Timothy C.G. Fisher, University of Sydney
Ilanit Gavious, Ben-Gurion University of the Negev
Jocelyn Martel, ESSEC Business School & THEMA
Earnings management occurs when managers deliberately manipulate the company’s earnings either to mislead stakeholders about the underlying economic performance of the company or to influence contractual outcomes. We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11.
Using the UCLA-LoPucki Bankruptcy Research Database, we merge a sample of 261 U.S. public firms that filed for Chapter 11 between 1995 and 2009 with firm-level financial information. We construct three measures of earnings management, two of which are accounting (accrual) manipulation measures (discretionary accruals and abnormal working capital accruals) and one a real activities manipulation measure (abnormal operating cash flows).
We find that upward earnings management (more positive or less negative abnormal accruals/operating cash flows) prior to filing significantly reduces the likelihood of confirmation, while downward earnings management significantly increases the likelihood of confirmation. We also find that the likelihood of emerging from Chapter 11 is significantly lower with upward earnings management. The impacts on confirmation and emergence are primarily due to the influence of earnings management values that are one- and two-standard deviations above or below the mean. Thus, our findings are consistent with creditors rewarding unduly conservative earnings reports while punishing overly optimistic earnings reports. We also find that auditor choice (Big 4 vs. non-Big 4) directly affects the probability of confirmation and of emergence from bankruptcy.
Overall, we find that upward management of earnings destroys economic value by making the survival of the firm less likely, an effect that has not previously been uncovered in the literature.
To access the full article, please click here.