Accounting, Organizations and Society xxx (2015) xxx–xxx
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Accounting, Organizations and Society
journal homepage: www.elsevier.com/locate/aos
Disclosure transparency about activity in valuation allowance
and reserve accounts and accruals-based earnings management
Cory A. Cassell a, Linda A. Myers a,⇑, Timothy A. Seidel b
a
University of Arkansas, Fayetteville, AR, United States
b
Utah State University, Logan, UT, United States
a r t i c l e i n f o
Article history:
Available online xxxx
Introduction
Accruals-based earnings management can be costly
because questionable accounting practices are likely to
be scrutinized by external auditors, investors, the board
of directors, regulators, and other stakeholders. Valuation
allowances and reserves provide managers with substan-
tial flexibility to manage earnings because they are based
on subjective estimates and are evaluated at higher levels
of materiality, making them inherently difficult to audit
(Griffith, Hammersley, & Kadous, 2013; Peecher,
Schwartz, & Solomon, 2007; Peecher, Solomon, &
Trotman, 2013). In addition, any differences identified by
the auditor are more likely to be waived when the
⇑ Corresponding author.
http://dx.doi.org/10.1016/j.aos.2015.03.004
0361-3682/Ó 2015 Elsevier Ltd. All rights reserved.
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
a b s t r a c t
We examine the relation between the transparency of disclosures about activity in valua-
tion allowance and reserve accounts and accruals-based earnings management. We clas-
sify disclosures as being transparent if they provide detailed information about activity in
the allowance and reserve accounts during the fiscal period. We find strong evidence that
the extent of accruals-based earnings management is lower among companies with
transparent disclosures than among companies without transparent disclosures. We also
investigate whether the extent of accruals-based earnings management is lower for com-
panies that provide transparent disclosures in one comprehensive schedule (i.e., the
Schedule II) relative to those that provide transparent disclosures spread throughout
the notes to the financial statements. Although regulators have expressed concern that
the omission of a Schedule II could indicate a greater likelihood of earnings management,
our results indicate that it is the omission of transparent disclosures rather than the
omission of a comprehensive schedule outlining activity in the allowance and reserve
accounts that affects earnings management. Our findings suggest that regulators, audi-
tors, and investors should consider subjecting companies that fail to provide transparent
disclosures to additional scrutiny.
Ó 2015 Elsevier Ltd. All rights reserved.
underlying accruals are more subjective (Joe, Wright, &
Wright, 2011; Knapp, 1987; Wright & Wright, 1997).
Thus, prior research suggests that companies are more
likely to attempt to manage reported earnings using these
types of accounts.1
We examine the relation between the transparency of
disclosure related to activity in valuation allowance and
reserve accounts and accruals-based earnings manage-
ment, where disclosures are classified as being transparent
if they provide detailed information about activity in the
accounts during the fiscal period (e.g., information about
1
For example, Nelson, Elliot, and Tarpley (2002) use a field-based
questionnaire in which 253 auditors from one Big 5 audit firm described
515 specific instances in which they believed that their clients were
attempting to manage earnings. The authors indicate that ‘‘by far the most
frequently identified attempts involve reserves’’ (Nelson et al., 2002, 176).
2 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
the current period expense accrual, write-offs, etc. for the
allowance for doubtful accounts).2 The U.S. Securities and
Exchange Commission (SEC) has long required that activity
in subjective accrual accounts be disclosed. Specifically,
within Regulation S-X, which prescribes the format and con-
tent of financial reports filed under the Securities Act of
1933 and the Securities Exchange Act of 1934, Rule 5-04
and Rule 12-09 require that companies file a Schedule II.3
The Schedule II should provide the beginning and ending
balances and the current period activity in all material
valuation allowances and reserves. The SEC exempts compa-
nies in certain industries,4 companies with immaterial bal-
ances in the valuation allowances and reserves, and
companies that provide comparable disclosures in the notes
to the financial statements from the Schedule II require-
ment. Thus, under current SEC regulations, companies are
required to provide transparent disclosures for material
allowance and reserve balances in either a Schedule II or
in the notes to the financial statements.5
Although the SEC requires transparent disclosure for
material allowance and reserve balances, we find that
compliance is lacking. Specifically, when we examine com-
panies where the aggregate prior year balance of the
allowance for doubtful accounts, inventory valuation
allowance, and deferred tax asset valuation allowance is
greater than one cent per share, thus removing companies
that would not be able to increase current year earnings
per share (EPS) by at least one cent even if they were to
fully eliminate these accruals, we find that approximately
30% fail to provide transparent disclosures (either in a
Schedule II or in the notes to the financial statements).6
Although the following statement made by Ronald A.
2
Barth and Schipper (2008) define financial reporting transparency as
the extent to which financial reports reveal an entity’s underlying
economics in a way that is understandable by those using the financial
reports. Bushman, Piotroski, and Smith (2004) define corporate trans-
parency as the widespread availability of firm-specific information about
publicly listed firms to parties outside of the firm. Our definition of
transparency is specific to our setting and relates to just one aspect of
overall reporting transparency, but it is consistent with definitions set forth
in prior research.
3
Schedule II is a supplemental schedule filed with the company’s form
10-K and is typically located after the footnotes to the financial statements.
Laws requiring the use of Schedule II can be traced to 37 FR 14602 (passed
on July 21, 1972) and re-designated and amended in 45 FR 63679 (on
September 25, 1980).
4
Excluded companies include registered investment companies, insur-
ance companies, bank holding companies and banks, and brokers and
dealers.
5
Note that because Rule 5-04 does not provide a definition of
materiality, materiality is left to management’s discretion. In 2000, the
SEC proposed a rule which would have required a disclosure similar to
Schedule II in the notes to the financial statements, rather than as a
supplementary schedule (SEC, 2000). The relocation of this disclosure
would have provided increased prominence and auditor responsibility for
the disclosure. The majority of comments received on the SEC’s proposed
rule opposed the proposal. The SEC did not finalize the proposed rule, so
Rule 5-04 of Regulation S-X remains applicable and materiality thresholds
continue to be subjective.
6
To further support this finding, we use the Audit Analytics SEC
comment letter database to identify SEC comment letters with specific
reference to Schedule II or to the allowances most frequently included in a
Schedule II. Our search resulted in many examples of the SEC requesting
increased disclosure of the activity in allowance and reserve accounts (in
accordance with Rule 5-04 of Regulation S-X).
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
Kima, a former Assistant Chief Accountant for the SEC,
focuses on problems associated with Schedule II compliance,
it captures the potential implications of non-transparent
disclosure in general,7
Unfortunately, despite such schedule being required of
most public companies, few companies seemingly fully
comply. The absence of otherwise required data, or
worse the outright omission of the schedule in its
entirety, should raise investor concerns that a company
may be engaging in some degree of inappropriate earn-
ings management. . . Any immateriality assertion by a
company’s management that has been predicated
exclusively on balance sheet measures is, at best, inap-
propriate and, at worst, an attempt to conceal inappro-
priate earnings management practices.
Consistent with claims in Kima (2007), we expect that
companies will use allowances and reserves to manage
earnings if the probability of detection is sufficiently low
and if the combined magnitude of these accrual accounts
is sufficiently large (so that their manipulation can have
a meaningful effect on reported earnings). With respect
to the first condition, we posit that non-transparent disclo-
sures about highly subjective accrual accounts provide
managers with flexibility to influence the market’s percep-
tions of earnings. Because market participants face lim-
itations when processing accounting information
(Hirshleifer & Teoh, 2003), they may be less likely to see
through the earnings management when companies dis-
close allowance and reserve accounts non-transparently.
Although prior research does not investigate the associa-
tion between accruals-based earnings management and
the transparency of accruals disclosures, evidence suggests
that managers use the flexibility in disclosure rules to
engage in real earnings management (Hunton, Libby, &
Mazza, 2006; Lee, Petroni, & Shen, 2006) and that transpar-
ent disclosures facilitate investors’ ability to detect earn-
ings management (Hirst & Hopkins, 1998).
Because disclosures of allowances and reserves must be
hand collected, we focus our analyses on the three
accounts most commonly included in a Schedule II – the
allowance for doubtful accounts, the valuation allowance
for deferred tax assets, and the valuation allowance for
inventories.8 We hand collect disclosures for all companies
in non-exempt industries that include at least one of the
three allowance and reserve balances in a Schedule II, in
the notes to the financial statements, or parenthetically in
the balance sheet in their 2008, 2009, or 2010 annual
reports.
We first investigate whether disclosure transparency
for a given allowance or reserve account affects discretion
in that account. Following Marquardt and Wiedman
(2004), we estimate the expected balance in each account
7
See SEC Schedule II – Visibility into the integrity of reported results.
AICPA CPA Insider Newsletter (October 1, 2007). Retrieved from http://www.
cpa2biz.com/Content/media/newsletters/cpainsider/cpainsider071001.jsp.
8
In addition to being the accounts most commonly included in Schedule
II disclosures, these accounts have also been the focus of prior research
examining earnings management in specific accounts. See, for example,
McNichols and Wilson (1988), Schrand and Wong (2003), Frank and Rego
(2006), and Cecchini, Jackson, and Liu (2012).
 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
by multiplying the prior year balance by the current year
growth rate. To further refine this measure for the allow-
ance for doubtful accounts, we also multiply by the growth
in days sales outstanding (to capture the change in col-
lectability). Similarly, for the inventory valuation allow-
ance, we multiply by the growth in days inventory
outstanding (to capture the change in inventory turnover).
Our measure of the discretion in each allowance and
reserve account is the difference between the actual
account balance and the expected balance. For each
account examined, we limit the sample to companies
where the disclosed beginning balance is at least one cent
per share. We contrast discretion in the individual allow-
ance or reserve account for companies that provide trans-
parent disclosure (either in a Schedule II or in the notes to
the financial statements) with that for companies that pro-
vide non-transparent disclosure. We find that discretion in
the each of the three accounts, the allowance for doubtful
accounts, the valuation allowance for inventories, and the
valuation allowance for deferred tax assets is greater (i.e.,
more income-increasing) when these accounts are dis-
closed non-transparently.
Although we focus on the three allowance accounts
most commonly included in a Schedule II (and not on all
valuation and qualifying accounts that could be included
in the schedule), we supplement our primary tests by
examining broad measures of earnings management. In
these tests, we contrast overall discretion in accruals for
companies that provide transparent disclosures for all
material (disclosed) allowance and reserve balances (either
in a Schedule II or in the notes to the financial statements)
