Earnings Management in the Context of Fair Value Accounting: Adjusting the Modified Jones Model to Fair Value Accounting

Since the late 1980s, the Financial Accounting Standards Board has implemented several new fair value accounting rules that have resulted in unrealized fair value gains or losses in net income. However, accrual-based earnings management models such as the Modified Jones Model (MJM) of Dechow, Sloan, and Sweeney (1995) and other accrual models in the literature do not consider the net income effects of fair value accounting. The fair value hierarchy of Statement of Financial Accounting Standard No. 157 implies that valuation of level 1 and level 2 instruments is subject to observable market inputs, whereas the valuation inputs of level 3 are unobservable. Therefore, with respect to earnings management, level 3 instruments are more likely to be manipulated relative to level 1 and level 2 instruments. In this paper, we adjust the MJM by adding level 1 and level 2 instruments as explanatory variables to nondiscretionary accruals; we classify net income effects of level 3 instruments as discretionary accruals in our Fair Value Adjusted Modified Jones Model (FVAMJM). We show that the FVAMJM is more powerful than the MJM in detecting earnings manipulation based on level 3 instruments and is equally good in detecting expense and revenue manipulations. In addition, the nondiscretionary accruals derived under FVAMJM have incremental explanatory power to firm market value beyond the accruals of the traditional MJM; the discretionary accruals derived under FVAMJM contribute to identifying companies meeting or beating earnings targets after controlling for MJM discretionary accruals.