So let's go to the spreadsheet for

Arfabark company where we'll look at an example of how to calculate the model.

We'll again focus on 2009 as a potential year that they might have manipulated.

I pulled in probably way more years of data than I need because we're not gonna

do a time serious model, but at least you need some prior data to look for

time trends.

The first few columns are all the raw data that I need to calculate the model.

The purple columns are the variables that go into the model.

The orangeish columns are the intercept and

coefficient parameters that are estimated from industry year regressions.

That's why they change every year.

And so I will also give you a spreadsheet where you can pull in these parameters for

the industry and a given year.

So then you can use these estimated parameters and

the variables to come up with normal R&D.

Take the total R&D minus the Normal R&D to come up

with the Discretionary R&D and if we look in 2009 there's a small negative.

2010 there's a small positive but these are within the realm of,

sort of, normal, bouncing around and discretionary R&D.

So I think we would conclude from this that there's no evidence of

manipulation using R&D in 2009 or 2010 which is not

a surprise cuz we didn't really expect there to be strong incentives.

So to see if the model works let's do a manipulation.

So in 2009 I drastically cut R&D.

And if we look at the discretionary R&D number it becomes much larger negative.

So it's -0 .019.

Now remember, if you want to manipulate earnings upward with a discretion

expenditure, you need to cut it, right, cut the expense to make earning higher.

So negative discretion RD would be indication

of trying to make earnings go higher.

And notice in the next year we get a big positive.

That's because if you cut R&D in one year, and

then don't manipulate in the next year.

It will automatically swing up to a big positive because the model is based on

this change in R&D.

So it does look like the model picks up a cut in R&D in this case.