Discussion of Evidence of Earnings Management from the Provision for Bad Debts

Abstract

This paper is an empirical study of the provision for bad debts by firms in three industries (publishing, business services, and nondurable wholesalers) selected from Compustat as having especially high (i) accounts receivable to total assets and (ii) bad debts expense to net income. The authors' objective is to model the provision for bad debts in the absence of earnings management and to use the expected provision from that model to test for earnings management. The authors posit two underlying motivations for earnings management, income smoothing and a variant of the prediction developed by Healy [1985] that managers of firms with explicit bonus plans will manage earnings consistent with the incentives engendered by specific plan parameters. The authors argue that the latter prediction can be generalized to firms without explicit bonus plans so that managers of all firms with unusually high or low income have incentives to choose income-decreasing accounting accruals. The authors partition 906 firm-year observations for 106 sample firms into deciles based on deviations from (i) the average ratio of earnings to total assets (labeled ROA) over the sample period and (ii) the firm's prior year ROA.1 They consider firms in the top (bottom) decile as firms with unusually high (low) earnings, and their statistical tests compare observations in deciles 1 and 10 to those in deciles 2-9. Both hypothesized motivations for earnings management imply an income-decreasing measure of earnings discretion in the top decile, assuming that sample firms' managerial compensation plans have formal or implicit upper bounds, as

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