with that for companies that provide non-transparent dis-
closures for all disclosed allowance and reserve balances.
We find that companies that provide transparent disclo-
sures report smaller signed, absolute value, and positive
(income-increasing) discretionary accruals than do compa-
nies that provide non-transparent disclosures.
Having established a negative association between dis-
closure transparency and the extent of earnings manage-
ment in subjective accrual accounts, we next investigate
whether the placement of transparent disclosures matters.
As evidenced by the rules surrounding Schedule II and by
subsequent (defeated) regulatory proposals which would
have required that a Schedule II be included in the notes
to the financial statements, regulators appear to believe
that the transparent disclosure of all accrual accounts in
a single schedule will facilitate and enhance investors’ abil-
ity to process the information relative to comparable, but
separate, disclosure in the notes. These beliefs are consis-
tent with context theory (Medin & Schaffer, 1978), which
suggests that the presentation of an isolated piece of infor-
mation can lead to different interpretations relative to
when this information is combined with other information.
These beliefs are also consistent with the proximity com-
patibility principle (Carswell & Wickens, 1996; Wickens
& Carswell, 1995), which suggests that information pro-
cessing can be enhanced when the information is dis-
played in close proximity, and with cognitive load theory
(Sweller, 1988, 1989), which suggests that individuals will
be unable or unwilling to exert the cognitive effort neces-
sary to integrate information presented separately
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
3
(Dietrich, Kachelmeier, Kleinmuntz, & Linsmeier, 2001;
Krische, 2005).9 Thus, we expect that the transparent disclo-
sure of allowance and reserve accounts in a single schedule
(i.e., in a Schedule II) will aid users’ understanding of the
(collective) information about activity in allowance and
reserve accounts, which should facilitate the detection of
earnings management in these accounts. Because managers
have little incentive to manage earnings if their actions will
be detected, we expect less earnings management among
companies that provide a Schedule II.
For tests using the estimated discretion in individual
allowance and reserve accounts, we limit our samples to
companies that provide transparent disclosures for the
given account (either in a Schedule II or in the notes to
the financial statements) and have a prior year account
balance greater than one cent per share. For tests using
the broad accruals measures, we limit our sample to com-
panies that provide transparent disclosures for all dis-
closed allowance and reserve accounts where the
aggregate prior year balance of these accounts exceeds
one cent per share. We find no significant difference in
the estimated discretion (either in individual accounts or
in the broad accruals measure) between companies that
provide a Schedule II and companies that provide transpar-
ent disclosures in the notes to the financial statements. Our
inability to find support for this prediction could be due to
a lack of task complexity, the effect of a different (and com-
peting) aspect of context being important in our setting, or
a lack of power in our tests. We discuss these possibilities
in Section ‘Results summary’.
We expect our study to be of interest to standard setters
and financial statement users as they consider proposals
put forth in the International Accounting Standard Board
(IASB) and the Financial Accounting Standards Board
(FASB) joint project related to financial statement pre-
sentation. One such proposal would require note disclosure
of detailed activity in balance sheet accounts to facilitate
user understanding of the current period change in position
(FASB, 2010). Our results suggest that the proposed
requirement could be beneficial because we document a
negative association between the transparency of disclo-
sure and earnings management. Our study should also be
of interest to regulators, auditors, and investors because
our findings suggest that the disclosure transparency of
subjective accounts could be used as a mechanism to iden-
tify companies that may warrant additional scrutiny.
We also provide empirical evidence that addresses con-
cerns expressed by former SEC Assistant Chief Accountant
Ronald A. Kima, who suggests that the omission of a
Schedule II could indicate a greater likelihood of earnings
management. We find evidence that the omission of trans-
parent disclosure, and not necessarily the omission of a
Schedule II, affects earnings management.
The remainder of this paper is organized as follows: the
next section provides a review of related prior literature
9
Several experimental studies provide evidence that the placement of
equivalent information affects investor and analyst judgments. See, for
example, Hopkins (1996), Hirst and Hopkins (1998), Maines and McDaniel
(2000), and Hodge, Hopkins, and Wood (2010). Also see Libby and Emett
(2014) for a broad overview of the literature related to placement effects.
4 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
and develops our hypotheses. The third section describes
our empirical design. We discuss the sample and present
results from our analyses in the fourth section. The final
section provides our conclusions.
Prior literature and development of hypotheses
Greater information asymmetry can provide companies
greater flexibility to manage earnings (Schipper, 1989). For
example, Richardson (2000) finds that increased informa-
tion asymmetry, measured by the bid-ask spread and ana-
lyst forecast dispersion, is associated with higher levels of
discretionary accruals. In addition, Hunton et al. (2006)
argue that lobbying efforts by managers to persuade stan-
dard setters to allow less transparent disclosure about
components of comprehensive income provides indirect
evidence that managers value the flexibility provided by
less transparent disclosures to manage earnings. Hodder
and Hopkins (2014) provide similar evidence; they find
that bank managers’ demand for reporting opacity lead
them to oppose accounting rules that would increase dis-
closures about financial instruments.
Some studies examine the relation between the trans-
parency of specific disclosures and earnings management
(Hirst & Hopkins, 1998; Hunton et al., 2006; Lee et al.,
2006). These studies, however, focus exclusively on the
relation between the transparency of comprehensive
income disclosures and ‘‘real’’ earnings management deci-
sions (i.e., the opportunistic selling of available-for-sale
securities) as well as the market’s ability to detect this real
earnings management. Hunton et al. (2006) provide
experimental evidence suggesting that managers are more
likely to avoid missing consensus analyst forecasts by
increasing current income through the sale of available-
for-sale securities when the presentation of comprehen-
sive income is less transparent. In addition, increasing cur-
rent income through the sale of available-for-sale
securities is less likely when the presentation of compre-
hensive income is more transparent or when pre-managed
earnings exceed consensus analyst forecasts. Similarly,
using archival data, Lee et al. (2006) find that property-lia-
bility insurers with a history of selectively selling avail-
able-for-sale securities chose the less transparent format
for disclosing comprehensive income in the first year of
Statement of Financial Accounting Standards No. 130’s
adoption. With respect to the detection of earnings man-
agement, Hirst and Hopkins (1998) find experimental evi-
dence that transparent comprehensive income disclosures
enable buy-side financial analysts to detect opportunistic
selling of available-for-sale securities and that they adjust
their target prices accordingly. Collectively, this stream of
research suggests that increased disclosure transparency
about certain accounts or transactions will reduce the like-
lihood that earnings are managed using real earnings man-
agement because increased transparency facilitates the
detection of earnings management by market participants.
Lobo and Zhou (2001) and Shaw (2003) examine the
relation between disclosure quality and accruals-based
earnings management but they use a measure of overall
disclosure quality rather than a measure of the trans-
parency of disclosures for specific accruals that may be
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
used to manage earnings. Specifically, they measure disclo-
sure quality using the Association for Investment
Management Research (AIMR) scores. These scores are
based on industry-specific analyst evaluations of overall
disclosure quality and analysts consider annual and quar-
terly SEC filings, along with other published information.
Both Lobo and Zhou (2001) and Shaw (2003) find a nega-
tive association between AIMR scores and discretionary
accruals, suggesting that companies with higher overall
disclosure quality report lower discretionary accruals.
However, Shaw (2003) finds that this conservatism is lim-
ited to years with good news (i.e., positive stock returns or
cash flows from operations). In years with bad news, com-
panies with higher AIMR scores report higher levels of
income-increasing discretionary accruals. Thus, Shaw’s
findings suggest that companies with higher overall disclo-
sure scores smooth earnings more aggressively than do
companies with lower overall disclosure scores.
We extend prior research by investigating whether the
disclosure transparency about specific accruals is associ-
ated with accruals-based earnings management. While
prior research provides evidence that real earnings man-
agement is lower in the presence of more transparent com-
prehensive income disclosures, prior research does not
provide evidence about accruals-based earnings manage-
ment in the presence of more transparent disclosure of
subjective accrual accounts. Additionally, regulators have
expressed concern that a lack of transparency in these
accounts could be related to earnings management.10
Because subjective accruals are evaluated at higher
levels of materiality (FASB, 1980) and any audit adjust-
ments proposed to these accruals are more likely to be
waived (Joe et al., 2011; Knapp, 1987; Wright & Wright,
1997), auditors may not be effective at identifying and con-
straining earnings management in these accounts if disclo-
sures about the activity in these accounts are not
transparent.11 Because greater transparency about these
accounts could aid in the detection of accruals-based earn-
ings management, we expect companies that provide trans-
parent disclosures about activity in accrual accounts to
engage in less earnings management through these
accounts. Our first hypothesis, stated in the alternative form,
is as follows:
Hypothesis 1. The extent of accruals-based earnings man-
agement will be lower for companies that provide trans-
parent disclosures about activity in accrual accounts.
10
For example, Kima (2007) states, [g]iven their inherent uncertainty,
contra-asset accounts and liability reserves typically constitute the soft
underbelly of any set of consolidated financial statements. Thus, contra
asset accounts and liability reserves pose the greatest accounting chal-
lenges to ethical managements as they attempt to derive the best possible
estimates. Unfortunately, ethically-challenged managements often exploit
the softness of contra-asset accounts and liability reserves to engage in
inappropriate earnings management, i.e., tucking away earnings for a rainy
day.
11
Alternatively, increased disclosure transparency may not affect
accruals-based earnings management behavior because auditors have
visibility into these accounts regardless of the level of disclosure trans-
parency and auditors have incentives to constrain accruals-based earnings
management in order to adhere to SEC guidelines and auditing standards
(PCAOB, 2003, 2010; SEC, 1999).
 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
We also expect that earnings management may differ
when companies provide a Schedule II versus when com-
panies provide similar information about the activity in
subjective accruals elsewhere in the notes to the financial
statements. That is, there may be differences in earnings
management behavior within the set of companies that
provide transparent disclosures about activity in allowance
and reserve accounts.
Medin and Schaffer (1978) introduce context theory,
which suggests that the presentation of an isolated piece
of information can lead to different interpretations relative
to when this information is combined with other informa-
tion. In addition, the proximity compatibility principle
(Carswell & Wickens, 1996; Wickens & Carswell, 1995)
