Earnings quality in ex‐post failed firms

Abstract

This paper analyses earnings quality in ex‐post failed firms. Using a large sample of UK bankrupt firms, we find that failed firms manage earnings upwards in the four years prior to failure. This manipulation is achieved in two ways: (1) through accounting (accruals) manipulation; and (2) by implementing real operating actions that deviate from normal practice. We show that these two types of manipulation lead to reduced earnings reliability. We use conditional conservatism as a proxy for reliability, as prior literature links conditional accounting conservatism to better governance and positive economic outcomes. Our results show that conditional conservatism decreases substantially in the years prior to failure. Finally, we show that accruals manipulation is more pronounced in ex‐post bankrupt firms with low ex‐ante probability of failure, and that ex‐post bankrupt firms with high ex‐ante failure probability, having likely exhausted the opportunities for accrual manipulation, manipulate real operations more aggressively.

Keywords::

• firm failure
• accruals management
• real earnings management
• conditional conservatism
• earnings quality
• bankruptcy

Notes

Juan Manuel García Lara is at Universidad Carlos III de Madrid, Beatriz García Osma is at Universidad Autónoma de Madrid and Evi Neophytou is at Athens University of Economics and Business.

The authors are grateful to Pauline Weetman (the editor), Peter F. Pope, Steve Young and two anonymous reviewers for their helpful comments and suggestions. The paper has benefited from presentations at the 2006 EAA annual conference and at the 1st International Conference in Accounting and Finance at the University of Macedonia, Thessaloniki. We acknowledge financial contribution from the European Commission INTACCT Research Training Network (MRTNCT‐ 2006–035850), and the Spanish Ministry of Science and Innovation (ECO2008–0638/ECON and SEJ2007‐ 67582/ECON and SEJ2005–08644/ECO).

Correspondence should be sent to Beatriz García Osma, Universidad Autónoma de Madrid, Departamento Contabilidad, Avda. Fco Tomas y Valiente 5, Madrid 28049 (Spain). Tel. [phone]. E‐mail: [email protected].