Managerial discretion in distressed firms

This study examines the earnings management behaviour of 455 distressed US firms that filed for bankruptcy during the period 1986–2001. We examine (a) possible earnings management during the years prior to bankruptcy-filing, (b) whether qualified audit opinions cause conservative earnings management behaviour, (c) whether earnings management differs between firms that discontinued operations and firms that survived thereafter, and (d) the effect of earnings management on subsequent stock returns. Our results are consistent with downwards earnings management 1 year prior to the bankruptcy-filing. Results also show that (a) firms receiving unqualified audit opinions 4 or 5 years prior to the bankruptcy-filing event manage earnings upwards in subsequent years, consistent with Rosner [2003. Earnings manipulation in failing firms. Contemporary Accounting Research 20, 361–408], (b) more conservative earnings management seems to be related to the qualified audit opinions rendered in the preceding year, (c) firms with long-term negative accruals the year of bankruptcy-filing have a greater chance to survive thereafter, and (d) more pronounced (negative) earnings management is associated with more negative (next year's) subsequent returns.     

Earnings Behaviour of Financially Distressed Firms: The Role of Institutional Ownership

Using a sample of 859 U.S. bankruptcy-filing firms over the period 1986–2004, we examine the earnings behaviour of managers during the distressed period by looking at sources of abnormal accruals prior to the bankruptcy-filing year. Results show that managers of highly distressed firms shift earnings downwards prior to the bankruptcy filing. We test and provide evidence in support of two potential contributing factors. First, top-level management turnover among distressed firms leads new managers to earnings bath choices during the distressed period. Second, qualified audit opinions exert pressure on managers to follow more conservative earnings behaviour during the distressed period. Evidence is also provided that the management of distressed firms with lower (higher) institutional ownership has greater (lesser) tendency to manage earnings downwards. Results also show that higher institutional ownership mitigates the negative abnormal returns of firms with top management turnover. To the authors' knowledge, this is the first study that attempts to examine whether institutional ownership relates to market reaction in conjunction with a top management turnover or a qualified audit opinion during the distressed period. Prior studies focused on the investigation of earnings management or institutional ownership (separately) during the distressed period, but did not examine if the effect of institutional ownership on earnings behaviour also influences subsequent returns. Thus, the results of this study should be of interest to analysts, standard setters and regulatory bodies since our results show that management turnover, qualified audit opinions and firm governance mechanisms affect the quality of earnings and the level of abnormal returns.     

Idiosyncratic volatility puzzle: influence of macro-finance factors

Review of Quantitative Finance and Accounting - We analyze the cross-sectional relation between expected idiosyncratic volatility and stock returns. The expected idiosyncratic volatility is...     

Alternative bankruptcy prediction models using option-pricing theory

We examine the empirical properties of the theoretical Black–Scholes–Merton (BSM) bankruptcy model. We evaluate the predictive ability of various existing modifications of the BSM model and extend prior studies by estimating volatility directly from market-observable returns on firm value. We show that parsimonious models using our direct market-observable volatility estimate perform better than alternative, more sophisticated, models. Our findings suggest the adoption of simpler modelling approaches relying on market data when implementing the BSM model.     

Optimal equity valuation using multiples: The number of comparable firms

We examine how the accuracy of a multiples-based valuation changes as the number of comparable firms used to estimate the valuation multiple increases. Our research is motivated by a contrast between the approach followed by practitioners, who typically use a small number of closely comparable firms, and the academic literature which often uses all firms in an industry. Using a simple selection rule based on growth rates, we find that using 10 closely comparable firms is as accurate on average as using the entire cross-section of firms in an industry. The loss of accuracy from using five comparable firms rather than 10 firms or the entire industry is not great.