases, we scrutinized balance sheets for evidence of structural change.14 The nal sample covers 13 industries, with rms in the sample representing 10 percent of the industrial rms listed on the Australian Stock Exchange (ASX). The sample is restricted to rms already listed in 1984/1985 that survive until 1995/1996. Therefore, it does not represent new or short-lived rms. Any study using Australian rms that requires a lengthy time-series of data, however, is likely to be based on a similar sample, so the results reported in this study are relevant to future research using time-series Australian data. Table 2 reports the industry representation in the sample, the number of rm-year observations per industry, and the list of sample rms. Variables Total accruals (TAt) was dened earlier. Other dependent variables used in the analysis are the components of total accruals, WORKCAPt and DEPAMORTt. WORKCAPt is the non-cash change in working capital for period t, scaled by one-period-lagged total assets (CAt CLt Casht STDt)/(At1), and DEPAMORTt is the depreciation and amortization expense for period t, scaled by lagged total assets. Change in revenue, REVt, is operationalized as the change in

Modeling Total Accruals in an International Environment TABLE 2

299

Sample Firms
Panel A: Sample Selection Firms with annual reports contained on Connect 4 January 1997 disk - latest year held 1996 - latest year held 1995 less: Firms in nance industry1 Foreign rms, rms with nancial statements in foreign currency less: Firms with fewer than 12 years continuous data available on combined AGSM and Connect 4 database for period 19841996 Firms resulting from mergers or takeovers during the period Firms in receivership during the period Firms with change in nancial reporting period Firms in mining industry Number of rms in sample Panel B: Industry representation of rms in sample2
No. of Firm-Year Observations No. of Firm-Year After Deletion of Percentage of Observations Extreme No. of Industry Before Deletion Observations Firms in Represented in of Extreme (Additional Tests Sample Sample Observations Sample) 0 7 2 5 5 8 5 2 6 4 2 2 2 3 53 0 26.9 18.2 10.9 29.4 21.1 14.3 6.9 5.7 3.4 20.0 5.9 6.5 21.4 10.04 0 76 22 55 55 88 54 22 66 44 22 22 22 33 581 0 73 22 48 51 80 51 19 62 42 22 22 17 32 541

197 310 507 (113) (8) 386 (282) (10) (1) (12) (28) 53

Industry Alcohol & Tobacco Building Materials Chemicals Development & Contractors Diversied Industrial Engineering Food & Household Media Miscellaneous Industrial Miscellaneous Services Paper & Packing Retail Tourism & Leisure Transport

Industry Code 8183 7174 101103 6165 231 111115 9196 151155 221228 211219 121126 131134 241243 141144

No. of Firms on ASX August 1996 15 26 11 46 17 38 35 29 105 117 10 34 31 14 528

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Continued
Panel C: Sample Firms Australian National Industries Amalgamated Holdings Amcor Arnotts Atkins Carlyle Australian Chemical AWA Ballarat Brewing Boral Brambles Brickworks Bridgestone Burns Philip Campbell Brothers
1

Clyde Industries Coventry GP Crane CSR Email Evans Deakin Faulding GUD Gibson Chemical Gowing Bros Henry Walker Hills Howard Smith ICI

James Hardie Joe White Lanes Leighton Lend Lease Ludowici Macmahon Maryborough Sugar Mayne Nickless National Can National Consolidated News OPSM Protector Pacic Dunlop

Peter Kurts QUF Reece Australia Siddons Spotless TNT Telecasters Nth Qld Tubemakers Wattyl Wesfarmers Westeld Holdings

Firms deleted are those in the following industries: 161 Banks and Finance; 181185 Entrepreneurs; 171172 Insurance; 191195 Investment and Financial Services; 201202 Property Trusts. 2 Extreme observations deleted on the following basis: where the one-period change in either total assets or revenue is greater than 50%.

total operating revenue from year t 1 to year t, and is scaled by one-period-lagged total assets. The hypotheses developed earlier suggest four PPE measures: net PPE, gross PPE, PPE excluding non-depreciable assets and including all depreciable assets, and PPE adjusted for the effects of upward asset revaluations for the current period. The alternative measures of PPE15 are dened below: PPEBS is the written-down-value of property, plant and equipment reported on the balance sheet. PPEGR measures the gross value of assets disclosed as property, plant and equipment, as specied in Jones (1991). It is calculated as the writtendown value of property, plant and equipment (PPEBS) plus accumulated depreciation on all assets in that class. TAMORT is calculated as gross property, plant and equipment (PPEGR) less the amount of freehold land separately disclosed in property, plant and equipment, and less any other assets disclosed as property, plant and equipment that are not being amortized.16 To this total is added the gross value of any other non-current assets that are being depreciated, including goodwill and identiable intangible assets. TAMORTNR is measured as the gross value of all non-current assets amortized during the period, whether disclosed as property, plant and equipment; other assets; or intangibles (TAMORT) less increments to the asset revaluation reserve for depreciable or amortizable assets for the period.

