Earnings quality in ex-post failed firms

Abstract

This paper analyses earnings quality in ex-post failed firms. Using a large sample of UK bankrupt firms,
\nwe find that failed firms manage earnings upwards in the four years prior to failure. This manipulation is achieved
\nin two ways: (1) through accounting (accruals) manipulation; and (2) by implementing real operating actions that
\ndeviate from normal practice. We show that these two types of manipulation lead to reduced earnings reliability.
\nWe use conditional conservatism as a proxy for reliability, as prior literature links conditional accounting conservatism
\nto better governance and positive economic outcomes. Our results show that conditional conservatism
\ndecreases substantially in the years prior to failure. Finally, we show that accruals manipulation is more pronounced
\nin ex-post bankrupt firms with low ex-ante probability of failure, and that ex-post bankrupt firms with high ex-ante
\nfailure probability, having likely exhausted the opportunities for accrual manipulation, manipulate real operations
\nmore aggressively