Accounting Based Regulation and Earnings Management

61 Pages Posted: 16 Oct 2015 Last revised: 3 Jun 2016

See all articles by Radhakrishnan Gopalan

Radhakrishnan Gopalan

Washington University in St. Louis - John M. Olin Business School

Xiumin Martin

Washington University in Saint Louis - Olin School of Business

Kandarp Srinivasan

Northeastern University - D’Amore-McKim School of Business

Date Written: June 1, 2016

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. Firms with income-decreasing pre-bankruptcy accruals have worse post-bankruptcy performance, suggesting that pre-bankruptcy accruals are a strong signal of opportunistic bankruptcy filing. We also find evidence for upward earnings management among firms with positive, but low networth in an effort to avoid bankruptcy filing. Overall, our paper underscores the importance of factoring economic incentives in designing regulation using accounting numbers. Validating our findings, the proposed new bankruptcy law in India does away with the accounting rule.

Keywords: bankruptcy, emerging markets, regulation, accruals, accounting rules, tunneling

JEL Classification: G33, M41

Suggested Citation

Gopalan, Radhakrishnan and Martin, Xiumin and Srinivasan, Kandarp, Accounting Based Regulation and Earnings Management (June 1, 2016). Available at SSRN: https://ssrn.com/abstract=2674272 or http://dx.doi.org/10.2139/ssrn.2674272

Radhakrishnan Gopalan

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Xiumin Martin (Contact Author)

Washington University in Saint Louis - Olin School of Business ( email )

Saint Louis, MO 63130
United States

Kandarp Srinivasan

Northeastern University - D’Amore-McKim School of Business ( email )

360 Huntington Ave.
Boston, MA 02115
United States

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