Adjusted median accrual: Meaning, Criticisms & Real-World Uses

What Is Adjusted Median Accrual?

Adjusted Median Accrual is a measure used in financial accounting to estimate the portion of a company's total accruals that are considered discretionary. It falls under the broader category of earnings quality analysis. Accruals represent the non-cash component of earnings, reflecting revenues earned but not yet received in cash (such as accounts receivable) and expenses incurred but not yet paid in cash (such as accounts payable). The concept of Adjusted Median Accrual aims to identify the part of these accruals that management might have manipulated to influence reported earnings, rather than those arising from normal business operations. It is often employed by analysts and researchers seeking to detect potential earnings management practices.

History and Origin

The concept of disentangling discretionary from non-discretionary accruals gained prominence in accounting research during the late 20th century, particularly as academics sought to develop models for detecting earnings management. Early models, such as the original Jones model introduced by Jones (1991), attempted to estimate normal accruals based on changes in revenue and property, plant, and equipment. However, these models were refined to address certain limitations. A significant advancement came with the Modified Jones Model, proposed by Dechow, Sloan, and Sweeney (1995), which adjusted for changes in accounts receivable to better isolate discretionary components, recognizing that revenue manipulation often involves credit sales. This model laid foundational groundwork for subsequent variations, including the Adjusted Median Accrual approach, which further refines the estimation by incorporating industry medians to control for economic factors common to a peer group, thus providing a more robust benchmark for "normal" accruals.

Key Takeaways

Adjusted Median Accrual is a quantitative tool used in financial analysis to estimate the discretionary portion of a company's total accruals.
It serves as an indicator of potential earnings management, where management may use accounting choices to smooth or inflate reported profits.
The calculation involves isolating accruals that are not attributable to changes in sales and property, plant, and equipment, and then adjusting for industry-specific norms.
A significantly positive or negative Adjusted Median Accrual can signal aggressive or conservative accounting practices, respectively.
While a valuable diagnostic tool, its interpretation requires careful consideration of the company's industry, business model, and economic environment.

Formula and Calculation

The calculation of Adjusted Median Accrual typically begins with the Modified Jones Model and then adjusts it by benchmarking against industry peers. The core idea is to remove the "normal" (non-discretionary) portion of accruals, leaving behind the "discretionary" component.

First, total accruals (TA) are calculated, usually as:

TA = (Net Income - Cash Flow from Operations)

TA = (\Delta Current Assets - \Delta Cash - \Delta Current Liabilities - \Delta Short-Term Debt - Depreciation Expense)

where:

(\Delta Current Assets) represents the change in current assets.
(\Delta Cash) represents the change in cash and cash equivalents.
(\Delta Current Liabilities) represents the change in current liabilities.
(\Delta Short-Term Debt) represents the change in short-term debt.
(Depreciation Expense) is the depreciation expense.

Next, non-discretionary accruals (NDA) are estimated using a regression model. A common iteration, derived from the Modified Jones Model, considers the change in revenue recognition and gross property, plant, and equipment (PPE). The "adjusted" part comes from modifying the revenue change by subtracting the change in net receivables to account for potential manipulation through credit sales.

The Modified Jones Model for non-discretionary accruals is:

\frac{NDA_t}{A_{t-1}} = \alpha_1 \left(\frac{1}{A_{t-1}}\right) + \alpha_2 \left(\frac{\Delta REV_t - \Delta REC_t}{A_{t-1}}\right) + \alpha_3 \left(\frac{PPE_t}{A_{t-1}}\right)

Where:

(NDA_t) = Non-discretionary accruals in period t
(A_{t-1}) = Total assets at the end of period t-1
(\Delta REV_t) = Change in revenue in period t from period t-1
(\Delta REC_t) = Change in net receivables in period t from period t-1
(PPE_t) = Gross property, plant, and equipment in period t
(\alpha_1, \alpha_2, \alpha_3) = Coefficients estimated from cross-sectional or time-series regressions.

Adjusted Median Accrual then takes these steps further by comparing a company's actual accruals to the median non-discretionary accruals of a similar industry group, controlling for performance or other factors. The deviation from this median is the Adjusted Median Accrual. The coefficients (\alpha_1, \alpha_2, \alpha_3) are typically derived from industry-specific or peer-group regressions rather than firm-specific time-series regressions.

Interpreting the Adjusted Median Accrual

Interpreting the Adjusted Median Accrual involves assessing the magnitude and direction of the discretionary component of a company's accrual accounting. A positive Adjusted Median Accrual suggests that a company's reported earnings are higher than what would be expected given its normal operations and industry peers, potentially indicating income-increasing earnings management. Conversely, a negative Adjusted Median Accrual may suggest income-decreasing earnings management, where a company might be "taking a big bath" (recognizing all possible expenses at once) to clear the decks for future periods or to understate current performance for strategic reasons.

