EVIDENCE OF MANAGER INTERVENTION TO AVOID WORKING CAPITAL DEFICITS

SCOTT D. DYRENG, Duke University

WILLIAM J. MAYEW, Duke University
KATHERINE SCHIPPER, Duke University

*Address correspondence to scott.dyreng@duke.edu, Fuqua School of Business, Duke University,

Box 90120, Durham, NC 27708, 919-660-8004 (phone), 919-660-7971 (fax). This research was
supported by the Fuqua School of Business, Duke University. We appreciate the helpful
comments of Bob Ashton, Jeff Brovet, Dave Burgstahler, Qi Chen, Michael Clement, Robert
Freeman, Jeff Gramlich, Ross Jennings, Lisa Koonce, Mary Lea McAnally, Grace Pownall, Terry
Shevlin, Senyo Tse, Joe Weber, and workshop participants at Duke University, Emory University,
Florida State University, Northwestern University, Singapore Management University, University
of Illinois, University of Washington, the Yale Summer Accounting Research Conference, and the
2012 Colorado Summer Accounting Research Conference. This paper was previously titled Do
Distribution Discontinuities Reflect Manager Intervention in Financial Reporting? Evidence from
Working Capital Deficits.
 EVIDENCE OF MANAGER INTERVENTION TO AVOID WORKING CAPITAL DEFICITS

SCOTT D. DYRENG, Duke University

WILLIAM J. MAYEW, Duke University
KATHERINE SCHIPPER, Duke University

ABSTRACT
We study the managerial propensity to intervene in financial reporting by examining working
capital deficits, measured as current ratios less than 1.0. Current ratios represent important balance
sheet liquidity indicators to lenders and creditors, and have an identifiable and naturally occurring
reference point at 1.0, analogous to the profit/loss income statement reference point. We find that
distributions of reported current ratios exhibit a severe discontinuity at 1.0, that the discontinuity
increases with exogenous increases in the cost of credit in the economy, and that determinants of a
firms likelihood to achieve a given current ratio are diagnostic precisely at the 1.0 discontinuity
location but not at other nearby locations in the current ratio distribution. Firms that avoid working
capital deficits report lower proportions of inventory and higher proportions of accounts receivable
and, when credit is tight, higher proportions of cash, consistent with managers increasing sales
volume so as to capitalize profit margins and thereby increase current assets.

KEY WORDS: WORKING CAPITAL, CURRENT RATIO, DISTRIBUTION

DISCONTINUITY, BALANCE SHEET MANAGEMENT

JEL CLASSIFICATION: M41

1
1. Introduction

We examine the distributional properties of current ratios to assess whether managers

intervene in financial reporting to avoid working capital deficits. Our analysis extends accounting

research that provides evidence on whether managers purposefully intervene in financial reporting

in an attempt to influence investor perceptions. For example, accounting researchers have assessed

the distributional properties of income statement numbers to draw inferences about earnings

management (McNichols 2000). In contrast to research which focuses on earnings properties, we

take a balance sheet perspective, and focus on current ratios.

The current ratio has been used by creditors since the 1890s (Horrigan 1968; Waymire

and Basu 2007); prior research suggests managers are keenly aware of the importance of reported

current ratios in shaping perceptions of liquidity (Lev 1969; Gramlich et al. 2001). Just as

managers intervene to avoid reporting losses on income statements (Hayn 1995; Burgstahler and

Dichev 1997), we propose that managers will exhibit similar loss avoidance behavior on the

balance sheet, specifically, in the management of working capital to avoid reporting a working

capital deficit. The definition of working capital establishes total current liabilities as the reference

point for total current assets, just as earnings establishes expenses plus losses as the reference

point for revenues plus gains. The working capital definition thus identifies a current ratio of 1.0

as the target for analyzing loss avoidance behavior in the context of working capital management.

We argue that an incentive to intervene in the accounting process to avoid reporting a

working capital deficit arises if managers believe stakeholders make asymmetrically negative

assessments of liquidity and credit quality, so that a working capital deficit is viewed more

negatively than a similar-sized working capital surplus is viewed positively. Based on this

reasoning, we predict a discontinuity in the distribution of current ratios, specifically, an

unexpectedly small (large) frequency of reported current ratios just below (above) 1.0. Our results

are consistent with this expectation. Using a large sample of quarterly current ratios reported by

2
U.S. firms between 1968 and 2013, we find a statistically significant discontinuity in the current

ratio distribution precisely at 1.0.

As discussed by Burgstahler and Chuk (2013), management interventions to avoid

missing a benchmark reference point should vary with the costs and benefits of those

interventions. In our context, these costs and benefits should vary with tight and loose credit,

based on the view that tight credit would increase stakeholder interest in assessing liquidity and

credit quality, and exacerbate any existing tendency to make asymmetric assessments. To probe

this possibility, we investigate whether the magnitude of the current ratio discontinuity varies in

times of tight and loose credit. To avoid the endogeneity that arises because the credit conditions a

firm faces likely result at least partly from managements operating choices, we use time series

differences in the effective federal funds rate to capture exogenous variation in credit conditions in

the macro-economy. We find that the distribution of current ratios for observations in the highest

quartile of effective federal funds rates exhibits a statistically larger discontinuity than does the

distribution of current ratios for observations in the lowest quartile.

We provide two analyses that strengthen inferences from our analyses of distribution

discontinuities. First, we estimate firm level logistic regressions for current ratio observations

falling in the intervals [bins] immediately surrounding 1.0. We estimate five logistic regressions

that model the probability a firms current ratio falls in the higher of two adjacent bins: 0.95 vs.

0.96, 0.97 vs. 0.98, 0.99 vs. 1.00, 1.01 vs. 1.02 and 1.03 vs. 1.04. Except for the 0.99 vs. 1.00 bin

comparisons, these are pseudo comparisons that do not contain a theoretically justified reference

point. We expect significant explanatory power for the model that compares the 0.99 vs. 1.00 bins

but not for the other comparisons.

Results of this test corroborate the distributional evidence; the higher the effective federal

funds rate, the higher the likelihood a firm will fall into the 1.0 current ratio bin. This result holds

when we control for the information environment using size, the existence of explicit debt and

3
lease contracts, and firm profitability, each of which is a statistically significant predictor in its

own right. In the pseudo estimations involving bins close to 1.0, these associations do not

systematically exist. This implies that management uses the posited current ratio reference point of

1.0, as opposed to exhibiting a general tendency toward reporting higher current ratios.

Our second analysis provides evidence of the actions management takes to avoid working

capital deficits. Results of these tests suggest that, unconditional on whether credit is tight, firms

reporting a small working capital surplus have lower proportions of inventory and higher

proportions of net accounts receivable in total current assets than firms reporting a small working

capital deficit. This outcome is consistent with managerial interventions to capitalize profit

margins on the balance sheet and thereby increase current assets and, possibly, also consistent with

manipulation of the allowance for doubtful accounts; we cannot provide direct evidence of the

latter possibility because the allowance for doubtful accounts is not sufficiently populated in the

quarterly data we examine. When credit is tight in the economy, we find additional evidence that

the proportion of cash in current assets is larger, and the proportion of short term debt in current

liabilities is lower for firms reporting small working capital surpluses, and some evidence of long

term debt increases. This last finding is consistent with either strategic reclassification of short

term debt to long term (Gramlich et al. 2001; Gramlich et al. 2006) or renegotiations with lenders.

Finally, we extend our analysis internationally, since working capital deficit avoidance

should not be jurisdiction-specific. We find evidence of a discontinuity in current ratios at 1.0 in

non-U.S. data, indicating that the phenomenon we document for U.S. firms generalizes to an

international context. We also find evidence that working capital deficit avoidance is more

pronounced in common law countries, consistent with the view that financial reporting in common

law countries is more informative for decision makers relative to code law countries.

Our study extends the accounting literature on benchmark beating behavior, which has

mostly focused on the income statement, to the balance sheet (Holthausen and Watts 2001). Our

4
results also complement prior research showing that managers intervene in balance sheet reporting

to avoid violating explicit debt covenants (Dichev and Skinner 2002) and government solvency

targets (Gaver and Paterson 2004). Finally, our results suggesting that balance sheet management

varies with credit availability extend previous findings on the association between macroeconomic

conditions and financial reporting outcomes. For example, while existing research focuses on

investor responses to earnings during periods of changing interest rates (Collins and Kothari 1989)

and business cycles (Johnson 1999), our results shed light on how variation in credit availability

influences managerial choices that affect financial reporting outcomes.

2. Theory and hypothesis development

Managerial incentives to achieve benchmarks

Our aim is to shed light on factors that shape financial reporting behaviors, taking as

given that managers consider how stakeholders use reported information. Previous research, for

example, Burgstahler and Dichev (1997) and Degeorge et al. (1999), posits that if the marginal

stakeholder evaluates the firm using reference points or thresholds, managers will rationally seek

to avoid reporting outcomes that fall below those reference points or thresholds. As discussed by

Burgstahler and Dichev (1997) and Degeorge et al. (1999), stakeholders may use reference points

because they are loss averse (Kahneman and Tversky 1979).1 Or, as pointed out by Degeorge et

al. (1999, p. 7), thresholds come to the fore because people depend on rules of thumb to reduce

transactions costs. Regardless of the source of this behavioral propensity, the predicted outcome

is a threshold mentality (Degeorge et al. 1999, p. 6) such that decision makers perceive

1
Prospect theory, as developed by Kahneman and Tversky (1979), posits, among other things, that
decision makers behave as if they evaluate outcomes relative to a specified threshold, which they
describe as a reference point, and that decision makers value functions are concave in gains and
convex in losses measured relative to the reference point. We do not view our analysis of working
capital deficit avoidance as a test of prospect theory because our analyses do not consider decision
makers value functions, other than the possible existence of a reference point.

5
continuous accounting numbers or accounting ratios in discrete categories, and managers respond

to this perception.

Accounting equations can be used to identify reference points or thresholds for certain

reporting contexts. The following expression for net income that underpins the literature on

managerial loss avoidance shows that the reference point for revenues + gains is expenses +

losses:

= ( + ) ( + ) (1)

Favorable (unfavorable) deviations from the reference point result when revenues + gains are

greater (less) than expenses + losses. Taking (1) as the determinant of a reference point, a test for

managerial intervention in financial reporting can be based on the distribution of reported earnings

relative to zero (McNichols 2000). If stakeholder preferences imply asymmetric reporting

incentives, managers should take actions to avoid reporting net losses, implying an unexpectedly

low (high) number of earnings observations just below (above) zero.2 Hayn (1995), Burgstahler

and Dichev (1997) and Degeorge et al. (1999) document that earnings distributions do indeed

exhibit this loss avoidance discontinuity.3 Subsequent studies analyze factors that drive the

discontinuity, including earnings components (Beaver et al. 2003), managerial incentives (Dechow

et al. 2003; Ayers et al. 2006) and research design choices (Durtschi and Easton 2005, 2009;

Burgstahler and Chuk 2013; Burgstahler 2014, Jorgensen et al. 2014).

