Accounting Conservatism and Creditor Recovery Rate. John Donovan Richard Frankel

Transcription

1 Accounting Conservatism and Creditor Recovery Rate John Donovan Richard Frankel Xiumin Martin* Olin Business School Washington University in St. Louis Current version: April 2014 *We thank Brad Badertscher, Bryan Graden, Tim Gray (copy editor), Sudarshan Jayaraman, Jared Jennings, Josh Lee, Nemit Schroff (discussant) and participants at the 2013 Nick Dopuch Conference and participants at the Kansas University and Notre Dame accounting seminars.

2 Abstract We examine the relation between accounting conservatism and creditor recovery rates for firms in default. We also test the link between conservatism and the length of distress resolutions. We find creditors of firms with more conservative accounting before default have significantly higher recovery rates and shorter bankruptcy resolutions. Conservative firms also are more likely to violate debt covenants before default and enter bankruptcy more quickly after large negative shocks. Last, conservative firms show a significantly higher probability of emerging from bankruptcy. These results suggest accounting conservatism preserves creditor value conditional on default. Key words: Accounting conservatism, recovery rate, bankruptcy resolution, covenant violation JEL: M4, G32, G33, G34

3 I. INTRODUCTION We investigate whether accounting conservatism is associated with lenders recovery rates from borrowers in default. Prior research indicates accounting conservatism facilitates borrowing. 1 Conservatism can reduce borrowing rates i) by quickly transferring control rights to creditors, thereby facilitating renegotiation of lending terms and forcing changes to borrower investment and financing practices well before financial distress, and ii) by improving creditor recovery rates in financial distress. We refer to the first role of conservatism as default-risk control and the second role as recovery-risk control. Our goal is to isolate accounting conservatism s relation to recovery risk. When financial reporting is conservative, net assets are less likely to overstate liquidation value. Higher recovery rates could result for several reasons. First, creditors can gain more timely access to control rights through early covenant violation, preventing wealth transfers to other parties and the continuation of inept management practices. Second, conservatism can undermine shareholders ability to extract value in negotiations with bondholders. Andersen and Sundaresan (1996) show that, in the presence of costly liquidation, a creditor may not want to force liquidation. 2 In this circumstance, the borrower may have an incentive to underperform on the debt contract. However, that incentive can be limited if the creditor can threaten liquidation when the firm s liquidation value exceeds the promised payment on the debt. The incentive conflict can be reduced if the creditor can gain decision rights before the liquidation value falls below the promised payment on the debt, minimizing bankruptcy costs. Third, conservatism can reduce information asymmetry between investors with regard to the liquidation value of assets, facilitating more rapid agreement, thereby limiting direct and indirect costs that grow with the 1 Prior studies document that accounting conservatism is associated with reduced cost of credit (Ahmed et al., 2002; Wittenberg-Moerman, 2008; Zhang, 2008; Nikolaev, 2010; Brockman et al., 2012), lower default risk (Ahmed et al., 2002), and the development of credit markets (Ball et al., 2003; Ball et al., 2008). 2 The idea that the threat of liquidation is necessary to deter strategic default by borrowers can also be found in Harris and Raviv (1991), Bolton and Scharfstein (1996), and Hart and Moore (1998). 1

4 length of the bankruptcy. A reorganization plan is deemed rejected by a class of creditors if the class would receive more in liquidation (Bankruptcy Reform Act of 1978, Section 1129 (7) (A)). Financial statements can serve as a starting point in negotiations. Brown (1989) notes the time consuming, costly nature of valuation proceedings as courts have little appellate court guidance and lack expertise in case-by-case fact finding. Alternatively, conservative accounting might have little effect on creditor collections. Debt agreements could be altered in light of accounting policies. Guay and Verrecchia (2006) argue, Bias can be accommodated readily within many contracting settings by simply adjusting the parameters of the contract (p. 156). The net-asset threshold triggering technical default, for example, could be raised to counteract the effects of less conservative accounting policies. If so, we expect no relation between conservative accounting and creditor recovery rates. However, adjustments to book value that convert it to an approximation of liquidation may be difficult to replicate in a debt covenant. Our study aims to assess the descriptive validity of these competing stories. We collect a sample of public firms in default from Moody s Ultimate Recovery Rate database over the period of We use five measures of accounting conservatism (Basu, 1997; Ball and Shivakumar, 2005; Beatty et al., 2008; Zhang, 2008) and one composite measure based on the average quintile rank of the individual measures. This composite is negatively correlated with measures of asset write-downs after bankruptcy filing, suggesting that it identifies firms that are less likely to have overstated net assets. We find a positive relation between accounting conservatism and creditor recovery rate. The positive relation holds for 3 Moody s defines default as (1) a missed or delayed disbursement of interest, principal, or both; (2) bankruptcy, administration, legal receivership, or other legal blocks to the timely payment of interest, principal, or both; or (3) a distressed exchange. Contemporaneous work by Carrizosa and Ryan (2013) uses credit insurance as a proxy for expected default probability and expected recovery rates. Our results, using actual recoveries, complement theirs. 2

