Fundamenal Analyss of Recevables and Bad Deb Reserves Mchael Calegar Assocae Professor Deparmen of Accounng Sana Clara Unversy e-mal: mcalegar@scu.edu February 21 2005
Fundamenal Analyss of Recevables and Bad Deb Reserves ABSTRACT Ths paper (1) denfes facors ha nfluence changes n accouns recevable and bad deb reserves and (2) measures he relaon beween unexpeced changes n he rao of oal accouns recevable-o-sales and he rao of bad deb reserves-o-sales and (3) esmaes he relaon beween changes n he accouns recevable-o-sales rao and he bad deb reserve-o-recevables rao and changes n fuure earnngs. The resuls show ha exreme changes n boh raos are sgnals of declnng fuure performance when he frm s currenly profable and are sgnals of beer fuure performance when he frm s currenly unprofable. Relavely large changes n hese raos sgnfy changes n a company s recevable cred polcy whch n urn sgnal changes n a company s economc oulook. These fndngs are mporan because prevous sudes examnng he mpac of curren unexpeced changes n accouns recevable or bad deb reserves on fuure earnngs and sock reurns somemes repor conradcory or nconssen resuls. Daa Avalably: Publcly avalable. 2
Fundamenal Analyss of Recevables and Bad Debs 1. Inroducon Ths paper denfes and ess several fnancal arbues ha are assocaed wh changes n recevables and bad deb reserves and examnes he mpac of changes n recevables and bad deb reserves on fuure earnngs. My objecve s o beer undersand he exen o whch changes n hese balance shee accouns sgnal changes n fuure fnancal performance. Snce Ohlson [1995] demonsraes ha curren book value earnngs forecass and expeced capal coss consue suffcen daa o deermne nrnsc frm value an nvesgaon of he relaon beween fundamenal sgnals and fuure earnngs s a drec es of he relaon beween hese sgnals and secury prces. Ths approach o fundamenal analyss follows Penman [1992] and Abarbanell and Bushee [1997] who advocae ess ha lnk fundamenal sgnals o fuure earnngs changes. Modern accounng research n fundamenal analyss begns wh Ou [1984 1990] and Ou and Penman [1989] who use sascal approaches o denfy nonearnngs accounng numbers ha are assocaed wh frm values and hen deermne he exen o whch hese nonearnngs varables convey nformaon abou fuure earnngs ha s no refleced n sock prces. Laer sudens use a "dreced search" approach o denfy specfc nonearnngs accounng numbers ha are deermnans of frm values (e.g. Bernard and Noel [1991]; Lev and Thagarajan [1993]; Sober [1993]; Abarbanell and Bushee [1997]; Thomas and Zhang [2002]. In general hese pror sudes model a lnear relaonshp beween changes n balance shee raos and changes n fuure performance. 1 Unlke hese pror sudes however I show ha changes n balance shee raos (lke oal recevables-o-sales and bad deb reserves-o-oal recevables) can sgnal eher good news or bad news dependng on he frm s curren fnancal performance. The regresson models n hs sudy reduce he unexplaned poron of changes n recevables and bad deb reserves and mprove he predcve ably of changes n hese accouns on fuure earnngs. 1 The sole excepon s Sober (1993) who models expeced recevables as a funcon of nvenory and sales. 1
Ths paper makes hree conrbuons o he research leraure on fundamenal accounng analyss. Frs denfes several fnancal facors ha are assocaed wh changes n accouns recevable and bad deb reserves. Modelng he relaonshp beween hese facors and changes n recevables and bad deb reserves should enable analyss o form beer expecaons of changes n hese accouns as compared o models ha relae changes n recevables or bad deb reserves o sngle drvers. Second he resuls show ha unexpeced changes n he rao of oal recevables-o-sales are negavely assocaed wh unexpeced changes n he rao of bad deb reserves-o-oal recevables. Ths fndng s conssen wh companes smulaneously managng her recevables and reserves o acheve desred earnngs oucomes. Las he resuls show ha he relaon beween changes n he accouns recevable-o-sales rao and he bad deb reserve-o-recevables rao and changes n fuure earnngs depends on curren performance and he absolue value of he change. Exreme changes n boh raos are sgnals of declnng fuure performance when he frm s currenly profable and are sgnals of beer fuure performance when he frm s currenly unprofable. Relavely large changes n hese raos sgnfy changes n a company s recevable cred polcy whch n urn sgnal changes n a company s economc oulook. These conrbuons of hs sudy are mporan because secury analyss nvesors and oher users of fnancal saemen nformaon need o base her fundamenal analyss of frm valuaons on sound and relable models. The paper shows ha a conexual analyss of changes n balance shee accruals can lead o beer predcons of fuure performance. Accounng researchers and nvesmen advsors who analyze earnngs qualy hrough her examnaon of dscreonary accruals measured usng he modfed Jones model [Dechow e al. 1995] can also benef from hs sudy by ncorporang my model of unexpeced changes n recevables n her measuremen of dscreonary revenues. 2. Pror Research Analyss ofen ce he recevables-o-sales rao as a key measure n deermnng curren earnngs qualy and sgnalng fuure changes n fnancal performance. Accordng o Palepu e al. [2004] unusual ncreases n he recevables-o-sales rao may sugges ha he company s relaxng s cred polces or 2
