Do Transparent Disclosures About Activity in Judgmental Accounts Affect Earnings Quality?

Abstract

We examine the relation between the transparency of disclosures about activity in valuation allowance and reserve accounts and accruals-based earnings management. We classify 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 companies 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, auditors, and investors should consider subjecting companies that fail to provide transparent disclosures to additional scrutiny.