Bankruptcy Law, Creditor Rights, and Earnings Management: Evidence from India

Abstract

This study investigates whether the implementation of a creditor-friendly bankruptcy law encourages firms to engage in earnings management. We exploit the 2016 enactment of the Insolvency and Bankruptcy Code (IBC) in India as an exogenous policy shock for this investigation. Our results show that bankruptcy risk, on average, does not motivate firms to manage their earnings. However, after the IBC was implemented in 2016, we notice an increase in firms’ tendencies to indulge in earnings management when their bankruptcy risk increases. This effect is expected to be more pronounced in the cross-section of financially distressed firms, given their higher bankruptcy risk. Nevertheless, we find no evidence in support of this claim. Thus, we suggest that our findings are driven by firm managers’ efforts to conceal their pursuit of empire-building activities from equity holders’ scrutiny during periods of heightened bankruptcy risk. These insights may assist policymakers in evaluating the consequences of creditor-friendly bankruptcy laws with learnings for future legislative endeavours.