5 using both family recovery rate, which is the debt-principal weighted recovery rate of each issue, and issue-specific recommended discounted recovery rate while controlling for issue characteristics, firm characteristics, and macroeconomic factors. In addition, more conservative firms spend less time in bankruptcy, suggesting that accounting conservatism reduces information asymmetry, facilitating agreements between borrowers and lenders. The data further demonstrate that firms with higher levels of financial reporting conservatism are more likely to violate covenants before distress resolution and more quickly enter bankruptcy proceedings after large negative shocks. Conservative firms also have higher cash flow-interest expense coverage and higher cash flow to total assets ratio before default. These results suggest that timely covenant violation, quicker default, and higher asset productivity are likely to be the mechanisms through which creditors of conservative borrowers improve collections upon default. We also find that accounting conservatism is positively associated with the likelihood of emergence from bankruptcy, implying that conservatism aids the resolution of financial distress. Collectively, our findings highlight the role of accounting conservatism in controlling recovery risk. Our paper is related with Zhang (2008). We illustrate the differences between the populations studied by the two papers in Figure 1. Zhang (2008) studies firms that experience a negative shock. We focus on the subsample of firms that cannot make promised payments to creditors. Zhang argues that conservative reporting benefits creditors by providing a timely signal that accelerates covenant violation, conditional on the occurrence of losses. She suggests that conservative financial reporting can give lenders a measure of the lower bound of the borrower s collateral value. Understated collateral might be associated with a higher recovery rate in default. We aim to examine this proposition. [Insert Figure 1 here] 3

6 To the extent that conservative financial reporting is a management choice, enforced through reputational concerns, commitment to timely loss reporting might break down if default is the last period in managements game. While management turnover in actual defaults is likely higher than in technical defaults, it is not universal e.g., Gilson (1989) finds that the average turnover rate of CEOs in distressed firms is 71% and does not mark the end of managers careers. 4 The possibility that managers will adopt an end-game strategy suggests that an empirical link between accounting conservatism and creditor recovery in bankruptcy might not exist. Thus, we compliment Zhang s (2008) work by investigating whether conservatism enhances creditor value in the event of shocks that cause default. We also draw on research examining the relation between creditor rights and borrowers financing and investment policies (e.g., Chava and Roberts, 2008; Roberts and Sufi, 2009a, 2009b; Nini et al., 2009). These papers suggest that borrowers adjust policies to favor creditors following covenant violations. Like these authors, we are reluctant to wrench efficiency implications from our correlations. Yet Chava and Roberts (2008) note that the severity of agency problems increases with information asymmetry. They find the transfer of decision rights to creditors has larger effects on borrower investment when information asymmetry is greater. Research suggests that conservative accounting reduces information asymmetry between outside investors and managers (LaFond and Watts, 2008; LaFond and Roychowdhury, 2008). Our results extend these ideas. Conservatism, by narrowing information asymmetry that surrounds the liquidation value of net assets, can limit the upheaval surrounding financial distress. This paper proceeds as follows: Section 2 reviews literature on accounting conservatism and debt contracts and the institutional details of bankruptcy and develops hypotheses. Section 3 describes our sample and our measures of accounting conservatism. Section 4 presents empirical 4 68% firms in default in our sample (Table 1) emerge from bankruptcy proceedings. 4

7 results. Section 5 discusses robustness tests. Section 6 concludes. II. RELATED LITERATURE, INSTITUTIONAL DETAILS, AND HYPOTHESES DEVELOPMENT Related literature This paper relates to prior literature on the contracting role of financial reporting conservatism (Basu, 1997; Watts, 2003a; Watts, 2003b). Conservatism is defined as the differential verifiability required for recognition of profits versus losses (Watts, 2003) leading to timing differences in recognition (i.e., anticipate no profit but all losses). The literature argues conservative financial reporting reduces information asymmetry and facilitates contracting. Debtholders payoffs are an asymmetric function of firm value. Their entire investment can be lost when the firm performs poorly, but their payoff is limited to promised interest and principal payments when the firm performs well. To ensure satisfaction of their claims, creditors focus on the lower portion of the borrower s net asset distribution (Townsend, 1979; Watts, 2003). Thus creditors demand conservatism for early warning of financial deterioration via timely covenant violations and for measurement of the firm s ability to pay debts. While both aspects can reduce creditors recovery risk, the former also allows lenders to take actions to minimize default risk (e.g., forcing changes to borrower investment and financing practices well before financial distress as in Nini et al., 2009). Ahmed et al. s (2002) analysis finds that higher levels of accounting conservatism are associated with lower cost of debt and that this association increases with borrowers leverage and dividend payments. This suggests that conservatism protects lenders by constraining dividend payments and mitigating other incentive conflicts between equity and debt holders. Zhang (2008) finds more conservative firms are more likely to violate a covenant over the life of 5