arfcally loadng up s dsrbuon channels o record revenues durng he curren perod. If cred polces are relaxed unduly he frm may face recevable wre-offs n subsequen perods as a resul of cusomer defauls. Relavely large changes n recevables may also sugges ha he company s recordng unrealzed recevables as sales. For example Marquand and Wedman [2004] fnd ha unexpeced recevables are sgnfcanly hgher when frms ssue equy and sgnfcanly lower jus before a managemen buyou and Rosner [2003] shows ha unexpeced recevables are sgnfcanly hgher n falng frms pror o bankrupcy. 2 Consequenly many commenaors vew a dsproporonae ncrease n recevables as a sgnal of bad news. Conssen wh hs vew Lev and Thagarajan [1993] fnd ha curren annual excess sock reurns are declnng n unexpeced recevables and Chan e al. [2004] fnd ha fuure annual excess sock reurns are declnng n unexpeced recevables. However oher sudes examnng he mpac of curren unexpeced changes n recevables on fuure earnngs and sock reurns repor conradcory or nconssen resuls. For example Sober [1993] repors ha ha unexpeced changes n recevables are posvely relaed o he nex quarer's earnngs changes (bu no o earnngs changes n subsequen quarers) and Abarbanell and Bushee [1997] fnd ha unexpeced changes n accouns recevable are posvely relaed o fuure annual earnngs changes and unrelaed o fuure sock reurns. Lev and Thagarajan [1993] also repor ha he predced relaon beween unexpeced changes n bad deb reserves and fuure sock reurns s found only durng ceran perods of relavely hgh nflaon. These conradcory resuls sugges ha oher facors may nfluence he assumed relaonshp beween unexpeced recevables and fuure reurns. 2 Mos of hese sudes measure unexpeced recevables n dfferen ways. Lev and Thagarajan [1993] and Abarbanell and Bushee [1997] defne unexpeced recevables by frs calculang expeced recevables and expeced sales as he average recevables and average sales over he pror wo years. Unexpeced recevables s calculaed as he percenage dfference beween acual and expeced recevables dvded by he percenage dfference beween acual and expeced sales. Chan e al. [2004] defne unexpeced recevables as he dfference beween he curren year recevables-o-sales rao and he expeced recevables-o-sales rao whch s calculaed as he rao beween oal recevables for he pas fve years over oal sales over he pas fve years. Marquand and Wedman [2004] base her calculaon of unexpeced recevables on he modfed Jones model as hey frs calculae expeced recevables by mulplyng pror year s recevables by he rao of curren year sales o pror year sales. Unexpeced recevables s deermned by dvdng he dfference beween acual and expeced recevables by oal asses. Rosner [2003] uses hree dfferen measures: change n recevables dvded by asses; percenage change n recevables; and percenage change n recevables dvded by percenage change n sales. Fnally Sober [1993] calculaed unexpeced recevables as he resdual of a regresson model ha regresses he recevables-o-sales rao on he nverse of curren sales pror year s recevables-o-sales rao and he dfference beween he recevables-o-sales rao for he pror quarer o he same quarer of he pror year. 3
The relaon beween unexpeced recevables and fuure earnngs s also affeced by changes n a frm s bad deb reserves because he unexpeced recevables measured n hese sudes are calculaed ne of bad deb reserves. In mos cases however researchers eher gnore he mpac of changes n bad deb reserves on unexpeced recevables or assume ha company sraeges nvolvng bad deb reserves wll complemen sraeges nvolvng recevables. Exsng sudes for he mos par expec managers o make esmaes of bad deb reserves ha faclae sraeges o eher smooh earnngs or mee earnngs or regulaory arges. For example here s a large body of research ha frms n he bankng and nsurance ndusres adjus her loan loss reserves o avod regulaory nervenon. 3 Beaver e al. [2003] fnd ha P&C nsurance companes wh relavely large losses and relavely small earnngs undersae her loan loss reserves whle hose wh relavely large earnngs end o oversae her reserves. In a sudy ha ncludes boh fnancal and nonfnancal frms Teoh e al. [1998] show ha he bad deb reserves of frms plannng o sells shares n an nal publc offerng (IPO) are sgnfcanly lower han mached frms n he IPO year and n he year pror o he IPO. In oher sengs however sudes fal o fnd he predced relaonshp lnear relaonshp beween unexpeced changes n bad deb reserves and conemporaneous earnngs or excess sock reurns. For example Lev and Thgarajan [1993] fal o fnd ha declnng deb reserves sgnal lower sock reurns. In addon McNchols and Wlson [1988] fnd ha bad deb reserves for nonfnancal frms are relavely hgh when curren earnngs are eher exremely large or exremely negave. These resuls sugges ha he relaon beween unexpeced changes n bad deb reserves and changes n fuure earnngs may be more complex han assumed n mos research sudes. 3. Developmen of Hypoheses 3.1 IDENTIFYING FACTORS THAT INFLUENCE CHANGES IN RECEIVABLES AND BAD DEBT RESERVES Accouns recevable s repored on he balance shee a ne realzable value whch s he ne amoun expeced o be receved on collecon. The ne realzable value s deermned by subracng an esmae of 3 See Felds e al. [2001] for a summary of hs leraure. More recen sudes by Beay e al. [2002]; Beaver e al. [2003]; Gaver and Paerson [2004]; and Kanagaranam e al. [2004] reach smlar conclusons n dfferen sengs. 4
