Allowance for uncollectible accounts as a tool for earnings management. Evidence from South Korea

• Date: 03 May 2016
• DOI: https://doi.org/10.1108/IJAIM-06-2015-0040
• Pages: 162-184
• Published date: 03 May 2016
• Author: Hyun-Ah Lee,Won-Wook Choi
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Allowance for uncollectible

accounts as a tool for

earnings management

Evidence from South Korea

Hyun-Ah Lee

School of Business, Gachon University, Gyeonggi-Do, Korea, and

Won-Wook Choi

School of Business, Yonsei University, Seoul, Korea

Abstract

Purpose – This study aims to verify the circumstances under which managing the allowance for

uncollectible accounts is used as a tool of earnings management.

Design/methodology/approach – The authors investigate whether bad debt expense, which is an

income statement counterpart of allowance for uncollectible accounts, is adjusted downward when

pre-managed earnings is slightly above zero earnings, prior year’s earnings or analysts’ forecasts.

Findings – The ndings of this study show that rms manage bad debt expense downward to avoid

losses, sustain the prior year’s earnings and meet or beat analysts’ forecasts. The authors also nd that

the understatement of bad debt expense to meet earnings benchmarks is pronounced for rms with high

tax costs.

Social implications – Standard setters and auditors can gain a better understanding in detail of the

practices and methods of managing earnings via the allowance for uncollectible accounts.

Originality/value – This study is the rst to examine earnings management via the allowance for

uncollectible accounts in non-nancial Korean rms. In addition, the ndings provide the evidence that

rms prefer to use the allowance for uncollectible accounts as a strategic tool to meet benchmarks,

especially when their tax costs are high.

Keywords Earnings management, Allowance for uncollectible accounts, Bad debt expense,

Benchmark, Tax cost

Paper type Research paper

1. Introduction

Reported earnings based on accounting standards are the most popular measure of a

rm’s economic performance widely used by market participants and stakeholders for

making economic decisions. Earnings that fail to meet benchmarks such as loss

avoidance, the previous years’ earnings or analysts’ consensus estimates increase

uncertainty about a rm’s future prospects and may even hurt stock valuation (Graham

et al., 2005). Thus, managers have incentives to manage earnings to meet the

benchmarks even if economic value is sacriced (Gaver et al., 1995;Guidry et al., 1999;

Healy, 1985;Holthausen et al., 1995). Opportunistic earnings management for the

purpose of meeting benchmarks deteriorates the value of information about rms’

actual performance and leads to economic loss for market participants and stakeholders.

Archival and experimental literature in the accounting eld has extensively examined

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

IJAIM

24,2

162

Received 26 June 2015

Accepted 24 August 2015

InternationalJournal of

Accountingand Information

Management

Vol.24 No. 2, 2016

pp.162-184

©Emerald Group Publishing Limited

1834-7649

DOI 10.1108/IJAIM-06-2015-0040

the earnings management behavior, particularly the use of discretionary accruals which

are regarded as a way of facilitating earnings management. However, discretionary

accruals estimated by modied Jones model (Dechow et al., 1995) have considerable

measurement error because the non-discretionary portion of aggregated accruals is

eliminated with limited variables, such as sales, xed assets and account receivable.

Discretionary accruals cannot be used to detect earnings management when

sub-components have been adjusted in opposite directions. For example, the effect of

earning management is balanced out when one sub-component adjusted in the previous

year is reversed downward even though another sub-component is adjusted upward.

Moreover, in Korea, where book-tax conformity is high and aggressive tax shelters are

utilized to a very limited extent, managers are highly likely to attempt to reduce taxable

income by adjusting accruals that are highly correlated with tax reporting

requirements[1]. In this case, aggregate discretionary accruals cannot verify earnings

management if rms adjust accruals with relatively low book-tax conformity upward to

increase reported earnings.

Thus, some studies suggest the effectiveness of an approach, in which single specic

items instead of aggregate discretionary accruals are investigated (McNicholson and

Wilson, 1988;Frank and Rego, 2006;Jackson and Liu, 2010).This approach allows more

precise detection of earnings management and decreases measurement error by

allowing researchers to select variables closely related to the adjusted item and

effectively eliminating non-discretionary portions. Though the single-accrual approach

has the disadvantage that earnings management can be detected only if a specic item

is adjusted, it provides a more profound understanding of earnings management

behavior and can be helpful in establishing a related accounting policy. Thus, the

single-accrual approach is adopted in this study, and incentives for earnings

management and management behavior are investigated with a focus on the allowance

for uncollectible accounts.

According to the Korean Generally Accepted Accounting Principles (referred to as

“K-GAAP” hereafter), the allowance for uncollectible accounts should be recognized

based on a reasonable and objective assessment when collectability of credit sales is

uncertain. Its income statement counterpart, bad debt expense, is determined by the

estimation of the allowance for uncollectible accounts and impacts reported earnings.

However, reasonable and objective assessment is not clearly stated in the guidelines. In

practice, rms generally estimate the allowance for uncollectible accounts by

conducting a traditional analysis based on the historical bad debt ratio or evaluating

collectability of specic receivables. Substantial managerial discretion may be used in

the calculation of the historical bad debt ratio and evaluation of the collectability of

receivables. Thus, the allowance for uncollectible accounts may be a very useful tool for

the detection of earnings management.

A recent press release of the Financial Supervisory Service shows that the

understatement of the allowance for uncollectible accounts was the most frequently

detected form of earnings management among all accounting standards violations for

the three years from 2010 to 2012[2]. The understatement of this allowance is

accomplished by the manipulation of the age of receivables and classication of

defaulted accounts receivable as normal receivables. The fact that the understatement of

allowance was the mostly frequently detected violation suggests that rms are highly

163

Allowance for

uncollectible

accounts