2
Asymmetric managerial payoff functions could also generate earnings discontinuities. For
example, a compensation contract that specifies a bonus for positive earnings, or earnings greater
than a prior periods earnings, or earnings greater than analyst expectations, would create
contractual reference points. We are not aware of a study documenting the systematic and explicit
use of these reference points in compensation contracts. Survey evidence in Graham et al. (2005)
concludes that managers are interested in reporting earnings that exceed these reference points to
influence stock prices, and less so for explicit contracting reasons. However, Matsunaga and Park
(2001) provide evidence consistent with boards paying lower bonuses when earnings fall short of
analyst expectations or prior earnings (but not when earnings levels fall below zero).
3
In addition to the zero net income reference point, researchers have documented discontinuities
using prior period earnings and analyst forecasts as reference points.

6
Testing for managerial interventions in financial reporting using working capital deficits

Research on discontinuities in earnings distributions commonly proposes that the

stakeholder of interest is an equity investor. Given financial reporting is designed to provide useful

information to both equity investors and creditors, we focus on the balance sheet, where the

stakeholder of interest is a creditor (Horrigan 1968; Basu 2003; Waymire and Basu 2007). Taking

the view that creditors wish to assess timely repayment, we focus on working capital, a key metric

for liquidity analysis (Horrigan 1968). We test whether managers exhibit loss avoidance behavior

with respect to working capital, defined as follows:

= (2)

As specified in (2), working capital has a well-defined reference point.4 The reference point for

total current assets is total current liabilities, analogous to expenses plus losses as the reference

point for revenues and gains in (1). Loss avoidance behavior with respect to working capital

implies a manager will seek to avoid reporting a working capital deficit.

A well-defined reference point makes our analysis amenable to a distribution-based

approach (McNichols 2000), while our focus on working capital avoids the sample selection and

scaling issues that can plague inferences from analyses of earnings levels (Durtschi and Easton

2005, 2009). Since total current assets and total current liabilities are standard line items in

financial reports, measuring working capital imposes few sample selection criteria. We measure

working capital using the current ratio, total current assets divided by total current liabilities, to

eliminate firm size effects. Current ratios are scale free and therefore require no further deflation,

so there is no sample attrition from identifying a deflator and no confounding effects from

4
The reference points for other working capital based metrics, specifically, the quick ratio and
acid test ratio, are not as well defined as the reference point for the current ratio, so we do not
predict discontinuities at 1.0 for these two ratios. In untabulated results, we find statistically
significant discontinuities in bins 0.07, 0.08, 0.57, 1.00, 2.40, 3.60, and 5.75 for the quick ratio,
and in bins 0.62, 0.74, 2.66, 3.40, 3.70, and 4.61 for the acid test ratio.

7
properties of the deflator itself.5 Avoiding a working capital deficit in (2) is equivalent to avoiding

a current ratio below 1.0.

Reference point for the current ratio

Using the distribution of current ratios to test for managerial interventions to affect

financial reporting outcomes requires that (1) stakeholders use the current ratio to form judgments

and reach decisions, and (2) higher current ratios are preferred to lower current ratios by

stakeholders in the vicinity of the benchmark (the reference point), thereby providing incentives to

managers to report values above the benchmark. With respect to the first condition, current ratios

represent one of the oldest metrics used by creditors to analyze a borrowers (or potential

borrowers) repayment potential, originating in the separation of current items from non-current

items on borrower financial statements in the 1890s (Horrigan, 1968). Beaver (1966) highlights

the seminal nature of the current ratio, stating that ratio analysis began with the development of a

single ratio, the current ratio, for a single purpose the evaluation of credit-worthiness.

Empirically, research shows that lenders contract explicitly on current ratios (Dichev and

Skinner 2002; Sufi 2009), and the importance of current ratios likely extends beyond explicit

contracts. Bowen et al. (1995) suggest that trade creditors are concerned with assessing timely

payment as part of implicit contracting. Consistent with balance sheets providing liquidity

information for potential use in implicit contracting, the Credit Research Foundation, an industry

advocate for trade creditors, provides the following guidance:

Although analysis of the customer's profitability and capital position are [sic]
important, the most important factor to the trade creditor is the customer's
liquidity position. We can begin to analyze the liquidity and quality of the
current assets by calculating the current ratio. It is an indicator of the customer's
ability to meet its short-term obligations with current assets. We should be

5
Beaver et al. (2007) note that earnings level distributions are potentially confounded by earnings
components, including special items and taxes. We have identified no analogous components of
total current assets or total current liabilities that would generate a current ratio distribution
discontinuity around 1.0.

8
 very concerned if the customer has a low current ratio (Credit Risk Foundation,
2004).

With respect to the second condition, research suggests lenders, creditors, and financial

analysts view 1.0 as the minimum acceptable current ratio, with ratios less than 1.0 viewed as

evidence of liquidity deficiencies and cause for concern (Altman and McGough 1974; Barren

1992, Kristy 1994).6 Authoritative guidance for auditor judgments about an entitys ability to

continue as a going concern over the next 12 months (SAS No. 59) requires auditors to consider

negative trends, including working capital deficiencies. Research has documented explicit mention

of working capital deficits to support the issuance of a going concern opinion (Lee et al. 2005;

Johnson 2010).7 Given this evidence, we believe that, in the vicinity of 1.0, higher current ratio

values are preferred to lower values.

Of course, 1.0 may not be the only relevant current ratio benchmark. In analyzing

earnings management, researchers commonly study whether managers avoid reporting losses,

avoid earnings decreases, and avoid earnings that fall short of analysts expectations (Ayers et al.

2006; Koonce and Mercer, 2005; Brown and Caylor, 2005). While working capital deficit

avoidance on the balance sheet is analogous to loss avoidance on the income statement, there is no

analogy for reporting a current ratio that exceeds either the previous periods ratio or analysts

expectations.8

6
Anecdotal evidence of reliance on current ratios can also be found in commercial contracts. For
example, the Design-Bid-Build Construction Contract used by the Board of Regents of the
University System of Georgia in 2010 (found at
http://www.usg.edu/ref/contracts/contract_docs/dbb/gen_contract/ConstrContract-
TemplwBid.pdf) includes the following criterion for evaluating a bidder: Whether the bidder can
demonstrate sufficient cash flow to undertake the project as evidenced by a Current Ratio of 1.0 or
higher (section 16(c) of Bid Requirements).
7
Going concern opinions are costly, making suppliers, customers and other potential creditors
reluctant to do business with the firm (Mutchler 1984; Menon and Swartz 1987). As Francis
(2004) notes, the issuance of a going concern opinion might push a company into bankruptcy as
lenders and suppliers withdraw credit or change their terms.
8
Analysts do not typically forecast working capital, so there is no analyst working capital target
for management to consider. The I/B/E/S database does not provide working capital forecast

9
 Unlike the case of earnings, where prior period outcomes have been shown to be key

benchmarks, prior period outcomes are not likely an important benchmark for working capital.

The theory of optimal working capital management implies management balances sufficient

working capital to avoid liquidity and solvency problems against excessive working capital that

can reduce profits. This theory means that the prior periods current ratio will not be a benchmark

because repeatedly exceeding prior period current ratio levels will result in excessive working

capital.9 Working capital management implies that working capital will move over time to stay

close to the (firm-specific) optimal level; this behavior does not satisfy the benchmark beating

condition necessary for this study. Moreover, a firms optimal working capital is typically not

observable to firm outsiders, including researchers.

Although our main focus is on working capital deficit avoidance, that is, on current ratios

that just exceed 1.0, we acknowledge that managers may consider other benchmarks stated in

contractual arrangements; we analyze this possibility later in the paper. We also acknowledge the

existence of the 2.0 rule of thumb for working capital adequacy (Horrigan 1968). Our focus on 1.0

as the benchmark of interest is predicated on both the fact that the 1.0 benchmark has the sharpest

mapping into the notion of loss avoidance and the view that falling below 1.0 (described as the

minimum acceptable current ratio) has more severe consequences than does falling below 2.0

(described as an adequate ratio). 10

values. To identify an implicit analyst-based working capital forecast, a researcher would need to
identify analyst reports that contain a forecasted balance sheet.
9
In untabulated analysis, we plot the distribution of quarterly changes in current ratios in 0.01
intervals for our sample. The distribution of changes is normally distributed around the -0.01 bin,
with no discontinuity at zero. That the distributional peak occurs at -0.01 is consistent with firms,
in the pooled time series of data, using less working capital over our sample period.
10
Since we examine the entire distribution of current ratios, we are able to identify other targets,
such as 2.0, that appear to be of interest to management. We do not observe a distribution
discontinuity at 2.0.

10
 We assume that higher current ratios in the vicinity of 1.0 are on average desirable,

because, in the vicinity of 1.0, higher current ratios imply stronger liquidity but not excessive

working capital. In the vicinity of 1.0, stakeholders are therefore hypothesized to conclude

liquidity is asymmetrically insufficient when current assets fall below the 1.0 reference point,

current liabilities, even if a current ratio of 0.99 is not economically meaningfully different from a

current ratio of 1.01. The negative assessment associated with a working capital deficit of a

specific magnitude (e.g., current ratio of 0.99) will substantially outweigh the positive assessment

associated with a working capital surplus of the same magnitude (current ratio of 1.01), relative to

a benchmark of 1.0. This leads to the following hypothesis:

HYPOTHESIS 1: Current ratios are managed to avoid working capital deficits.

3. Sample selection and empirical analysis

Sample

The sample selection begins with the 1,118,825 unique firm-quarter observations

available on the quarterly Compustat North America database from 1968 through fiscal 2013 with

nonzero total assets (atq). Consistent with prior work (Beaver et al. 2007; Burgstahler and Dichev

1997) we remove 263,406 observations from financial institutions (SIC codes 6000-6500) and

utilities (SIC codes 4400-5000). Current ratios are not well defined for financial institutions and

utilities face regulation that may limit managements actions to achieve current ratio targets. We

remove 20,076 observations in the Fama and French (1997) industry group Restaurants, Hotels

and Motels since the median firm in this industry operates with current ratios below one, which

by definition implies that for this industry 1.0 cannot connote a minimally acceptable level current

ratio.11 Finally, we remove 66,098 observations with missing or zero current assets (actq) or

11
These firms operate in SIC codes 5800-5829, 5890-5899, 7000, 7010-7019, 7040-7049, and
7213. If we retain this industry group, we continue to find evidence consistent with managers
intervening to avoid reporting working capital deficits as reported in Figure 1. In particular, the

11
current liabilities (lctq). From this sample, we drop the lowest 5% of current assets (actq) and

current liabilities (lctq). The final sample contains 771,752 firm-quarter observations.

Table 1 Panel A presents current ratio descriptive statistics by Fama and French (1997)

industry classifications, sorted in ascending order by the median current ratio of the industry. The

entertainment and transportation (medical equipment and pharmaceutical products) industries

exhibit the smallest (largest) median current ratios. Table 1 Panel B provides descriptive evidence

on the pooled sample current ratio and its components. The median (mean) current ratio is 1.976

(2.866), suggesting that the median firm has roughly twice the amount of current assets as current

liabilities, and the average firm, nearly three times as much. In terms of composition, total current

assets are roughly 30% cash, 35% net accounts receivable, 27% inventory, and 7% other current

assets. Total current liabilities are roughly 41% accounts payable, 36% other current liabilities,

19% current portion of long term debt, and 3% taxes payable.

