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1. Introduction
Recently, Bernard and Noel (1991) [hereafter BN] studied what can be
learned from inventory disclosures. BN review alternative economic models
of the production-inventory cycle and discuss their implications for using
inventory disclosures to predict future sales and future earnings. They test
these implications on seven manufacturing industries where many firms
disclose details on the components of inventories. BN also study the retail
department store industry, where firms do not disclose detailed inventory
components.
BN's results for manufacturers suggest that inventory data convey in-
formation to investors in at least two different ways.
1. Unexpected inventory changes are positive leading indicators of fu-
ture sales, even after controlling for current sales. This relation is
driven primarily by unexpected changes in raw materials and work-
in-process inventories. It would be consistent with the "production
smoothing" and/or "lead time" models of inventory, where inven-
tory changes refiect managers' private information about demand.
2. Unexpected inventory changes appear to be weak negative leading
indicators of future earnings and profit margins, even after controlling
for current sales and earnings. This relation appears to be traceable
to unexpected changes in finished goods inventories. It would be
consistent with a "stockout" model of inventories, where current
demand is only partially reflected in current sales, the remainder
being reflected in the frequency of stockouts. That is, low (high)
ending inventories indicate a high (low) frequency of stockouts, and
447
448 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
is twofold. First, obtaining such evidence represents one more step toward
filling in the gaps necessary to understand and explain stock price reactions
to unexpected accruals.^ Second, and more generally, this type of evidence
is a logical building block in better understanding fundamental analysis.'*
The primary findings of this study are that, for manufacturers, receiv-
ables provide information useful for predicting future sales, eamings, and
margins that are incremental to that contained in total inventory balances.^
For predictions of future sales, in contrast to the ability of unexpected
inventory balances to predict sales several quarters ahead, the predictive
power of unexpected receivables is short-lived; it is evident only in one-
quarter-ahead predictions of sales. On the surface, this result is consistent
with a sales momentum explanation where receivables balances indicate the
level of sales for the last few weeks of a quarter. However, industry-level
evidence for the sales momentum explanation is weak, and more detailed
predictions of this explanation are not supported by the data.
For manufacturers, receivables appear to be most useful for predicting
future eamings and margins. Unexpected receivables balances are strong
negative leading indicators of eamings and margins for all prediction ho-
rizons, consistent with an "eamings quality" explanation. This is evident
in both pooled results for manufacturers and in industry-by-industry results
for five of seven manufacturing industries. In contrast, there is (at best)
only a weak negative relation between unexpected total inventories and next
quarter's eamings and margins that grows stronger in multiple-step-ahead
predictions. These effects are traceable primarily to predictions made at the
end of interim quarters; there is no reliable evidence that fourth-quarter
receivables balances (or fourth-quarter total inventory balances, for that
matter) are useful in predicting future eamings or margins.
Given knowledge of only aggregate sales for the quarter (5,), the
conditional expectation for the firm's end-of-quarter receivables balance
is
E{R,\S) = 2/3 5,.
Three situations are of interest: a base case with level monthly sales
and scenarios A and B where sales increase and decrease, respectively,
from the original level, during the third month of the quarter. In each
situation, actual receivables balances are assumed to consist of the last
60 days' (two months') sales, but unexpected receivables for quarter t
(UR,) are based on the conditional expectation for receivables given sales
for the quarter t (5,).
In the base case, sales are $1,000 per month in each of the three months
of the quarter. The actual receivables balance would be $2,000, derived as
follows:
INCREMENTAL INFORMATION CONTENT OF RECEIVABLES 453
Actual Receivables
Month Sales Balance
1 $1,000
2 1,000 X 1.0 $1,000
3 1,000 X 1.0 1,000
$3,000 $2,000
Actual Receivables
Month Sales Balance
1 $1,000
2 1.000 X 1.0 $1,000
3 1.300 X 1.0 1,300
$3,300 $2,300
Since the new, higher level of sales in month 3 is aggregated with the
original level of sales occurring in months 1 and 2 in the receivables ex-
pectations model, unexpected receivables are positive:^
UR, = $2,300 - 2/3($3,300) = $100.