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Model As described earlier, the Jones model regression equation is companyspecic. Due to variability between rms, the constant and the variable coefcients are estimated from a time-series regression on company data. To assess the overall improvement in the explanatory power of the model, however, it is necessary to t the regression using pooled data yet continue to permit constants and regression line slopes to vary between companies. Indicator variables are included in the model using pooled data:
nc1

TAt1(1/At1)2(Revt)3(PPEt)

k1 nc1

Z (1/A
k k k k

t1

)
nc1 k1

k1

Z (Rev ) Z PPE
t k k t

(4)

where: Zk 1 if company k, 0 otherwise. and nc is the number of companies. The regression is tted once on the pooled data and provides an overall R2 and level of signicance for the model. We use the Vuong (1989) test described in Dechow (1994) to assess the statistical signicance of differences in the explanatory power of the models using different PPE measures. Descriptive Statistics Table 3, Panel A reports descriptive statistics for the dependent and independent variables, and Table 3, Panel B reports Pearson correlations for the continuous independent variables, including the PPE variable series. The high and signicant correlations between the four PPE variables suggest they capture substantially the same construct. The correlations between change in operating revenue and all other variables are statistically signicant but low. These correlations mitigate against nding statistically signicant coefcients on individual independent variables. Since the key focus of this study, however, is the incremental explanatory power from alternative PPE specications, the multicollinearity is not problematic.

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Dependent and Independent Variables Firm-Year Observations from 1984 to 1996

n 581 Panel A: Descriptive Statistics Variable TA REV PPEBS PPEGR TAMORT TAMORTNR DEPAMORT WORKCAP Mean 0.0266 0.1353 0.4071 0.5960 0.5790 0.5725 0.0404 0.0670 Std. Dev. 0.0878 0.2319 0.2057 0.2908 0.2962 0.2967 0.0241 0.0960 Median 0.0254 0.1113 0.3886 0.5705 0.5747 0.5719 0.0378 0.0645 Min. .5775 1.0133 0.00 0.00 0.00 0.00 0.00 0.5900 Interquartile Range 0.0821 0.2292 0.2276 0.3146 0.3262 0.3228 0.0233 0.0976 Max. .4417 1.2224 1.5500 2.2400 2.1700 2.1600 0.1900 0.4300

Panel B: Pearson Correlation Coefcients for Independent Variables REV REV PPEBS PPEGR TAMORT TAMORTNR
*** signicant at 0.01 where TAt TAt CAt CASHt CLt STDt DEPAMORT total accruals in year t scaled by total assets in period t 1 CAt CASHt CLt STDt DEPN, AMORTt change in current assets from year t 1 to year t change in cash from year t 1 to year t change in current liabilities from year t 1 to year t change in short-term debt from year t 1 to year t (total depreciation and amortization expense in year t ) scaled by total assets in year t 1 (CAt CASHt CLt STDt ) scaled by total assets in year t 1 change in operating revenue from year t 1 to year t , scaled by total assets in year t 1 written-down value of property, plant and equipment reported on the balance sheet gross value of assets disclosed as property, plant and equipment (PPEBS plus accumulated depreciation) gross property, plant and equipment less freehold land disclosed separately in property, plant and equipment less other assets disclosed as property, plant and equipment which are not being amortized, plus other assets included in noncurrent assets that are being depreciated, other than identiable intangible assets gross value of all non-current assets being amortized during the period, whether disclosed as property, plant and equipment, other assets, or intangibles, less increments to the asset revaluation reserve for depreciable or amortizable assets for the period (i.e., TAMORT less increments to asset revaluation reserve arising from asset revaluations during the period).