8 a loan, conditional on experiencing a negative shock. She also shows that lenders reward more conservative firms with lower interest rates at loan inception, potentially due to expected benefits from swift control rights transfers. Tan (2013) examines the impact of a covenant violation on ex post conservatism and finds financial reporting conservatism increases after debt covenant violations. This increase is more pronounced when lenders gain greater power by appointing a chief restructuring officer. Beatty et al. (2008) observe that debt covenants terms alone do not satisfy lenders demand for conservatism. They find that more conservative firms are more likely to have conservative modifications to covenant calculations in their debt contracts. That is, asymmetric timeliness and contract modifications complement each other in reducing agency costs. Biddle et al. (2013) test the relation between accounting conservatism and bankruptcy risk and find that asymmetric timeliness is associated with lower estimated bankruptcy risk. Their sample consists of all firms, regardless of their financial condition. By including nondistressed firms in their sample, they address how conservatism affects default risk but not recovery risk. 5 Carrizosa and Ryan s (2013) study is related to ours. Using expected recovery rates estimated from CDS spreads, they show that implied recovery rates increase with the combination of conservatism and covenants. Their method requires an estimate of default probability to infer recovery rates. Our work differs from theirs by using realized recovery rates. Focusing on actual defaults also enables us to examine the intermediate links of the reduced form correlation. On the other hand, our approach requires control for selection bias that is absent in Carrizosa and Ryan s (2013) design. Background on bankruptcy 5 Default risk is the probability of default, while recovery risk is the product of default probability and recovery rate given default. 6

9 Financial distress can be resolved either inside or outside the bankruptcy court. Bankruptcy Reform Act of 1978 governs disputes that arise in bankruptcy court. A bankruptcy is a comprehensive process for the resolution of impaired contractual claims against the firm. The 1978 code provides for either liquidation (Chapter 7) or reorganization (Chapter 11). Outsidethe-court resolution typically involves an agreement between creditors and shareholders to restructure the firm s financial claims and is implemented through an exchange offer (distressed exchange). Chapter 11 of the U.S. Bankruptcy Code allows the firm to continue operating while seeking to satisfy credit claims. Research fixes on the direct and indirect costs of bankruptcy and on deviations from absolute priority rule in resolving financial distress through bankruptcy (Weiss, 1990; Franks and Torous, 1993; Kalay et al., 2007) where absolute priority rule specifies that senior claimholders receive the total value of their defaulted claim before junior claimholders or equity holders receive consideration (Weiss, 1990; Franks and Torous, 1994). These studies indicate that the direct costs of bankruptcy are relatively low. Weiss (1990) reports that direct costs are approximately 3% of the firms total assets and that deviations from absolute priority are frequent in bankruptcy resolution. Subsequent papers (e.g., Capkun and Weiss, 2008; Ayotte and Morrison, 2009) document that increased creditor control over bankruptcy in recent years results in fewer violations of absolute priority rule and improved creditor recovery rates. Studies also seek factors associated with creditor recovery rates during bankruptcy. Acharya et al. (2007) find that creditor recovery rates are significantly lower when an industry is in distress. Franks and Torous (1994) examine the recovery rates of different classes of creditors in the event of a distressed exchange or a bankruptcy filing. Bris et al. (2003) examine recoveries for defaults in Arizona and New York over the period of 1995 to They find the creditors of 7

