Business Model Shocks and Abnormal Accrual Models

Economics challenge the specification of discretionary accrual models. Since rent seeking firms pursue differentiated business strategies, firms in the same industry have heterogeneous accrual generating processes. Moreover, Schumpeter’s “creative destruction” forces existing firms to revise their extant business models. We present evidence that such business model shocks are widespread, propagate through multiple years of financial statements, reduce accrual models’ goodness of fit, and result in unrealistically large unsigned “abnormal” accruals. Further, there is a spillover effect among firms in the same industry in that one firm’s abnormal accrual is affected by business model shocks experienced by the other firms in the industry. We show that business model shocks not only add noise to abnormal accruals, but can also introduce biases into both unsigned and signed discretionary accruals. Our results suggest that removing observations with business model shocks leads to better specified accrual models, and reduces both Type I and Type II errors in tests of earnings management.