Journal of Accounting Research

Vol. 26 Supplement 1988

Printedin U.S.A.

Discussion of
Evidence of Earnings Management from the
Provision for Bad Debts
LINDA DeANGELO*

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 (/) 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.^ 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
* University of Michigan.
' Strictly speaking, these variables are not return on assets measures because interest on
deht is not added back to net income.
32
Copyrightfc),Institute of Professional Accounting 1989

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33

discussed in Healy [1985]. For the bottom decile, income smoothing

implies an income-increasing discretionary measure and the current
variant of the bonus plan hj'pothesis, an income-decreasing one.
The paper's proxy for managerial accounting discretion is the residual
provision for bad debts (resprov). The authors model the expected
provision for bad debts as a linear function of the beginning balance in
the allowance for bad debts and the magnitude of current and next year's
write-offs. This approach treats the beginning balance in the allowance
account and all write-offs as exogenous. By controlling for these factors,
the authors argue, their model purges the nondiscretionary component
of bad debts expense; i.e., the model yields a residual bad debts provision
that primarily reflects managerial accounting discretion.
Tbe paper's results for the resprov variable are generally inconsistent
with income smoothing, and consistent with the authors* variant of
Healy's bonus plan hypothesis. Specifically, the authors observe incomedecreasing resprov for the two extreme deciles under both ROA partitions,
and the median of these observations generally differs significantly from
the median for deciles 2-9. When the sample is partitioned into deciles
based on the ratio of cash flows from operations (not the deviation of
operating cash flows from their expected value) to total assets, the median
resprov for the extreme deciles does not differ significantly from the
median resprov for deciles 2-9.
Results are mixed when the authors apply this general approach to
total accruals, the primary measure of managerial accounting discretion
employed by Healy. For the change in ROA partition, total accruals are
insignificantly different from zero in the lowest decile and significantly
income-decreasing in the highest one. For the deviation from the mean
ROA partition, total accruals are significantly income-decreasing in the
lowest decile and significantly income-increasing in the highest one. For
the cash flows from operations partition, total accruals are significantly
income-increasing in the lowest decile, and significantly income-decreasing in the highest decile.
The authors interpret their findings on the residual bad debt provision
as inconsistent with income smoothing, and consistent with the hypothesis that "firms manage their earnings by choosing income-decreasing
accruals when income is extreme." They interpret their findings on total
accruals as indicating that "the behavior of discretionary accrual proxies
used in prior studies is more consistent with economic conditions than
earnings management." In otber words, they suggest that Healy's [1985]
results that managers' accounting choices refiect the incentives engendered by earnings-based bonus plans may have been induced by his use
of cash from operations to classify firms as having premanipulation
earnings above the upper bound, and earnings to classify firms as having
premanipulation earnings below the lower bound.
Tbe discussion at the conference largely centered on the difficulties/
limitations of the current paper's (i) operationalization of the bonus plan

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MANAGEMENT'S ABILITY TO AFFECT

ACCRUALS: 1988

hypothesis, {ii} model of the expected provision for bad debts, and {Hi)
means of partitioning the data into subsamples in which earnings management was and was not expected to occur.

Operationalization of the Bonus Plan Hypothesis

Conference participants expressed the concern that, because the paper's research design does not incorporate firm-specific details of bonus
plan parameters, readers have little basis for assessing differences between the current paper's results and those in Healy [1985]. Healy's
empirical analysis incorporates the details of bonus plan parameters into
the partitioning scheme, allowing him to adopt more (although not
perfectly) precise partitions for his sample observations. The current
paper partitions on the basis of extreme deciles of unexpected ROA and
cash from operations. Because of these differences in partitioning
schemes, one cannot attribute differences in results solely to differences
in the proxy variable for income discretion employed in the two studies.
Some participants expressed concern that the paper's failure to incorporate the details of bonus plans into its research design is particularly
problematic because a material number of managerial compensation
plans do not have upper bounds. For example, Healy reports that only
29% of his sample (447 of 1,527 firm-years) are subject to an upper bound
constraint (Healy [1985, table 1]). For firms without an upper bound,
the current empirical formulation of the bonus plan hypothesis is misspecified, since managers have incentives to take income-increasing (not
income-decreasing) accounting choices in the upper income region.^ Such
misspecification may also potentially explain some of the differences
between the current paper's results and those in Healy [1985].
In sum, because the current tests do not incorporate the details of
bonus plan parameters, there is unresolved ambiguity about why the
current results differ from Healy's. While the authors claim the difference
is due to their superior proxy for managerial accounting discretion, an
alternative explanation is that Healy's study incorporates economically
relevant details of bonus plan parameters that the current study does
not. Some conference participants felt that these issues could be resolved
if the current paper were to incorporate firm-specific bonus plan parameters into its partitioning scheme.