Distributional test of Hypothesis 1

Following prior research, we test for distribution discontinuity in the region of interest

using linear interpolation. The null hypothesis is that the number of firm-quarter observations in

any current ratio interval is equal to the average of the number of observations in the two

immediately adjacent intervals (Burgstahler and Dichev, 1997; Dichev and Skinner, 2002; Brown

and Caylor 2005; Beaver et al. 2007). We construct intervals (bins) with width of 0.01; we believe

this bin width is fine enough to observe changes in the shape of the distribution and wide enough

to filter out noise.12 The test statistic for interval i is ( )/( ( )), where is

standardized difference in the current ratio bin preceding (following) 1.0 is -4.30 (5.98),
significant at the 1% level (results not tabulated).
12
As discussed in Dichev and Skinner (2002) the researcher needs to choose bin widths that are
fine enough to observe changes in the shape of the distribution and wide enough to filter out noise.
Silverman (1986) and Degeorge et al. (1999) suggest bin widths of 2(IQR)n-1/3, where IQR is the
interquartile range of the variable of interest and n is the number of observations. This formula
gives a bin with of about 0.04 in our sample. We observe a discontinuity at 1.0 in the current ratio

12
the actual number of observations in interval i, ( )is the expected number of observations in

interval i, calculated as (+1 + 1 )/2, and ( ( )) is the estimated standard

deviation of the difference.13 Under the null hypothesis, these standardized differences are

distributed ~(0, 1). Under the alternative hypothesis, managerial interventions will shift

observations from the bin immediately preceding 1.0 (a working capital deficit) to the bin

immediately following 1.0 (a working capital surplus). This shifting should result in unusually

negative (positive) standardized differences for the bin immediately before (after) 1.0. Because the

intervals on either side of the 1.0 current ratio benchmark are not independent, for statistical tests

we draw inferences by focusing on whether the standardized difference for the bin immediately

preceding the benchmark is significantly negative (Burgstahler and Dichev 1997; Brown and

Caylor 2005).

Figure 1 displays the sample current ratio distribution between 0.01 and 7.0. Visual

inspection reveals a positively skewed distribution with a discontinuity at the bin immediately

preceding the current ratio value 1.0, denoted with the arrow. Inferences based on linear

interpolation techniques, such as the ones we use, are potentially mis-specified at inflection points

in the distribution. The distribution begins to curve at a current ratio of 1.2, and peaks at about 1.4

before curving downward, but in the region surrounding 1.0 the distribution increases in a linear

fashion. This suggests linear interpolation techniques for statistical testing are appropriate, and we

observe the discontinuity at 1.0 is highly statistically unusual. The standardized difference for the

interval immediately to the left of 1.0 is -3.39 (4.73 to the right). Both standardized differences

distribution with this wider bin width. A 0.01 bin width allows us to maintain precision in
subsequent tests when we (1) decompose the overall sample to analyze current ratio distributions
for federal funds rate quartiles and (2) conduct logistic regression analysis on the bins immediately
adjacent to the 1.0 current ratio bin.
13
The variance of the difference between the observed and expected number of observations in
interval i is constructed following Beaver et al. (2007) as Npi (1-pi) + (1/4)N(pi-1+pi+1)(2-pi-1- pi+1),
where N is the total number of observations and pi is the probability that an observation will fall
into interval i.

13
exceed the value of -2.33 required of a standard normal test statistic for a 1% significance level in

a one-tailed test. This result supports Hypothesis 1.

In untabulated analysis, we conduct two tests to confirm that the distribution

discontinuity in Figure 1 is not an artifact of examining a quotient distribution. First, we generate a

pseudo current ratio distribution; we confirm this distribution is smooth and has no discontinuity

at 1.0. Second, we plot the distribution of working capital (total current assets less total current

liabilities) scaled by total assets and observe a statistically significant (at the 1% level)

discontinuity immediately preceding the zero working capital level. No other statistically

significant discontinuity exists anywhere else in the distribution. 14 These results imply that our

inferences are not simply the result of using current ratios. That said, we do not base our analysis

primarily on scaled working capital because we want to avoid the potential for scaling itself to be

a confounding factor. For example, firms with more total assets likely have more current assets,

generating a mechanical association between numerator and denominator we wish to avoid.

Interpretation of the 1.0 current ratio discontinuity

In Figure 1 the number of observations in the interval containing the 1.0 current ratio is

2,706, compared with 2,189 in the immediately-preceding interval, a difference of 517

observations. The magnitude of this difference is partly a function of bin width; a wider bin width

results in a larger number of observations at the discontinuity. Our inferences are not affected by

our choice of bin width, up to a width of 0.04.15

The 517 firm-quarter observations are, of course, a small portion of the entire plotted

sample of over 750,000 firm-quarter observations. Comparing the 517 observation difference to

14
Scaling working capital by shareholders equity, when shareholders equity is positive, instead
of assets, also reveals a statistically significant discontinuity around zero.
15
For example, if we use bin widths of 0.04 as mechanically prescribed by Silverman (1986) and
Degeorge et al. (1999), we observe a statistically significant discontinuity at, and only at, 1.0, with
10,380 (8,601) observations in the bin containing (preceding) 1.0, a difference of 1,779
observations.

14
the entire sample of current ratios is not meaningful, as evidence on managerial interventions in

balance sheet reporting must be based on analysis of the portion of the distribution that is close to

the reference point. We display a wide range of current ratios graphically only to show the shape

of the current ratio distribution and to illustrate that there are no other obvious discontinuities in

the distribution like the one we observe at a current ratio value of 1.0. Examining the entire

distribution reveals, for example, that the discontinuity at 1.0 does not appear to be a manifestation

of a general managerial preference to report current ratios with zero and five in the tenths digit

location (Thomas 1989), as we observe no statistically significant discontinuities at current ratio

values evenly divisible by 0.5 except at 1.0.16 More specifically, we find no evidence of a

discontinuity at 2.0, which has been suggested as a rule of thumb for working capital adequacy, as

a target of interest.

We next consider the magnitude of the difference (517 observations) between the number

of observations in the 1.0 current ratio bin and the number in the immediately preceding bin,

relative to the fraction of observations in the zero versus immediately-preceding-zero bins of

price-scaled earnings distributions, as reported by previous research. To make a standardized

comparison, we first note that the difference in the number of observations in the 1.0 current ratio

bin versus the immediately-preceding current ratio bin is about 11%, that is, 517/(2,706+2,189).

We can compare this percentage to amounts reported by Beaver et al. (2007, Table 3) in their

analysis of price-scaled earnings level distributions with various definitions of the net income

numerator. They document 767 (1,687) observations in the interval immediately preceding

16
There are statistically fewer than expected observations in the current ratio bins with values
2.42, 3.88, 3.89, and 5.74. That we observe four other discontinuities is not surprising. We test for
discontinuities across 700 current ratio bins; at the 1% significance level, we expect to find seven
discontinuities by chance. To ascertain whether the current ratio target of 1.0 is of particular
importance, in subsequent analysis we model the determinants of reporting a current ratio of 1.0
relative to other (pseudo) targets.

15
(including) zero, a difference of 920 observations (37%), when net income is the numerator; 722

(1,208), a difference of 486 (25%) when pretax income is the numerator, and 852 (1,149), a

difference of 297 (15%) when income before special items is the numerator. In percentage terms,

the magnitude of our current ratio discontinuity is most comparable to the discontinuity in price-

scaled earnings before special items, the numerator Beaver et al. (2007) suggest is appropriately

purged of confounding effects.

Figure 1 and related analyses demonstrate unconditional, pooled sample evidence of the

existence of a distribution discontinuity at 1.0, the predicted reference point. We next consider

whether the discontinuity varies conditional on settings where the 1.0 reference point is believed

to be more or less important. Since the unconditional distribution discontinuity is driven by a

small number of observations, as compared to the pooled sample, the resulting low power will

make it difficult to identify statistically significant determinants of the discontinuity.

Effects of credit tightness in the economy distributional evidence

An assumption underpinning H1 is that stakeholders such as lenders and trade creditors

use working capital information from the financial statements to assess liquidity and credit quality.

We conjecture that stakeholders analyses of the current ratio should vary with economic

conditions. For example, tighter credit, such as when the federal funds rate is high, increases

financing costs and likely increases lender (including trade creditor) scrutiny of liquidity

indicators.17 On the other hand, plentiful credit, such as when the federal funds rate is low,

reduces the necessity for a lender to focus tightly on working capital, or any other metric that

informs about liquidity. Moreover, when credit is plentiful, the cost to a borrower from dropping

below the 1.0 current ratio reference point might be smaller because the supply of credit is rich,

17
This intuition is similar to Bradley and Roberts (2004), who show that financial covenants in
private lending agreements are more extensive during economic downturns, and is also related to
Chava and Purnanandam (2011), who show that bank-dependent borrowers are affected more than
other firms during a credit crunch.

16
and the firm might have other opportunities to obtain credit. Managerial propensity to avoid

working capital deficits should, therefore, be more pronounced when it is more likely that a

stakeholder uses the current ratio to evaluate credit quality or liquidity, and when the costs of

dropping below the 1.0 threshold are largest.

To examine this issue empirically, we begin by assigning to each observation the average

daily effective federal funds rate corresponding to the calendar month that matches the month of

the fiscal quarter end.18 We assume that, on average, when the effective federal funds rate is high,

credit is tight, and when the effective federal funds rate is low, credit is plentiful. We expect to

observe a relatively larger (smaller) discontinuity in the current ratio distribution when the federal

funds rate is high (low). Using variation in the cost of credit as a conditioning factor is particularly

appealing because the cost of credit is a macro factor that is exogenous to the firm (Ball 2008).

To assess the effect of credit tightness, we group the entire current ratio sample depicted

in Figure 1 into quartiles based on the effective federal funds rate, and plot these four current ratio

distributions in Figures 2a-2d. Visual inspection reveals that the overall current ratio distribution

shifts to the right as credit becomes tighter (proxied by increasing effective federal funds rates),

and the working capital deficit discontinuity becomes more striking. The test statistics for the

current ratio bin immediately preceding (to the right of) 1.0 are -0.782 (0.659), -1.108 (2.738), -

0.969 (1.507), and -4.262 (4.786) in Figures 2a, 2b, 2c, and 2d, respectively, where Figure 2d

contains the observations with the highest effective federal funds rates. For observations

associated with the lowest quartile of the effective federal funds rate, the discontinuity in the bin

immediately to the left of the 1.0 current ratio bin is not statistically significant at conventional

18
Federal funds rate data are obtained from the Federal Reserve website:
http://www.federalreserve.gov/releases/h15/data/Monthly/H15_FF_O.txt

17
levels. In the highest quartile of the effective federal funds rate, the discontinuity is statistically

significant at better than the 1% level.