coupled with cognitive load theory (Sweller, 1988, 1989)
suggest that information processing can be enhanced
when the information is displayed in close proximity.
Consistent with these theories, experimental research pro-
vides evidence that disclosure format and placement
affects investors’ ability to process information and/or
detect earnings management (Hirst & Hopkins, 1998;
Hodge et al., 2010; Krische, 2005; Maines & McDaniel,
2000). For example, Hirst and Hopkins (1998) show that
professional investors and analysts often overlook infor-
mation about unrealized gains and losses on marketable
securities when this information is presented in a state-
ment of stockholders’ equity rather than in a statement
of comprehensive income, and Maines and McDaniel
(2000) find a similar effect among nonprofessional inves-
tors. Krische (2005) finds that investors adjust their
evaluations of current period earnings to a greater extent
when transparent disclosures about prior period transitory
gains and losses are repeated in the current year versus
when they are made only in the prior year. Finally,
Hodge et al. (2010) find that the proximity of financial
information improves nonprofessional investors’ ability
to process such information, where improved information
processing is reflected in more accurate cash flow
forecasts.
This prior evidence suggests that the transparent disclo-
sure of allowance and reserve accounts in a single schedule
(i.e., in a Schedule II) will aid users’ understanding of the
(collective) information about activity in allowance and
reserve accounts, which should facilitate the detection of
earnings management in these accounts. Because man-
agers have little incentive to manage earnings if their
actions will be detected, we would expect less earnings
management among companies that provide a Schedule
II. Our second hypothesis, stated in the alternative form,
is as follows:
Hypothesis 2. The extent of accruals-based earnings man-
agement will be lower for companies that provide a
Schedule II than for companies that provide comparable
information in the notes to the financial statements.
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
5
Empirical design
Self-selection bias
We model the decision to disclose allowances and
reserves transparently using variables that should influ-
ence the quality of voluntary disclosure. Because Lang
and Lundholm (1993) find that analyst ratings of compa-
nies’ disclosure practices (using AIMR scores) are higher
for larger companies, companies with better performance,
and companies that issue securities in the current or future
periods, we include measures of company size (Size), per-
formance (CFO, ROA, Loss), and the issuance of new securi-
ties (Issue). We include measures of company sales growth
(Growth) and industry sales growth (Ind_Growth) because
managers should increase disclosure when it is more diffi-
cult for analysts to assess value based on historical num-
bers (Frankel, Johnson, & Skinner, 1999). Because prior
research finds a negative association between leverage
and voluntary disclosure (Chow & Wong-Boren, 1987;
Eng & Mak, 2003), we include leverage (Leverage). Prior
work also finds that companies with greater information
asymmetry are likely to benefit from additional disclosure
(Chen, DeFond, & Park, 2002; Gu & Li, 2007; Lang, 1991) so
we follow Gu and Li (2007) and include company age (Age)
and analyst coverage (Analyst_Coverage) to proxy for the
extent of information asymmetry. We include institutional
ownership (Inst_Holdings) because prior research finds a
positive association between AIMR scores and institutional
ownership (Bushee & Noe, 2000). We include a number of
variables to proxy for auditor quality (Big 4, Specialist, and
Tenure) because prior work finds a positive association
between auditor quality and disclosure quality
(Almutairi, Dunn, & Skantz, 2009; Dunn & Mayhew,
2004). Because companies committed to high-quality
internal controls might also be committed to high-quality
disclosure, we control for internal control material weak-
nesses (ICMW). We include the Herfindahl index to proxy
for proprietary costs (HERF) because companies should
be less likely to commit to high-quality disclosures when
proprietary costs are high, and we include an indicator
for litigious industry membership (Lit) because managers
might provide high-quality disclosures in an effort to avoid
litigation (Field, Lowry, & Shu, 2005; Skinner, 1994, 1997).
Finally, because Lennox, Francis, and Wang (2012) recom-
mend the use of an exclusion restriction when estimating
selection models, we also include the level of investment
in research and development (R&D). Research and develop-
ment activities should affect the proprietary costs of dis-
closure but should not affect the discretionary portion of
current period working capital accruals because research
and development activities relate to future product or ser-
vice offerings for which no sales have yet been made and
no costs have yet been capitalized. Our first-stage probit
model is as follows:
6 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
PrðTransparent Allit ¼ 1Þ
¼ k0 þ k1 ðSizeit Þ þ k2 ðCFOit Þ
þ k3 ðROAit Þ þ k4 ðLossit Þ
þ k5 ðIssueit Þ þ k6 ðGrowthit Þ
þ k7 ðInd Growthit Þ
þ k8 ðLeverageit Þ þ k9 ðAgeit Þ
þ k10 ðAnalyst Coverageit Þ
þ k11 ðInst Holdingsit Þ
þ k12 ðBig4it Þ
þ k13 ðSpecialistitÞ
þ k14 ðTenureit Þ þ k15 ðICMWit Þ
þ k16 ðHERFit Þ þ k17 ðLitit Þ
þ k18 ðR&Dit Þ
where
Transparent_All an indicator variable set equal to
one if the company provides
transparent disclosures for all
material (disclosed) valuation
allowances and reserves, either in
a Schedule II or in the notes to the
financial statements, and zero
otherwise
Size the natural log of total assets
CFO operating cash flow in the current
year divided by total assets at the
beginning of year
ROA return on assets, measured as net
income divided by total assets
Loss an indicator variable set equal to
one if net income is less than zero,
and zero otherwise
Issue an indicator variable set equal to
one if the company issued equity
or debt in the year, and zero
otherwise
Growth sales growth measured as sales
less prior year sales, scaled by
prior year sales
Ind_Growth industry sales (for the 2-digit SIC
code industry) divided by prior
year industry sales
Leverage long-term debt plus the current
portion of long-term debt, divided
by total assets
Age the number of years to date
during which total assets is
reported in Compustat
Analyst_Coverage an indicator variable equal to one
if at least one analyst covers the
company (from I/B/E/S), and zero
otherwise
Inst_Holdings the percentage of company stock
held by institutions
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
Big4 an indicator variable set equal to
one if the auditor is from the Big 4,
and zero otherwise
Specialist an indicator variable set equal to
one if the auditor is an industry
specialist, defined following
Reichelt and Wang (2010) as an
auditor whose audit fee market
share in the 2-digit SIC code
exceeds 30% at the national level,
and zero otherwise
Tenure the number of consecutive years
to date of the auditor–client
relationship
ICMW an indicator variable set equal to
one if at least one material
ð1Þ weakness in internal controls is
disclosed in the year, and zero
otherwise
HERF the Herfindahl index estimated by
summing the squared market
shares of all companies in the 2-
digit SIC code industry, where
market share is measured using
sales
Lit an indicator variable set equal to
one if the company operates in a
high litigation risk industry (SIC
codes 2833-2836, 3570-3577,
3600-3674, 5200-5961, and
7370), and zero otherwise
R&D research and development
expense scaled by total assets
i and t company and year indicators
We include the inverse Mills ratio (IMR) derived from
estimating this model in our second-stage models to miti-
gate concerns relating to selection bias.12
Tests of earnings management
We perform tests of our hypotheses using two
approaches to identify earnings management behavior.
First, we investigate whether companies that provide
transparent disclosures for individual allowance and
reserve accounts use less discretion in those accounts rela-
tive to companies that provide non-transparent disclo-
sures. Second, because we do not examine all valuation
and qualifying accounts, we supplement our primary tests
12
Because many of the factors that influence managers’ disclosure
choices are unobservable and some of these unobservable factors are likely
to be correlated with the extent of earnings management, we control for
these unobservable factors by including the inverse Mills ratio in the
second stage of a two-stage Heckman procedure. Tucker (2010) argues that
the two-stage Heckman procedure is useful in settings where managers
have considerable discretion and where the decision-making process is
more opaque to researchers. Relative to propensity score matching (PSM),
the Heckman approach is preferred in our setting because PSM relies
exclusively on observables to address the self-selection problem.
 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
by examining broad measures of earnings management.
Specifically, we investigate whether companies that pro-
vide transparent disclosure of all material (disclosed)
allowances and reserves report discretionary accruals that
are less positive (i.e., less income-increasing) or smaller in
magnitude (absolute value) than companies that provide
non-transparent disclosures. We discuss the construction
of our earnings management measures and the associated
empirical models in the remainder of this section.
Measures of discretion in individual accrual accounts
Prior research examines the use of discretion in specific
accounts to manage earnings. Although several studies
model discretion in the allowance for doubtful accounts
(Cecchini et al., 2012; Jackson & Liu, 2010; McNichols &
Wilson, 1988), their models require information such as
bad debt expense and write-offs that is only available for
companies that provide transparent disclosure. Because
our goal is to examine differences in discretion between
companies that provide transparent disclosure and those
that do not, we build on a simple model from Marquardt
and Wiedman (2004). Marquardt and Wiedman (2004)
capture discretion in the allowance for doubtful accounts
by taking the difference between the current year allow-
ance and the prior year allowance, and adjusting the cur-
rent year allowance for changes in gross accounts
receivable relative to the prior year. While changes in gross
accounts receivable can affect the allowance for doubtful
accounts, this model assumes that collectability of the
underlying receivables remains constant. We extend their
model to incorporate changes in the collectability of the
underlying receivables. Specifically, because the ratio of
days sales outstanding is a measure of the average number
of days that a company takes to collect revenue after a sale
has been made, changes in this ratio should capture
changes in the collectability of the underlying receivables.
We incorporate this into the model as follows:
DISC ARALLit ¼ ½ARALLit  ðARALLit1
 ðGROSSARit =GROSSARit1 Þ
 ðDSOit =DSOit1 Þ=Total Assetsit1
where
DISC discretion in the allowance for doubtful
ARALL accounts
ARALL the allowance for doubtful accounts
GROSSAR gross accounts receivable
DSO days sales outstanding, calculated as gross
accounts receivable divided by daily sales
(sales/365)
Because prior research does not model the valuation allow-
ance for inventories, we model discretion in this account
using an approach that is consistent with the approach
we use to model discretion in the allowance for doubtful
accounts. Specifically, we estimate discretion in the valua-
tion allowance for inventories as the difference between
the current and prior year allowance, adjusting the current
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
7
year allowance for changes in gross inventories and
changes in the age or salability of the inventory. We proxy
for changes in the age or salability of the inventory using
the days inventory outstanding ratio. This ratio measures
how long it takes the company, on average, to sell its
inventory.13 Thus, we use the following model to estimate
discretion in the valuation allowance for inventories:
DISC INVALLit ¼ ½INVALLit  ðINVALLit1
 ðGROSSINVit =GROSSINVit1 Þ
 ðDIOit =DIOit1 Þ=Total Assetsit1 ð3Þ
where
DISC discretion in the valuation allowance for
INVALL inventory
INVALL the valuation allowance for inventory
GROSSINV gross inventory
DIO days inventory outstanding, calculated as
gross inventory divided by daily cost of
sales (cost of sales/365)
Finally, for the valuation allowance for deferred tax assets,
we simply estimate discretion as the difference between
the current and prior year allowance, adjusting the current