uncollecble accouns from he oal amoun due from cusomers. To dfferenae hese accouns from each oher I defne he ne book value of accouns recevable as ne recevables he oal amoun due from cusomers as oal recevables and he esmae of uncollecble accouns as bad deb reserves. For a gven frm n a gven ndusry oal accouns recevable s an ncreasng funcon of sales whle he bad deb reserve s an ncreasng funcon of oal accouns recevable. The relaon beween hese raos s modeled n he followng equaon: NR = AR 1 BD ) (1) ( where AR s he rao of oal recevables-o-oal sales (or oal recevables rao ) a he end of year BD s he rao of bad deb reserves-o-oal recevables (or bad deb rao ) and NR s he rao of ne recevables-o-oal sales (or ne recevables rao ). These hree raos are hereafer ncluded under he umbrella erm recevable raos. Recevable raos are prmarly nfluenced by he frm s ndusry s ndvdual cred polcy and he economc envronmen. An opmal recevable polcy maxmzes ne earnngs (no oal sales) and esablshes a cred sraegy ha allows for a ceran poron of s cred sales o be uncollecble. If s cred polcy s oo gh he frm loses poenal sales and he resulan earnngs. If cred polcy s oo loose uncollecble sales creae ou-of-pocke losses. Cred polcy s reacve because he opmum level of recevables depends on he perceved credworhness of he frm s cusomers. When he ndusry oulook s rosy cred polcy s loosened as frms can expec o collec a hgher percenage of her cred sales. When he ndusry oulook declnes creded polcy s ghened as frms can expec hgher defaul raes among less credworhy cusomers. If company cred polcy s reacve hen here should be a lag beween changes n he economc envronmen and changes n he cred polcy. I s exremely dffcul for cred analyss o predc he peaks and roughs of an economc cycle. Consequenly he ghenng or loosenng of a cred polcy wll probably occur afer a company has experenced verfable sgnals ha economc condons have changed. For example an mprovng economc envronmen may be evdenced by ncreases n purchase orders from 5
cusomers. The resulan loosenng n cred polcy s lkely o be erave n naure. Laer when he economy experences slowng or declnng growh he company s cred polcy wll slowly adjus o he new economc envronmen as decson makers canno be mmedaely ceran ha a peak has occurred. The effec of an mprovng economc envronmen has a slghly dfferen mpac on he bad deb rao. There can be a subsanal lag beween he recordng of company cred sales whch are usually recorded a he me of sale and he fnal adjusmens ha are made o he bad deb reserve whch generally occurs afer he ousandng recevables a he balance shee dae have been analyzed for collecbly. Ths lag beween recordng cred sales and recordng adjusmens o he bad deb reserve creaes a sronger lnk beween changes n he economc envronmen and changes n he bad deb rao because adjusmens o he bad deb reserve can be made wh hndsgh. By conras cred decsons affecng recevables mus be made on he spo. The ably o record adjusmens o he bad deb reserves wh hndsgh resuls n a poenally sronger relaonshp beween changes n he bad deb rao and changes n he busness envronmen and frm acves. Snce cusomers are less lkely o defaul n a favorable economc envronmen changes n he bad deb rao should be a decreasng funcon of changes n cusomer profably and frm performance. Manageral ncenves o ncrease he presen value of her expeced compensaon may cause managers o nerfere wh a frm s opmal cred polcy f he company s n danger of mssng earnngs arges. In hese suaons managers have economc ncenves o emporarly loosen cred polces creang hgher levels of recevables and sales o mee or bea hese arges. Companes ha choose o emporarly boos earnngs may also accomplsh her goal by mnmzng he expense recorded as he provson for bad debs. In urn hs wll reduce he bad deb rao. By conras when frms are meeng her earnngs arges managers are less lkely o engage n sraeges ha shf ncome from fuure years no he curren year. Insead once earnngs arges are me managers may shf ncome from he curren year o he fuure year and may se up addonal bad deb reserves ha could be drawn down n a subsequen perod. Ths analyss of recevable cred polcy leads o four esable predcons concernng he change n he frm s oal recevables rao. Based on hs analyss changes n he oal recevables rao are (1A) 6
