We use discretionary accruals as a measure of earnings quality (Beneish and Vargus, 2002; Chan, Chan, Jegadeesh, and Lakonishok, 2006). According to the accounting identity, earnings are equal to cash flows plus accruals. Accruals are accounting adjustments designed to better reflect firms’ fundamental operations. However, accruals are subject to managers’ discretion, which may distort reported earnings. The accrual component of earnings exhibits less persistence than the cash flowcomponent of earnings in predicting future earnings, and investors tend to focus on reported earnings and often ignore the possibility that accruals are less likely to recur in the future (Sloan, 1996). However, some portion of accruals is not subject.