year allowance for changes in gross deferred tax assets.14
Thus, we use the following model to estimate discretion in
the valuation allowance for deferred tax assets:
DISC DTAALLit ¼ ½DTAALLit  ðDTAALLit1
 ðGROSSDTAit =GROSSDTAit1 ÞÞ=Total Assetsit1
ð4Þ
where
13
Accounting Standards Codification (ASC) Topic 330 states, ‘‘in account-
ð2Þ ing for inventories, a loss shall be recognized whenever the utility of goods
is impaired by damage, deterioration, obsolescence, changes in price levels,
or other causes. The measurement of such losses shall be accomplished by
applying the rule of pricing inventories at the lower of cost or market.’’ Two
methods for dealing with the requirements in ASC Topic 330 have emerged
in practice: (1) a direct (write-off) method where ending inventory is
recorded at net realizable value if it is less than cost and the associated loss
is recorded against cost of goods sold (COGS), and (2) an indirect
(allowance) method where a valuation allowance is established to record
any decline in value below cost, with the associated loss recorded against
COGS. We find that approximately 19% of the 7669 sample company-year
observations with a current or prior year inventory balance disclose an
associated current or prior year inventory valuation allowance. Thus, the
use of the indirect (allowance) method appears to be common in practice.
14
In untabulated analysis, we re-estimate discretion in the deferred tax
asset valuation allowance by not only adjusting for the change in the
underlying deferred tax asset, but also adjusting for the change in net
operating losses (NOLs) because Miller and Skinner (1998) suggest that
NOLs are the most important component of deferred tax assets for
determining the size of the valuation allowance. We accomplish this by
multiplying the prior year allowance by the ratio of the current to prior
year gross deferred tax assets and by the ratio of current to prior year NOLs.
When current or prior year NOLs are zero, we set this ratio equal to one. All
results using this measure of discretion in the deferred tax asset valuation
allowance are consistent with those tabulated.
8 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
DISC discretion in the valuation allowance for
DTAALL deferred tax assets
DTAALL the valuation allowance for deferred tax
assets
GROSSDTA gross deferred tax assets
DISC ARALL, DISC INVALL, and DISC DTAALL are multiplied
by negative one to capture income-increasing discretion.15
Measures of overall discretion in accruals
We employ two different models to estimate discre-
tionary accruals. First, following Kothari, Leone, and
Wasley (2005), we estimate performance-matched discre-
tionary accruals using the modified Jones (1991) model
(Dechow, Sloan, & Sweeney, 1995) and we incorporate
controls for the asymmetric recognition of gains and losses
(Ball & Shivakumar, 2006). Specifically, we estimate discre-
tionary accruals as the residual from the following model,
estimated by year and 2-digit SIC code industry:
TAit ¼ b0 þ b1 ðDREVit  DRECit Þ þ b2 ðPPEit Þ
þ b3 ðCFOit Þ þ b4 ðNEG CFOit Þ þ b5 ðNEG CFOit
 CFOit Þ þ eit ð5Þ
where
TA total accruals (calculated as income before
extraordinary items less cash flow from
operations)
DREV the change in net revenues from year t  1
to year t
DREC the change in net receivables from year
t  1 to year t
PPE gross property, plant, and equipment
NEG_CFO an indicator variable set equal to one if
CFO is less than zero, and zero otherwise
all other variables are as defined previously. With the
exception of NEG_CFO, all variables in Model (5) are scaled
by total assets at the beginning of the year. We identify
company-year matches by identifying the company-year
15
To assess the validity of these measures, we performed internet
searches to identify instances where these specific allowance accounts
were restated. Our searches included key words ‘‘restate,’’ ‘‘restatement,’’
‘‘allowance for doubtful,’’ ‘‘bad debts,’’ ‘‘inventory reserve,’’ ‘‘valuation
allowance,’’ and ‘‘deferred tax valuation allowance.’’ We identified nine
such restatements in the first few pages of the search results (four, three,
and two restatements relate to the allowance for doubtful accounts, the
valuation allowance for inventories, and the deferred tax asset allowance,
respectively). For each restatement identified, we estimated discretion in
the affected allowance account separately using the original (unrestated)
data and the restated data. We then contrasted the estimated discretion in
the allowance account using restated data relative to unrestated data. For
all nine restatements examined, we find a decrease in the estimated
discretion in the allowance account as a result of the restatement. These
results suggest that the likelihood of a misstatement in a given allowance
account is increasing in the discretion in that account, where the discretion
in the account is estimated using Models (2) through (4).
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
observation within the same 2-digit SIC code industry with
the closest prior year return on assets. The performance-
matched discretionary accrual estimate is the difference
between the company-year and the matched company-
year estimates.
Second, following recent studies (Francis, Pinnuck, &
Watanabe, 2014; Hope, Thomas, & Vyas, 2013), we esti-
mate performance-adjusted discretionary accruals using
the Jones (1991) model. Specifically, we estimate discre-
tionary accruals as the residual from the following model,
estimated by year and 2-digit SIC code industry16:
TAit ¼ f0 þ f1 ðDREV it Þ þ f2 ðPPEi tÞ þ f3 ðROAit Þ þ eit ð6Þ
where all variables are as previously defined. All variables
in Model (6) are scaled by total assets at the beginning of
the year.
For both discretionary accruals measures, we separately
examine signed and positive (income-increasing) discre-
tionary accruals to capture behavior that inflates current
period earnings. We also examine the absolute value of
discretionary accruals to capture the magnitude of earn-
ings management regardless of its direction (Klein, 2002;
Reynolds & Francis, 2000).17
The association between disclosure transparency and earnings
management
We use the following model to test our first hypothesis,
where the measure of earnings management is based on
discretion in the individual allowance accounts:
DISC ALLit ¼ a0 þ a1 ðTransparent Indit Þ þ a2 ðSizeit Þ
þ a3 ðCFOit Þ þ a4 ðROAit Þ þ a5 ðLossit Þ
þ a6 ðIssueit Þ þ a7 ðGrowthit Þ
þ a8 ðInd Growthit Þ þ a9 ðLeverageit Þ
þ a10 ðAgeit Þ þ a11 ðAnalyst Coverageit Þ
þ a12 ðInst Holdingsit Þ þ a13 ðBig4it Þ
þ a14 ðSpecialistit Þ þ a15 ðTenureit Þ
þ a16 ðICMWit Þ þ a17 ðHERFit Þ þ a18 ðLitit Þ
þ a19 ðIMRit Þ þ a20 ðALL Scaledit Þ
þ aj ðIndustry FEÞ þ ak ðYear FEÞ þ mit ð7Þ
where
16
For both Models (5) and (6), we estimate discretionary accruals using
all available companies with sufficient data in Compustat during the
sample period. We exclude industry-years with fewer than 20 observations
and winsorize all continuous variables at the 1% and 99% levels to mitigate
the influence of outliers.
17
We also perform (untabulated) tests using a third broad accruals
measure based on the model developed by Dechow and Dichev (2002) and
modified by McNichols (2002), Francis, LaFond, Olsson, and Schipper
(2005), and Hope et al. (2013). Specifically, following Hope et al. (2013), we
use the absolute value of the residual from the modified Dechow and
Dichev (2002) model as a proxy for accruals quality and we find similar
results using this measure.
 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
DISC ALL one of three measures: (i) DISC
ARALL – discretion in the allowance
for doubtful accounts estimated
using Model (2), (ii) DISC INVALL –
discretion in the valuation
allowance for inventory estimated
using Model (3), or (iii) DISC
DTAALL – discretion in the
valuation allowance for deferred
tax assets estimated using Model
(4);
Transparent_Ind an indicator variable set equal to
one if the company provides
transparent disclosure of the
individual allowance or reserve
account, either in a Schedule II or in
the notes to the financial
statements, and zero otherwise;
IMR the inverse Mills ratio estimated
using Model (1);
ALL_Scaled one of three measures: (i)
ARALL_Scaled, (ii) INVALL_Scaled,
or (iii) DTAALL_Scaled;
ARALL_Scaled ARALL, scaled by total assets;
INVALL_Scaled INVALL, scaled by total assets;
DTAALL_Scaled DTAALL, scaled by total assets;
Industry FE industry fixed effects, where
industries are defined following
Ashbaugh, LaFond, and Mayhew
(2003)a
Year FE year fixed effects
a
We use SIC codes to define industries as follows: agriculture (0100-
0999), mining and construction (1000-1999, excluding 1300-1399), food
(2000-2111), textiles and printing/publishing (2200-2799), chemicals
(2800-2824; 2840-2899), pharmaceuticals (2830-2836), extractive
(1300-1399; 2900-2999), durable manufacturers (3000-3999, excluding
3570-3579 and 3670-3679), transportation (4000-4899), retail (5000-
5999), services (7000-8999, excluding 7370-7379), computers (3570-
3579; 3670-3679; 7370-7379), and utilities (4900-4999).
all other variables are as previously defined. We estimate
Model (7) separately for each of the three allowance
accounts.We use the following model to test our first
hypothesis, where the measure of earnings management
is based on one of the two broad accruals measures:
DiscAccit ¼ c0 þ c1 ðTransparent Allt Þ þ c2 ðSizeit Þ
þ c3 ðCFOit Þ þ c4 ðROAit Þ þ c5 ðLossit Þ
þ c6 ðIssueit Þ þ c7 ðGrowthit Þ
þ c8 ðInd Growthit Þ þ c9 ðLeverageit Þ
þ c10 ðAgeit Þ þ c11 ðAnalyst Coverageit Þ
þ c12 ðInst Holdingsit Þ þ c13 ðBig4it Þ
þ c14 ðSpecialistit Þ þ c15 ðTenureit Þ
þ c16 ðICMWit Þ þ c17 ðHERFit Þ þ c18 ðLitit Þ
þ c19 ðIMRit Þ þ cj ðIndustry FEÞ
þ ck ðYear FEÞ þ mit
Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
9
where
DiscAcc one of two measures of discretionary
accruals as estimated using Model (5) or (6);
for both measures, we estimate Model (8)
separately for signed, positive (income-
increasing) only, and absolute value
discretionary accrualsa
a
To examine positive (income-increasing) discretionary accruals, we
use tobit when estimating Model (8).
all other variables as previously defined. The coefficient of
interest in Model (7) is a1, the coefficient on
Transparent_Ind, and the coefficient of interest in Model
(8) is c1, the coefficient on Transparent_All. Consistent
with Hypothesis 1, we expect the coefficients on
Transparent_Ind and Transparent_All to be negative and
significant in all specifications of Models (7) and (8).
Models (7) and (8) include controls for company size
(Size), age (Age), sales growth (Growth), and industry sales
growth (Ind_Growth) because prior research indicates that
these company characteristics affect the level of discre-
tionary accruals (Anthony & Ramesh, 1992; Becker,
DeFond, Jiambalvo, & Subramanyam, 1998; Myers, Myers,
& Omer, 2003). To control for the effects of company per-
formance, we include cash flow from operations (CFO)
and return on assets (ROA) (Dechow et al., 1995).
Following prior research, we also control for the issuance
of debt and equity financing (Issue) (Rangan, 1998),
whether analysts cover the company (Analyst_Coverage)
(Yu, 2008), the effects of financial distress (Loss) (Francis
& Yu, 2009), institutional holdings (Inst_Holdings)
(Chung, Firth, & Kim, 2002), the presence of a material
weakness in internal controls (ICMW) (Ashbaugh-Skaife,
Collins, Kinney, & LaFond, 2008), leverage (Leverage)
(DeFond & Jiambalvo, 1994), the risk of litigation (Lit)
(DeFond & Subramanyam, 1998), and market competition
(HERF) (Cheng, Man, & Yi, 2011). We also control for audi-
tor characteristics that might influence the extent of earn-
ings management. Specifically, we include controls for
auditor size (Big 4) (Becker et al., 1998), industry special-
ization (Specialist) (Balsam, Krishnan, & Yang, 2003;
Dunn & Mayhew, 2004; Reichelt & Wang, 2010), and the
length of the auditor–client relationship (Tenure) (Myers
et al., 2003). We include the inverse Mills ratio (IMR), esti-
mated using Model (1), to control for unobservable charac-
teristics associated with the decision to provide
transparent disclosures. In Model (7) we include the size
of the allowance account relative to total assets to control
for differences in estimated collectability of receivables,
future salability of inventory, and expected use of deferred
tax assets. Finally, we include industry and year fixed
effects to control for variation in discretionary accruals
across industries and over time, and we cluster standard
errors by company to control for serial dependence
(Petersen, 2009).
ð8Þ
To test our second hypothesis, where the measure of
earnings management is based on discretion in individual
10 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx

Table 1 variable that is set equal to one if the company provides

Sample selection. a Schedule II, and zero otherwise.18
ARALL INVALL DTAALL
Panel A: Samples for tests of discretion in individual allowance and
reserve accounts Sample description and empirical results
Company-year observations that 4405 1159 1754
provide a Schedule II Sample description
Company-year observations that 1790 63 170
disclose the allowance or reserve
balance transparently in the notes As described above, our analyses are limited to three of
to the financial statements the most common allowance and reserve accounts that are
Company-year observations that 2382 216 630 included in Schedule II – the allowances for doubtful
provide non-transparent
accounts, inventory, and deferred tax assets. We hand col-
disclosure for the allowance or
reserve account lect data on disclosure transparency for annual reports
Less: Company-year observations (1987) (206) (94) filed from 2008 through 2010 using a multi-step proce-
where the allowance is immaterial dure. We first identify companies that include a Schedule
(i.e., where the prior year balance II in their annual reports using a key word search in 10-K
is less than once cent per share)
Wizard for ‘‘valuation and qualifying’’ and ‘‘Schedule II.’’
Sample for Tests of H1 6590 1232 2460 We classify these companies as providing transparent dis-
Less: Company-year observations (1351) (141) (618)
where non-transparent disclosure
closures for each allowance and reserve account included
is provided for the allowance or in the schedule (Transparent_Ind = 1) and for allowance
reserve account and reserve accounts in general (Transparent_All = 1).
Sample for Tests of H2 5239 1091 1842 Next, we identify companies that do not use the words
‘‘valuation and qualifying’’ or ‘‘Schedule II’’ and do not pre-
Panel B: Samples for tests of overall discretion in accruals sent a Schedule II in their annual reports but still disclose a
Sample for Sample for balance for at least one of the three allowance and reserve
Tests of H1 Tests of H2 accounts using a key word search in 10-K Wizard for
Companies that provide transparent disclosures ‘‘allowance for doubtful,’’ ‘‘allowance for bad debts,’’
(Transparent_All = 1) ‘‘uncollectible,’’ ‘‘inventory reserve,’’ ‘‘excess,’’ ‘‘obsolete,’’
Company-year observations that 4664 4664
‘‘slow-moving inventory,’’ ‘‘valuation allowance,’’ and/or
provide a Schedule II
Company-year observations that 1941 1941 ‘‘deferred tax asset valuation allowance.’’ We use the
disclose all material (disclosed) results of this search to identify companies that provide
allowance and reserve balances transparent disclosure of the allowances for doubtful
transparently in the notes to the accounts, inventory, or deferred tax assets in the notes to
financial statements
the financial statements. We set Transparent_Ind equal to
Companies that provide non-transparent disclosures one if the company provides transparent disclosure for a
(Transparent_All = 0)
Company-year observations that 2854 NA
given disclosed allowance and reserve account, and zero
provide non-transparent otherwise, and we set Transparent_All equal to one if the
disclosure for all material company provides transparent disclosures for all disclosed
(disclosed) allowance and reserve allowance and reserve accounts, and zero otherwise.19
balances
Appendix A presents the distribution of accounts
Less: Company-year observations (2032) (1009)
where prior year aggregate included in a Schedule II for company-year observations
allowance and reserve balances are where a Schedule II is provided as well as the frequency
less than one cent per share and size of allowance and reserve accounts for all
Samples for tests of overall discretion 7427 5596 company-year observations where allowance and reserve
in accruals
18
The samples consist of company-year observations with necessary data In these tests, we exclude the IMR because Model (1) does not
from Compustat and Audit Analytics to construct the variables in our differentiate between companies that provide a Schedule II and companies
models. For all samples, we exclude company-year observations where that provide transparent disclosures in the notes to the financial
transparent disclosures are provided for some, but not all, material (dis- statements.
closed) valuation allowance and reserve accounts. 19
We classify disclosure about activity in allowance and reserve accounts
as transparent when companies provide in a tabular format (i.e., in a
Schedule II or in the notes to the financial statements) or within the
allowance and reserve accounts, we eliminate all observa- narrative text of a footnote, detailed information about activity in the
tions where disclosures are not transparent for the given accounts during the fiscal period. Although we make this binary distinction,
we recognize that there may be differing degrees of transparency, in that it
individual account (i.e., where Transparent_Ind = 0 for a
is possible that companies can provide some of this information elsewhere
given account). To test our second hypothesis, where the in the financial statements (e.g., in the case of the provision for bad debts, in
measure of earnings management is based on one of the the statement of cash flows). Although we did not collect this additional
two broad accruals measures, we eliminate all observa- information, we find that for a random sample of 20 companies classified as
tions where Transparent_All = 0. In these tests, we modify providing non-transparent disclosure in these accounts, only 2 separately
disclosed the provision for bad debt in the statement of cash flows. In
Model (7) by replacing Transparent_Ind with Schedule_II addition, this separate disclosure is arguably less transparent to users of the
and we modify Model (8) by replacing Transparent_All financial statements and is more closely aligned with non-transparent
with Schedule_II, where Schedule_II is an indicator disclosure.

Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx 11

Table 2
Descriptive statistics.

Variable N Mean P25 Median P75 N Mean P25 Median P75 Diff in mean
Transparent_Ind = 1 Transparent_Ind = 0
DISC ARALL 5239 0.000 0.001 0.000 0.002 1351 0.001 0.001 0.000 0.002 0.001
DISC INVALL 1091 0.001 0.003 0.000 0.003 141 0.016 0.003 0.000 0.002 0.014⁄
DISC DTAALL 1842 0.001 0.002 0.000 0.001 618 0.005 0.000 0.000 0.000 0.004⁄
Transparent_All = 1 Transparent_All = 0
DiscAcca 5596 0.043 0.018 0.021 0.073 1831 0.097 0.015 0.033 0.125 0.054⁄⁄⁄
AbsDiscAcca 5596 0.125 0.019 0.048 0.107 1831 0.223 0.024 0.067 0.181 0.098⁄⁄⁄
DiscAccb 5596 0.013 0.063 0.010 0.046 1831 0.003 0.060 0.006 0.068 0.010⁄⁄
AbsDiscAccb 5596 0.088 0.024 0.055 0.108 1831 0.129 0.027 0.064 0.135 0.042⁄⁄⁄
Size 5596 6.542 5.222 6.500 7.808 1831 5.613 3.614 5.407 7.587 0.929⁄⁄⁄
CFO 5596 0.078 0.043 0.091 0.137 1831 0.107 0.008 0.074 0.129 0.184⁄⁄⁄
ROA 5596 0.004 0.028 0.034 0.075 1831 0.153 0.092 0.017 0.068 0.148⁄⁄⁄
Loss 5596 0.327 0.000 0.000 1.000 1831 0.430 0.000 0.000 1.000 0.104⁄⁄⁄
Issue 5596 0.125 0.000 0.000 0.000 1831 0.140 0.000 0.000 0.000 0.015⁄
Growth 5596 0.127 0.093 0.038 0.154 1831 0.457 0.111 0.035 0.210 0.331
Ind_Growth 5596 0.029 0.038 0.029 0.096 1831 0.036 0.038 0.047 0.128 0.007⁄⁄
Leverage 5596 0.234 0.020 0.177 0.338 1831 0.367 0.015 0.184 0.383 0.133⁄⁄⁄
Age 5596 23.200 12.000 18.000 30.000 1831 20.502 11.000 17.000 27.000 2.698⁄⁄⁄
Analyst_Coverage 5596 0.786 1.000 1.000 1.000 1831 0.559 0.000 1.000 1.000 0.227⁄⁄⁄
Inst_Holdings 5596 0.549 0.203 0.636 0.871 1831 0.335 0.000 0.172 0.699 0.214⁄⁄⁄
Big 4 5596 0.773 1.000 1.000 1.000 1831 0.590 0.000 1.000 1.000 0.183⁄⁄⁄
Specialist 5596 0.234 0.000 0.000 0.000 1831 0.190 0.000 0.000 0.000 0.045⁄⁄⁄
Tenure 5596 10.460 5.000 8.000 13.000 1831 9.050 4.000 7.000 12.000 1.409⁄⁄⁄
ICMW 5596 0.053 0.000 0.000 0.000 1831 0.102 0.000 0.000 0.000 0.048⁄⁄⁄
HERF 5596 0.070 0.034 0.047 0.078 1831 0.066 0.031 0.042 0.084 0.004⁄⁄
Lit 5596 0.146 0.000 0.000 0.000 1831 0.193 0.000 0.000 0.000 0.047⁄⁄⁄
a
Estimated using Model (5).
b
Estimated using Model (6).

