The Impact of Conservatism and Supply Chain Finance on Bad Debt Expense

Abstract

Standard accrual models assume a linear relation between accruals and changes in sales. However, due to conservatism, working capital items such as receivables can be written off but are rarely written up, creating an asymmetry that linear models do not capture. We compare the modified Jones model with models based on accounting methods for bad debt expense (BDE). We find that models that incorporate conservatism have much better explanatory power, especially during recessions when write-offs are bigger. Moreover, modeling conservatism highlights the effect of contracting innovations that influence the risk of receivables and hence BDE. We find that supply chain finance, which has gained popularity after the 2007-08 financial crisis, contributed to recent decreases in the levels and volatilities of write-offs and BDE. Our study highlights the importance of modeling individual accruals using accounting methods, adjusting for conservatism, and incorporating business innovations that affect accounting practice.