PPEBS 1.000 .925*** .784*** .773***

PPEGR

TAMORT

1.000 .141*** .145*** .151*** .145***

1.000 .911*** .905***

1.000 .997***

WORKCAP REVt PPEBS PPEGR TAMORT

TAMORTNR

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RESULTS
Total Accruals As discussed in the previous section, the analysis is conducted using a pooled sample regression so that the overall improvement in the model can be assessed as the PPE variable is progressively rened. A pooled sample is necessary so that one R2 statistic can be generated for each version of the model and improvements (if any) can then be tested for signicance. Jones (1991) used company-specic regressions because her hypotheses focused on whether individual companies were engaging in earnings management. The method adopted in this study is similar to that adopted in Dechow (1994). The results for the pooled sample regression on the full sample appear in Panel A, Table 4. All models are signicant, and the explanatory power and signicance of the models exceed those reported in Jones (1991). Reasons for differences include: We report one R2 for the pooled sample. Jones reports the mean, median, and distribution of R2 for separate regressions for each company in her sample; 2. We have a larger sample than Jones; 3. We draw our sample from a different time period and institutional setting; and 4. We include changes in short-term debt in our measure of total accruals, whereas Jones (1991) does not because of data restrictions. 1. The results using the full sample indicate that using four alternative measures of PPE creates differences between the R2 statistics for the regressions. The differences in R2 statistics are tested for signicance using the Vuong test. The only signicant ( 0.10) improvement in R2 arises when PPE is measured gross rather than net. The R2 for gross property, plant and equipment (PPEGR) is approximately 5.5% greater than the R2 for written-down property, plant and equipment (PPEBS) (0.405 compared to 0.384). (Vuong test z-statistic 1.57; 1-tailed p 0.058.) When PPE is measured excluding non-depreciable assets and including all amortizable assets (TAMORT), the models explanatory power is not signicantly greater than that of the regressions using either gross or written-down PPE. Analysis of the test suggests that this is due to an increase in the variance component of the z statistic used to compare the TAMORT and PPEGR regressions from that used to compare the PPEGR and PPEBS regressions. The increased variance is presumably due to differences between the depreciation treatments of tangible assets and the amortization treatments of intangible assets.

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OLS Regression Results for Y Total Accruals Firm-Year Observations from 1984 to 1996
nc1

TAt 11/At1 2Revt 3PPEt where Z k {1 if company k , 0 otherwise nc is the number of companies

k1

nc1

kZk1/At1

k1

nc1

kZkRevt

k1

kZkPPEt

Net Versus Gross Book Value of Tangible Assets PPEBS Panel A Full Sample ( n 581) R2 Percentage Increase in R 2 From Previous Model# Model F -Statistic (2-Tailed p ) .384 na 1.652 (.000) .405 5.469* 1.807 (.000) PPEGR*

Incorporating Intangible Assets in PPE TAMORT

Adjusting PPE for the Effects of Current Period Asset Revaluation TAMORTNR

.420 0.0 1.922 (.000)

.418 0.476 1.907 (.000)

Panel B Full Sample Excluding Extreme Observations ( n 541) R2 Percentage Increase in R 2 From Previous Model Model F -Statistic (2-Tailed p ) .431 na 1.822 (.000) .440 2.088 1.888 (.000) .438 0.229 1.869 (.000) .437 0.229 1.863 (.000)

# As all models use the same formula and are tted using the same sample, the appropriate statistic for comparison is R 2 . * Increase in R 2 from previous model signicant at 0.10 (Vuong z -statistic: 1.56835, one-tail p 0.0582) Extreme observations deleted on the following basis: where the one-period change in either total assets or revenue is greater than 50%. where: TAt total accruals in year t scaled by total assets in period t 1 (CAt CASHt CLt STDt DEPN, AMORTt ) CAt change in current assets from year t 1 to year t CASHt change in cash from year t 1 to year t CLt change in current liabilities from year t 1 to year t STDt change in short-term debt from year t 1 to year t DEPAMORTt total depreciation and amortization expense in year t A t 1 total assets at end of year t 1 REVt change in operating revenue from year t 1 to year t , scaled by total assets in year t 1 PPEBS written-down value of property, plant and equipment reported on the balance sheet PPEGR gross value of assets disclosed as property, plant and equipment (PPEBS plus accumulated depreciation) TAMORT gross property, plant and equipment less freehold land disclosed separately in property, plant and equipment less other assets disclosed as property, plant and equipment which are not being amortised plus other assets included in non-current assets that are being depreciated, other than identiable intangible assets TAMORTNR gross value of all non-current assets being amortized during the period, whether disclosed as property, plant and equipment, other assets, or intangibles, less increments to the asset revaluation reserve for depreciable or amortizable assets for the period (i.e., TAMORT less increments to asset revaluation reserve arising from asset revaluations during the period).