The number of observations immediately preceding (including) the 1.0 current ratio

benchmark is 606 (649), a difference of 43 observations in the lowest federal funds rate quartile.

In the highest quartile, the comparable observations are 425 (671), a difference of 246

observations. Thus, 47.6% of the 517-observation difference displayed in Figure 1 stems from the

highest quartile of the federal funds rate distribution. If this rate has no impact on the

discontinuity, we would expect each effective federal funds quartile to contain 25% of the

difference in observations. A two by two contingency table comparing the lowest and highest

federal funds quartiles across firms in the bin just to the left and right of 1.0 gives a 2 of 21.488

(p-value <0.0001). An alternative way to test whether the discontinuity is statistically larger in the

highest quartile of observations sorted on the effective federal funds rate (Figure 2d) compared

with the lowest quartile (Figure 2a), is to follow the research design in Altamuro et al. (2005) and

estimate the following OLS regression:

_ = 0 + 1 + 2 + 3 + (3)

where:

_ is the difference between the expected number of observations and the

actual number of observations in current ratio bin b from the distribution in
which the bin resides, with bin width equal to 0.01. The expected number of
observations in each bin b is estimated using the average number of observations
in the bins immediately adjacent to bin b.
is an indicator variable that equals 1 if the observation is from the distribution in
Figure 2d (the highest effective federal funds rate quartile), and zero if the
observation is from the distribution in Figure 2a (the lowest effective federal
funds rate quartile).
is an indicator that equals 1 if the observation falls in the bin including the
benchmark current ratio of 1.0, -1 for the bin immediately to the left of the
benchmark current ratio of 1.0, and zero otherwise.
equals the product of and .

18
 In (3), the dependent variable, _, measures the unexpected number of

observations in each bin of both the highest and lowest federal funds rate quartile current ratio

distributions displayed in Figures 2a and 2d, respectively. The coefficient of captures the

extent to which firms are more likely to have working capital surpluses and less likely to have

working capital deficits when the effective federal funds rate is low. The coefficient on

captures incremental discontinuity when the effective federal funds rate is high. We expect

3 > 0.

Results from estimating (3) are presented in Table 2. The coefficient on is positive

(2 =25.500) and significant at better than the 1% level, suggesting that the discontinuity exceeds

(falls short of) expectations by 25.500 more observations in the region including (below) the

benchmark 1.0 current ratio than at other locations in the distribution when the effective federal

funds rate is low. The incremental coefficient on is positive (3 =123.25) and

significant at better than the 1% level, consistent with the discontinuity becoming more

pronounced when the effective federal funds rate, our proxy for tight credit, is high.

Effects of credit tightness in the economy multiple regression analysis

While the comparison of distributions across quartiles sorted on the effective federal

funds rate has research design advantages (McNichols 2000), an alternative approach is to focus

solely on the observations that reside on either side of the working capital surplus/deficit

threshold. This approach allows for an investigation of whether the level of the effective federal

funds rate affects the probability a firm meets or exceeds a current ratio of 1.0, controlling for

other firm-specific factors.

We estimate the following logistic regression for the firm-quarter observations in current

ratio bins 0.99 and 1.00, that is, firm-quarter observations residing in the current ratio intervals

[0.99, 1.00) and [1.00, 1.01), respectively:

19
 , = 0 + 1 , + 2 , + 3 , + 4 ,
+ 5 , + 6 ,1 + , (4)

where:

, is an indicator that equals 1 if the ratio of current assets (actq) to current

liabilities (lctq) reported by firm i in quarter t is in the interval [1.00, 1.01) and
zero otherwise.
, equals the average daily effective federal funds rate as reported by the Federal
Reserve for the calendar month associated with the final month of fiscal quarter
t of firm i.
, equals the natural logarithm of total assets (atq) reported by firm i in quarter t.
, is an indicator that equals 1 if firm i reported income before extraordinary items
(ibq) less than zero in quarter t, and zero otherwise.
, is an indicator that equals 1 if firm i reported either short term debt (dlcq) or
long term debt (dlttq) at quarter t, and zero otherwise.
, is an indicator that equals 1 if firm i reported nonzero total minimum rental
payments (mrct) in fiscal year y containing quarter t, and zero otherwise.19

The dependent variable, , indicates whether the firm avoided reporting a working

capital deficit. If this outcome is more likely when the effective federal funds rate is higher, as

suggested by the distributional evidence, we expect 1 >0. We include firm size () for

two reasons. First, larger firms have richer information environments (Atiase 1985) that provide

better and more direct information about liquidity and creditworthiness, inducing reduced reliance

on the current ratio. Second, if auditors are less likely to issue a going concern opinion for larger

firms (McKeown et al. 1991; Behn et al. 2001), financial statement information that might

otherwise underpin a going concern opinion, such as a working capital deficit, is more likely to be

ignored. These factors imply 2 <0.

We include an indicator for negative income () to control for the economic

condition of the firm and to rule out the possibility that the current ratio discontinuity is somehow

uncovering the profit/loss discontinuity (Hayn 1995; Burgstahler and Dichev 1997; Degeorge et

al. 1999; Beaver et al. 2007). If poor economic condition results in both a reported loss and a

19
Minimum lease payment information is not recorded in Compustat on a quarterly basis. We
assume that any lease commitments outstanding at fiscal year-end were also outstanding during
each quarter of the fiscal year.

20
lower current ratio, we expect 3 <0. On the other hand, managers who expect to report a loss may

have more incentive to avoid reporting a working capital deficit as well, since the two negative

signals may be reinforcing. This would imply 3 >0. Given the competing explanations, we do not

predict the sign of this coefficient.

We include two indicator variables, and , to proxy for the presence of

lending or leasing agreements that may contain current ratio covenants. To the extent managers

prefer to avoid reporting working capital deficits because of explicit debt and/or lease covenants,

we expect 4 >0 and 5 >0. On the other hand, stakeholders who have implicit contracts with the

firm (Bowen et al. 1995) may rely more heavily on current ratios from financial reports because

they have less access to the kinds of alternative information that an explicit contract could specify.

In such a case, we would expect 4 <0 and 5 <0. Which effect dominates is difficult to specify ex

ante, so we do not make signed predictions with respect to and .

Finally, we include the one quarter lagged value of the dependent variable. Firms that

avoided a working capital deficit in the prior quarter likely have incentives to continue to do so,

whereas firms that did not avoid a working capital deficit in the prior quarter likely face lower

incentives to avoid a working capital deficit in the current quarter. Moreover, including working

capital deficit avoidance in the prior quarter helps control for firm-specific factors that may not

have changed since the previous quarter, such as the operating environment. Both factors imply

6 >0.

In Panel A of Table 3, we provide descriptive statistics on these variables for the current

ratio bins of interest (bins 0.99 and 1.00) and the four immediately preceding and following bins,

included to provide benchmarks for interpreting the activity in bins 0.99 and 1.00. With respect to

the effective federal funds rate, bins after bin 1.00 exhibit higher rates than bins before bin 1.00.

However, the largest federal funds rate increase in consecutive bins occurs moving from the 0.99

21
bin (4.566%) to the 1.00 bin (4.918%). This result is consistent with firms who find themselves

just below bin 1.00 in a tight credit environment taking actions to move from bin 0.99 to bin 1.00.

These data also reveal a tendency for larger firms to have larger current ratios, although

the increasing trend drops when moving from bin 0.99 to bin 1.00. The percentage of firms

reporting losses tends to increase as the current ratio decreases; however, the lowest loss incidence

across all current ratio bins occurs at the 1.00 bin (41.9%). These findings are consistent with

small firms and firms reporting losses having higher incentives to avoid reporting a working

capital deficit. With respect to our proxies for explicit contracts, the proportions of observations

reporting debt or minimum lease payments reach their lowest levels in the 1.00 bin, consistent

with firms who rely more on implicit rather than explicit contracts having more incentives to avoid

working capital deficits.

In Table 3 Panel B, we report in column (3) the results of estimating Eq. (4). Consistent

with predictions and corroborating previous inferences, the coefficient on the effective federal

funds rate is positive (1=0.028, p-value<0.01). This result holds incrementally to other factors,

each of which is an important predictor in its own right. 20 Larger firms appear less concerned

with avoiding working capital deficits (2=-0.021, p-value = 0.07), while firms that avoided a

working capital deficit in the prior quarter are more likely to continue to do so (6=0.383, p-

value<0.01). Firms reporting losses are less likely to avoid working capital deficits (3=-0.215, p-

value<0.01), consistent with poor operating performance translating into both losses and lower

current ratios, rather than with the presence of losses increasing the incentive to avoid working

20
An alternative interpretation is that federal funds rate does not capture effects of the tightness of
credit in the economy, but rather the sample concentration of old economy firms relying on
trade credit for inventory. The federal funds rate was higher in the 1980s relative to later sample
years, and the concentration of new economy intangible intensive firms increased in later years
of the sample (Srivastava 2014). To ensure our federal funds rate is not capturing the effects of
differing firm types, we re-estimate the results including Fama French 48 industry fixed effects
firms, and find the coefficient on federal funds rate to be nearly identical to the coefficient
reported in Table 3 Panel B (coefficient = 0.024, p-value= 0.01).

22
capital deficits. Firms with debt and leases are less likely to avoid working capital deficits (4=-

0.248, p-value = 0.036; 5=-0.258, p-value< 0.01). This evidence suggests that our results are not

simply additional evidence of management intervention to avoid violating explicit covenants in

(Dichev and Skinner 2002), but are consistent with working capital deficits being of particular

importance for implicit contracting (Bowen et al. 1995).

Analysis of pseudo current ratio reference points

To provide additional evidence on the discontinuity at the working capital deficit

reference point, we also estimate (4) for the bins preceding the 0.99 bin and following the 1.00

bin. In particular, we compare firms in current ratio bins 0.95 with 0.96, 0.97 with 0.98, 1.01 with

1.02 and 1.03 with 1.04, and report the results in columns (1), (2), (4) and (5) of Table 3 Panel B,

respectively. In these comparisons, we define firms reporting the higher current ratio of the pair as

achieving a pseudo current ratio target. For example, when we compare firms in the 0.95 and 0.96

current ratio bins, observations located in the 0.96 (0.95) bin are assigned a value of one (zero). Of

course, 0.96 is not theoretically an important reference pointit is a pseudo target. Thus, if the

results in Column (3) of Table 3 Panel B reflect a managerial intervention, we should see our

hypothesized effects only in Column (3) and no systematic evidence in the other four columns.

The only firm-specific factor consistently associated with achieving both pseudo current

ratio targets and the reference point target of 1.0 is whether the firm achieved the pseudo target in

the prior period. In each column, we observe a statistically positive coefficient on the MBt-1

variable. This implies stickiness in the current ratio in the sense that firms above a current ratio

pseudo target, or above the reference point 1.0, in a prior quarter tend to remain there in the

current quarter.