Scenario B illustrates the mirror image of scenario A—sales are again
$1,000 in months 1 and 2, but decrease to $700 in month 3, producing an
actual receivables balance of $1,700.
7. Alternatively, if sales had steadily increased by $100 per month, from $1,000 in month 1 to
$1,100 in month 2, and to $1,200 in month 3. all essential quantities (sales for the quarter, the actual
receivables balance, and expected accounts receivable) would be the same. Thus, unexpected receivables
would still equal $100.
454 JOURNAL OF ACCOUNTING, AUDITING & HNANCE
8. Parallel to the alternative scenario described in note 7, assuming sales were steadily decreasing
by $100 per month would again produce the same essential results.
9. The actual expectations models for receivables in the empirical work control for seasonality.
INCREMENTAL INFORMATION CONTENT OF RECEIVABLES 455
Earnings Predictions:
Et — •£'(-4
8^ + (t)£ V,.
0,-4 'Jt-5
Margin Predictions:
8M + ^ M l + ^ M 4 + ^
As in BN, these bench mark prediction models are estimated with pooled
cross-sectional, time-series data on an industry-by-industry basis.
BN's expectations models for total inventory (/) and its components—
raw materials (RM), work-in-process (WP), and finished goods (FG)—are
summarized below. These models include past values of both sales and
inventory as regressors. Because data on inventory components are available
only annually, values of total inventory are used in place of component data
at the nonseasonal lags.
Expectations Model for Total Inventory (/):
T bo + TT - + ^4 ^ - ^
"i—:: + b
St-,
458 JOURNAL OF ACCOUNTING, AUDITING & HNANCE
+ *5—^ + be + e,.
»J(-4 ^1-5
S, - 5,_
^ + be + e,.
lag and the first lag of the seasonal difference of the dependent variable,
each scaled by the contemporaneous value of sales. Making similar ad-
justments to the equation for receivables gives the following receivables
expectations model:
Expectations Model for Receivables:
l - + e,.
Jr-
12, Some of the noise in the relation between receivables and current sales levels may be due to
the relative ease with which firms can sell receivables to a factor and remove them from their balance
sheets, as compared with sales of most items of inventory.
460 JOURNAL OF ACCOUNTING, AUDITING & HNANCE
TABLE 2
Distribution of Receivables Scaled by Sales for the Same Quarter
(RJS,)
Selected Fractiles
Industry' Mean Median .10 .25 .75 .90
"SIC codes for industries are 2830-2839 Pharmaceuticals (DRUGS), 3400-3499 Metal products
and fabrication (METALS), 3500-3599 Nonelectrical machinery (MACHINERY), 3670-3679 Elec-
tronic products (ELECTRONICS), 3680-3689 Computing equipment (COMPUTING), 3700-3799
Transportation equipment (TRANSPORT), 3800-3899 Instrumentation & controls (INSTRUMENTS),
5300-5399 Retail department stores (RETAIL),
period (1978-1987) ends before consolidation of all majority owned subsidiaries was mandatory. (Fi-
nancial Accounting Standards Board [FASB] Statement No. 94, Consolidation of all Majority Owned
Subsidiaries, issued in October 1987. was effective for financial statements for fiscal years ending after
December 15, 1988.) Thus, receivables from captive finance subsidiaries are included in receivables
here only for firms that voluntarily consolidated such subsidiaries before the effective date of FASB
94. To tiie extent that some nontrade receivables are included in prior periods receivables balances, the
terms involving lagged receivables balances should remove somefirm-specificand even seasonal variation
in such items. The remaining variation will show up as noise in unexpected receivables.
14. The benchmark prediction equations for sales, earnings, and margins are modified for multiple-
quarter-ahead predictions as described in BN (p. 171). Also, following their convention, values of the
dependent variables for the one-year-ahead predictions are averages of the next four quarters' sales,
earnings, and margins figures.