Modeling Total Accruals in an International Environment

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The regression using the variable that includes all amortized assets and excludes all related asset revaluation increments (TAMORTNR) has an insignificantly lower R2 than the regressions using TAMORT (total amortized noncurrent assets). As such, there is no evidence that non-current asset revaluations affect the explanatory power of the Jones (1991) model.17 Data Limitations and Additional Tests: Asset Revaluation. Companies do not disclose the change in their accumulated depreciation due to asset revaluations. Therefore, using the amount of the asset revaluation reserve increment to estimate the impact of upward asset revaluation increments on the gross value of depreciable assets introduces an error of indeterminate size. Additional data problems arise because some revaluation increments are not reported in the asset revaluation reserve.18 Additionally, when several assets within a class are revalued in the same period, the net change from all revaluations is credited to the asset revaluation reserve.19 Therefore, if management revalues some assets upwards and some downwards in the same period, the increment is less than if the revaluations were recognized in different accounting periods. Further data constraints arise because (non-depreciable) freehold land is not separated from (depreciable) buildings in the notes to the accounts. When the regressions are restricted to observations where land is disclosed separately by the rms (n 301), the results are similar to those for the full sample. Removal of land and other non-amortized assets from property, plant and equipment offers no improvement in the models explanatory power over gross property, plant and equipment. The model with the highest R2 remains the model where PPE is measured as total assets that are subject to amortization (TAMORT, R2 0.582; PPEGR, R2 0.572). Deletion of Extreme Values From Sample. The Jones (1991) model develops predictions of discretionary accruals based on a time series of observations for each rm, a method that assumes that the underlying process is stationary. In Panel B, Table 4 we report additional tests using a sample excluding observations where there is evidence of a major structural change for an additional test. For all PPE measures the R2 values increase from those reported in Panel A, Table 4.20 The R2 advantage of gross property, plant and equipment (PPEGR) over written-down property, plant and equipment (PPEBS) declines from 5.5% to 2.1% and is no longer signicant. The R2 statistic for total amortized assets (TAMORT) is insignicantly different from both PPEGR and PPEBS. Overall, the results reported in Table 4 indicate that rening the PPE variable offers the greatest advantage when the set of observations contains more variability. Total accruals for rms with no evidence of structural change appear to be well explained by any PPE proxy, including written-down property, plant and equipment.

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Components of Total Accruals To assess whether the improvement in the R2 statistic as PPE is progresively rened is related solely to the improvement in explaining depreciation expense, we t the regressions using DEPAMORT and WORKCAP as dependent variables. DEPAMORT is depreciation and amortization expense for year t scaled by total assets at t 1. WORKCAP is the non-cash change in working capital, scaled by total assets at t 1. The explanatory power of the regressions using PPEBS, TAMORT, and TAMORTNR is compared with the explanatory power of the regression using gross property, plant and equipment (PPEGR). Results appear in Table 5. All the regressions with depreciation and amortization as the dependent variable for the full sample produce high R2 values for the full sample of 581 observations (Panel A, Table 5). The explanatory power of the regressions using gross property, plant and equipment (PPEGR, TAMORT, TAMORTNR) are almost identical at 0.968 or 0.969. The regression using gross property, plant and equipment is also only 1.79% better than that using written-down property, plant and equipment (PPEBS), 0.951. The difference in explanatory power, however, from using gross rather than written-down values is signicant (Vuong test z 4.556, p 0.001). Panel A also shows results for the dependent variable depreciation and amortization expense for the sample excluding extreme values (n 541). The R2 values are higher than those for the full sample and the differences in R2 and F statistics are smaller. Similar to the results for total accruals as the dependent variable, as reported in Table 4, the more homogeneous the data, the smaller the advantage from rening the PPE proxy. Nonetheless, the benet from using the gross rather than the written-down PPE measure is still signicant (Vuong test z 3.905, p 0.001). Table 5 also presents results from using the change in working capital as the dependent variable (Panel B). The levels of R2 are lower than those for depreciation and amortization expense, although the models are still highly signicant. Also, the increase in the explanatory power of the models when PPE is measured gross rather than net of depreciation remains signicant, although only for the full sample (Vuong test z 2.558; 1-tailed p 0.005). The usual interpretation of the Jones model is that PPE explains depreciation and amortization expense only, and the change in revenue predicts the change in working capital. The different explanation of the change in working capital caused by rening the measure of PPE is not consistent with this expectation. The regressions of the components of total accruals, DEPAMORT and WORKCAP, on the independent variables illustrate that the explanatory power of the Jones model in relation to both depreciation expense and change in working capital is signicantly improved by using gross PPE measures rather than writtendown measures. but is not improved signicantly by including within PPE