Three pieces of evidence suggest the 1.0 current ratio is of particular importance relative

to pseudo targets. First, the MBt-1 coefficient magnitude is roughly two to three times larger in

23
Column (3) relative to its magnitude in columns containing pseudo targets. Second, we observe a

positive and statistically significant coefficient on the federal funds rate only in Column (3). Third,

explanatory variables exhibit statistically significant associations only in Column (3), making the

performance of the prediction model highest in Column (3) as measured by pseudo R2 or area

under the ROC curve.21

Analysis of managerial interventions to avoid working capital deficits

Collectively, the results presented in Table 3 are consistent with managers taking

(unspecified) actions to avoid reporting working capital deficits. Managers might increase reported

working capital by, for example, manipulating accrual estimates, by reclassifying short term debt

to long term debt under the intent and ability to refinance provisions of SFAS 6 (Gramlich et al.

2001; Gramlich et al. 2006), or by increasing sales so as to capitalize gross margins on the balance

sheet (in cash or receivables). Because of the limitations of Compustat data, we are unable to

identify strategic working capital accruals manipulations. For example, Compustat reports

accounts receivable net of the allowance for doubtful accounts in quarterly data, and reports the

allowance for doubtful accounts only for the fourth fiscal quarter.22

Compustat data provide sufficient detail to examine how the components of total current

assets and total current liabilities differ between firms in the 0.99 and 1.00 current ratio bins. With

respect to the composition of current assets, if managers take actions to increase sales, so as to

capitalize profit margins, and/or purposefully underestimate the allowance for doubtful accounts,

we expect inventory (net accounts receivable and cash) to comprise a smaller (larger) proportion

21
The only exception is the negative coefficient of -0.015 (p-value = 0.09) on the federal funds
rate in Column (4) which compares the 1.01 current ratio with 1.02. If firms take real actions to
achieve the 1.0 target in Column (3) in response to the federal funds rate and overshoot the 1.0
current ratio, they may end up reporting current ratios of 1.01. This would induce a coefficient of
the opposite sign in Column (4) relative to Column (3). We present some evidence consistent with
this conjecture in the next section.
22
The bins analyzed in Table 4 contain 21,504 observations, of which 17% have non-missing
values for the allowance for doubtful accounts.

24
of total current assets for firms in the 1.00 current ratio bin compared to the 0.99 bin.23 With

respect to current liabilities, research suggests firms strategically reclassify short term debt as long

term under SFAS 6 (Gramlich et al. 2001; Gramlich et al. 2006). This would imply that the

proportion of short term debt in current liabilities would be smaller for firms in the 1.00 current

ratio bin compared with the 0.99 bin. Moreover, the proportion of total outstanding debt that is

long term should increase if short term debt is being reclassified as long term.

In Table 4, we report the proportions of inventory, net accounts receivable, and cash

within total current assets for firms in the 1.00 current ratio bin compared to the 0.99 bin, as well

as comparisons for the 0.95 versus 0.96 bins, the 0.97 versus 0.98 bins, the 1.01 versus 1.02 bins,

and the 1.03 versus 1.04 bins. We report proportions for all observations (Panel A) in the specified

bins, and separately for observations in years when the federal funds rate is high (Panel B). We

perform this second analysis because earlier results showed that the discontinuity is strongest

when the federal funds rate is highest.

In Panel A of Table 4, the comparison of interest is the 0.99 bin with the 1.00 bin.

Inventory comprises 23.0% of total current assets for firms in the 1.00 current ratio bin,

statistically smaller (at the 1% level) than the 24.8% observed for firms in the 0.99 bin. This 1.8%

difference in proportional inventory is offset by a 2.4% increase in proportional net accounts

receivable, significant at the 1% level. We observe no differences in the proportion of cash

between the 0.99 and 1.00 bins. Collectively, these comparisons are consistent with managers

increasing credit sales to capitalize product margins and, perhaps, reducing the allowance for

doubtful accounts.

23
Alternatively, managers might capitalize more costs in inventory by increasing production. This
would imply that within the inventory account, the proportion of raw material (work in progress
and finished goods) would be higher for firms in the 0.99 (1.00) current ratio bin. Data fields for
inventory components in the quarterly Compustat database are not well populated until 2005,
which precludes a formal assessment during our sample period.

25
 If managers intervene to avoid reporting working capital deficits, we should not observe

systematic differences in the proportions of current asset components in adjacent current ratio bins

that precede and follow the 0.99 and 1.00 current ratio bins. We find no significant difference for

any adjacent bin comparison, except that the proportion of inventory is statistically lower in the

1.01 current ratio bin compared with the 1.02 bin. This result is consistent with managers

attempting to avoid a working capital deficit but overshooting the 1.00 bin. Since increasing

sales to capitalize margins is a real activity, it is likely difficult to know before the close of a fiscal

period precisely how much profit margin capitalization will be required to avoid reporting a

working capital deficit. Managers may, as a result, sell enough that the current ratio increases past

1.00 to 1.01, in which case the proportion of inventory will be driven downward relative to the

1.02 bin proportion.

Turning to the composition of total current liabilities reported in the last two columns of

Table 4, Panel A, we find that the proportion of short term debt is smaller on average for firms in

the 1.00 current ratio bin compared with firms in the 0.99 bin, but not statistically different. To

assess whether these results are consistent with reclassification of short term debt to long term, the

last column reports the proportion of total outstanding debt that is long term. If short term debt is

reclassified to avoid reporting working capital deficits, the proportion of total debt that is long

term should increase. We observe a larger proportion of long term debt to total debt for firms

reporting a working capital surplus versus a deficit (61.6% vs. 60.8%); the difference is not

significant at conventional levels.

In Table 4, Panel B we report analogous results from time periods when the federal funds

rate is in the upper quartile of the distribution. Comparing the 0.99 bin to the 1.00 bin, the ratio of

inventory to current assets is abnormally high (low) in the 0.99 (1.00) bin by about 2.0%,

significant at the 10% level. This decrease is offset by a 3.4% increase in the ratio of cash to total

current assets, significant at the 1% level. Net accounts receivable as a proportion of total current

26
assets increases by 0.2%, which is not statistically significant. This implies that in times of tight

credit, managers seek to capitalize margins, more so from cash sales as opposed to credit sales

and/or make greater efforts to convert credit sales to cash.

Results in the last two columns indicate that short term debt is abnormally low in the 1.00

bin relative to the 0.99 bin, and that long term debt is abnormally high in the 1.00 bin relative to

the 0.99 bin, consistent with evidence in Gramlich et al. 2001; Gramlich et al. 2006 that firms

reclassify short term debt as long term to increase the current ratio. Compared with the results in

Table 4 Panel A, the evidence from the tight credit subsample suggests firms attain current ratio

targets with a preference towards mechanisms that result in relatively more cash in current assets

and relatively less debt in current liabilities. This evidence is consistent with stakeholders in tight

credit conditions seeking evidence of liquidity from balance sheets, and managers supplying it.

We believe the weight of the evidence in Table 4 supports the inference that managers

intervene to increase the current ratio, and avoid reporting a working capital deficit, by increasing

sales to capitalize margins on the balance sheet, by reclassifying short term debt to long term debt,

and, possibly, by reducing the allowance for doubtful accounts.

Analysis of the debt covenant hypothesis

An alternative interpretation of our results is that the current ratio benchmark of 1.0

happens to be a common feature in debt covenants, and our results confirm Dichev and Skinners

(2002) finding that firms attempt to avoid violating explicit debt covenants. Given the negative

coefficient on DEBT in the logistic regressions reported in Table 3 Panel B Column 3, we view

this explanation as unlikely. Nonetheless, to investigate this alternative interpretation directly, we

extract all 26,373 unique deals in Dealscan during 1988-2013 that contain at least one financial

covenant. Of these 26,373 deals, 3,539 (just over 13%) contain current ratio covenants. This

finding suggests debt covenants are not likely to be an important factor in our large sample tests.

27
 We also compare current ratio values specified in loan covenants with actual current

ratios of borrowing firms in the quarter immediately preceding loan initiation. We are able to

obtain these data for 1,830 observations, a subset of the 3,539 deals with a current ratio covenant.

In Figure 3a, we plot the distribution (in black) of 1,830 current ratio values specified in loan

covenants. The 1.0 current ratio represents over 34% of the observations, by far the most common

covenant value. The next most frequent is 1.5, just under 15% of the observations. In Figure 3a,

we also plot (in grey) the distribution of reported current ratios in the period immediately prior to

loan initiation; there is no clustering at any particular current ratio level. These descriptive results

cannot, by design, provide definitive evidence. However, one plausible explanation why a current

ratio value of 1.0 appears so frequently in loan contracts available in Dealscan is that contract

designers internalize stakeholder reference points. Taking this perspective, lenders write loan

contracts as if they believe stakeholders evaluate liquidity asymmetrically around a current ratio

reference point of 1.0.

We report two additional analyses of the relation between our results and the explicit

contracting explanation. First, to isolate firms that are not likely to have binding current ratio

covenants, we identify the 111,915 firm-quarter observations from the sample summarized in

Figure 1 that report no short term or long term debt. In Figure 3b, we replicate the analysis from

Figure 1 and plot the frequency distribution for these no-debt observations using bin sizes of 0.02.

We use a larger bin size relative to the full sample given the smaller number of observations. The

distribution shows a visually salient spike at the current ratio value of 1.0; the test statistic is -

2.857 (4.875 to the right of 1.0). The number of observations in the bin preceding (including) the

1.0 current ratio benchmark is 246 (398), a difference of 152 observations. This result suggests

that avoiding working capital deficits is important for firms not reporting debt of any sort, a

finding that is not predicted by the explicit debt contracting hypothesis, but is consistent with

28
stakeholders with implicit claims relying on balance sheet information to assess liquidity (Bowen

et al. 1995).

Second, we re-estimate the model in (4) and include an indicator variable that equals 1

when a firm reports a current ratio covenant exactly equal to 1.0 in Dealscan and zero otherwise.

The estimated coefficient is positive, as the debt covenant hypothesis would predict, but not

reliably different from zero (p-value = 0.441); including the indicator does not affect inferences

drawn from results reported in Table 3 Panel B (results not tabulated). We caution that this test has

very low power, as there are only 14(20) observations with an explicit 1.0 current ratio covenant in

the 0.99 (1.00) current ratio bins.

4. Extension to an International Setting

Working capital deficit avoidance should not be unique to U.S. firms. To provide

evidence on the cross-jurisdictional generalizability of our findings, we expand our analysis to an

international setting. We expect to observe a discontinuity in the current ratios of non-U.S. firms,

similar to the result in Figure 1. Our design also allows us to exploit natural variation in legal

traditions, which have been shown to affect the decision usefulness of financial statements. Ball et

al. (2000) point out that legal traditions (specifically, code law versus common law) influence the

design of accounting rules; they argue that in code law countries financial reports are less

informative to financial market participants. If so, the reports should also be less likely to be used

for making liquidity assessments. Based on this reasoning, we predict that working capital deficit

avoidance should be more pronounced in common law countries than in code law countries.

