A Critical Evaluation of the Jones Models and the Industry Approach for the Estimation of Discretionary Accruals

ABSTRACT We critically examine two important methodological issues related to the estimation of discretionary accruals: the Jones models and the industry approach, both of which are considered the norms in the earnings management studies. We document that the original Jones models are the regression-through-the-origin (RTO) models. The RTO Jones models unduly overstate the significance of PPE and R2, produce inconsistent coefficients and non-zero mean discretionary accruals. If we include the intercept in the models, then they lack power. We show that the RTO Jones models are theoretically flawed while their non-RTO variations are empirically flawed. We also address the issue of using the industry approach as a sole approach for the estimation of discretionary accruals. We document that the CFO approach outperforms the industry approach. Lastly, we document that the prediction error method outperforms the estimation error method in detecting earnings management.