Self-Fulfilling Prophecies of Failure: The Endogenous Balance Sheets of Distressed Companies

Abstract:     
This paper analyses a problem at the intersection of accounting, law and economics: the economically efficient operation of legal arangements for company failure is undermined because valuations of assets and liabilities become unstable once a firm is distressed. The paper draws on the three disciplines to show the pivotal role of asset and liability valuations in answering the legal question, whether the firm is insolvent, and the economic question, whether the firm should fail, and its assets be redeployed to an alternative use. US and UK evidence reveals a disconcerting indeterminacy in these processes: the probability that a firm will fail affects significantly the valuations asigned to assets and liabilities; but at the same time the valuation of assets and liabilities itself determines the probability of failure. This balance sheet endogeneity is then shown to delay economically efficient management changes under debtor-oriented US Chapter 11, and to induce unnecessary costly bankruptcy with creditor-oriented UK receivership.

Number of Pages in PDF File: 33

Keywords: bankruptcy, exit, asset valuation

JEL Classification: G33, K22, M41, M44

working papers series