Real earnings management in bankrupt firms

Abstract

AbstractWe investigate: (1) whether managers in bankrupt firms manipulate earnings through real earnings management (REM); (2) the incentives and tradeoff strategies to engage in REM; (3) how REM influences the subsequent firm performance and bankruptcy probability. We find that bankrupt firms are more likely to manipulate earnings via REM than continuous firms. There is an increasing trend of REM activities in the 5‐year window before bankruptcy. The major incentive for bankrupt firms to engage in REM is the issuance of new debt. Bankrupt firms treat REM and accrual‐based earnings management (AEM) as complementary tools for earnings management. We further find that REM is associated with low future firm performance. The REM score defined in this study can more accurately predict bankruptcy than the Altman Z score by 15%. Overall, the findings in this paper will help investors, regulators, and academics identify REM activities and understand the incentives and consequences of REM.