10 firms that emerge from Chapter 11 restructurings recover more than those of firms that are liquidated through Chapter 7. Some suggest that more rapid restructuring of distressed firms results in a more efficient bankruptcy process. Jensen (1991) writes: [It] often takes years to resolve individual cases. As a result of such delays, much of the operating value of businesses can be destroyed. Moreover, the recently enacted bankruptcy reform legislation, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCAP), contains elements designed to expedite bankruptcies. 6 The reason may be that the direct costs of restructuring such as fees for retaining investment bankers, attorneys, and restructuring professionals increase with time. Shorter workouts also reduce the indirect costs by limiting its impact on firm reputation, freeing management from drawn-out negotiations, and reducing the extent to which firms forego investment opportunities. Consistent with this view, Thorburn (2000) finds that the costs of bankruptcy increase with the time in default. Acharya et al. (2007) find a statistically significant negative relationship between bond recovery rates and the time spent in default. Hypotheses development By applying a higher verification standard for recognizing gains, conservative reporting gives lenders a measure of the lower bound of a firm s net assets that closely tracks liquidation value. Future values of the firm and net assets, for example, are generally not verifiable because many unrealized or unverifiable gains are contingent on firms continued operation. Watts (2003) argues that lenders are better protected when using the lower bound of the current value 6 Specifically, the BAPCPA limits a debtor s exclusivity period to file a reorganization plan at 18 months after the commencement of the bankruptcy case and its exclusivity period to solicit vote on the plan at 20 months after the filing of a plan ( 411). In contrast, the former bankruptcy code allows the court to extend both exclusivity periods indefinitely so long as the requisite cause is established. These new absolute deadlines may encourage more rapid plan proposals by debtors and thus lead to shorter proceedings as debtors try to minimize the ability of creditors to stall so as to cause the loss of exclusivity. Other amendments of the BAPCPA that may also expedite proceedings include a requirement for the debtor to make faster decisions on unexpired leases ( 404) and an absolute plan-filing deadline for small business cases ( 437). 8

11 of net assets to make lending decisions at the loan inception and to assess the ability of the borrower to repay. The protection afforded by conservatism becomes even more salient when firms are in distress. For two firms with the same reported net assets before default, the one with conservative accounting likely has higher collectible value of net worth. This, in turn, results in higher recovery rate. Andersen and Sundaresan (1996) further argue that borrowers can exploit liquidation costs, because, when liquidation is costly and liquidation value is less than the full debt payment, the creditor may not want to force liquidation even if the borrower does not fully comply with his obligations. They show the owner behaves strategically by underperforming on the debt contract in these circumstances, thus forcing the creditor to accept less than the contract amount. However, the ability of creditors to credibly threaten shareholders with liquidation can limit the owner s strategic debt service when the firm s liquidation value exceeds the promised payment on the debt. Under these conditions, the owner bears the full liquidation costs. The incentive conflict therefore can be reduced if the creditor can gain decision rights before liquidation value falls below the promised payment on the debt. As conservative financial reporting offers a reliable indicator of liquidation values, we argue that creditors will promptly exercise their decision rights before the liquidation value falls below the contract amount, leading to higher recovery rates when borrowers are conservative. Last, the information asymmetry between creditors and shareholders with respect to the firm s asset values can increase the costs associated with bargaining to reach a reorganization plan during bankruptcy, and prolonged renegotiation can lower creditors recovery rate. If accounting conservatism reduces such information asymmetry, we expect a positive relation between accounting conservatism and creditor recovery rate and a negative relation between accounting conservatism and the duration of financial distress resolution. Based on the above reasoning, our two hypotheses are stated below: 9

12 H1: Accounting conservatism is positively associated with creditor recovery rates of firms in financial distress. H2: Accounting conservatism is negatively associated with the duration of financial distress resolution. III. SAMPLE SELECTION AND MEASURES Sample selection We identify firms in bankruptcy using Moody s Ultimate Recovery Database (URD), which includes data on 987 firms defaulting on total debt obligations greater than $50 million over the period of Moody s URD identifies a default when a firm files for bankruptcy, misses an interest payment due on its debt, or enters into a distressed exchange with existing debtholders. 7,8 For each firm included in the URD, Moody s provides the date of default, date of emergence, the description and total principal amount of each financial instrument in default, and other detailed information on each security. The key data item of interest for our study is the creditor recovery rate. The URD database offers three recovery methods: the settlement method, the liquidity method, and the trading-price method. In the first, the value of the settlement instruments is taken at or close to emergence. In the second, the value of the settlement instruments is estimated at the time of a liquidity event, such as the maturity of the instrument, the call of the instrument, or a subsequent default event. And in the third, the value is based on the trading pricing of the defaulted instrument taken at or post-emergence. Moody s recommends a method to calculate recovery rate for each default that best represents the actual recovery. The most common is the settlement method. Furthermore, a firm s family recovery rate 7 The missed or delayed disbursement of interest, principal, or both includes delayed payments made within a grace period. 8 Moody s excludes financial institutions as these firms are highly regulated, making their recoveries somewhat inconsistent and inappropriate for analyzing loss-given-default. 10

