Earnings Management or Measurement Error? The Effect of External Financing on Unexpected Accruals

We demonstrate that managers’ “normal” operating decisions associated with large (positive or negative) net external financing activities are likely to lead to significant measurement errors in unexpected accruals. The problem occurs pervasively in samples drawn from different time periods, samples that reflect a wide variety of alleged earnings management stimuli, as well as random samples. Simulation tests show that even at modest levels of net external financing changes, rejection frequencies for the null hypothesis of no earnings management rise dramatically. These results are robust to controls for performance and firm growth. Further analysis suggests that net debt financing is more likely to induce measurement error than equity financing. We find that the use of a matched-firm approach using industry and external financing matches is generally appropriate. These findings highlight the importance of controlling for the effect of external financing on unexpected accruals measures, and also have implications for research testing earnings management and financial reporting quality.