To examine our predictions, we collect the 726,290 quarterly observations available on

the quarterly Compustat Global database from the 28 countries examined in Leuz et al. (2013)

from the inception of the database to fiscal year 2013 and apply the same sample selection

29
requirements as in our earlier tests.24 Table 5 reports descriptive statistics on current ratios by

country and legal tradition (code law versus common law), applying the coding used in prior

research (Leuz et al. 2003; Ball et al. 2000; LaPorta et al. 1998). The largest numbers of

observations come from Japan and the United Kingdom. The median current ratio ranges from a

low of 1.089 in Pakistan to a high of 1.915 in Australia. The sample is roughly equally split

between code and common law countries, with 48% of the sample representing code law

countries.

Figure 4a presents the current ratio distribution for the sample of international firms. Like

the distribution for U.S. firms, this distribution exhibits a discontinuity at 1.0; the test statistic for

the interval immediately to the left of a current ratio equal to 1.0 is -2.797 (4.869 to the right),

significant at better than the 1% level in a one-tailed test. To assess whether this overall effect

varies by legal tradition, Figures 4b and 4c present the distributions for code law countries and

common law countries, respectively. Visually the distribution appears to have a more striking

discontinuity in common law countries. The test statistic for code law countries is -1.556 (1.991 to

the right); this statistic is significant at approximately the 10% level in a one-tailed test. The test

statistic for common law countries is -2.435 (4.956 to the right), significant at the 1% level. These

results suggest that the effects are more pronounced in common law countries, where financial

reports are more designed to assist external stakeholder decision making. Because these results are

based on recent data (1999-2013), they also support the view that current ratios remain an

important focus of management attention.

To assess whether the discontinuities in common law and code law countries are

statistically different, we first use a two by two contingency table comparing the observations in

24
Specifically, we require firms to have total assets (atq), positive values of current assets (actq)
and current liabilities (lctq). We exclude regulated industries and the Restaurant, Hotels and
Motels industry as defined earlier, and observations where the country of incorporation is
missing.

30
the bins just to the left and right of 1.0 across common law and code law countries and find a 2 of

6.883 (p-value <0.009). We also re-estimate the model in (3), replacing the indicator for high

versus low effective federal funds rate with an indicator for common law versus code law country:

_ = 0 + 1 + 2 + 3 + (5)

where all variables are as defined above, except that equals 1 if the firm is from a

common law country and zero otherwise. Based on the distributional evidence, we expect 3 > 0.

Results of estimating (5), presented in Table 6, confirm this prediction. The coefficient on the

interaction term is positive (3 =90.000) and significant at the 1% level, implying a larger current

ratio discontinuity in common law countries than in code law countries. This result corroborates

the conclusions of Ball et al. (2000) and extends the focus from the income statement to the

balance sheet. We leave for future research a more refined international analysis, which might

examine whether current ratio discontinuities are more pronounced in specific individual

countries, or whether country-specific institutional arrangements beyond the legal system help

explain why managers intervene to avoid reporting working capital deficits.

5. Conclusions and Limitations

We examine whether distribution discontinuities are diagnostic of managerial

intervention in the accounting process to avoid reporting working capital deficits. Distributions of

current ratios for both U.S. firms and non-U.S. firms reveal discontinuities at 1.0, consistent with

predictions. The magnitude of the discontinuity for U.S. firms is larger when credit is tight,

proxied by a high effective federal funds rate, suggesting that variation in macroeconomic

conditions influences the importance managers ascribe to avoiding working capital deficits. For

non-U.S. firms, the magnitude of the discontinuity is more pronounced for observations from

common law countries, our proxy for jurisdictions where financial reports are more intended to

provide decision-useful information.

31
 We provide several additional analyses that support our main results. We show that the

determinants of a U.S. firms likelihood to report a given current ratio value are diagnostic for

avoiding a working capital deficit but not for pseudo working capital targets. We also provide

evidence that our results are not due to loan contracts with covenants that set required current

ratios equal to 1.0. Regarding how managers might go about avoiding working capital deficits, we

find U.S. firms reporting a working capital surplus report lower inventory and higher accounts

receivable as a proportion of current assets relative to firms reporting a working capital deficit. In

times of tight credit, firms avoiding working capital deficits also report lower inventory and higher

cash as a proportion of total assets, in addition to a lower (higher) proportion of short term debt to

total current liabilities (total long term debt). These results are consistent with managers increasing

sales so as to capitalize profit margins on the balance sheet and thereby increase reported current

assets, and also with strategic reclassification of short term debt to long term, in order to avoid

reporting a working capital deficit.

Viewed as a whole, the evidence supports the conclusion that managers intervene to

achieve a balance sheet reporting objective that is derived from stakeholder usage of reference

points. While we focus on working capital deficits and the current ratio, future research might

exploit the distributional approach (McNichols 2000) to investigate distributions of other balance

sheet ratios important for other stakeholders. While we do not focus on financial firms, future

research could assess whether balance sheet capital adequacy targets set by regulators of U.S.

banks and thrifts (Core and Schrand 1999) influence managerial reporting behavior. Finally, our

analysis relies on linear interpolation to identify distribution discontinuities. Opportunities also

exist for applying different statistical techniques, such as nonlinear interpolation, so as to study

reference points that naturally occur at locations of inflection in the distributions of financial

accounting numbers.

32
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36
TABLE 1
Descriptive Statistics

Panel A: Distribution of current ratios by Fama and French (1997) industry ranked on
median current ratio

Fama French (1997) Industry N Mean Std Dev P25 P50 P75
Entertainment 14,985 1.763 2.321 0.685 1.147 1.942
Transportation 10,068 1.331 0.875 0.864 1.181 1.583
Petroleum and Natural Gas 54,556 1.951 2.715 0.772 1.217 1.986
Personal Services 9,153 1.869 1.867 0.914 1.372 2.178
Real Estate 5,545 2.230 2.743 0.939 1.416 2.427
Candy & Soda 2,426 1.758 1.295 1.011 1.427 2.086
Construction 7,821 2.000 2.084 1.205 1.519 2.128
Coal 2,062 2.310 2.980 1.027 1.547 2.384
Printing and Publishing 7,901 2.064 1.976 1.034 1.562 2.403
Shipping Containers 3,117 1.926 1.214 1.332 1.644 2.125
Healthcare 15,554 2.370 2.377 1.155 1.704 2.739
Retail 49,973 2.086 1.503 1.296 1.732 2.409
Beer & Liquor 3,528 2.284 1.931 1.214 1.735 2.723
Food Products 17,165 2.174 1.758 1.254 1.739 2.495
Trading 10,747 3.562 4.831 0.980 1.739 3.605
Other 12,280 2.973 4.010 1.009 1.751 2.997
Wholesale 36,703 2.293 1.855 1.319 1.799 2.661
Business Services 96,042 2.617 2.674 1.183 1.821 3.014
Agriculture 3,491 3.197 3.897 1.321 1.831 2.982
Automobiles and Trucks 14,395 2.235 1.664 1.312 1.889 2.605
Defense 1,547 2.797 2.359 1.259 1.902 3.665
Business Supplies 14,152 2.205 1.506 1.428 1.910 2.568
Chemicals 18,169 2.472 2.234 1.419 1.948 2.708
Rubber and Plastic Products 10,271 2.326 1.816 1.385 1.965 2.706
Recreation 8,191 2.622 2.381 1.363 2.002 3.032
Fabricated Products 4,097 2.376 1.791 1.431 2.011 2.781
Tobacco Products 1,014 2.242 1.279 1.277 2.022 2.853
Steel Works Etc 15,053 2.380 1.786 1.528 2.024 2.742
Shipbuilding, Railroad Equipment 1,562 2.311 1.647 1.454 2.035 2.704
Aircraft 4,887 2.509 1.843 1.525 2.074 2.831
Consumer Goods 16,822 2.573 1.838 1.515 2.154 3.026

37
Machinery 32,587 2.612 1.900 1.571 2.164 3.038
Construction Materials 22,863 2.631 1.945 1.575 2.189 3.086
Electrical Equipment 15,034 2.941 2.665 1.585 2.228 3.304
Computers 36,330 3.079 2.846 1.435 2.282 3.696
Textiles 6,943 2.725 1.340 1.909 2.531 3.245
Apparel 12,912 3.083 2.062 1.842 2.571 3.659
Electronic Equipment 52,048 3.475 2.989 1.731 2.601 4.193
Precious Metals 13,307 5.080 5.732 1.263 2.723 6.414
Non-Metallic and Industrial Metal Mining 13,965 5.521 6.172 1.402 2.745 7.062
Measuring and Control Equipment 18,524 3.688 3.065 1.852 2.798 4.464
Medical Equipment 26,969 4.077 3.764 1.790 2.894 4.883
Pharmaceutical Products 46,993 5.376 5.196 1.826 3.419 6.992

Panel B: Current ratio components

Variable N Mean Std Dev P25 P50 P75

Current Ratio 771,752 2.866 3.077 1.287 1.976 3.162
Total Current Assets ($MM) 771,752 386.269 1,208.517 10.592 44.969 192.843
Total Current Liabilities ($MM) 771,752 247.813 856.181 4.748 19.789 94.885
Cash to Total Current Assets 771,752 0.297 0.294 0.049 0.188 0.487
Accounts Receivable to Total
Current Assets 771,752 0.348 0.224 0.177 0.344 0.484
Inventory to Total Current Assets 771,752 0.272 0.237 0.027 0.253 0.451
Other Current Assets to Total
Current Assets 771,752 0.073 0.090 0.021 0.045 0.089
Accounts Payable to Total
Current Liabilities 771,752 0.408 0.248 0.218 0.373 0.568
Other Current Liabilities to
Total Current Liabilities 771,752 0.360 0.261 0.142 0.338 0.547
Current Portion of Long-term Debt
to Total Current Liabilities 771,752 0.186 0.217 0.003 0.098 0.306
Taxes Payable to Total
Current Liabilities 771,752 0.031 0.063 0.000 0.000 0.034
Working Capital to Total Assets 771,752 0.238 0.321 0.077 0.246 0.434
Quick Ratio 771,752 2.221 2.986 0.808 1.295 2.295
Acid Test Ratio 771,752 2.048 2.919 0.682 1.147 2.095

38
TABLE 1 (Continued)

Notes:
The sample is771,752 observations drawn from 1,118,825 unique firm-quarter observations available on the
quarterly Compustat North America database from 1968 through fiscal 2013 with nonzero total assets. We
remove 263,406 observations from financial institutions and utilities (SIC Codes 6000-6500 and 4400-5000),
20,076 observations from the Fama and French (1997) industry group Restaurants, Hotels, and Motels.
66,098 observations with zero current assets or zero current liabilities, and the lowest 5% of current assets
and current liabilities.

Panel A reports the distribution of current ratios by Fama and French (1997) industry. CURRENT RATIOi,t is
the ratio of current assets (actq) to current liabilities (lctq) reported by firm i in quarter t.

Panel B reports the distribution of various working capital accounts. The components of current assets and
current liabilities examined in the table are: accounts receivable (rectq), inventory (invtq), other current assets
(acoq), accounts payable (apq), other current liabilities (lcoq), current portion of long-term debt (dlcq), and
taxes payable (txpq). Working capital to total assets is current assets less current liabilities divided by total
assets ((actq-lctq)/atq). The quick ratio is current assets less inventory divided by current liabilities ((actq-
invtq)/lctq). The acid test ratio is cash + receivables divided by current liabilities ((cheq+rectq)/lctq.