posvely relaed o changes n he economc envronmen; (2A) negavely relaed o changes n sales growh; (3A) negavely relaed o changes n curren earnngs and (4A) posvely relaed o ncenves o ncrease earnngs due o mssng earnngs arges. Predcon (1A) s based on he hypohess ha frms wll loosen cred polcy n good mes and ghen cred polcy n bad mes. Predcons (2A) and (3A) are based on he hypohess ha changes n cred polcy wll lag acual changes n he busness envronmen. These predcons are also nfluenced by manageral ncenves o delay recognon of sales f he company s beang s earnngs arges. Predcon (4A) s based on he earnngs managemen hypohess. The above analyss also leads o four esable predcons concernng a frm s bad deb reserve rao. Based on hs analyss changes n he bad deb rao are (1B) negavely relaed o changes n he economc envronmen; (2B) negavely relaed o changes n sales growh; (3B) negavely relaed o changes n curren earnngs and (4B) negavely relaed o ncenves o ncrease earnngs due o mssng earnngs arges. Predcons (1B) (2B) and (3B) are based on he observaon ha defaul of recevables s more lkely o occur n a depressed economc envronmen han n good mes. Predcon (4B) s based on he earnngs managemen hypohess whch suggess ha company execuves wll reduce her reserves o ncrease curren earnngs f he company s n danger of mssng fnancal arges. The relaon beween changes n oal recevables and changes n bad deb reserves s dffcul o predc. On he one hand an ncrease n he oal recevables rao may ndcae ha a company s loosenng s cred polcy whch should resul n a hgher level of bad deb reserves. However as I menoned before ncreasng bad deb reserves wll reduce ncome whch offses a recevable polcy borne from an earnngs managemen sraegy. Moreover a looser cred polcy durng a boomng busness economy may no creae hgher bad deb raos because cusomers are less lkely o defaul n hese crcumsances. As s dffcul o predc ex ane whch of hese facors s sronger I make no predcon concernng hs relaonshp. In addon o hese predcable changes n recevable raos oher se of facors can nroduce abnormal shocks o he relaon beween oal recevables and sales. For example he sraegc decson o begn offerng company cred cards o cusomers could cause he recevable raos o skyrocke n he year of hs decson. In addon companes ha charge hgher neres raes on her recevable balances have 7
economc ncenves o ncrease he oal recevable rao as long as he presen value of he ncome from he ousandng recevables exceed he presen value of he carryng coss. Abnormal shocks can also occur when companes securze loans wh recevables. In ceran crcumsances he srucure of he loan ransacon could perm companes o reduce her recevable balance by he amoun of he loan reducng he oal recevables rao. The unexpeced bankrupcy of a major cusomer could also dramacally change a company s expeced recevable raos. These facors are dffcul o predc and are reaed as random flucuaons n he regresson models descrbed below. 3.2 THE RELATION BETWEEN RECEIVABLE RATIOS AND FUTURE CHANGES IN EARNINGS The above analyss suggess ha changes n a company s cred polces ofen resul from changes n he frm s perceved economc oulook. In parcular he analyss shows ha an ncrease n he oal recevables rao could eher sgnal good news or bad news dependng on he reason for he change. Companes may exend more cred n roser economc condons o oban addonal sales (good news) or loosen cred polces o shf earnngs from he fuure o he curren year (bad news). Symmercally a decrease n he oal recevables rao could eher sgnal good news or bad news. AR raos wll declne when sales growh s ncreasng due o ncreases n cusomer demand (good news) or as companes ghen cred polces n a depressed busness envronmen (bad news). Ths vew conrass sharply wh he wdely perceved vew ha decreases n he ne recevable rao always sgnal good news and ncreases n he ne recevable rao always sgnal bad news. In he absence of changes n he economy or busness prospecs cred polces should reman somewha consan. Hence oher han changes due o sraegc choces (e.g. cred card naon or loan securzaon) a change n he company s recevable raos should sgnal a change n he company s economc oulook. Ths change could ndcae beer economc condons for profable companes worsenng economc condons for unprofable companes or a reversal of forune. In he absence of conrary daa a change n he cred polcy of a profable frm s more lkely o sgnal a reversal of forune nsead of mprovng fuure profs because managers are less lkely o change 8
successful polces han unsuccessful polces. When a polcy s currenly successful company decson makers are more lkely o engage n sasfcng behavor (Smon 1957). Accordng o Smon managers wll rely on soluons ha are ok sasfacory or reasonable raher han opmal because of bounded raonaly. When a polcy s no workng however managers wll change he polcy because hey clearly see he old one s no workng. Hence I predc ha a change n he ne recevables rao he oal recevables rao or bad deb rao s a sgnal of lower fuure earnngs when he frm s currenly profable. The nerpreaon of a change n he recevable raos of an unprofable frm s less clear. In hs case a change n he curren cred polcy could sgnal a reversal of forune nsead of worsenng losses f he change n he polcy s made n response o posve changes n he busness envronmen. However f he frm s currenly sufferng losses s possble ha he manager wll depar from he curren polcy even f appears o be currenly opmal n he hopes ha he change could help he frm. Thus here are wo opposng nerpreaons ha whou addonal evdence s dffcul o assess. 