Conservatism in Bad Debt Estimation: A Reexamination and Extension

• In Event: Real effects of conservative reporting
  In Paper Session: Real Effects of Cnservative Reporting

Abstract

The allowance for uncollectible accounts and the associated bad debt expense on the income statement are critical accruals for companies with significant receivables. However, research examining the extent to which these accounts are used to manage earnings is limited. We extend this research by examining a more recent time period than prior studies as well as by examining bad debt estimation for a groups of receivables not examined in prior studies, consumer receivables. Consumer receivables differ from trade credit in several key respects, including transaction size, credit risk, and disclosure requirements. We compare firms that extend credit to businesses (trade credit) and firms that extend credit to consumers (consumer credit). We ask: how does the degree of conservatism in the allowance for doubtful accounts differ between trade credit firms and consumer credit firms? We find trade credit firms and consumer credit firms differ significantly. Consistent with prior research, trade credit firms exhibit significant and mostly increasing conservatism in estimating bad debt expense. Trade credit firms create reserves that allow earnings management, even recognizing income increasing bad debt accruals. In contrast, consumer credit firms estimate uncollectible accounts close to write-offs in the subsequent period and show no signs of earnings management. Possible reasons for these differences include greater ability to more accurately estimate bad debt expense for consumer debt due to homogeneity of account groups as well as additional disclosure requirements required for these firms. We suggest additional requirements of consumer credit firms limit their ability to make opportunistic accruals.

Authors

• Frances L Ayres, The University of Oklahoma

• Matthew Alan Cobabe, The University of Oklahoma

• Atul Rai, Wichita State University