Firm Exit Through Bankruptcy – The Effect of Accounting Bias on Product Market Competition

Abstract

We analyze the effect of accounting biases on the profits of firms that compete in a Cournot product market. We find accounting biases strictly decrease firms' profits when the firms are fully equity-financed. However, different results emerge when we introduce debt into the firms' financial structures. Firms must report interim accounting signals, on which their debt covenants are based. We contrast firms' profits under an unbiased accounting system, a conservative accounting system and an aggressive accounting system. Conservative accounting system increases the likelihood of debt covenant violations and firm liquidation. Interestingly, the increased likelihood of could make the borrowing firms better off by turning the surviving firm into a monopolist that captures the entire market share. In addition, conservative accounting bias gives the banks more decision rights in liquidating or re-organizing the firms' operations, thus reducing the excessive liquidation problem. Absent renegotation, conservative accounting system improves the banks' payoffs.