13 is calculated as the total value distributed to creditors at the date of resolution, relative to the total liabilities in default at the date of default. The family recovery rate measures the weightedaverage collection percentage across all creditor classes. 9,10 We supplement the Moody s URD using the UCLA Bankruptcy Research Database (BRD) over the period from This database includes details on 886 firms filing for bankruptcy; 381 of the observations overlap with the URD dataset. However, creditor recovery rates are only available for sample firms identified through the Moody s URD. Our financial and return data are obtained from the Compustat annual industrial file and CRSP monthly stock file. Of the total sample of 1,492 bankrupt firms contained in the Moody s URD and the UCLA BRD, 896 firms contain the necessary data to compute our conservatism measures. Figure 2 shows the sample composition. We exclude all firms lacking Compustat data to compute control variables. The final sample for our tests of creditor recovery rates contains 557 firms in financial distress over the period of [Insert Figure 2 here] Measures of accounting conservatism To remediate noise in firm-specific measures of conservatism, we employ five measures of financial reporting conservatism (four used in prior literature) and create a composite measure based on the average quintile rank of the individual measures. All firm-specific measures of conservatism are estimated over the ten years beginning in the fiscal year immediately before default. If financial information required for estimation is unavailable at the measurement date, 9 Moody s follows the standard groups for credit class set by the US bankruptcy court. In the cases of distressed exchanges and other types of restructurings, debt is classified in a fashion consistent with that of the bankruptcy court by a Moody s analyst. 10 All our results are robust to using issue-specific recommended discounted recovery rates, as well as nominal recovery rates. 11 We thank Lynn LoPucki for providing his Bankruptcy Research Database, available at 11

14 we use the prior period data, where available. Our first measure of conservatism, Cons_Basu, uses the firm-specific Basu (1997) measure. Specifically, for each firm in our sample, we estimate the sensitivity of earnings to bad news relative to good news and the ratio of the two sensitivities serves as the first measure. Our second measure of conservatism, Cons_r2, is the relative explanatory power of bad news in earnings versus the explanatory power of good news in earnings following Zhang (2008) and Basu (1997). One limitation of these measures is that they rely on the firm s stock price to identify news and economic earnings (Givoly and Hayn, 2000). We employ additional measures that do not rely on stock returns. Following Ball and Shivakumar (2005), our third measure of conservatism, Cons_BS, estimates the extent to which firms record bad news in earnings through write-offs and losses in accruals. Our fourth measure, Skewness, captures the difference between the skewness of operating cash flows and earnings, following Beatty et al. (2008). Each of these measures attempts to identify asymmetric treatment of bad news and good news in earnings. Given that each of our sample firms performs poorly, operationally and financially, before the bankruptcy filing, our interest is the extent to which accounting earnings captures the deterioration that leads to bankruptcy. Our final individual measure of conservatism, Special Items Ratio, attempts to measure the recognition of this type of news. We compute the average special items recorded in the Income Statement (SPI) scaled by the average total assets over the three years prior to default as a proxy for these recorded losses. 12 We then compute Special Items Ratio as the ratio of special items to cumulative firm stock returns on CRSP in the three years before default. (Appendix A contains a detailed discussion of the five measures of 12 All results continue to hold if we compute the sum of special items recorded in the Income Statement scaled by the average total assets over the three-year period prior to default as a proxy for the recorded losses. 12

15 conservatism.) We standardize each conservatism measure to have a mean of zero and standard deviation of 1 to make the coefficients of conservatism across different proxies comparable. Finally, we create a composite measure of conservatism, All Conservatism, based on the average quintile rank of each individual measure, requiring at minimum two individual conservatism measures to calculate the composite measure. IV. EMPIRICAL RESULTS Descriptive statistics Table 1 presents descriptive statistics for all sample firms in bankruptcy over the period of , identified using Moody s Ultimate Recovery database and the UCLA Bankruptcy Research database. The number of observations for each dependent variable varies depending on its availability in each of these two data sources. Each test uses the maximum observations available. Creditor recovery rates (Recovery Rate) are family recovery rates and are only available for the 594 sample firms identified in the Moody s Ultimate Recovery Database. The mean (median) creditor recovery rate across all creditor classes is 53.39% (52.46%), indicating that creditors of sample firms lose substantial value on their claims. The average sample firm in the Moody s URD defaults on approximately $1.1 billion of total debt, corresponding to average creditor losses of approximately $513 million. Factors that can improve creditor recovery rates therefore can have significant economic value. Asset writedowns after firms enter bankruptcy account for about 0.7% of total assets, while losses reported after bankruptcy filing are approximately 0.1% of total assets. Approximately 66% of sample firms violate a debt covenant in the year before default, consistent with the idea that financial distress triggers debt covenants. On average, 68% of sample firms emerge from bankruptcy, and sample firms require approximately 422 days (14 months) to resolve financial distress. This 13