39
TABLE 2

Regression analysis of the discontinuity in the current ratio distribution for firm-quarter
observations when the federal funds rate is high (see Figure 2d) and low (see Figure 2a)

Estimate
Variable Predicted Sign (P-Value)
INTERCEPT (?) 0.014
(0.9854)

HFF (?) -0.014

(0.9897)

TBIN (+ ) 25.500***
(0.0001)

HFF*TBIN (+ ) 123.250***
(0.0001)
N 1,396
Adj R-Square 0.014

Notes:
The table reports results of estimating (3): _ = 0 + 1 + 2 + 3 +
. _ is the difference between the expected number of observations and the actual number of
observations in current ratio bin b from the distribution in which the bin resides, with bin width equal to 0.01.
The expected number of observations in each bin b is estimated using the average number of observations in
the bins immediately adjacent to bin b; is an indicator variable that equals 1 if the observation is from
the distribution in Figure 2d (the highest effective federal funds rate quartile), and zero if the observation is
from the distribution in Figure 2a (the lowest effective federal funds rate quartile); is an indicator that
equals 1 if the observations falls in the histogram bin including the target current ratio of 1.0, -1 for the
histogram bin immediately to the left of the target current ratio of 1.0, and zero otherwise;
equals the product of and . *, **, * represent statistical significance at the 1%, 5% and 10%
levels in a two-tailed test. Standard errors are presented in parentheses below the coefficient estimates. The
total number of observations equals the 1,400 bins collectively presented in Figure 2a and Figure 2d, less four
observations representing the first and last bins presented in each displayed distribution. For these
observations, adjacent bins needed to construct the expected number of observations are unavailable, making
the dependent variable _ undefined.

40
TABLE 3
Descriptive statistics and regression analysis of observations in the current ratio bins surrounding the working capital surplus and
deficit threshold

Panel A: Descriptive statistics for firm-quarter observations in current ratio distribution bins surrounding 1.0

Current Ratio Histogram Bin

Variable 0.95 0.96 0.97 0.98 0.99 1.00 1.01 1.02 1.03 1.04
N Observations 2,138 2,083 2,170 2,120 2,172 2,675 2,524 2,572 2,528 2,603
CURRENT RATIO 0.955 0.965 0.975 0.985 0.995 1.005 1.015 1.025 1.035 1.045
FF 4.528 4.501 4.514 4.547 4.566 4.918 4.834 4.702 4.780 4.774
LOGASSETS 4.726 4.773 4.791 4.838 4.908 4.753 4.873 4.879 5.000 4.970
LOSS 0.467 0.470 0.483 0.463 0.447 0.419 0.429 0.439 0.439 0.443
DEBT 0.951 0.947 0.947 0.947 0.942 0.919 0.931 0.942 0.943 0.946
LEASE 0.733 0.737 0.724 0.733 0.731 0.667 0.714 0.728 0.735 0.722
YEAR 1998 1998 1998 1998 1998 1997 1997 1997 1997 1997
MB_lag1 0.518 0.559 0.519 0.546 0.529 0.613 0.534 0.559 0.506 0.549

41
TABLE 3 (Continued)

Panel B: Logistic regression analysis of the determinants of meeting or exceeding current ratio targets

CURRENT RATIO Bin Comparison: 0.95 vs. 0.96 0.97 vs. 0.98 0.99 vs 1.00 1.01 vs. 1.02 1.03 vs. 1.04
Estimate Estimate Estimate Estimate Estimate
Variable Predicted Sign (P-value) (P-value) (P-value) (P-value) (P-value)
INTERCEPT (?) -0.036 -0.060 0.467*** -0.155 -0.012
(0.8256) (0.7039) (0.0006) (0.2389) (0.9310)
FF (+ ) -0.002 0.003 0.028*** -0.015* -0.004
(0.8193) (0.7717) (0.0029) (0.0887) (0.6855)
LOGASSETS (?) 0.005 -0.000 -0.021* -0.005 -0.007
(0.6748) (0.9849) (0.0736) (0.6554) (0.5249)
LOSS (?) -0.025 -0.110 -0.215*** 0.007 -0.039
(0.7187) (0.1059) (0.0009) (0.9076) (0.5272)
DEBT (?) -0.093 -0.027 -0.248** 0.196 0.073
(0.5169) (0.8446) (0.0358) (0.1014) (0.5555)
LEASE (?) 0.005 0.044 -0.258*** 0.044 -0.074
(0.9457) (0.5288) (0.0001) (0.4934) (0.2408)
MB t-1 (+ ) 0.169*** 0.132** 0.383*** 0.099* 0.184***
(0.0088) (0.0365) (0.0001) (0.0884) (0.0014)
N Observations 4,221 4,290 4,847 5,096 5,131
N Observationis MB = 1 2,083 2,120 2,675 2,572 2,603
Pseudo R2 0.003 0.002 0.024 0.002 0.003
Area Under ROC Curve 0.527 0.522 0.576 0.526 0.527

42
TABLE 3 (Continued)

Notes:
CURRENT RATIOi,t is the ratio of current assets (actq) to current liabilities (lctq) reported by firm i in quarter t; MBi,t is an indicator that equals one if the ratio
of current assets (actq) to current liabilities (lctq) reported by firm i in quarter t is in the higher of the two adjacent current ratio bins being compared and zero
otherwise; ASSETSi,t equals total assets (atq) reported by firm i in quarter t; FFi,t equals the average daily effective federal funds rate as reported by the Federal
Reserve for the calendar month associated with the final month of fiscal quarter t of firm i. LnASSETS i,t equals the natural logarithm of ASSETS; LOSSi,t is an
indicator that equals 1 if firm i reported income before extraordinary items (ibcomq) less than zero in quarter t, and zero otherwise; DEBTi,t is an indicator that
equals 1 if firm i reported either short term debt (dlcq) or long term debt (dlttq) at quarter t, and zero otherwise. LEASEi,t is an indicator that equals 1 if firm i
reported total minimum rental payments (mrct) in fiscal year y containing quarter t, and zero otherwise. YEAR is the fiscal year. The number of observations
reported in each bin is smaller than the number of observations displayed in Figure 1 due to requiring each bin to have non-missing values for each regression
variable.

Panel B reports results from the logistic regression estimation of (4): , = 0 + 1 , + 2 , + 3 , + 4 , + 5 , +

6 ,1 + , .*, **, * represent statistical significance at the 1%, 5% and 10% levels in a two-tailed test. Robust standard errors clustered by firm are
presented in parentheses below the coefficient estimates.
aCutpoints used for classification are the unconditional mean of MBt of the sample analyzed.
bThe Receiver Operating Characteristic (ROC) curve analysis is used to quantify the accuracy of the logistic prediction equation at classifying participants as
having misreported or not. The ROC curve is a graph of the sensitivity versus 1 specificity of the prediction test. This area measures the global performance
of the test. The greater the area under the ROC curve (AUC), the better the performance.

43
TABLE 4
Examination of how firms avoid reporting small working capital deficits
Panel A: Full Sample

Accounts Short-term
Current Inventory Receivable Cash to Debt to Long-term
Ratio to Total to Total Total Total Debt to
Histogram Number of Current Current Current Current Total
Bin Observations Assets Assets Assets Liabilities Debta
0.95 2,138 0.227 0.445 0.204 0.263 0.612
0.96 2,083 0.236 0.435 0.208 0.262 0.597
Difference 0.009 -0.009 0.003 -0.001 -0.015
Prediction (?) (?) (?) (?) (?)
T-Stat 1.182 -1.177 0.480 -0.145 -1.332
P-Value 0.237 0.239 0.631 0.884 0.183
0.97 2,170 0.238 0.432 0.207 0.266 0.607
0.98 2,120 0.240 0.432 0.207 0.264 0.605
Difference 0.002 0.001 -0.000 -0.002 -0.002
Prediction (?) (?) (?) (?) (?)
T-Stat 0.294 0.087 -0.045 -0.286 -0.193
P-Value 0.768 0.931 0.964 0.775 0.847
0.99 2,172 0.248 0.429 0.205 0.267 0.608
1.00 2,675 0.230 0.454 0.201 0.259 0.616
Difference -0.018*** 0.024*** -0.004 -0.008 0.008
Prediction (- ) (+ ) (+ ) (- ) (+ )
T-Stat -2.620 3.276 -0.590 -1.181 0.816
P-Value 0.004 0.001 0.277 0.119 0.207
1.01 2,524 0.235 0.440 0.205 0.259 0.615
1.02 2,572 0.251 0.432 0.202 0.267 0.610
Difference 0.016** -0.008 -0.004 0.008 -0.004
Prediction (?) (?) (?) (?) (?)
T-Stat 2.352 -1.144 -0.530 1.252 -0.449
P-Value 0.019 0.253 0.596 0.210 0.653
1.03 2,528 0.246 0.438 0.205 0.264 0.622
1.04 2,603 0.248 0.431 0.202 0.269 0.620
Difference 0.003 -0.007 -0.002 0.004 -0.002
Prediction (?) (?) (?) (?) (?)
T-Stat 0.392 -0.964 -0.372 0.660 -0.240
P-Value 0.695 0.335 0.710 0.509 0.810

44
TABLE 4 (Continued)
Panel B: Highest federal funds rate quartile sample

Accounts Short-term
Current Inventory Receivable Cash to Debt to Long-term
Ratio to Total to Total Total Total Debt to
Histogram Number of Current Current Current Current Total
Bin Observations Assets Assets Assets Liabilities Debta
0.95 418 0.279 0.466 0.156 0.338 0.578
0.96 430 0.297 0.430 0.165 0.341 0.562
Difference 0.018 -0.036** 0.009 0.002 -0.016
Prediction (?) (?) (?) (?) (?)
T-Stat 1.033 -2.104 0.661 0.150 -0.709
P-Value 0.302 0.036 0.509 0.881 0.478
0.97 427 0.298 0.438 0.175 0.343 0.552
0.98 445 0.300 0.436 0.163 0.325 0.577
Difference 0.002 -0.002 -0.012 -0.018 0.025
Prediction (?) (?) (?) (?) (?)
T-Stat 0.130 -0.120 -0.810 -1.101 1.093
P-Value 0.896 0.904 0.418 0.271 0.275
0.99 424 0.302 0.455 0.145 0.326 0.569
1.00 666 0.282 0.452 0.179 0.296 0.613
Difference -0.020* -0.002 0.034*** -0.030** 0.044**
Prediction (- ) (+ ) (+ ) (- ) (+ )
T-Stat -1.313 -0.148 2.676 -2.019 2.097
P-Value 0.095 0.441 0.004 0.022 0.018
1.01 585 0.287 0.451 0.160 0.317 0.589
1.02 587 0.311 0.445 0.163 0.331 0.593
Difference 0.024 -0.005 0.002 0.014 0.005
Prediction (?) (?) (?) (?) (?)
T-Stat 1.644 -0.365 0.188 1.034 0.242
P-Value 0.100 0.715 0.851 0.301 0.809
1.03 581 0.296 0.462 0.152 0.314 0.618
1.04 585 0.297 0.458 0.165 0.317 0.610
Difference 0.001 -0.004 0.013 0.003 -0.007
Prediction (?) (?) (?) (?) (?)
T-Stat 0.073 -0.273 1.123 0.192 -0.391
P-Value 0.942 0.785 0.262 0.848 0.696

45
TABLE 4 (Continued)

Notes:
***, **, * represent statistical significance at the 1%, 5% and 10% levels in a two-tailed test, one-
tailed when predicted.

aThis ratio is calculated only when a firm has nonzero total debt. The numbers of firms with
nonzero total debt are 2,034, 1,972, 2,055, 2,007, 2,045, 2,459, 2,349, 2,422, 2,384, and 2,463, for
current ratio bins 0.95 through 1.04, respectively.