Modeling Total Accruals in an International Environment TABLE 5

307

OLS Regression Results Firm-Year Observations From 1984 to 1996

Panel A: Where Y DEPAMORT DEPAMORTt 1 1/At 1 2 Revt 3 PPEt
nc 1

where Z k {1 if company k , 0 otherwise. and nc is the number of companies. Full Sample, n 581 R Percentage Increase in R 2 Over Previous Model Model F -Statistic (2-Tailed p )
2

k1

nc 1

k Zk 1/At 1

k1

nc 1

k Zk Revt

k1

k Zk PPEt

PPEBS .951 na 51.194 (.000)

PPEGR* .968 1.79%* 79.486 (.000)

TAMORT .969 0.10% 81.885 (.000)

TAMORTNR .968 0.10% 81.111 (.000)

* increase in R 2 from previous model signicant at 0.001 (Vuong z -statistic: 4.556; one-tailed p 0.000)

Sample Excluding Extreme Observations, n 541 R2 Percentage Increase in R 2 Over Previous Model Adjusted R 2 Model F -Statistic ( p -value)

PPEBS .962 na .946 60.472 (.000)

PPEGR* .973 1.14%* .962 85.405 (.000)

TAMORT .973 0.0% .962 86.255 (.000)

TAMORTNR .973 0.0 .961 85.529 (.000)

* increase in R 2 from previous model signicant at 0.001 (Vuong z -statistic: 3.905; one-tailed p 0.000)

Panel B: Where Y WORKCAP ( n 581) WORKCAPt 1 1/At 1 2 Revt 3 PPEt

nc 1

where Z k {1 if company k , 0 otherwise. and nc is the number of companies. Full Sample, n 581 R Percentage Increase in R 2 Over Previous Model Model F -Statistic (2-tailed p )
2

k1

nc 1

k Zk 1/At 1

k1

nc 1

k Zk Revt

k1

k Zk PPEt

PPEBS .596 na 3.920 (.000)

PPEGR* .622 4.36%* 4.362 (.000)

TAMORT .634 1.93% 4.602 (.000)

TAMORTNR .632 0.32% 4.566 (.000)

* increase in R 2 from previous model signicant at 0.010 (Vuong z -statistic: 2.558; one-tailed p 0.005)

depreciable or amortizable assets other than property, plant and equipment. The increased explanatory power of change in working capital is a particularly valuable improvement, since the Jones model explains comparatively less of this component of total accruals.

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Continued
Sample Excluding Extreme Observations, n 541 R2 Percentage Increase in R 2 Over Previous Model Adjusted R 2 Model F -Statistic (2-tailed p )

PPEBS .650 na .504 4.462 (.000)

PPEGR .662 1.85% .522 4.714 (.000)

TAMORT .664 0.30% .524 4.740 (.000)

TAMORTNR .663 0.15% .523 4.724 (.000)

DEPAMORTt depreciation and amortization expense for period t scaled by total assets at t 1 (i.e., total gross value of non-current assets being amortized at the end of year t , scaled by total assets at year t 1) WORKCAPt (CAt CASHt CLt STDt ) scaled by total assets at t 1 PPEBS written-down value of property, plant and equipment reported on the balance sheet PPEGR gross value of assets disclosed as property, plant and equipment (PPEBS plus accumulated depreciation) TAMORT gross property, plant and equipment less freehold land disclosed separately in property, plant and equipment less other assets disclosed as property, plant and equipment which are not being amortized (PPEAM) plus other assets included in non-current assets that are being depreciated, other than identiable intangible assets (i.e., ANCAGW plus the gross value of identiable intangible assets being amortized during the period) TAMORTNR [gross value of all non-current assets being amortized during the period, whether disclosed as property, plant and equipment, other assets, or intangibles, less increments to the asset revaluation reserve for depreciable or amortizable assets for the period (i.e., TAMORT less increments to asset revaluation reserve arising from asset revaluations during the period).]