One Variable Versus a Portfolio Approach

The authors argue that prior studies of earnings management employ
an accrual methodology that may not be capable of separating accounting
choice variables from accounting parameters. As a result, studies that
~ One can of course argue that there are informal limits on managerial compensation,
but it is unclear why the relevant limiting variable should be accounting earnings and not,
for example, the firm's stock price performance.

EVIDENCE OF EARNINGS MANAGEMENT

35

claim to have documented earnings management may in reality not have

done so, while studies that claim to have found no earnings management
may actually have discovered it. The current paper's response to this
well-recognized problem is not to study the portfolio of accounting choices
inherent in the accrual approach but rather to focus on a single accounting choice,' the provision for bad debts by firms with material accounts
receivable and bad debts expense.
The authors recognize that the paper's focus on one accounting choice
is a limitation of their approach, relative to that used in prior studies of
earnings management. In particular, both the income-smoothing and
bonus plan hypotheses are predictions about the joint effect on net income
of a multitude of accounting choices. Neither hypothesis predicts that
every component of earnings will be managed, a prediction that sufficient
empirical analysis would almost certainly refute. Importantly, as a matter
of logic, one could observe no unusual adjustments in bad debts expense
(and thereby conclude that the earnings have not been managed) when
in reality the manipulation takes place via the interaction of all management's accounting decisions. Conversely, one could observe unusual
adjustments in bad debt expense (and erroneously conclude that earnings
were managed) because other discretionary earnings components were
not incorporated into the research design.
In short, as the authors recognize, the choice of research design for
earnings management tests involves trade-offs among various proxy
measures of earnings discretion. Each of the approaches taken in the
current and prior studies has both advantages and disadvantages, with
no one approach likely to dominate in every research context. The
advantage of a portfolio approach is that predictions about income
management relate to at least the total of all accounting adjustments
(and often to alterations in investment and financing decisions as well).
While a one-variable approach is inferior on this dimension, it offers the
opportunity to develop more detailed models of that variable's predicted
behavior, absent earnings management.

Limitations of the Proxy for Accounting Discretion

The paper examines a readily observable accounting choice: the provision for bad debts for firms in industries with both material accounts
receivable and material bad debts provisions. Because the paper's proxy
for earnings discretion represents a highly visible accounting choice,
outsiders who would be negatively affected by earnings management have
a differential ability to adjust reported accounting numbers to "undo"
that choice (relative to their ability to "undo" the more subtle accounting
choices that comprise total accruals).
' I use the term accounting "choice," while recognizing that the fact that these choicef.
are not entirely discretionary is the central focus of the paper.

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LINDA DeANGELO

Moreover, accounting textbooks commonly describe the provision for

bad debts as determined by a mechanical estimation procedure such as a
fixed percentage of credit sales or receivables of a given age (see, e.g.,
Kieso and Weygandt [1986, pp. 276-78]).^ Widespread use of such
mechanical procedures by managers/auditors could severely constrain
managerial discretion over reported bad debts expense. In fact, the use
of a mechanical formula may well be a response to managerial incentives
to manage earnings, either by managers who wish to signal the limits on
their accounting discretion to outsiders or by independent auditors who
have reputations to protect.
In any case, if bad debts are commonly estimated (and/or their "reasonableness" evaluated by auditors) via a mechanical procedure, the
potential for earnings management via bad debts expense may be quite
low. Along these lines, some conference participants expressed concern
that tbe paper's resprov variable might be economically immaterial.
Specifically, they were not convinced that managers could materially
influence reported earnings by manipulating this variable. Tbese individuals suggested that the authors provide evidence on the materiality of
their discretionary measure by reporting the magnitude of resprov relative
to net income over the sample period. While the authors state that the
median provision for bad debts is 8% of reported income, some participants believed that a more relevant measure of materiality is the ratio of
the residual provision to reported income.

Limitations of the Model

If managers' discretion over the provision for bad debts is quite limited,
their ability to manage earnings via adjustments in uncollectible accounts
receivable would seem to consist largely of judgment about the timing
and magnitude of specific write-offs. These write-offs would, in turn,
affect the bad debts provision when estimated, e.g., as a percentage of
outstanding receivables of a given age. The paper, however, treats current
and next year's write-offs as exogenous, an approach that troubled
conference participants for a number of reasons. First, the authors state
that they could increase the power of their tests by treating write-offs as
discretionary. Some participants thought that, given the paper's objective
of providing more powerful tests of earnings management and the likely
endogeneity of write-offs, tbe authors should refme their model to include
write-offs as a choice variable.
A second problem that participants identified with the current model
is that, because its independent variables are each at least partially
discretionary, the factors the model controls may primarily be discretionary, and not nondiscretionary, factors. It is important to note that we
^ One participant suggested that the authors model the provision for bad debts as a
function of the level of sales and the ending balance in accounts receivable, given that
accounting textbooks describe these methods as common estimation techniques.

