Earnings Smoothing and Bankruptcy Risk in Liquidating Private Firms

Abstract

Smooth earnings are preferred by managers and creditors because they represent a stable business operations as well as low loan default risks and thus creditors reward firms which have smooth earnings with better loan covenant terms and lower interest rates. Nonetheless, recent literature shows that earnings smoothing in public firms is associated with stock price crash risk. Using Altman Z” score to measure firm’s specific bankruptcy risk, this study examines the association between accrual earnings smoothing and bankruptcy risk in liquidating private firms in UK and finds that earnings smoothing significantly negatively affects those firms' bankruptcy risk. The finding implies that financially distressed firms engage with less earnings smoothing, possibly because they do not have the opportunity to engage in accrual earnings smoothing anymore. Nonetheless, further examination shows that these firms engage less with earnings smoothing because they are being monitored by external creditors, indicated by significantly high leverage during the last period before they are being liquidated.