Academic journal article Academy of Accounting and Financial Studies Journal

The Effects of Chapter 11 Bankruptcy on Earnings Forecasts

Academic journal article Academy of Accounting and Financial Studies Journal

The Effects of Chapter 11 Bankruptcy on Earnings Forecasts

Article excerpt

ABSTRACT

Prior studies in the area of management forecasts contain one common characteristic, they assess voluntary earnings disclosures during normal operating periods, when the incentive structure is generally routine and ongoing. This research tests whether voluntary earnings disclosures released during non-normal operating periods (specifically chapter 11 bankruptcy filing ) differ from disclosures released during normal operating periods in terms of credibility. In terms of bias and information content, findings suggest that forecasts tend to significantly differ during normal versus non-normal operating periods. With increasing bankruptcy filings taking place today, these findings have practical implications on users of forecast information.

INTRODUCTION

Prior research in the study of voluntary earnings disclosures finds that managers release information that is unbiased relative to subsequently revealed earnings and that tends to contain more bad news than good news (Baginski et al., 1994; Frankel, 1995). Such releases are also found to contain information content (Patell, 1976; Waymire, 1984; Pownell & Waymire, 1989). Although forecast release is costly, credible disclosure will occur if sufficient incentives exist. These incentives include bringing investor/manager expectations in line (Ajinkya & Gift, 1984), removing the need for expensive sources of additional information (Diamond, 1985), reducing the cost of capital to the firm (Diamond & Verrechia, 1987), and reducing potential lawsuits (Lees, 1981).

All of the aforementioned empirical studies have one common characteristic, they assess voluntary earnings disclosures during normal operating periods, when the incentive structure is generally routine and ongoing. The research question addressed in this study is: Do voluntary earnings disclosures released during non-normal operating periods (specifically management changes) differ from disclosures released during normal operating periods in terms of credibility? This question links earnings management to voluntary disclosures of earnings. For several years researchers have found that some degree of earnings management may exist in mandatory disclosures. I argue that incentives leading to earnings management may manifest in voluntary disclosures. If the potential exists for voluntary disclosures to be managed, then to what extent do investors rely upon the forecast information?

In addressing this research question, I rely upon literature that indicates different incentive structures during non-normal operating periods that may lead to earnings management. DeAngelo (1986) shows that managers have incentives during management buyouts to manage earnings downward in attempts to reduce buyout compensation. Collins and DeAngelo (1990) show that earnings management occurs during proxy contests, and market reaction to earnings during these contests is different than during normal operating periods. DeAngelo (1990) finds that managers have incentives during merger activities to manage earnings upward so as to convey to current stockholders that the potential merger will not adversely affect their investment. Perry and Williams (1994) find that management of accounting earnings occurs in the year preceding "going private" buyouts. Stunda (1996) finds that managers exert greater upward earnings management during mergers and acquisitions.

This study assesses the effect that chapter 11 bankruptcy filings have on management forecast credibility. In accomplishing this, the presence of earnings forecast management is tested by using bias measures along with the market reaction to the forecast during the bankruptcy period. The study focus is on firms involved in chapter 11 bankruptcy (non-normal operating periods) during the period 1983-2001. Results are compared to forecasts released in periods of non-bankruptcy (normal operating periods). Based upon statistical analysis, conclusions are drawn that identify whether bankruptcy becomes a factor that influenced management earnings forecasts more during non-normal operating periods than during normal operating periods. …

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