EVIDENCE OF EARNINGS MANAGEMENT

37

have no independent means of determining what the current model

doesi.e., whether it increases or decreases the nondiscretionary component of the provision for bad debts. Some participants suggested that
the authors attempt to validate their model on other samples (in which
they did not expect to observe earnings management) and to perform
other diagnostic checks to increase reader confidence that it controls for
nondiscretionary accruals. At a more fundamental level, however, nondiscretionary accruals are not observable, hence we have no valid empirical basis for assessing the current model's ahility to detect earnings
management relative to that of alternative approaches such as total
accruals.
Conference participants also expressed difficulties with the incorporation of future write-offs into the model. These difficulties ranged from
a concern that future write-offs are not known at the time bad debts are
estimated, to concerns about the simultaneity of the provision estimation.
With respect to the latter, some participants argued that, by incorporating write-off data from periods other than the current one, the model in
effect averages out earnings management across (i) years in which
managers have incentives to manipulate earnings and {ii) years in which
they do not. Intuitively, some portion of earnings management attributed
to the current period is simply an offsetting adjustment to managers'
accounting choices in other time periods. If material (and some participants argued it was quite likely to be so if earnings are managed), this
averaging effect reduces the power of the tests.
Other participants expressed concern over potential time-series and
cross-sectional variation in the model's coefficients. With respect to the
former, the authors suggest that a shift in demand for the firm's products
or a change in credit conditions could cause an exogenous shift in the
provision for had debts, absent earnings management. Yet the study does
not incorporate controls for economy-wide factors that might proxy for
such shifts. One participant suggested that the authors could increase
reader confidence that the results were not time-dependent by providing
the time distribution of the earnings observations in the extreme deciles.
With respect to uncontrolled firm-specific factors, several conference
participants suggested that the authors investigate whether firms with
extreme earnings observations experienced contemporaneous events that
might affect managers' ahility or incentives to manage earnings. Prior
research suggests that such events include corporate control events such
as acquisitions, management buyouts, and proxy contests, as well as
union negotiations and trade import hearings. Managers of firms experiencing both {i) one of these events and (ii) unusually high or low
income are likely to react differently from managers of firms simply
experiencing unusually high or low income. One individual suggested
that the authors determine whether a material number of firms with
extreme earnings observations received auditors' consistency exceptions
for changes in their estimation techniques for bad debts expense.

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LINDA DeANGELO

Another participant expressed concern that the paper's model does not
incorporate the incentives of auditors in tbe process through which
reported earnings are determined. Specifically, auditors' conservative
bias suggests that managers have greater discretion to increase the
provision for bad debts than to decrease it, relative to the auditor's
assessment of its unbiased value. Moreover, it seems reasonable to believe
that auditors more closely scrutinize the reported earnings of firms with
unusually low earnings. If so, then managers' ability to effect incomeincreasing accounting adjustments is differentially constrained in the
lower income region. In short, managers' ability to manipulate earnings
is unlikely to be constant across firms witb and without extreme earnings
observations.
Overall, conference participants seemed to agree that these difficulties
with the authors' model of the expected provision for bad debts leave
open the possibility that the paper's results largely reflect contemporaneous economic events ratber than earnings management.

Difficulties with the Paper's Partitioning Scheme

Many conference participants had difficulties with the paper's partitioning scheme. One individual pointed out that the results appear to
depend on the choice of deciles 1 and 10 as extreme earnings observations
and that tbe authors do not provide sensitivity checks on that choice
(e.g., by treating deciles 1 and 2 combined and deciles 9 anri 10 combined
as the extreme observations). He also suggested that resprov should
increase monotonically in deciles 2-9, a prediction that appears inconsistent with the data. Another individual disputed tbe latter claim,
arguing that, under the null hypothesis of no earnings management, the
behavior of resprov should be random in deciles 2-9. At a minimum,
conference participants thought that the authors should more carefully
specify the behavior of resprov they expected to observe in deciles 2-9
and provide sensitivity checks on their choice of deciles 1 and 10 as
extreme earnings portfolios.
One participant pointed out that the paper's two ROA partitions are
based on deviations from an expected income statement variable, while
the cash flow partition is based on tbe level of an income statement
variable. Moreover, resprov is "denominated in the same units" as the
ROA partitions; i.e., it measures tbe deviation from an expected income
statement variable. However, it is denominated in different units from
the cash flow partition, wbicb is based on the level of cash flows and not
the deviation of cash fiows from their expected value. Total accruals, on
tbe other hand, measure tbe level of an income statement variable and
are therefore denominated in the same units as the cash flow partition
but different units from the ROA partitions. The appropriate accrual
measure for the ROA partitions would seem to be unexpected accruals.
The authors should reframe their partitioning variables and discretionary

