Do Firms Manage Their Earnings Prior to Filing for Bankruptcy

ABSTRACT We investigate the earnings management behavior of firms that file for bankruptcy and find that firms, which eventually file for bankruptcy, attempt to manage their earnings in order to make their financial statements appear more favorable over the years prior to filing for bankruptcy. Eventually, as the need to file for bankruptcy becomes imminent, they reverse their earnings management. More interestingly, the earnings management behavior of those bankrupt firms convicted of fraud versus those not convicted of fraud is different. Whereas non-fraudulent bankrupt firms reverse their earnings management prior to filing, fraudulent bankrupt firms do not. We also compare the earnings management behavior of bankrupt firms to an industry matched control sample. We find that the control firms do not engage in similar earnings management, even though they too are experiencing similar stock price performance and are of similar size. INTRODUCTION U.S. generally accepted accounting principles allow managers of firms considerable discretion with respect to how revenues and expenses are reported. In turn, this affords management the opportunity to engage in minor to severe earnings management practices with respect to how financial statements are prepared. Schilit (2002) claims that managers misreport the financial performance of their firm (i.e., manipulate earnings) for several reasons: (1) it is profitable to do it, (2) it is relatively easy to do it, and (3) it is highly unlikely that they will get caught. We investigate whether firms filing for bankruptcy manage their earnings in reporting periods leading up to the bankruptcy filing date. The sole objective of this paper is to address the question of whether firms manage their earnings prior to filing for bankruptcy. One plausible explanation for why managers of firms that eventually file for bankruptcy manage their earnings is to mask poor operating performance. Hopefully this makes financial statement users believe that their firm's problems are insignificant and supports the firm's stock price. In this case we would expect to see our bankrupt sample to be recording revenue prematurely (or fictitiously) in periods prior to the bankruptcy filing date, and subsequently incurring a disproportionate amount of accounts receivable for a given level of sales. Likewise, managers of firms could make favorable adjustments to their schedule of aging accounts receivables to boost sales and net income. When managers make their financial statements look better, we call this positive earnings management. If operating performance does not eventually improve (which is usually the case for bankrupt firms), then attempts to make the financial statements look better in prior periods will eventually have to be reversed. The reversal of earnings management is a result of the accounting process. A good example of the affects of earnings management on later reporting periods occurred over the period 1995-1997 when Sunbeam Corporation booked about $50 million in sales of barbeque grills in the winter, which boosted sales and profits, but subsequently caused sales and profits in the spring to be lower. Earnings over this period eventually had to be restated. Faced with a heavy debt load, shareholder lawsuits, and an investigation into its accounting practices, Sunbeam filed for bankruptcy on February 1, 2001 . When managers make their financial statements look worse, we call this negative earnings management. In this case we would expect to see our bankrupt sample to be incurring negative earnings management in periods prior to the bankruptcy filing date. BRIEF LITERATURE REVIEW OF EARNINGS MANAGEMENT & BANKRUPTCY It is well publicized in the press that firms manage earnings and it is not uncommon for some managers to engage in fraudulent activities. Schilit (2002) discusses earnings management techniques, illustrates how managers use them in practice, and gives numerous examples of fraudulent earnings management behavior. …