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The exact reasons the fourth-quarter results differ from those of interim
quarters are unknown. To be sure, the predictive ability tests for a single
quarter are less powerful than tests for the three interim quarters or tests for
all four quarters combined. However, there could be reasons why the pre-
dictive ability of fourth-quarter receivables balances would systematically
differ from that of interim receivables balances. For example, managers
may engage in end-of-year balance sheet window dressing by factoring
receivables, or by altering credit terms to speed up collections (e.g., offering
larger discounts). Similarly, managers might exert more effort at year-end
to manage nontrade receivables, such as amounts due from unconsolidated
affiliates. Such activities would add noise to unexpected receivables at year-
end that might not be present at interim dates.
Tests like those in Table 3 were also conducted on an industry-by-
industry basis. Although the industry-level results are not separately tabu-
lated here, the following is a summary of cases where the coefficients for
unexpected receivables were significant (at the .05 level in two-tailed tests)
in regressions including data from all quarters. For predictions of sales,
receivables are significant positive leading indicators of sales (as in the
pooled results in panel A of Table 3) only in industry 1 (drugs), there for
both one- and two-quarter-ahead predictions. However, receivables are sig-
nificant negative leading indicators of sales (opposite the pooled results) in
two-quarter-ahead predictions in industry 3 (machinery) and in three- and
four-quarter-ahead predictions for industry 7 (instruments). Therefore, there
is little evidence supporting the sales momentum explanation at the industry
level.
In contrast, for predictions of eamings and margins, there is more con-
sistency between the pooled results (in panels B and C of Table 3) and
industry-level results. For industry 1 (dmgs), receivables are significant
negative leading indicators of both eamings and margins at all horizons
except the one-quarter-ahead predictions. For industry 2 (metals), receiv-
ables are significant negative leading indicators only of eamings and there
only in one-quarter-ahead predictions. For industry 3 (machinery), receiv-
ables are significant negative leading indicators of both eamings and margins
in one-quarter- and one-year-ahead predictions, and of margins alone in
two-quarter-ahead predictions. For industry 4 (electronics), receivables are
significant negative leading indicators f both eamings and margins at all
horizons except for two-quarter-ahead predictions of margins. For industry
6 (transportation), receivables are significant negative leading indicators of
both eamings and margins in one-quarter- and one-year-ahead predictions.
The only industry-level result on eamings and margins that is opposite the
pooled results and significant at even the .10 level (in a two-tailed test) is
466 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
15. Assuming a 360-day year, the average collection period = 90 days x R/S,.
16. The purpose of this modification is to eliminate any tendency for unexpected receivables for
firms classified ex post as having high (low) average receivables-to-sales ratios to be systematically
positive or negative.
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467
468 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
17. Some of the estimated coefficients are larger for firms with low average receivables-to-sales
ratios. However, this is not evidence in favor of the sales momentum explanation. The reasoning is that
in such firms, receivables balances support a greater amount of sales activity, thus greater estimated
coefficients would naturally be expected. Here, the appropriate comparison involves only the significance
levels of the coefficients.
INCREMENTAL INFORMATION CONTENT OF RECEIVABLES 469
TABLE 5
Predictability of Sales, Earnings, and Margins for Manufacturers
Based on Inventory Components and Receivables Data
Sample Size (N) and Coefficients (t-statistics) on Designated Regressors***
Panel A:
Predictions of (Changesin) Sales, Based on Lagged Sales, Inventory, and Receivables Data
Panel B:
Predictions of (Changes in) Earnings, Based on Lagged Eamings, Inventory, and Receivables Data
Panel C:
Predictions of (Levels of)Margins, Based on Lagged Margins, Inventory, and Receivables Data
18. See Stot)er (1993) for some examples of models that include such interaction terms.
19. If large acquisitions and divestitures are distorting the data, the unexpected components of all
current operating assets (receivables and inventories) would be expected to move together. Although
the data screens are intended to remove such distorted observations, it is possible that some remain in
the sample. BN (n. 17, p. 170) generally recognize that data distortions from acquisitions and divestitures
could bias their coefficients on all of the inventory components upward. (They argue that this econometric
problem would be most severe in the sales and earnings equations, but the equation for profit margins
should be relatively unaffected.) If such effects are present here, then the interaction terms may simply
pick up the effects of removing the upward bias in other coefficients.