4. Sample The daa used o es he hypoheses developed n he pror secon s prmarly aken from he 2004 Compusa Norh Amerca ndusry annual daabase ncluded n he 2004 Wharon Research Daa Servces daa managemen sysem over he years 1973-2003. The poenal sample ncludes all frms oher han hose n he fnance nsurance and real esae secors (SIC codes 6000-6999) or publc admnsraon (SIC codes 9000-9999) wh a leas hree consecuve years of annual daa usng he same fscal year ends. 4 Addonal hsorcal daa on quarerly curren-dollar gross domesc produc (used o measure changes n he economc envronmen) are aken from he webse of he Bureau of Economc Analyss. Table 1 presens descrpons of all varables used n he analyss and summary sascs for a subse of he varables. All of he varables oher han dummy varables used n he analyss are calculaed as annual 4 Companes ha change fscal year ends durng hs hree year perod are elmnaed from he sample because her raos are no comparable across me. 9
changes n raos. Mos raos are calculaed n a wo sep process. 5 Frs he rao s calculaed a he begnnng and a he end of he accounng perod. Once he rao s calculaed I sor he rao by value and wnsorze he rao values n he exreme one percen for each year n he sample. 6 Second I subrac he rao calculaed a he begnnng of he accounng perod from he rao calculaed a he end of he accounng perod. Afer he change n he rao s calculaed I elmnae he exreme one percen for each year n he sample. I use hs smple process o elmnae oulers (manly due o small denomnaors). In addon o usng frm-based raos o analyze fnancal performance analyss frequenly compare he change n frm raos across me o benchmark raos across me. Ths benchmark rao could be a sngle frm a subse of hgh-qualy compeors or a mean ndusry rao. I s ofen useful o compare frm performance o ndusry performance because busness polces are ofen common among frms n he ndusry and he economc envronmen s smlar for frms n he ndusry. For example f he cusomers of a produc are experencng fnancal dffcules hen all frms n an ndusry ha sell hese producs o hese cusomers probably face he same problem n collecons and sales and many frms wll respond o hs problem n he same way. In hs suaon f a frm s ne recevable rao s hgher han he benchmark frms hs relaon could ndcae ha he frm could have greaer wre-offs n he fuure. In addon s mporan o conrol for he change n ndusry benchmarks when analyzng he change n recevable raos because frm raos may be ncreasng (decreasng) a faser or slower raes han he ndusry. For example s possble ha a frm ha appears o ghenng s cred polcy when compared o s rao n he pror year may n fac be ghenng less han ohers when compared o he change n raos of comparable frms. I conrol for hs effec n he analyss by consrucng varables ha measure he change n he dfference beween he frm recevables rao and he mean ndusry recevables rao. These varables are calculaed afer he recevable raos have been wnsorzed and he exreme raos have been elmnaed. Mean ndusry raos are calculaed for each frm year for each ndusry secor (based on wo-dg SIC codes) usng all avalable frm raos on 5 Two varables he change n sales growh ( SGR) and he change n quarerly gross domesc produc ( GDPGR) are calculaed as dfferences n percenages raher han dfferences n raos because hese varables represen changes n growh raes raher han dfferences n raos. 10
an equal-weghed bass. Mean ndusry oal recevable raos are desgnaed by he erm INR mean ndusry oal recevable raos are desgnaed by he erm IAR and mean ndusry oal recevable raos are desgnaed by he erm IBD. The change n he dfference beween he frm recevable rao and he relaed mean ndusry recevable rao s deermned by frs subracng he ndusry rao from he frm rao and hen subracng he dfference n he raos a he begnnng of he year from he dfference n he raos a he end of he year. 7 Afer he elmnaon procedures are compleed he sample consss of 62832 frm year observaons. 5. Resuls 5.1 DESCRIPTION OF REGRESSION MODELS I examne he effec of varous facors on changes n he oal recevable rao and he bad deb rao n he followng regresson equaons: AR AR = α1 α2 1 α3 α4 3 α5 3 α SGR 5 INV α AROA 6 EPS α GDPGR 7 ε EPS (2) BD BD = β1 β2 1 β3 β4 3 β5 3 β SGR 5 AR β AROA 6 EPS β GDPGR 7 ε EPS (3) where AR s he change n frm 's oal recevables rao for year ; BD s he change n frm 's bad deb rao for year ; INV s he change n he frm s nvenory-o-sales rao; EPS3 s a dummy varable equal o one f he frm s curren earnngs per share s beween zero and hree cens per share; EPS3 s a dummy varable equal o one f EPS3 = 0 and curren year EPS equals or exceeds pror year EPS by hree cens or 6 In some cases (.e. recevable raos) he rao s nonnegave. In hese cases I wnsorze only he op one percen of rao values. 7 I am no happy wh hs varable for several reasons. Frs he frm s recevable rao s ncluded n he ndusry benchmark. Ths can have a bg mpac on frms n small ndusres. Second he ndusry could concevably conss of a sngle frm. Should I only nclude hs varable for ndusres ha have more han XX number of frms? If so wha s XX? Also as you wll see n able 2 hese change n ndusry varables are hghly correlaed wh he change n he recevable rao. I am hnkng of subsung a dfferen varable ha compares he frm s rao o he ndusry rao (nsead of he comparng he change n he frm s rao o he change n he ndusry rao). I could hen creae dummy varables for exremely posve and exremely negave dfferences and somehow consruc neracon varables. When 11