46
TABLE 5
Distribution of current ratios by country
Country Legal Tradition N Mean Median Std Dev
Pakistan Common 7,321 1.471 1.089 2.496
Spain Code 3,563 1.935 1.249 17.346
Italy Code 7,593 1.813 1.332 4.881
Korea Code 6,477 7.348 1.323 285.935
Belgium Code 3,133 2.233 1.428 4.216
Netherlands Code 5,090 1.794 1.403 4.089
Greece Code 6,752 1.625 1.397 1.285
France Code 21,116 1.892 1.417 4.324
Thailand Common 15,608 2.796 1.455 14.633
Finland Code 4,988 1.838 1.465 1.947
United Kingdom Common 49,235 2.497 1.472 4.682
Indonesia Code 9,968 5.022 1.470 56.993
Denmark Code 4,023 2.375 1.519 3.836
South Africa Common 10,163 2.358 1.529 5.445
Japan Code 77,571 2.078 1.488 10.395
Philippines Code 4,443 10.647 1.525 79.581
Austria Code 2,415 2.487 1.536 19.087
India Common 38,500 3.568 1.521 18.011
Norway Code 6,415 4.032 1.616 28.603
Ireland Common 2,230 2.692 1.596 5.250
Sweeden Code 14,791 2.807 1.678 7.530
Hong Kong Common 5,863 3.264 1.699 11.785
Singapore Common 19,290 2.551 1.690 5.120
Germany Code 21,144 3.218 1.767 28.508
Malaysia Common 34,480 3.072 1.776 6.321
Taiwan Code 36,972 2.743 1.795 7.408
Switzerland Code 7,041 2.704 1.867 4.732
Australia Common 42,342 4.233 1.915 8.068
Total 468,527

Code Law 225,032 3.103 1.590 10.085

Common Law 243,495 2.770 1.552 50.750

Notes:
This table reports descriptive statistics for current ratios (total current assets divided by total current
liabilities) for all observations reported in the Compustat Global database from 1999 through 2013
with the following restrictions: observations must have nonzero values for both current assets and
current liabilities, must not be in the Restaurants, Hotels and Motels industry, must not be in a
regulated industry, must have a populated country incorporation code, and must be identified as a
common law or code law country in Leuz et al. (2003).
TABLE 6
Regression of the extent of the discontinuity in the current ratio distribution for firm-quarter
observations in common law and code law countries

Estimate
Variable Predicted Sign (P-Value)
INTERCEPT (?) 0.012
(0.9904)

COMMON (?) 0.021

(0.9876)

TBIN (+ ) 91.500***
<.0001

COMMON*TBIN (+ ) 90.000**
(0.0291)
N 1,396
Adj R-Square 0.076

Notes:
The table represents an empirical estimation of (5): _ = 0 + 1 + 2 +
3 + . _ is the difference between the expected number of observations and
the actual number of observations in current ratio bin b from the distribution in which the bin resides, with
bin width equal to 0.01. The expected number of observations in each bin b is estimated using the average
number of observations in the bins immediately adjacent to bin b; is an indicator variable that
equals one if the observation is from the distribution in Figure 4c (from a Common Law country), and zero if
the observation is from the distribution in Figure 4b (from a Code Law country); is an indicator that
equals 1 if the observation falls in the histogram bin including the target current ratio of 1.0, -1 for the
histogram bin immediately to the left of the target current ratio of 1.0, and zero otherwise;
equals the product of and . *, **, * represent statistical significance at the 1%, 5%
and 10% levels in a two-tailed test. Standard errors are presented in parentheses below the coefficient
estimates. The total number of observations equals the 1,400 bins collectively presented in Figure 4b and
Figure 4c, less four observations representing the first and last bins presented in each displayed distribution.
For these observations, adjacent bins needed to construct the expected number of observations are
unavailable, making the dependent variable _ undefined.

48
Figure 1 Current ratio distribution

3500

3000

2500

2000

1500

1000

500

0
0.01
0.21
0.41

1.21
1.41
1.61
1.81
2.01
2.21

3.21
3.41
3.61
3.81
4.01

5.01
5.21
5.41
5.61
5.81
6.01

6.81
0.61
0.81
1.01

2.41
2.61
2.81
3.01

4.21
4.41
4.61
4.81

6.21
6.41
6.61
Notes:
Figure 1 plots the empirical distribution of quarterly reported current ratios (current assets divided by current liabilities) during the period 1968-2013. The distribution
interval [bin] widths are 0.01, and the location of a current ratio equal to 1.0 is identified with an arrow. The first interval to the right of the current ratio value 1.0 contains
all current ratios in the interval [1.0, 1.01), and the interval to the left of the current ratio value 1.0 1.0 contains all current ratios in the interval [0.99, 1.0). The vertical axis
represents the number of observations in each current ratio interval, and the horizontal axis indicates the level of the current ratio. The distribution displays bin intervals
.01 to 7.0, including 720,586 of the total 771,752 sample observations.

49
 Figure 2a Current ratio distribution for the lowest quartile of the effective Figure 2b Current ratio distribution for the second lowest quartile of the
federal funds rate effective federal funds rate

900 900
800 800
700 700
600 600
500 500
400 400
300 300
200 200
100 100
0 0
0.01

0.41
0.61

1.21
1.41

1.81
2.01

2.41
2.61

3.21
3.41

3.81
4.01

4.41
4.61
4.81

5.21
5.41

5.81
6.01

6.61
6.81

0.01

0.41
0.61

1.21
1.41

1.81
2.01

2.41
2.61

3.21
3.41

3.81
4.01

4.41
4.61
4.81

5.21
5.41

5.81
6.01

6.61
6.81
0.21

0.81
1.01

1.61

2.21

2.81
3.01

3.61

4.21

5.01

5.61

6.21
6.41

0.21

0.81
1.01

1.61

2.21

2.81
3.01

3.61

4.21

5.01

5.61

6.21
6.41
Figure 2c Current ratio distribution for the second highest quartile of the Figure 2d Current ratio distribution for the highest quartile of the effective
effective federal funds rate federal funds rate

900 900
800 800
700 700
600 600
500 500
400 400
300 300
200 200
100 100
0 0 0.01
0.21
0.41
0.61
0.81
1.01
1.21
1.41
1.61
1.81
2.01
2.21
2.41
2.61
2.81
3.01
3.21
3.41
3.61
3.81
4.01
4.21
4.41
4.61
4.81
5.01
5.21
5.41
5.61
5.81
6.01
6.21
6.41
6.61
6.81
0.01

0.41
0.61

1.21
1.41

1.81
2.01

2.41
2.61

3.21
3.41

3.81
4.01

4.41
4.61
4.81

5.21
5.41

5.81
6.01

6.61
6.81
0.21

0.81
1.01

1.61

2.21

2.81
3.01

3.61

4.21

5.01

5.61

6.21
6.41

Notes:
Figure 2 plots the empirical distribution of quarterly reported current ratios (current assets divided by current liabilities) splitting the sample into quartiles
based on the effective federal funds rate in the sample. The distribution interval widths are 0.01, and the location of a current ratio equal to 1.0 is identified
with the arrow. The first interval to the right of the current ratio equal to 1.0 contains all current ratios in the interval [1.0, 1.01), and the interval to the
left of the current ratio equal to 1 contains all current ratios in the interval [0.99, 1.0). The vertical axis represents the number of observations in each
current ratio interval, and the horizontal axis indicates the level of the current ratio.

50
Figure 3a Histogram of current ratio covenant values in Dealscan

40

35

30

25

20

15

10

0
0.20
0.30

0.60
0.70

1.00
1.10

1.40
1.50

1.80
1.90

2.20
2.30
2.40

2.60
2.70
2.80

3.00
0.00
0.10

0.40
0.50

0.80
0.90

1.20
1.30

1.60
1.70

2.00
2.10

2.50

2.90
Notes:
In Figure 3a, the black histogram bars show the frequency of specified values of current ratios in covenants for 1,830 Dealscan debt contracts. The grey
histogram bars show the frequency of actual reported current ratio values reported by the firm in the quarter immediately prior to the contract date. The vertical
axis is the fraction of observations in the bin. The horizontal axis represents the value of the current ratio. The location of a current ratio equal to 1.0 is identified
with by the arrow.

51
Figure 3b Current ratio distribution for firms with no reported short-term or long-term debt

500
450
400
350
300
250
200
150
100
50
0
0.02
0.22

0.62

1.02
1.22

1.62

2.02
2.22

2.62

3.02
3.22

3.62

4.02
4.22

4.62

5.02
5.22

5.62

6.02
6.22

6.62
0.42

0.82

1.42

1.82

2.42

2.82

3.42

3.82

4.42

4.82

5.42

5.82

6.42

6.82
Notes:
Figure 3b plots the empirical distribution of quarterly reported current ratios (current assets divided by current liabilities) for the 108,229 firm-quarter
observations in Figure 1 where no short term or long term debt is reported. Bin sizes of 0.02 are utilized for display. The first interval to the right of the
current ratio equal to 1.0 contains all current ratios in the interval [1.0, 1.02), and the interval to the left of the current ratio equal to 1.0 contains all
current ratios in the interval [0.98, 1.0). The distribution displays bin intervals .02 through 7.0.

52
 Figure 4a Current ratio distribution for all international observations Figure 4b Current ratio distributions for code law country observations

Figure 4c Current ratio distribution for common law country observations

Notes:
Figure 4 plots the empirical distribution of quarterly reported current ratios (current assets divided by current liabilities) identified in the Compustat Global database from
inception through fiscal year 2013 as described in Table 5. The distribution interval widths are 0.01 and the location of a current ratio equal to 1.0 is identified with the
arrow. The first interval to the right of the current ratio equal to 1.0 contains all current ratios in the interval [1.0, 1.01), and the interval to the left of the current ratio equal
to 1.0 contains all current ratios in the interval [0.99, 1.0). The vertical axis represents the number of observations in each current ratio interval, and the horizontal axis
indicates the level of the current ratio. Figure 4a plots all observations in the bin intervals .01 through 7.0, which represents 444,557 of the total 468,527 sample observations
from the Compustat Global database. Figure 4b is the same as Figure 4a, but plots only those observations from code law countries (see Table 5). Figure 4c is the same as
Figure 4a, but plots only those observations from common law countries (see Table 5).

53