INCREMENTAL INFORMATION CONTENT OF RECEIVABLES 471
components, and future sales, earnings, and margins are complex and may
be context dependent. It is likely, then, that parsimonious explanations such
as sales momentum and earnings quality capture only a part of the story.
Further work is necessary to sort out such interactions and better understand
the economic logic underlying them.^"
5. Concluding Remarks
This study provides evidence on the incremental information content of
receivables in predicting future sales, earnings, and profit margins. It extends
the results of Bernard and Noel (1991) (BN) by adding unexpected receiv-
ables, along with the variables they investigate—total inventory and its
components—to their prediction models for sales, earnings, and margins.
The tests are conducted on the BN sample. Although this permits direct
comparisons with the results of BN, it also represents a limitation of this
study. The sample is a nonrandom one; BN selected their industries to have
sufficient data to estimate expectations models for inventories, receivables,
sales, earnings, and margins on an industry-by-industry basis. Therefore,
caution should be exercised in generalizing the results beyond the eight
industries represented in this sample.
Two simple explanations for the potential information content of re-
ceivables guide the investigation: the earnings quality explanation and the
sales momentum explanation. The major findings are that, for manufactur-
ers, receivables provide information useful for predicting future sales, earn-
ings, and margins that is incremental to that contained in total inventory
balances. Like unexpected inventory balances, unexpected receivables are
positive lead indicators of future sales. Relative to evidence on unexpected
inventory balances predicting future sales multiple quarters ahead, however,
the predictive power of unexpected receivables is short-lived; it is evident
only in one-quarter-ahead predictions of sales. On the surface, these results
are consistent with a sales momentum explanation, where receivables bal-
ances indicate the level of sales for the last few weeks of a quarter. The
20. A potential way around the data problems caused by the effects of acquisitions and divestitures
is to use statement of cash flows data on changes in total inventories and receivables >om operations,
which exclude these effects. Future work in this area might profitably exploit statement of cash flows
data by estimating the prediction equations within these years based on " a s - i f inventory and receivables
balances that ignore changes in total inventory and receivables due to acquisitions and divestitures. The
resulting estimates would not be contaminated by the effects of acquisitions and divestitures and thus
represent tests of the predictive ability of pure changes in inventories and receivables from firms' operating
activities. Quarterly data from the statement of cash flows are available on Compustat beginning with
the first quarter of 1987. However, there are trade-offs involved, as receivables data from 1988 on will
also include receivables from captive finance subsidiaries that were not consolidated during the sample
time period examined here (see note 13).
472 JOURNAL OF ACCOUNTING, AUDITING & HNANCE
data do not support more detailed predictions of the sales momentum ex-
planation, however.
The pattern is different for predictions of manufacturers' future earnings
and margins. Although unexpected total inventories are strong negative
leading indicators of future earnings and margins in multiple-step-ahead
predictions, the relation between unexpected total inventories and next quart-
er's earnings and margins is weak. In contrast, pooled results for manufac-
turers indicate that unexpected receivables balances are strong negative
leading indicators of earnings and margins for all prediction horizons. This
effect is traceable primarily to predictions made at the end of interim quarters;
there is no evidence that fourth-quarter receivables balances (or fourth-
quarter total inventory balances, for that matter) are useful in predicting
future sales, earnings, or margins. For all four quarters combined, at least
some evidence of a significant negative relation between future earnings and
margins is also observed in industry-level results for five of seven manu-
facturing industries.
When combined with data on inventory components, available only at
year-end, fourth-quarter unexpected receivables still do not predict sales,
earnings, or margins. However, information on unexpected receivables may
be important in expanded models that include interaction terms representing
cases where unexpected receivables and unexpected inventory components
have opposite signs. Such interactions suggest that the links between un-
expected receivables, unexpected inventories, and future sales, earnings,
and margins may be more complex than contemplated by the simple ex-
planations guiding this study.
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INCREMENTAL INFORMATION CONTENT OF RECEIVABLES 473
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