Analysts use this metric as part of a broader financial analysis to evaluate the sustainability and quality of reported earnings. A consistently large positive or negative Adjusted Median Accrual, especially when deviating significantly from industry norms, can be a "red flag" for further investigation into a company's accounting policies and practices. It's crucial to consider the economic context; for instance, a rapidly growing company might naturally have higher accruals due to increased sales on credit. However, if such a company's Adjusted Median Accrual is an extreme outlier compared to its fast-growing peers, it warrants closer scrutiny.

Hypothetical Example

Consider two hypothetical companies, TechCo A and TechCo B, both in the software industry, with similar size and growth rates. We want to calculate their Adjusted Median Accrual for the year.

TechCo A Data (Year 1):

Total Assets (end of Year 0): $100 million
Revenue (Year 1): $50 million
Revenue (Year 0): $40 million
Net Receivables (end of Year 1): $15 million
Net Receivables (end of Year 0): $10 million
Gross PPE (Year 1): $30 million
Total Accruals (calculated): $5 million

TechCo B Data (Year 1):

Total Assets (end of Year 0): $120 million
Revenue (Year 1): $60 million
Revenue (Year 0): $48 million
Net Receivables (end of Year 1): $18 million
Net Receivables (end of Year 0): $12 million
Gross PPE (Year 1): $35 million
Total Accruals (calculated): $4 million

Industry Median Coefficients (Hypothetical, derived from similar tech companies):

(\alpha_1 = 0.02)
(\alpha_2 = 0.10)
(\alpha_3 = 0.05)

Step 1: Calculate Non-Discretionary Accruals (NDA) for TechCo A

(\Delta REV_A = 50 - 40 = 10) million
(\Delta REC_A = 15 - 10 = 5) million

\frac{NDA_A}{100} = 0.02 \left(\frac{1}{100}\right) + 0.10 \left(\frac{10 - 5}{100}\right) + 0.05 \left(\frac{30}{100}\right) \\ \frac{NDA_A}{100} = 0.0002 + 0.10 \left(\frac{5}{100}\right) + 0.05 (0.30) \\ \frac{NDA_A}{100} = 0.0002 + 0.005 + 0.015 \\ \frac{NDA_A}{100} = 0.0202 \\ NDA_A = 0.0202 \times 100 = 2.02 \text{ million}

Step 2: Calculate Adjusted Median Accrual for TechCo A

Adjusted Median Accrual for TechCo A = Total Accruals - NDA
Adjusted Median Accrual for TechCo A = $5 million - $2.02 million = $2.98 million

Step 3: Calculate Non-Discretionary Accruals (NDA) for TechCo B

(\Delta REV_B = 60 - 48 = 12) million
(\Delta REC_B = 18 - 12 = 6) million

\frac{NDA_B}{120} = 0.02 \left(\frac{1}{120}\right) + 0.10 \left(\frac{12 - 6}{120}\right) + 0.05 \left(\frac{35}{120}\right) \\ \frac{NDA_B}{120} = 0.000167 + 0.10 \left(\frac{6}{120}\right) + 0.05 (0.2917) \\ \frac{NDA_B}{120} = 0.000167 + 0.005 + 0.014585 \\ \frac{NDA_B}{120} = 0.019752 \\ NDA_B = 0.019752 \times 120 = 2.37 \text{ million}

Step 4: Calculate Adjusted Median Accrual for TechCo B

Adjusted Median Accrual for TechCo B = Total Accruals - NDA
Adjusted Median Accrual for TechCo B = $4 million - $2.37 million = $1.63 million

In this hypothetical example, TechCo A has a higher Adjusted Median Accrual ($2.98 million) compared to TechCo B ($1.63 million), suggesting that TechCo A might be engaging in more income-increasing earnings management relative to its industry peers and normal operations.

Practical Applications

Adjusted Median Accrual is a vital tool in financial analysis, with several practical applications across investing, market analysis, and regulatory oversight. Investors and analysts use it to gauge the quality of a company's reported income statement figures. A low or zero Adjusted Median Accrual, relative to peers, generally suggests higher earnings quality, as it implies less reliance on subjective accounting estimates that could be used for manipulation.