less; SGR s he change n he frm s growh rae n cash colleced from sales; AROA s he frm s curren year adjused reurn on asses; GDPGR s he change n he annual growh of gross domesc produc for he company s fscal year; and ε represens error erms. Lagged varables of each dependen varable are ncluded o conrol for possble mean reverson n hese raos across me and INV s ncluded because changes n sales smulaneously affec nvenory and recevables. EPS3 and EPS3 are ncluded o conrol for he lkelhood ha he curren year s earnngs were managed o eher avod a loss or mee or bea pror year s earnngs. If frms use recevables and bad deb reserves o manage her earnngs hen he coeffcens on hese varables are predced o be posve because frms wh hese characerscs have a greaer probably of managng her accruals o ncrease earnngs (Burgsahler and Dchev 1997). SGR and AROA respecvely measure he effec of changes n curren year sales growh and earnngs performance on AR and BD. To remove he mpac of curren perod changes n AR and AR on frm earnngs AROA s calculaed by removng he poron of sales and cos of goods sold arbuable o changes n he oal recevables rao he changes n bad deb expense due o changes n he bad deb rao and he correspondng ax effec of hese changes on he frm s curren year ne ncome before exraordnary ems. The las varable GDPGR proxes for he change n he economc envronmen. The analyss n secon 3.1 predcs ha he coeffcens on he SGR and AROA varables s wll be negave n boh equaons as frms ha are mprovng sales growh and earnngs wll have lower AR raos and lower BD raos. The coeffcen on GDPGR s predced o be posve n equaon (2) and negave n equaon (3) as frms wll loosen her cred polces (ncreasng recevables) bu reduce her BD raos as economc condons mprove. The relaon beween changes n curren recevables raos and fuure changes n annual earnngs s examned n several ses of cross-seconal regressons. The frs se of sgnalng equaons examnes he you see he resuls hnk abou how you mgh wan o consruc ndusry varables o examne he effec of ndusry raos on he relaonshp. 12
relaon beween changes n he ne recevables rao ( NR ) and changes n nex year s reurn on asses ( ROA 1 ) whou conrollng for ndusry effecs. These regressons ake he followng form: HNR P NR P NR HNR NR NR P ROA P ROA ROA ε δ δ δ δ δ δ δ δ = ) ( ) ( ) ( ) ( 8 7 6 5 4 3 2 1 1 (4) where ROA s he change n frm 's reurn on asses (ROA) for year ; P s a dummy varable equal o one f curren perod ROA > 0; and HNR s a dummy varable equal o one f he NR for frm s n he hghes quarle of NR raos for year. 8 ROA s ncluded n he equaons o conrol for mean reverson n earnngs changes and s predced o have a negave coeffcen. P s ncluded o dfferenae frms ha have posve earnngs n year and HNR s ncluded o denfy frms ha have had sgnfcan ncreases n he ne recevable rao for he year. The neracon erms group frms by profably and he degree of change n her ne recevable raos. Under he reversal of forune heory frms wh ROA > 0 and relavely large unexpeced ncreases n ne recevables wll have lower fuure ROA. Hence he model predcs ha δ 8 < 0; (δ 7 δ 8 ) < 0; and (δ 6 δ 7 δ 7 δ 8 ) < 0; The second se of sgnalng equaons examnes he relaon beween NR and ROA 1 afer conrollng for changes n mean ndusry raos. These regressons ake he followng form: HNR P NR P INR NR P NR HNR NR INR NR NR P ROA P ROA ROA ε γ γ γ γ γ γ γ γ γ γ = ) ( ] ) ( [ ) ( ) ( ) ( ) ( 10 9 8 7 6 5 4 3 2 1 1 (5) where INR s mean ndusry ne recevable rao for frm n year. In hs se of equaons he change n he dfference beween frm and mean ndusry ne recevable rao (NR INR) s expeced o srenghen he negave relaon beween frms wh relavely hgh NR when curren ROA > 0. The hrd se examnes he effec of changes n gross recevables ( AR ) and bad deb reserves ( BD ) on ROA 1. When analyzng recevables s ofen useful o smulaneously analyze bad deb reserves because changes n he reserve affecs he ne recevable rao because pror research has shown ha 8 Insead of ncludng a dummy varable for frms n he hghes quarle I could merely nclude an neracon erm ha squares he change n he recevable raos. Would hs be beer? 13