16 resolution period is shorter than prior papers, which indicates the average time from the bankruptcy filing date to the emergence date approximates two to three years (Weiss, 1990; Franks and Torous, 1994). This is consistent with shorter resolution periods following the 2005 Act, which is intended to expedite the bankruptcy process. The mean (median) lag between bankruptcy filing and negative economic news reflected in stock returns is approximately 7.6 (10.0) months. On average, sample firms do not have sufficient operating cash flows to cover their annual interest expense before bankruptcy, with average (median) Int Coverage of (0.390). Additionally, sample firms display high leverage before filing for bankruptcy. The mean (median) firm s total debt is approximately 81% (70%) of the firm s total assets in the quarter before default, reinforcing the liquidity constraints indicated by coverage ratios. Sample firms incur losses prior to default, with mean (median) return on assets of ( ), consistent with these firms experiencing declining operating performance before default. Firms Herfindahl debt concentration ratio is 0.58 (0.56) at the mean (median), indicating that debt is concentrated with a few banks at default. Bank debt and secured debt constitute 37% and 44%, respectively, of total debt upon bankruptcy filing. The average firm carries approximately a B- S&P credit rating in the year before default, which suggests that, although the mean firm had the ability to meet its current obligations in the year before default, its financial condition was vulnerable to a decline in the near future. 13 [Insert Table 1 here] Table 2 presents Pearson and Spearman correlations among variables below and above 13 Standard & Poor s Guide to Credit Rating Essentials, available at defines a firm with a B credit rating as more vulnerable to adverse business, financial and economic conditions, but currently has the capacity to meet financial commitments. 14

17 the diagonal, respectively, with the significance below 10% level bolded. The table shows that creditor recovery rate is negatively associated with ex post asset write-downs and the duration of bankruptcy resolution and positively associated with the likelihood of emergence from bankruptcy. The five individual measures of accounting conservatism Cons_r2, Cons_Basu, Cons_BS, Skewness, and Special Items Ratio are all positively related with creditor recovery rates but only statistically significant for the Cons_r2 measure. In addition, the composite measure of conservatism is positively associated with recovery rate with statistical significance at the 10% level. Finally, firm size, bank share, and the percentage of secured debt are all positively associated while leverage is negatively associated with recovery rates. These univariate results highlight the importance of controlling for these factors while estimating the relation between accounting conservatism and creditor recovery rates. The correlation coefficients are low except for that between firm size and debt concentration (-0.658) and between bank share and percentage of secured debt. [Insert Table 2 here] Results of the relation between accounting conservatism and creditor recovery rate We hypothesize that accounting conservatism is positively associated with creditor recovery rates of firms in default in H1. To test this hypothesis, we estimate the following model: Recovery i = α 0 + β 1 Conservatism i + β 2 Size it + β 3 Leverage it-1 + β 4 Prior ROA it + β 5 Distressed Exchange i +β 6 Debt Concentration i + β 7 Bank Share i + β 8 Secure Debt% i + β 9 Bankruptcy Period i + β 10 Distressed Exchange i + β k Macroeconomic Controls + ε it (1) where Recovery is the dependent variable, which is the family recovery rate. 14 We follow 14 We also perform this analysis using the issue-specific recommended recovery rate as the dependent variable, measured at the debt instrument level, while controlling for firm and debt-contract specific variables. The results of this estimate are qualitatively similar to those presented in Table 4. Specifically, the Cons_Basu measure is 15

18 Acharya et al. (2007) and Zhang (2009) and select a comprehensive set of control variables in our test. Appendix B addresses the reasons for including these control variables, consisting of firm characteristics, debt structures, and macroeconomic variables. We also include Fama- French 12 industry and year fixed effects in the model. Table 3 presents the results of this test. Panel A tests the relation between conservatism and creditor recovery rates using OLS estimation with standard errors clustered by year. The coefficient on conservatism is positive for all five measures, and all but one is statistically significant at the 10% level or better. Based on All Conservatism, moving from the first to the fifth conservatism quintile, creditor recovery rate increases by 15%, approximately 29% relative to the mean. All other measures demonstrate a similar economic effect: a one standard deviation increase in conservatism is associated with an increase in creditor recovery rate ranging from 1.0% based on Cons_BS to 3.5% based on Cons_r2. The signs of the coefficients on control variables are largely consistent with our predictions. For example, firms that are larger, have a higher percentage of secured debt, and use distress exchange offers show higher creditor recovery rates. The duration of bankruptcy is negatively associated with recovery rates. The macroeconomic control variables also load with expected signs. Overall, we find evidence supporting H1 that higher levels of financial reporting conservatism are associated with higher creditor recovery rates for firms in financial distress. Our goal is to study creditor-recovery rates for firms unable to make current or future promised payments. If the URD dataset is not comprehensive, i.e., it contains a subset of observations in the darker circle of Figure 1, inferences based on it may be biased. To control for self-selection, we employ Heckman two-stage estimation. We use firms in the bottom 10% of insignificant (p-value.21), while the Cons_BS measure is statistically significant at less than the 1% level. All other results remain unchanged. 16