In practice, the Securities and Exchange Commission (SEC) often investigates companies for potential earnings management, particularly when accounting practices deviate significantly from Generally Accepted Accounting Principles (GAAP) or show unusual patterns. For instance, the SEC announced settled charges against Healthcare Services Group, Inc., and its former CFO for accounting and disclosure violations that led to inflated quarterly earnings per share (EPS) that met analyst consensus estimates for multiple quarters. This was part of the SEC's EPS Initiative, which leverages data analytics to identify such practices.² Such enforcement actions highlight the regulatory focus on ensuring the integrity of reported earnings. Analysts frequently employ models, including those related to Adjusted Median Accrual, to identify companies that might be at risk of such scrutiny due to aggressive accounting practices.

Furthermore, academics and researchers employ Adjusted Median Accrual models to study the prevalence and impact of earnings management across different industries and economic conditions. This research contributes to a deeper understanding of financial reporting behavior and its implications for market efficiency and investor protection.

Limitations and Criticisms

While Adjusted Median Accrual models are widely used for detecting earnings management, they are not without limitations and have faced considerable academic critique. One primary criticism is that these models are often prone to measurement error, meaning they might misclassify normal, economically driven accruals as discretionary, or vice-versa. This can lead to false positives or false negatives in identifying earnings management. Factors like unique business models, significant economic shocks, or industry-specific nuances can influence a company's accruals in ways that standard models may not fully capture, as discussed in academic literature.

Another concern is that the effectiveness of these models can vary depending on the specific industry, country, and economic environment. What constitutes "normal" accrual behavior in one context may be different in another. Some academic research on discretionary accruals suggests that the models might have low power in certain scenarios, struggling to reliably detect actual instances of manipulation. Additionally, the models rely on financial statement data, which is itself the output of the accounting process and thus susceptible to the very management practices being investigated. This inherent dependency can reduce the reliability of the Adjusted Median Accrual as a definitive measure of earnings manipulation. Investors should, therefore, use the Adjusted Median Accrual as one piece of evidence in a broader due diligence process, combining it with qualitative analysis, an examination of a company's internal controls, and a review of audit reports.

Adjusted Median Accrual vs. Discretionary Accruals

Adjusted Median Accrual is a specific methodology used to quantify discretionary accruals. The term "discretionary accruals" refers to the portion of a company's total accruals that are influenced by management's choices and judgments, rather than being strictly dictated by routine transactions or accounting rules. These are the accruals that management might use to smooth earnings, meet analyst forecasts, or achieve other reporting objectives.

Adjusted Median Accrual is one of several empirical models developed to estimate these discretionary accruals. It refines earlier models, such as the Modified Jones Model, by incorporating an industry-median adjustment. This adjustment attempts to control for common, non-discretionary economic factors that affect all firms in an industry, thereby isolating the firm-specific discretionary component more precisely. Therefore, while discretionary accruals are the concept of accounting choices influencing earnings, Adjusted Median Accrual is a method for measuring that concept, aiming to provide a more accurate estimate by benchmarking against industry norms. Other methods for estimating discretionary accruals also exist, each with its own assumptions and refinements.

FAQs

What is the purpose of calculating Adjusted Median Accrual?

The primary purpose of calculating Adjusted Median Accrual is to identify the non-operating, managerial component of a company's reported earnings. By isolating the portion of accruals that is "adjusted" for normal industry behavior, analysts can assess the extent to which management might be manipulating reported profits, thereby evaluating the quality of earnings.

How does Adjusted Median Accrual differ from total accruals?

Total accruals represent the difference between a company's net income and its cash flow from operations. It includes both non-discretionary accruals (which arise from routine business activities like depreciation and changes in working capital) and discretionary accruals (which result from managerial accounting choices). Adjusted Median Accrual focuses specifically on estimating the discretionary part, after accounting for expected accruals based on industry benchmarks.

Can a high Adjusted Median Accrual always indicate earnings manipulation?

Not always. While a high positive Adjusted Median Accrual can be a strong indicator of income-increasing earnings management, it's essential to consider the context. Rapidly growing companies, for example, might naturally have higher accruals due to increased sales on credit. However, if the Adjusted Median Accrual is significantly out of line with industry peers or historical trends, it warrants further investigation into the company's financial statements and accounting policies.

What role does FASB play in accrual accounting?

The Financial Accounting Standards Board (FASB) establishes the accounting standards (GAAP) that govern how companies prepare their financial statements, including rules related to accrual accounting. FASB Concepts Statement No. 6, "Elements of Financial Statements," for example, defines key elements like assets, liabilities, equity, revenues, and expenses, which form the basis for recognizing and measuring accruals.¹ These standards aim to ensure that financial reporting provides useful and relevant information to investors.