he perodc recordng of bad deb reserves s hghly subjecve and s ofen deermned sraegcally. The varables n hs se of regressons nclude he same conrol varables and neracon erms ha were ncluded n (4) and (5). In each equaon however I replace he NR-based varables wh hose based on AR and BD raos. Thus he regresson model ncludes wce as many regresson raos as n he pror equaons: ROA 1 = λ λ ROA λ ( AR IAR) 6 λ [ ( AR IAR) 9 λ ( BD IBD) 12 λ [ ( BD IBD) 15 1 2 λ P λ ( AR 3 7 P ] λ ( AR λ ( BD 13 λ ( ROA 10 HAR HBD P ] λ ( BD 4 16 P P ) λ AR P ) λ ( AR 8 HAR ) λ ( BD 14 5 HBD P ) ) λ BD 11 P ) ) ε (6) where HAR (HBD ) s a dummy varables equal o one f he AR ( BD ) for frm s n he hghes quarle of AR ( BD) raos for year and IAR (IBD ) s he mean ndusry oal recevables rao (mean ndusry bad deb reserve rao) for frm n year. 5.2 PEARSON CORRELATION MATRICES Table 2 presens wo panels of Pearson correlaons for he varables used n he analyss. Panel A shows he correlaon marx for varables used o examne he facors ha nfluence annual changes n he recevable raos whle panel B shows he correlaon marx for varables o examne he relaon beween curren changes n recevable raos and fuure changes n earnngs. Boh panels nclude ndependen varables ha are hghly correlaed wh each oher. In panel A he change n he pror year s oal recevable rao ( AR -1 ) s hghly correlaed wh he curren year s change n sales growh ( SGA ). In panel B each of he recevable raos ( NR AR and BD ) are posvely correlaed wh he correspondng change n he dfference beween he frm and he mean ndusry varables ( (NR - INR) (AR - IAR) and (BD - IBD) ) respecvely. 9 Unvarae analyss n panel A shows ha he curren annual change n oal recevables ( AR ) s negavely relaed o concurren annual changes n he bad deb reserve ( BD ) suggesng ha frms appear 9 Noe ha hese correlaons are huge and embarrassng. Ths leads me o beleve ha hese ndusry varables are poorly consruced. 14
o be reducng her bad deb reserve rao as her oal recevables rao ncreases. AR s also posvely correlaed o wh he curren change n he nvenory-o-sales rao ( INV ) whch s unexpeced a frs glance because an ncrease n recevables due o ncreased sales should reduce no ncrease nvenory. However hs relaon could also be caused by a declne n sales growh as slower sales could ncrease boh AR and INV. Ths nerpreaon of he correlaon s suppored by he negave correlaon beween each of hese varables and he change n sales growh ( SGR ). Wh he excepon of he earnngs managemen varables he predced causes of AR and BD are all hghly correlaed wh he expeced sgns. However he earnngs managemen varables (EPS3 and EPS3 ) are only correlaed wh BD suggesng ha managers are more lkely o use bad deb reserves nsead of cred sales o mee earnngs arges. The correlaons n panel B show ha changes n he ne recevable raos and he oal recevable raos are posvely correlaed wh fuure reurns whle changes n he bad deb raos are negavely correlaed wh fuure reurns. 5.3 RESULTS FOR AR and BD REGRESSION MODELS Table 3 presens he regresson esmaes of he annual changes n oal recevable raos ( AR) and changes n bad deb reserve raos ( BD) on a varey of varables ha are predced o cause hese changes. The able shows he resuls of four regressons. The regresson esmaes n he frs wo columns examne facors ha predc changes n AR whle he regressons he columns hree and four examne facors ha predc changes n BD. The resuls n column one are based on equaon (2) whle he resuls n column hree are based on equaon (3). The regressons n columns wo and four nclude addonal erms ha measure he exen o whch he resuls are affeced by wheher he frm s currenly profable. The adjused R 2 for he equaons vary beween 0.0717 and 0.0882. In equaon one he coeffcens on all varables oher han he earnngs managemen varables are sgnfcanly dfferen from zero n he expeced drecon. The coeffcens on EPS3 and EPS3 are posve bu only sgnfcan a he 0.126 and 0.106 levels respecvely. When he neracon erms are added n he column wo regressons he adjused 15
R 2 ncreases by abou 9 percen (from 0.0808 o 0.0882) and he coeffcen on EPS3 becomes sgnfcan a he 0.05 level. In he BD equaons all coeffcens are sgned n he expeced drecon and are sgnfcanly dfferen from zero a he 0.01 level. These resuls are conssen wh he analyss dscussed earler n he paper. 10 5.4 REGRESSION RESULTS THAT MEASURE THE EFFECT OF NR ON NEXT YEAR S ROA Table 4 presens he resuls of he frs se of regressons of fuure ROA performance on changes n he curren year s ne recevable raos and he conrol varables. The able s separaed no wo panels. Panel A shows he regresson resuls and panel B measures he mean change n fuure ROA sgnaled by he mean change n he ne recevable rao for frms grouped n he hghes and lowes quarles of NR over he sample perod. The resuls of hree regressons are presened n he able. The resuls n column one regresses ROA 1 on NR whou regard o he magnude of NR or wheher he frm s currenly profable. The resuls n column wo esmae he dfferenal effec of relavely large ncreases n NR on fuure reurns. Fnally he resuls n column hree examnes wheher effec of NR on fuure reurns s affeced by wheher he frm s currenly profable. In each regresson he coeffcens on he hree conrol varables ( ROA P and ROA P ) are sgnfcanly dfferen from zero a he 0.01 level. The frs column of able 4 shows ha he baselne resul ha NR s negavely relaed o fuure reurns a he 0.10 level. The resuls n he second column show ha he sgnalng effec of NR on fuure reurns s enhanced when he magnude of he change n he NR rao s aken no accoun as he adjused R 2 ncreases by abou 1.6 percen (from 0.0807 o 0.0820). The negave sgn on he ( NR HNR ) varable ndcaes ha relavely large posve changes n he ne recevable rao sgnal lower fuure reurns whle he posve sgn on he NR varable suggess ha relavely large negave changes n he NR also sgnal lower fuure reurns. 