EVIDENCE OF EARNINGS MANAGEMENT

39

measures to ensure that the units of all measures are consistent and
comparable.
Some of the difficulties with the paper's partitioning scheme are
elaborated in earlier sections of this discussion, e.g., the failure to
incorporate firm-specific details of bonus plan parameters, especially the
presence or absence of an upper bound. Moreover, the failure to control
for firm-specific events that might alter the incentives or ability of
managers to alter reported earnings seems especially problematic for
firms with extreme earnings observations. Conference participants returned throughout the seminar to concerns that firms with extreme
earnings observations differed in unspecified (and uncontrolled) ways
from other sample firms.
In fact, several participants argued that the paper's partitioning scheme
injects a selection bias because, by selecting firms with extreme earnings
observations, it selects companies that are experiencing contemporaneous material structural shifts. For example, it seems reasonable to
expect that firms with extremely low earnings observations are differentially likely to experience a hostile tender offer, proxy challenge, or
change in management. Such events, in turn, seem differentially likely
to result in major corporate restructurings via material asset sales, stock
issuances, stock repurchases, etc. If this selection bias is material, these
participants argued, then the behavior of resprov that the authors attribute to earnings management may primarily result from contemporaneous
events/structural shifts that differentially characterize firms with extreme earnings observations.
On the other hand, as another participant pointed out, these structural
changes are endogenous. Hence both the structural shift and earnings
management can be responses to some underlying shift in an unspecified
parameter. For example, the threat of a hostile takeover might cause
managers both (t) to sell off the division the hostile bidder is seeking
and {ii) to overstate reported earnings. As a result, the problem of
contemporaneous structural change is not a simple one. On the one hand,
absent controls for these changes, the authors might erroneously conclude
that earnings are managed when the observed significant shift in resprov
primarily refiects the structural changes. On the other hand, controls for
these changes may "throw out the baby with the bathwater" to the extent
that both structural changes and earnings management are responses to
the same underlying parameter shift. In short, these are difficult empirical issues for which the researcher's response is by no means obvious.
An analogous point is that a significant correlation between a proxy
variable for earnings discretion and a partitioning variable does not
necessarily indicate that the nondiscretionary component of the proxy
covaries materially with the partitioning variable. Rather, it simply
indicates that the total (of both discretionary and nondiscretionary
components) covaries with the partitioning variable. Such covariability
does not imply that variation in the partitioning variable causes the

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LINDA DeANGELO

variation in the proxy variable. For example, both could vary in response
to firm-specific factors of interest to the researcher. Hence the degree to
which a proxy variable for managerial accounting discretion covaries
with a partitioning variable is not a definitive measure of the "goodness"
of the proxy relation.

Concluding Remarks
Overall, most conference participants seemed to find the paper an
interesting first step in attacking a set of difficult empirical problems.
Clearly, the development of a model of unexpected accruals is an important endeavor, and the current paper represents a step in that direction.
Most participants also seemed to agree that the difficulties with the
current approach limit its usefulness as a replacement for the accrual
approach taken in prior studies. Rather, the current approach is probably
best viewed as a complementary means of testing for earnings management. In short, each approach has advantages and disadvantages, and
the choice of research design necessarily involves trade-offs that may
well be context-specific.
One final point. It is tempting to conclude, after reading the paper and
this discussion, that the research area of earnings management is fraught
with empirical difficulties. In one sense, this is true, largely because
managers with an informational advantage over academic researchers
have incentives to disguise any adjustments they make to reported
income. While researchers potentially can exploit large sample statistics
to observe earnings management that is not readily detectable at the
individual firm level, designing such studies remains problematic. In
another sense, it would be a shame to discourage research that isolates
particular settings in which earnings management is expected, since
these topics are among the most interesting in financial accounting. The
most productive approach would seem to be one that encourages both (i)
direct research on earnings management in specific contexts in which
reported earnings differentially affect the welfare of corporate claimants
and (ii) methodological papers that attempt to improve our means of
detecting such behavior.
REFERENCES
HEALY, P. M. "The Effect of Bonus Schemes on Accounting Decisions." Journal of
Accounting and Economics (April 1985): 85-107.
KIESO, D. E., AND J. J. WEYGANDT. Intermediate Accounting. 5th ed. New York; Wiley,
1986.