Accruals, the difference between income from continuing operations and cash flows from operations, result from accounting rules and journal entries for the recognition of revenues and expenses. Following Healy (1985) who examined the use of discretionary accruals by managers to manage earnings used in bonus calculation, the management of accruals for earnings management has been the subject of several dozen accounting studies. Healy (1985) defined discretionary accruals as “adjustments to cash flows selected by the manager” in order to affect reported net income.
In his model, discretionary accruals are constrained to sum to zero over two periods, i.e., they fully reverse in two periods. In studies on accruals by Healy (1985), Dechow (1994), Sloan (1996) and others, accounting accruals are generally described as a product of accounting entries and management estimations that have no cash flow effects. A basic characteristic of these accounting accruals is that they sum to zero over time and are therefore both more predictable and less persistent compared to cash flow components of earnings. Sloan (1996) documents the lower persistence of the accrual component of earnings. Hochberg, Newman and Rierson (2003) document a negative serial autocorrelation in accruals.
The negative autocorrelation of accruals presents management with a big problem with respect to the use of accruals to manage earnings. Specifically, left to themselves, accruals end up reversing over time, perhaps even within one year, thus undoing whatever original effect they had on earnings. For example, assume that a firm is interested in managing earnings and, using accepted accounting means such as valuation allowances, creates an upward adjustment in the value of ending inventory without cash effect (i.e., without spending additional cash for purchase). Such an action will result in a lower cost of goods sold and a higher income in the year of adjustment (and a positive accrual).
But the accounting transaction will also irreversibly increase the beginning balance in inventory value in the next period by a corresponding amount and hence will lead to a lower income (and thus a negative accrual) in that period. Assuming that accruals such as these are used for earnings management, management would therefore have incentives to either structure the original transaction in a way that it does not result in this type of reversible accrual, or create additional transactions that could interrupt or stop the predictable reversal that is built into the accounting journal entries.