Alternative Depreciation Policies The total accruals model assumes a linear relation between the dependent and independent variables. The most obvious connection between property, plant and equipment and accruals is via depreciation. This is likely to be a linear relation if depreciation is straight-line and the PPE variable is gross, as the depreciation expense is the same amount in each period, and the gross amount of the asset (at cost) is also the same (assuming no changes in holdings of PPE). Alternatively, it is likely to be linear if depreciation is reducing balance or some variant thereof and the PPE variable is net of accumulated depreciation, because the depreciation expense is a smaller amount each year and the asset (at writtendown value) is also reducing. Consistent with this expectation, when we examine the total accruals regressions for straight-line depreciation rms, we nd that the model using all gross assets except those not subject to depreciation (TAMORT) predicts both total accruals and depreciation with more explanatory power than the model using the net balance sheet measure (PPEBS) (Vuong statistics: 1.540 and 1.807; one-tailed p 0.062; 0.035). Contrary to expectation, though, for non-straight-line rms, the model using all gross assets except those not subject

Modeling Total Accruals in an International Environment

309

to depreciation (TAMORT) continues to predict depreciation expense with signicantly more explanatory power than the model using the net balance sheet measure (PPEBS) (Vuong statistics: 1.776; one-tail p 0.038). Alternative Models To test the robustness of our results, we run identical tests using the Dechow et al. (1995) modied Jones model of accruals. This model modies the REV economic impact variable to remove the effect of discretionary management on reported credit sales. The results are qualitatively similar, but there is no significant difference in the explanatory power of the models using gross and net measures of PPE (PPEBS and PPEGR). Practical Signicance of the Results The results using the modied Jones model support the interpretation of some of the results reported in Table 4 and Table 5. The improvement in the Jones models explanatory power is sometimes signicant if PPE is measured gross rather than net. The improvement is so small, however, that researchers should have condence substituting net PPE for gross PPE when examining the incidence of earnings management in Australian companies. Earnings management research without a comprehensive electronic database for data collection will likely appear unattractive if accumulated depreciation data have to be hand collected from the notes to the accounts in order to calculate gross PPE, intangible assets, and revaluation increments. The results of this paper show that research into important earnings management questions will be less costly in the future, as gross or net PPE is available directly from the balance sheet, and additional renements are not necessary.

CONCLUSIONS
We test whether renement of the PPE variable improves the explanatory power of the Jones model of non-discretionary accruals. The results show that the explanatory power of the Jones model increases, and independent variable coefcients acquire more signicance, when PPE includes gross values of assets rather than net values. Both components of total accruals depreciation and amortization expense and changes in working capital are more completely explained by gross property, plant and equipment measures than written-down property, plant and equipment balances. Around 96 percent of annual depreciation and amortization expense is explained by the gross value of total depreciated or amortized non-current assets. Such a high explanatory power is inconsistent with inter-period earnings management via depreciation and amortization. The im-

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proved explanation of the change in working capital is valuable because the original model does not explain working capital variation as well as it does depreciation and amortisation expense. The improvement in R2 statistics for the alternative PPE denitions is typically small, and loses signicance if extreme observations are removed from the sample. The practical signicance of this is that it appears to allow researchers substitute the cheaper-to-collect net PPE data for gross PPE, with no signicant difference in results. Our results should encourage researchers to investigate many important earnings management questions where previously they have been discouraged by the high cost of data collection. We also provide evidence that the Jones model provides reliable results in jurisdictions where depreciable assets are marked to market in the balance sheet even if the effects of upward asset revaluations are not incorporated into the model. Given international movement towards adopting current values within the balance sheet, to the extent that those assets are depreciable, our evidence will enable more condence in predictions of total accruals, and therefore of discretionary accruals. The validation of the Jones model in the Australian environment and the evidence that net PPE measures provide reliable results enhances the value of empirical studies to accounting regulators and other stakeholders wishing to assess the incidence and motivation for earnings management. Interested parties such as analysts, auditors, and standard-setters can rely on research using the Jones model (in a simplied form using net PPE) to determine if and when managers of Australian companies engage in earnings management. As has been shown by researchers in other countries, earnings management is sometimes undertaken to conceal poor results, to reduce the impact of changing accounting standards on earnings, and to smooth income. Its detection allows the stakeholders to better respond to the earnings announcements of rms.

