Tension in Financial Reporting: Reacting to a Peer Bankruptcy Announcement

Abstract

We investigate if and how a peer’s bankruptcy affects financial reporting by other firms within the industry. Prior research documents that the bankruptcy filing of a peer firm has negative capital market effects on other firms within the industry (lower stock market value and higher cost of debt). We argue that firms within an industry experiencing peer bankruptcies modify their financial reporting to mitigate such negative capital market effects. However, tension arises as to whether such modification is toward more conservative accounting or the opposite. Using a large sample of firms from 1980 to 2018, we find that following a peer firm bankruptcy filing, other firms within the industry exhibit a rise in conditional conservatism in their financial reporting. Our findings are robust to a battery of tests including the exclusion of distressed industries, the 2000 dot-com crash period, and the 2008 financial crisis period as well as employing an alternative proxy for conditional conservatism. The results are not significant for placebo bankruptcies 1 and 2 years before actual bankruptcies. Further analyses show that the spillover effects are more pronounced for firms in homogeneous industries, which exhibit higher leverage, with strong governance mechanisms, and in industries that experience strong market reaction following peer bankruptcy announcements. We also find that the bankruptcy filing of larger and older firms leads to stronger spillover effects.