10 I also ran regressons afer removng he frms n he lowes quarle of NR based on he assumpon ha he recevables for hese frms are relavely small and would have less mpac on he relaon. The adjused R 2 ncreases n each able by abou 0.005 (e.g. ncrease he adjused R 2 from 8% o 8.5%). I do no dscuss hs analyss n he paper. 16
The resuls n able 3 ndcae ha he curren profably of he frm affecs he sgnalng effec of NR on fuure reurns. As predced he coeffcen on he ( NR HNR P ) varable s negave and sgnfcanly dfferen from zero a he 0.01 level. Moreover coeffcen on he ( NR HNR P ) varable exceeds n absolue value he coeffcen on he ( NR P ) varable whch n urn exceeds n magnude he remanng coeffcens on he NR varables. By comparng he magnudes of he dfferen coeffcens he resuls show ha relavely large changes n he ne recevables rao for profable frms sgnal lower fuure ROA regardless of wheher he change s posve or negave whle relavely large negave changes n NR for loss frms sgnal hgher fuure ROA. Because he sgn of he coeffcen on he ( NR HNR ) varable s no sgnfcanly dfferen from zero a convenonal levels s dffcul o predc he effec of relavely large posve changes n he NR rao for loss frms on fuure ROA. Panel B of able 4 calculaes he mean change n nex year s ROA for four dfferen porfolos of frms. The frs porfolo consss of all profable frms wh ha are ranked n he lowes quarle of NR for he curren year whle he second porfolo ncludes all profable frms n he hghes quarle of NR for he curren year. The oher wo porfolos conss of unprofable frms n he lowes and hghes NR quarles respecvely. The mean changes n fuure ROA are deermned by mulplyng he mean change n he ne recevables rao for each group by he approprae coeffcen(s) from he regresson resuls. The resuls for he frs equaon are economcally nsgnfcan. However he resuls for he second and hrd columns show an ncreasng ably o sgnal sgnfcan changes n ROA 1. In he hrd column he resuls show ha he mean change n ROA 1 when ROA > 0 s -0.75 (-0.73) percenage pons for frms wh relavely large negave (posve) changes n he NR rao whle he mean change n ROA 1 for unprofable frms wh relavely large negave changes n he ne recevables rao s 0.44 percenage pons. These resuls are generally conssen wh he proposon ha exreme changes n ne recevables sgnal bad news when he frm s currenly profable and good news when he frm s currenly unprofable. 5.5 REGRESSION RESULTS THAT MEASURE THE EFFECT OF NR AND (NR INR) ON NEXT YEAR S ROA 17
Table 5 presens he resuls of regressng he change n fuure ROA on changes n he curren year s ne recevable raos changes n dfference beween frm and mean ndusry ne recevable raos and he conrol varables. The regresson resuls n panel A nclude wo specfcaons of equaon (5) wh he resuls n he frs column ncludng only one varable ha measures he change n he dfference beween frm and mean ndusry ne recevable raos (NR INR) whle he resuls n column wo nclude an addonal varable ha neracs (NR INR) wh frms ha are currenly profable. When hese addonal varables are ncluded n he equaon he adjused R 2 ncreases only by abou 0.5 percen (from 0.0820 o 0.0824) and he addonal varables are generally sgnfcan a convenonal levels. The groups of frms formed n panel B o measure he mean change n fuure ROA based on changes n he curren year ne recevables rao are dfferen han n able 4. In able 5 he groups conss of frms who are n he exreme quarles of NR and (NR INR) frms n each year. As addonal facors are used o dfferenae frms he sgnals begn o ake on dfferen characerscs. Once agan profable frms wh relavely large NR experence declnes n nex year s ROA whle loss frms wh relavely large negave NR experence ncreases n nex year s ROA. Whn each subcaegory of profable and unprofable frms however he change n fuure ROA s more negave for frms ha experence relavely large posve NR han hose ha experence relavely large negave changes n ne recevable raos. Ths dfferenal effec whn each subcaegory s conssen wh he analyss n pror sudes. 5.6 REGRESSION RESULTS THAT MEASURE THE EFFECT OF AR AND BD ON NEXT YEAR S ROA Table 6 presens he resuls for hree regresson equaons ha esmae how changes n oal recevables raos and changes n bad deb reserves sgnal changes n fuure ROA. The regresson esmaes n he frs column s based on he hrd regresson n able 4 (whch does no nclude varables ha esmae he dfferences beween frm and mean ndusry raos). The resuls n Panel A show ha subsung AR and BD raos for NR ncreases he adjused R 2 by abou 1.3 percen (from 0.082 o 0.0831). Conssen wh my expecaons relavely large changes n AR and BD s a sgnal 18