Table 3 financial statements, and a non-transparent disclosure in

The determinants of transparent disclosure.
the notes to the financial statements.
Variable Pred. DV = Transparent_All Table 1 describes the samples used in our tests of
Coefficient estimate p-Value Hypotheses 1 and 2. All samples include only those com-
pany-year observations with necessary data to construct
Intercept ? 0.098 .133
Size + 0.016* .076 the variables in our models available from Compustat
CFO + 0.326*** .001 and Audit Analytics, and we exclude company-year obser-
ROA + 0.076 .133 vations where transparent disclosures are provided for
Loss + 0.033 .206
some, but not all, material (disclosed) valuation allowance
Issue + 0.052 .849
Growth ? 0.003 .310
and reserve accounts. Panel A presents the samples for
Ind_Growth ? 0.303** .030 tests of discretion in individual allowance and reserve
Leverage  0.109*** .007 accounts. Of the company-year observations disclosing a
Age + 0.003** .023 Schedule II, 4405 include the allowance for doubtful
Analyst_Coverage + 0.175*** <.001
accounts in the schedule, 1159 include the inventory
Inst_Holdings + 0.579*** <.001
Big 4 + 0.230*** <.001 allowance, and 1754 include the deferred tax asset al-
Specialist + 0.078 .966 lowance. 1790, 63, and 170 company-year observations
Tenure + 0.004 .950 do not provide a Schedule II but provide transparent dis-
ICMW  0.019 .384
closure of the allowance for doubtful accounts, inventory
HERF  0.130 .304
Lit ? 0.139*** .002
reserve, and deferred tax asset allowance, respectively.
R&D ? 0.006* .063 Finally, 2382, 216, and 630 company-year observations
N 7427
do not provide transparent disclosure of the allowance
Area under the ROC curve 0.679 for doubtful accounts, inventory reserve, and deferred tax
asset allowance, respectively. We exclude observations
This table presents results of estimating Model (1). p-Values are one-
tailed if a sign is predicted, and two-tailed otherwise.
where the prior year balance in the account is less than
*
Statistical significance at the 10% level. one cent per share. The resulting samples for tests of
**
Statistical significance at the 5% level. Hypothesis 1 consist of 6590, 1232, and 2460 observations
***
Statistical significance at the 1% level. for the accounts receivable allowance, inventory allow-
ance, and deferred tax asset allowance, respectively. For
tests of Hypothesis 2, we exclude observations where
balances are disclosed. Appendix B provides examples of a non-transparent disclosures are provided for the given
Schedule II, a transparent disclosure in the notes to the allowance or reserve account. The resulting samples

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and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
12 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx

Table 4 balances transparently in the notes to the financial state-

The association between discretion in individual valuation allowance and ments, and 2854 observations that provide non-transpar-
reserve accounts and the transparency of disclosure for those accounts.
ent disclosure for all disclosed allowance and reserve
Variables Pred. DV = DISC DV = DISC DV = DISC balances. We then require that companies report an aggre-
ARALL INVALL DTAALL gate prior year balance in the three allowance accounts in
Intercept ? 0.002 0.023 0.016 excess of one cent per share, resulting in a sample of 7427
(.798) (.149) (.152) company-year observations. To test Hypothesis 2, which
Transparent_Ind  0.001** 0.012* 0.007*
(.041) (.091) (.095)
includes only those company-year observations that pro-
Size ? 0.000 0.001 0.001 vide transparent disclosures for all material (disclosed)
(.961) (.484) (.164) allowance and reserve accounts, our sample consists of
CFO ? 0.003 0.054** 0.009 5596 company-year observations.
(.456) (.022) (.409)
ROA ? 0.008* 0.009 0.007
(.088) (.542) (.168) Descriptive statistics and univariate tests
Loss ? 0.000 0.009** 0.019***
(.831) (.039) (<.001) Table 2 presents separate descriptive statistics for our
Issue ? 0.000 0.001 0.000 measures of discretion in individual allowance and
(.931) (.731) (.950)
reserve accounts for companies that provide transparent
Growth ? 0.000 0.003 0.000**
(.558) (.359) (.049) disclosure of the individual account (Transparent_Ind = 1)
Ind_Growth ? 0.000 0.020 0.001 and for companies that provide non-transparent disclo-
(.353) (.196) (.948) sure of the individual account (Transparent_Ind = 0). For
Leverage ? 0.001 0.006 0.000
all other variables, we present descriptive statistics for
(.727) (.126) (.918)
Age ? 0.000 0.000** 0.000 companies that provide transparent disclosures for all
(.890) (.027) (.840) disclosed allowance and reserve accounts
Analyst_Coverage ? 0.000 0.006 0.005 (Transparent_All = 1) and for companies that provide
(.743) (.126) (.444) non-transparent disclosures for all disclosed allowance
Inst_Holdings ? 0.002 0.003 0.002
and reserve accounts (Transparent_All = 0). We perform
(.563) (.317) (.575)
Big 4 ? 0.001 0.001 0.010* univariate tests to contrast mean values across the two
(.364) (.733) (.064) groups and find that companies providing transparent
Specialist ? 0.000 0.003* 0.004* disclosure for the inventory allowance and the deferred
(.515) (.070) (.080)
tax asset allowance have lower discretion in these
Tenure ? 0.000 0.000 0.000
(.609) (.560) (.602)
accounts. We also find that companies providing trans-
ICMW ? 0.001 0.008 0.014 parent disclosure for all disclosed allowances and
(.557) (.331) (.298) reserves report lower signed and absolute value discre-
HERF ? 0.001 0.013 0.021 tionary accruals than do companies providing non-trans-
(.687) (.224) (.182)
parent disclosures. The univariate tests also indicate that
Lit ? 0.001 0.001 0.007
(.496) (.685) (.254) there are systematic differences between companies that
IMR ? 0.008 0.010** 0.012 provide transparent disclosures and companies that do
(.463) (.047) (.330) not. For example, companies that provide transparent
ARALL_Scaled + 0.048*
disclosures are larger, have better performance (cash
(.086)
INVALL_Scaled + 0.202**
flows from operations, return on assets, incidence of loss,
(.024) etc.), are more likely to engage Big 4 and industry spe-
DTAALL_Scaled + 0.001* cialist auditors, are more likely to be covered by analysts,
(.097) and have a higher percentage of shares held by
Industry FE Included Included Included institutions.
Year FE Included Included Included
N 6590 1232 2460 Selection model results
Adjusted R2 0.071 0.105 0.048

This table presents the results of estimating Model (7). p-Values are in
parentheses below coefficient estimates and are one-tailed if a sign is
predicted, and two-tailed otherwise.
*
Statistical significance at the 10%, level.
**
Statistical significance at the 5% level.
***
Statistical significance at the 1% level.
consist of 5239, 1091, and 1842 observations for the
accounts receivable allowance, inventory allowance, and
deferred tax asset allowance, respectively.
Panel B presents the samples for tests of overall discre-
tion in accruals. The sample used to test Hypothesis 1 con-
sists of 4664 observations that provide a Schedule II, 1941
observations that disclose all allowance and reserve
Table 3 presents the results from estimating Model (1),
where we investigate the factors that affect the decision to
provide transparent disclosures. We find that the likeli-
hood of providing transparent disclosures
(Transparent_All = 1) is higher among companies that are
larger (Size), have higher cash flow from operations
(CFO), are older (Age), are covered by at least one analyst
(Analyst_Coverage), have a higher percentage of shares
held by institutions (Inst_Holdings), and engage a Big 4
auditor (Big 4). Transparent disclosures are less likely
among companies with higher industry sales growth
(Ind_Growth), with higher leverage (Leverage), operating
in litigious industries (Lit), and with larger research and
development expenditures (R&D).

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and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx 13

Table 5
The association between discretionary accruals and transparent disclosure, where DiscAcc is estimated using Model (5).

Variables Pred. DV = DiscAcc DV = AbsDiscAcc DV = PosDiscAcc

Intercept ? 0.414*** 0.753*** 0.592***
(<.001) (<.001) (<.001)
Transparent_All  0.028** 0.048*** 0.049***
(.025) (<.001) (<.001)
Size ? 0.026*** 0.024*** 0.031***
(<.001) (<.001) (<.001)
CFO ? 0.065* 0.053* 0.074**
(.073) (.066) (<.001)
ROA ? 0.158*** 0.195*** 0.007
(<.001) (<.001) (.560)
Loss ? 0.038*** 0.010 0.013
(.002) (.361) (.232)
Issue ? 0.008 0.029* 0.015
(.618) (.052) (.302)
Growth ? 0.002 0.003 0.003***
(.439) (.388) (.001)
Ind_Growth ? 0.011 0.175*** 0.090
(.860) (.008) (.126)
Leverage ? 0.056** 0.001 0.035***
(.029) (.985) (<.001)
Age ? 0.000 0.000* 0.000
(.354) (.088) (.785)
Analyst_Coverage ? 0.022 0.036** 0.054***
(.186) (.013) (<.001)
Inst_Holdings ? 0.032 0.028 0.045**
(.255) (.266) (.020)
Big 4 ? 0.017 0.022 0.029**
(.344) (.146) (.045)
Specialist ? 0.026** 0.024** 0.009
(.020) (.011) (.466)
Tenure ? 0.001** 0.001* 0.001*
(.020) (.098) (.086)
ICMW ? 0.030 0.020 0.003
(.267) (.333) (.863)
HERF ? 0.740** 0.325 0.283***
(.040) (.384) (.001)
Lit ? 0.004 0.002 0.008
(.829) (.921) (.570)
IMR ? 0.121 0.143 0.163***
(.220) (.112) (<.001)
Industry FE Included Included Included
Year FE Included Included Included
N 7427 7427 4817
Adjusted R2 0.075 0.217

This table presents the results of estimating Model (8). p-Values are in parentheses below coefficient estimates and are one-tailed if a sign is predicted, and
two-tailed otherwise.
*
Statistical significance at the 10% level.
**
Statistical significance at the 5% level.
***
Statistical significance at the 1% level.