19 returns in the intersection of Compustat and CRSP between 1987 and 2011 to approximate the population of insolvent firms. The first stage includes these firms as well as all firms in bankruptcy identified from the Moody s URD dataset and the UCLA Bankruptcy Research dataset. 15 The explanatory variables included in the first stage are Size, Leverage, Debt Rating, Litigation, and an indicator variable for Big N auditors, as well as the conservatism measures and macroeconomic control variables. All variables are defined in Appendix C. The percentage of concordant pairs is 91.1%, and the percentage of discordant pairs is 8.6%, suggesting that the explanatory variables predict whether a firm enters default reasonably well. Panel B of Table 4 reports the results of the second stage regression. The coefficients on each of our conservatism measures are both qualitatively and quantitatively similar to that reported in Panel A. Moreover, the coefficient on the inverse-mills ratio is positive and statistically significant in some models, suggesting that the Heckman method is removing a portion of the selection bias. For brevity, we report subsequent analysis based on this composite measure only. [Insert Table 3 here] The results of the relation between accounting conservatism and the duration of financial distress resolution We hypothesize that accounting conservatism is negatively associated with the duration of financial distress resolution in H2. To test this hypothesis, we estimate the following hazard model: ln h i (T) = h 0 (T) + γ 1 Conservatism i + γ 2 Size it + γ 3 Leverage it-1 + γ 4 Prior ROA it + γ 5 Litigation i + γ j Default Macroeconomic Controls+ γ k Emerge Macroeconomic Controls + ε it, (2) 15 The results of Heckman two-stage estimation are not sensitive to the use of this sample. We have also tried other ways of selecting the first-stage sample firms, including all Compustat firms, all Compustat firms with annual stock returns in the middle 10 percentile, or with negative cash flows, stock returns, or ROA over the period from of The results are robust to each of these samples used in the first stage. We choose the bottom 10 percent of Compustat firms to report because this yields the highest percentage of concordance pairs among all the alternatives. 17

20 where h i (T) is the probability that a bankrupt firm i emerges from bankruptcy at t given that the firm has survived up to T. h 0 (T) is the underlying hazard rate corresponding to the probability of emerging from bankruptcy when all the explanatory variables are set to zero. Because the dependent variable is the time to emergence, which is right skewed due to the presence of censored observations, we estimate model (2) using hazard model. 16,17 The dependent variable is defined as the time span in days between the bankruptcy filing date and the date of emergence. If the bankruptcy proceeding is incomplete, we define the dependent variable as the number of days beginning with the bankruptcy filing date to the end of the sample period. We censor all observations that did not emerge from bankruptcy. Year and Fama-French 12 industry fixed effects are included in the model. Table 4 reports the results of estimating model (3). Column (1) includes all firms that filed bankruptcy while column (2) excludes firm observations that exist through either an acquisition or a liquidation. The coefficient on the All Conservatism is positive and statistically significant at the 1% level for both columns, which indicates that the hazard of an emergence increases with this measure of conservatism. Overall, we find evidence suggesting that conservative financial reports facilitate agreement on a plan for reorganization. We also find that firms with higher leverage and better profitability tend to emerge with a shorter duration while bankruptcies during high GDP growth periods and periods with higher speculative interest rates tends to have longer duration. [Insert Table 4 here] The results of the relation between accounting conservatism and debt covenant violation 16 Specifically, we estimate the Cox proportional hazard model (Cox, 1972), where the hazard rate does not vary over time and the functional form of the baseline hazard is not required. 17 Right censoring occurs when firms may emerge after the data collection period or when firms never emerge from bankruptcy. 18

