Can We Trust the Financial Reporting of Distressed Firms?

This paper investigates discretionary accrual choices in financially distressed firms. I predict that financially distressed firms with favorable prospects use income-increasing discretionary accruals to signal private information and can do so credibly as signaling is costly. Using a sample of private SMEs for the years 2002-2015 and a matched pair design of future bankrupt firms (poor prospects) and their matched non-bankrupt peers (favorable prospects) I find support for the hypothesized relationship. I observe that the favorable prospect firms have income-increasing discretionary accruals, but fail to find such a relationship for the poor prospect firms. Compared to poor prospect firms, the favorable prospect firms’ discretionary accruals map to a higher extent into future operating cash flows, indicating an information enhancing effect of discretionary accruals. The results are robust to three different specifications of discretionary accruals, and are driven by incomeincreasing rather than income-decreasing discretionary accruals. Emphasizing the information enhancing effects of managers’ discretionary accrual choices my findings contribute to the current discussion on managerial discretion and its impact on earnings quality.