Abstract
We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11. Using data on 261 U.S. public firms, 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). Our key findings are that earnings management prior to bankruptcy reduces the likelihood of plan confirmation and emergence from Chapter 11. The findings are consistent with creditors rewarding conservative earnings reporting and punishing overly optimistic earnings reports. We find clear evidence 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 by the literature. We also find that auditor choice (Big 4 vs. non-Big 4) directly affects the probability for plan confirmation as well as the likelihood of emergence from bankruptcy.
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