Accounting Based Regulation and Earnings Management

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 postbankruptcy performance, suggesting that pre-bankruptcy accruals are a strong signal of opportunistic bankruptcy filing. There is also 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.