Acknowledgments: We are grateful for comments from Konrad Kubin, Bryan Howieson, Stuart McLeay, Donald Stokes, and participants at a seminar at Monash University; at the American Accounting Association Annual Meeting, 1998; at the Accounting Association of Australia and New Zealand Annual Conference, 1998; and at the European Accounting Association Annual Congress, 1998.

NOTES
1. Some possible reasons for earnings management are to increase managers bonus pay-outs; loosen debt-covenant constraints; reduce political costs; or improve the ability of reported earnings to reect rms underlying economic transactions and nancial positions, in order to assist decision making and contracting by stakeholders in the rm.

Modeling Total Accruals in an International Environment 2. 3.

311

4.

5.

6. 7. 8. 9. 10.

11. 12.

13.

14.

15.

For example, Jones (1991) nds that rms in the footwear industry used earnings management to ensure maintenance of tariff protection. Our reported tests examine the explanatory power of the Jones (1991) model. We also conducted equivalent tests using the Dechow et al. (1995) modied Jones model. The additional test yields results that are qualitatively similar, conrming the robustness of our ndings. Schipper (1989) denes earnings management as the purposeful intervention in the external nancial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process). The motivation for earnings management is not an issue considered in this study. We also do not examine whether the earnings management is within or outside GAAP (McNichols & Wilson, 1988). Jones (1991) does not use the change in short-term debt in her calculation of total accruals because of data constraints. The change in short-term debt is, however, added back to the change in current liabilities in most subsequent research (see for example Dechow, Sloan, & Sweeney, 1995). The usual assumptions are (1) E(i) 0 for all i; (2) Var (I) 2 for all i; (3) Cov (I j) 0 for all i j; (4) i is normally distributed for all i. This is true unless rms use a reducing balance method of depreciation. In Australia, most rms use straight-line depreciation. Hunt, Moyer, and Shevlin (1996) is one of the few studies that includes the balance of intangibles (# 33) in a model to capture the predetermined amortization of intangibles. AAS 18, Accounting for Goodwill. There is no requirement to recognize asset value increases in the accounts, although the Corporations Law requires disclosure of non-current asset values that varied from recognized values during the period under consideration. Such valuations are to be no more than three years old. Similarly, the evidence from the sample in this study is that 32.65 percent of observations have increments to the asset revaluation reserve. Downward asset revaluations were not counted. The Connect 4 database comprises annual reports for the top 500 companies listed on the Australian Stock Exchange (ASX). The rst annual report included for each company is from either 1992 or 1993. For example, of the 19 observations in a preliminary combined mining and industrial sample with changes in total assets for the period in excess of 100 percent, 16 are mining rms. There are 41 observations with changes in revenue for the period in excess of 100 percent, 38 relating to mining rms. Future research might investigate the effects of using the Jones model for different industries. Of the 40 extreme observations, we exclude seven rm-year observations because of simultaneous extreme changes in total assets and total revenue. We remove a further seven observations where extreme changes in revenue immediately follow or precede an extreme change in total assets (n 6), or where the revenue change is two years after total assets change (n 1). Two other rm-year observations with extreme changes in revenue are associated with an extreme change in total assets more than two years preceding or following. One rm has two extreme observations due to sales of non-current assets being included in operating revenue, and one rm-year observation is excluded due to an extreme change in revenue following a restructure. Three rm-year observations have changes in operating revenue greater than 50 percent, associated with a change in total assets of 40 percent. One rm-year observation with an extreme change in revenue is caused by the change from a single entity to a group entity. All PPE variables are measured at the end of year t and scaled by total assets at the end of year t 1.

312 16.

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17.

18.

19. 20.

Amortized assets are identied by the presence of an accumulated depreciation or amortization account, or by a note identifying the asset as being amortized. In those cases where the asset is being amortized but the amount of the accumulated amortization account is not separately disclosed, the gross value of the asset is estimated in a manner adapted from Godfrey and Koh (1997). Additional tests were performed for the progressive improvement in the explanatory power of the Jones model of (1) excluding land; (2) excluding land and other non-depreciated assets disclosed in property, plant and equipment; (3) including other amortized assets; and (4) including goodwill. Results (not reported) show that there are increases in the R2 statistics at each stage, but none of the increases are signicant. AASB 1010, Accounting for the Revaluation of Non-Current Assets, para 6.2, requires increments to be credited to the prot-and-loss account if the asset has been previously revalued downwards. AASB 1010, para 6.1. As the sample size has changed, comparisons between the two samples are based on the adjusted R2 statistic.

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