Multivariate results discretionary accruals measure estimated using Model

Tests of Hypothesis 1
Table 4 presents the results from tests of Hypothesis 1
where we examine discretion in individual allowance
accounts. For each account examined, we find a negative
and significant coefficient on Transparent_Ind (p < 0.10 in
all columns). Thus, consistent with Hypothesis 1, there is
a negative association between discretion in individual
allowance and reserve accounts and the transparency of
disclosures for those individual accounts.
Table 5 presents the results from tests of Hypothesis 1
where the measure of earnings management is the
(5). The coefficient on Transparent_All is negative and sig-
nificant when the dependent variable is signed, positive
(income-increasing), and absolute value discretionary
accruals (p < 0.025 in all columns). Table 6 presents the
results from tests of Hypothesis 1 where the measure of
earnings management is the discretionary accruals mea-
sure estimated using Model (6). As in Table 5, the coeffi-
cient on Transparent_All is negative and significant when
the dependent variable is signed, positive (income-increas-
ing), and absolute value discretionary accruals (p < 0.015 in
all columns). Taken together, the results in Tables 4–6 pro-
vide support for Hypothesis 1 – the extent of accruals-based

Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
14 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx

Table 6
The association between discretionary accruals and transparent disclosure, where DiscAcc is estimated using Model (6).

Variables Pred. DV = DiscAcc DV = AbsDiscAcc DV = PosDiscAcc

Intercept ? 0.033 0.217*** 0.092***
(.147) (<.001) (<.001)
Transparent_All  0.012*** 0.009** 0.019***
(.006) (.015) (<.001)
Size ? 0.006*** 0.011*** 0.014***
(.001) (<.001) (<.001)
CFO ? 0.023 0.017 0.026***
(.162) (.155) (<.001)
ROA ? 0.141*** 0.107*** 0.078***
(<.001) (<.001) (<.001)
Loss ? 0.035*** 0.023*** 0.018***
(<.001) (<.001) (.001)
Issue ? 0.003 0.004 0.003
(.598) (.369) (.648)
Growth ? 0.001*** 0.001 0.001***
(.005) (.460) (.002)
Ind_Growth ? 0.036* 0.032** 0.083***
(.084) (.029) (.001)
Leverage ? 0.013 0.000 0.023***
(.413) (.989) (<.001)
Age ? 0.001*** 0.000** 0.001***
(<.001) (.034) (<.001)
Analyst_Coverage ? 0.009 0.020*** 0.015**
(.136) (<.001) (.018)
Inst_Holdings ? 0.033*** 0.016* 0.062***
(<.001) (.067) (<.001)
Big 4 ? 0.007 0.001 0.004
(.294) (.844) (.528)
Specialist ? 0.003 0.005 0.000
(.392) (.114) (.923)
Tenure ? 0.000 0.000 0.000
(.406) (.669) (.392)
ICMW ? 0.015 0.025** 0.005
(.196) (.011) (.537)
HERF ? 0.004 0.122*** 0.086**
(.867) (<.001) (.012)
Lit ? 0.009 0.004 0.008
(.141) (.513) (.192)
IMR ? 0.000 0.054 0.033***
(.990) (.114) (.006)
Industry FE Included Included Included
Year FE Included Included Included
N 7427 7427 3503
Adjusted R2 0.208 0.298

This table presents the results of estimating Model (8). p-Values are in parentheses below coefficient estimates and are one-tailed if a sign is predicted, and
two-tailed otherwise.
*
Statistical significance at the 10% level.
**
Statistical significance at the 5% level.
***
Statistical significance at the 1% level.

earnings management is lower for companies that provide
transparent disclosures about activity in allowance and
reserve accounts.
Tests of Hypothesis 2
Table 7 presents the results from tests of Hypothesis 2
where we examine discretion in individual allowance
accounts. Here, we do not find a significant coefficient on
Schedule_II, indicating that there is no difference in the
extent of discretion in individual allowance and reserve
accounts between companies that provide a Schedule II
and companies that provide transparent disclosures in
the notes to the financial statements. Table 8 (Table 9) pre-
sents the results from tests of Hypothesis 2 where the
measure of earnings management is the discretionary
accruals measure estimated using Model (5) (Model (6)).
The coefficient on Schedule_II is insignificant in all col-
umns of Tables 8 and 9.20
Results summary
The results in Tables 4–6 indicate that the extent of
earnings management, as captured by measures of
20
In all analyses where we use a broad measure of earnings management,
we limit the sample to observations where the aggregate of the beginning
balances in the allowances for doubtful accounts, inventory, and deferred
tax assets is greater than one cent per share. However, we find similar
results using an alternative sample consisting of all observations with at
least one disclosed valuation balance.

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and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx 15

Table 7 Table 8
The effect of transparent disclosure placement on discretion in individual The effect of transparent disclosure placement on discretionary accruals,
valuation allowance and reserve accounts. where DiscAcc is estimated using Model (5).

Variables Pred. DV = DISC DV = DISC DV = DISC Variables Pred. DV = DiscAcc DV = DV =

ARALL INVALL DTAALL AbsDiscAcc PosDiscAcc
Intercept ? 0.005*** 0.002 0.026*** Intercept ? 0.260*** 0.525*** 0.382***
(.004) (.538) (<.001) (<.001) (<.001) (<.001)
Schedule_II ? 0.000 0.002 0.001 Schedule_II ? 0.004 0.001 0.003
(.537) (.276) (.642) (.651) (.934) (.800)
Size ? 0.000 0.001** 0.001 Size ? 0.008*** 0.009*** 0.010***
(.438) (.038) (.140) (.007) (.001) (.004)
CFO ? 0.008 0.025*** 0.027** CFO ? 0.761*** 0.286*** 0.909***
(.448) (.001) (.029) (<.001) (.001) (<.001)
ROA ? 0.004 0.009 0.052** ROA ? 0.503*** 0.177 0.454***
(.359) (.190) (.037) (<.001) (.141) (<.001)
Loss ? 0.000 0.002 0.008** Loss ? 0.041** 0.004 0.028**
(.815) (.314) (.039) (.017) (.831) (.026)
Issue ? 0.000 0.000 0.004*** Issue ? 0.001 0.020 0.008
(.722) (.944) (.007) (.967) (.105) (.549)
Growth ? 0.001 0.002 0.000** Growth ? 0.009*** 0.012*** 0.010***
(.257) (.531) (.031) (<.001) (<.001) (<.001)
Ind_Growth ? 0.000 0.001 0.000*** Ind_Growth ? 0.054 0.243*** 0.116**
(.253) (.105) (<.001) (.441) (.001) (.044)
Leverage ? 0.001 0.005* 0.003 Leverage ? 0.011 0.029* 0.010
(.789) (.073) (.306) (.600) (.078) (.515)
Age ? 0.000 0.000* 0.000** Age ? 0.000 0.000 0.000
(.791) (.058) (.013) (.286) (.573) (.801)
Analyst_Coverage ? 0.000 0.002 0.003 Analyst_ ? 0.020 0.017 0.035**
(.547) (.240) (.455) Coverage
Inst_Holdings ? 0.000 0.001 0.000 (.195) (.194) (.015)
(.734) (.551) (.909) Inst_Holdings ? 0.014 0.009 0.009
Big 4 ? 0.001 0.001 0.005 (.413) (.567) (.614)
(.391) (.237) (.147) Big 4 ? 0.013 0.024* 0.028**
Specialist ? 0.000 0.001 0.003 (.411) (.065) (.036)
(.773) (.278) (.121) Specialist ? 0.028*** 0.010 0.017
Tenure ? 0.000 0.000 0.000 (.006) (.264) (.134)
(.164) (.115) (.915) Tenure ? 0.001 0.000 0.001
ICMW ? 0.002 0.000 0.010 (.104) (.360) (.203)
(.374) (.962) (.342) ICMW ? 0.045 0.016 0.021
HERF ? 0.003 0.004 0.020 (.102) (.472) (.288)
(.564) (.594) (.106) HERF ? 0.512 0.226 0.175**
Lit ? 0.000 0.001 0.002 (.176) (.581) (.028)
(.908) (.586) (.506) Lit ? 0.010 0.016 0.012
ARALL_Scaled + 0.040 (.397) (.172) (.402)
(.131)
Industry FE Included Included Included
INVALL_Scaled + 0.036
Year FE Included Included Included
(.301)
DTAALL_Scaled + 0.000 N 5596 5596 3570
(.443) Adjusted R2 0.097 0.168

Industry FE Included Included Included This table presents the results of estimating Model (8) after replacing
Year FE Included Included Included Transparent_All with Schedule_II. p-Values are in parentheses below
N 5239 1091 1842 coefficient estimates and are one-tailed if a sign is predicted, and two-
Adjusted R2 0.083 0.055 0.096 tailed otherwise.
*
Statistical significance at the 10% level.
**
This table presents the results of estimating Model (7) after replacing Statistical significance at the 5% level.
***
Transparent_Ind with Schedule_II. p-Values are in parentheses below Statistical significance at the 1% level.
coefficient estimates and are one-tailed if a sign is predicted, and two-
tailed otherwise.
*
Statistical significance at the 10% level.
**
Statistical significance at the 5% level. Hypothesis 2. We acknowledge that these results are incon-
***
Statistical significance at the 1% level. sistent with both the theoretical arguments arising from
context theory and prior (primarily experimental) work
on placement and format effects. There are a number of
discretion in individual accounts and by broad measures of possible explanations for the lack of support for
discretionary accruals, is lower for companies that provide Hypothesis 2. First, it could be that investors do not find
transparent disclosures for allowance and reserve (or managers do not believe) that the task of processing
accounts. These results provide strong support for dispersed (in the notes to the financial statements) infor-
Hypothesis 1 and suggest that disclosure quality (as mea- mation about activity in allowance and reserve accounts
sured by disclosure transparency) matters. However, the is particularly difficult (i.e., the task is not cognitively
results in Tables 7–9 do not provide support for demanding). Second, it is possible that the transparent

Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
16 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx

Table 9
The effect of transparent disclosure placement on discretionary accruals, where DiscAcc is estimated using Model (6).

