Accounting Based Regulation And Earnings Management
Speaker(s)
Prof. Radhakrishnan Gopalan, Associate Professor, Olin School of Business, Washington University in St. Louis
ABSTRACT
We document the distortionary effects of accounting-based regulation on reported earnings. In India only firms with negative book value of equity (networth) can seek bankruptcy protection. Using a novel dataset of bankrupt firms from India, we show that firms manage earnings downward to seek bankruptcy protection. Strengthening creditor rights reduces downward earnings management among non-group affiliated firms. There is also evidence for upward earnings management among firms with positive, but low networth in an effort to avoid bankruptcy filing. Finally, we show that pre-bankruptcy accruals are a strong signal of opportunistic bankruptcy filing. Firms with income-decreasing pre-bankruptcy accruals have worse post-bankruptcy performance. Overall, our paper highlights distortions that arise from accounting-based rules and underscores the importance of factoring economic incentives in the design of such regulation.
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