Variables Pred. DV = DiscAcc DV = AbsDiscAcc DV = PosDiscAcc

Panel B: Second restricted sample
Intercept ? 0.055*** 0.127*** 0.058***
(<.001) (<.001) (<.001)
Schedule_II ? 0.005 0.003 0.002
(.181) (.370) (.698)
Size ? 0.005*** 0.006*** 0.009***
(<.001) (<.001) (<.001)
CFO ? 0.696*** 0.201*** 0.608***
(<.001) (<.001) (<.001)
ROA ? 0.652*** 0.325*** 0.573***
(<.001) (<.001) (<.001)
Loss ? 0.003 0.001 0.017***
(.846) (.903) (.001)
Issue ? 0.003 0.001 0.001
(.571) (.857) (.857)
Growth ? 0.000 0.004*** 0.001
(.807) (<.001) (.238)
Ind_Growth ? 0.016 0.035*** 0.076***
(.315) (.005) (.001)
Leverage ? 0.013 0.018* 0.033***
(.182) (.080) (<.001)
Age ? 0.000*** 0.000 0.001***
(<.001) (.192) (<.001)
Analyst_Coverage ? 0.014*** 0.014*** 0.016***
(.002) (.002) (.003)
Inst_Holdings ? 0.022*** 0.002 0.035***
(<.001) (.690) (<.001)
Big 4 ? 0.010** 0.005 0.011**
(.040) (.276) (.030)
Specialist ? 0.004 0.007** 0.008*
(.247) (.028) (.070)
Tenure ? 0.000 0.000 0.000
(.731) (.183) (.234)
ICMW ? 0.009 0.018** 0.003
(.282) (.011) (.741)
HERF ? 0.008 0.111*** 0.080***
(.732) (<.001) (.006)
Lit ? 0.007 0.007 0.004
(.147) (.147) (.500)
Industry FE Included Included Included
Year FE Included Included Included
N 5596 5596 2528
Adjusted R2 0.499 0.287

This table presents the results of estimating Model (8) after replacing Transparent_All with Schedule_II. p-Values are in parentheses below coefficient
estimates and are one-tailed if a sign is predicted, and two-tailed otherwise.
*
Statistical significance at the 10% level.
**
Statistical significance at the 5% level.
***
Statistical significance at the 1% level.

disclosure of allowance and reserve accounts in close Conclusion

proximity to the asset or liability accounts to which they
are related (as would be the case when transparent disclo-
sures are provided in the notes to the financial statements)
facilitates users’ understanding of the information about
activity in these allowance and reserve accounts. Finally,
it is possible that we have failed to control for systematic
variation in company characteristics or disclosure informa-
tion content between the two groups of companies (i.e.,
Schedule II companies and companies with transparent
disclosure in the notes to the financial statements) and this
limits the power of our tests. Because these factors are easy
to hold constant in an experimental setting, future experi-
mental work may be able to perform more rigorous tests of
Hypothesis 2.
In this paper, we investigate whether the extent of
accruals-based earnings management is lower when com-
panies provide transparent disclosures about activity in
valuation allowance and reserve accounts. Using a number
of proxies for the extent of accruals-based earnings man-
agement, including measures of account-level discretion
and broad measures of discretion, we find strong evidence
suggesting that the extent of earnings management is
higher among companies that do not provide transparent
disclosures about activity in allowance and reserve
accounts. These results support the IASB and FASB’s recent
joint project that seeks to improve disclosures about activ-
ity in individual accounts and we conclude that regulators,

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and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx 17

auditors, and investors should consider subjecting those Acknowledgements

companies that fail to provide transparent disclosures to
additional scrutiny.
We also investigate whether the extent of accruals-
based earnings management differs for companies that
provide transparent disclosures in one comprehensive
schedule (Schedule II) relative to companies that provide
transparent disclosures in the notes to the financial state-
ments. Although regulators appear to believe that a com-
prehensive schedule would be beneficial, our results
indicate that it is the omission of transparent disclosures,
not the omission of a comprehensive schedule outlining
activity in allowance and reserve accounts (i.e., Schedule
II), that affects earnings management. That is, companies
omitting Schedule II but providing transparent disclosure
of activity in allowance and reserve accounts elsewhere
in the notes to the financial statements are not more likely
to engage in earnings management than are companies
that provide a Schedule II. As discussed in the previous sec-
tion, we acknowledge that there are a number of alterna-
tive explanations for this result. Thus, we encourage
further work investigating whether the placement and/or
format of transparent disclosures matters.
We thank Hun Tong Tan (editor), two anonymous
reviewers, Joe Carcello, Bob Libby, James Myers, Terry
Neal, Mark Nelson, Karen Pincus, Doug Skinner, Jenny
Tucker, Paul Zarowin, workshop participants at the
University of Arkansas, the University of Hawaii at
Manoa, and the University of Tennessee, as well as confer-
ence participants at the 2013 American Accounting
Association Annual Meeting and at the 2014 Accounting,
Organizations and Society Conference on Accounting
Estimates for helpful comments and suggestions. We
gratefully acknowledge Deloitte LLP’s sponsorship of the
2014 Accounting, Organizations and Society Conference on
Accounting Estimates. Linda Myers gratefully acknowl-
edges financial support from the Garrison/Wilson Chair at
the University of Arkansas.
Appendix A
Accounts disclosed in Schedule II and the frequency and size of
valuation allowance and reserve accounts

Accounts disclosed in Schedule II Frequency Percent of observations

Allowance for doubtful accounts 4410 94.6
Valuation allowance for deferred tax assets 1744 37.4
Valuation allowance related to inventory 1159 24.8
Allowance for sales returns 528 11.3
Allowance for warranty 367 7.9
Allowance for cash discounts 206 4.4
Restructuring reserve 152 3.3
Other allowances/reserves 1089 23.3
Note: Frequencies are based on the 4664 sample company-year observations that provide a Schedule II. Other allowances/reserves include accounts such as
legal reserves, environmental reserves, liabilities for costs of discontinued operations, and excess of estimated costs over revenues on contracts.

Data availability Frequency and size of valuation allowance and reserve

accounts (as a percent of total assets)
The data used are publicly available from the sources
cited in the text.

Transparent (N = 6605) Non-transparent (N = 2854)

N Mean Median N Mean Median
Allowance for doubtful accounts 6200 0.013 0.004 2401 0.016 0.003
Valuation allowance for deferred tax assets 1924 0.238 0.021 630 2.642 0.147
Valuation allowance related to inventory 1222 0.020 0.010 216 0.042 0.010
Note: Although the size of the valuation allowance for deferred tax assets appears large, it is not unreasonable given that the amount of deferred tax assets
included in total assets is presented net of the allowance on the balance sheet. We read through disclosures made by companies with large deferred tax
asset valuation allowances (scaled by total assets) and note that these companies tend to have large net operating loss carryforwards, which they believe
will expire before they can be fully realized.

Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
and accruals-based earnings management. Accounting, Organizations and Society (2015), http://dx.doi.org/10.1016/j.aos.2015.03.004
18 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx

Appendix B

Disclosure examples

Schedule II
Avod Products, Inc. and Subsidiaries
Valuation and Qualifying Accounts
Years ended December 31, 2010, 2009, and 2008
Additions
(in millions) Balance at Charged to costs Charged to Deductions Balance at end
Description beginning of period and expenses revenue of period
2010
Allowance for doubtful $132.4 $215.7 $– $199.3a $148.8
accounts receivable
Allowance for sales returns 32.7 – 424.1 373.6b 83.2
Allowance for inventory 114.9 131.1 – 119.3c 126.7
obsolescence
Deferred tax asset valuation 370.2 92.5d – – 462.7
allowance

2009
Allowance for doubtful $101.9 $221.2 $– $190.7a $132.4
accounts receivable
Allowance for sales returns 25.5 – 370.5 363.3b 32.7
Allowance for inventory 97.0 120.0 – 102.1c 114.9
obsolescence
Deferred tax asset valuation 269.4 100.8d – – 370.2
allowance

2008
Allowance for doubtful $108.3 $195.1 $– $202.1a $101.9
accounts receivable
Allowance for sales returns 31.9 – 365.5 371.9b 25.5
Allowance for inventory 211.3 79.4 – 193.7c 97.0
obsolescence
Deferred tax asset valuation 278.3 – – 8.9e 269.4
allowance
a
Accounts written off, net of recoveries and foreign currency translation adjustment.
b
Returned product destroyed and foreign currency translation adjustment.
c
Obsolete inventory destroyed and foreign currency translation adjustment.
d
Increase in valuation allowance for tax loss carryforward benefits is because it is more likely than not that some or all of the deferred tax assets will not
be realized in the future.
e
Release of valuation allowance on deferred tax assets that are more likely than not to be realized in the future.

Transparent disclosure in the notes to the financial statements Non-transparent disclosure in the notes to the financial
statements
Inventories. Inventory is valued at the lower of cost, deter-
Balance at Additions Deductions Balance mined on a first-in, first-out basis (FIFO), or market.
beginning at end Inventory items are analyzed to determine cost and the
of period of market value and appropriate valuation reserves are estab-
period lished. At December 31, 2010 and 2009, the Financial
Statements include an allowance for excess or obsolete
Allowance for doubtful accounts and sales returns
inventory of $1.1 million and $1.8 million, respectively. At
2010 $6723 $5508 $(6035) $6196
December 31, 2010 and 2009, inventory included raw
2009 $7608 $6956 $(7841) $6723
material, work in process and packaging amounts of
2008 $9634 $5470 $(7496) $7608
$742,000 and $610,000, respectively, and finished goods
of $940,000 and $795,000, respectively.

Please cite this article in press as: Cassell, C. A., et al. Disclosure transparency about activity in valuation allowance and reserve accounts
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 C.A. Cassell et al. / Accounting, Organizations and Society xxx (2015) xxx–xxx
Revenue recognition. As of December 31, 2010 and
December 31, 2009, we included a provision for sales
allowances of $106,000 and $127,000, respectively, which
are reported as a reduction to account receivables. We also
included an estimate of the uncollectability of our accounts
receivable as an allowance for doubtful accounts of
$13,000 and $23,000 as of December 31, 2010 and 2009,
respectively. Additionally, accrued advertising and other
allowances as of December 31, 2010 include $1.5 million
for estimated future sales returns, $1.2 million for coopera-
tive incentive promotion costs and $828,000 for certain
other advertising and marketing promotions. As of
December 31, 2009 accrued advertising and other allowan-
ces include $1.5 million for estimated future sales returns
and $586,000 for cooperative incentive promotion costs.
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