21 To understand the institutional mechanisms linking accounting conservatism to higher creditor collection, we examine whether accounting conservatism is positively associated with covenant violations. The maintained assumption of this analysis is that control rights are transferred to creditors upon covenant violation, which will allow creditors to determine whether to liquidate borrowers in their own best interest. 18 Finding such evidence will also corroborate the results of Zhang (2008), demonstrating that accounting conservatism increases the probability of covenant violation for firms both bankrupt and solvent firms. We collect debt covenant data for our sample of default firms by searching and reading public disclosures in the firm s Form 10-K, Form 10-Q, and Form 8-K in each quarter over the five years before the default date using Morningstar s 10-K Wizard. 19,20 Following Nini et al. (2011), we identify a firm as having violated a covenant if the firm s disclosures specifically indicate that it violated a financial covenant, modified or amended a credit agreement to ensure compliance with covenants, or obtained a waiver for covenant violations during the period. To test the relation of accounting conservatism with covenant violations before the default date in a multivariate analysis, we estimate a probit model where the dependent variable equals 1 if the firm reported a covenant violation within a year before the date of default and 0 otherwise. The variable of interest is our composite measure of accounting conservatism. Consistent with Zhang (2008), Table 5 shows that accounting conservatism is significantly 18 This assumption is reasonable because Davydenko (2012) finds that at least 8% of all bond payment defaults are triggered by a covenant violation that prompts senior creditors (i.e., banks) to block a scheduled bond payment, triggering bankruptcy. 19 We thank Greg Nini, David Smith, and Amir Sufi for providing covenant violations data, available on Amir Sufi s website at the University of Chicago at This data set includes covenant violations for 26 of our sample firms, which we include in our analysis. Please refer to the appendix of Nini, Smith, and Sufi (2011) for details on information related to this data set. For the remaining 628 firms, we sift through filings on covenant violations with the aid of 10-K Wizard. 20 Public financial reports are available on 10-K Wizard after January 1, 1994; thus, we restrict our attention to firms defaulting on their obligations after Additionally, we eliminate firms with no public disclosures available on 10-K Wizard, which results in a total sample of 654 firms for our analysis. 19

22 positively associated with covenant violations in the year preceding default at the 1% level, which indicates that conservative firms are more likely to transfer control rights to creditors over this period. 21 [Insert Table 5 here] To provide further evidence on the means through which conservatism can affect recovery rates, we conduct additional analysis. If creditors exercise their control rights to preserve firm value and exert influence over the bankruptcy decision, we expect conservative firms will file for bankruptcy on a timelier basis following the realization of negative economic shocks. Using CRSP stock returns as a proxy for the negative news, we identify the month with the lowest monthly abnormal stock returns in the three fiscal years before default as the first month in which the negative shocks drive firms into bankruptcy. The natural log of the number of months from the first month of shocks to the date of default serves as the dependent variable. Using the same set of control variables in the covenant violation analysis, results presented in Table 6 show that accounting conservatism is significantly, negatively associated with the bankruptcy lag (coefficient estimate = and t-statistics = -2.79). Therefore the evidence suggests that conservative firms preserve firm value by reducing the lag between the realization of negative shocks and the bankruptcy filing date. [Insert Table 6 here] The results of the relation of accounting conservatism with interest coverage and cash flows prior to default Conservative firms are more likely to violate covenants after negative outcomes. Therefore conservative firms are likely to be more solvent and have greater liquidity at default 21 We also split firms into two groups, High Conservatism firms and Low Conservatism firms, based on the firm s composite measure of accounting conservatism: All Conservatism. Untabulated results indicate that more High Conservatism firms in our sample violate financial covenants (257) than Low Conservatism firms (176). 20

23 for two reasons. First, their managers have less time to destroy or transfer value. Second, their bankruptcy is more likely to result from a covenant-based transfer of control rights than a missed interest payment. Testing these conjectures illuminates the mechanism through which accounting conservatism boosts creditor recovery rates. We estimate the effect of conservatism on performance before default using the following model: Perform it-1,it-3 = α 0 + ω 1 Conservatism i + ω 2 Size it + ω 3 Avg. Leverage it-1, it-3 + ω 4 Avg. ROA it-1, it-3 + ω 5 Avg. Capex it-1, it-3 + ω 6 Avg. Dividends it-1, it-3 + ω 7 Litigation i +ω k Macroeconomic Controls + ε it (3) We use two different dependent variables. First, we measure the ratio of operating cash flows to annual interest expense, averaged over the three years before default. 22 If the borrower s solvency matters in the timing of the bankruptcy filing, we expect a positive coefficient on our composite measure of conservatism, indicating that conservative firms enter bankruptcy in a better liquidity position. Table 1 indicates that, on average, sample firms do not have sufficient cash flows to cover interest expense before default (average Int Coverage is 0.917). Therefore ensuring the firm has sufficient cash flows to repay interest on its debt significantly improves creditor collections. Second, we measure the ratio of annual operating cash flows to total assets, averaged over the three years before bankruptcy (CFO) as a proxy for asset productivity before default. We include control variables for firm size, leverage, and profitability, as well as capital expenditures and dividends paid to shareholders; these financial control variables are averaged over the three years before default, matching the measurement of the dependent variable. 22 Accounting conservatism mechanically reduces earnings through recognition of unrealized losses, as indicated by the negative and significant correlation between our conservatism measures and ROA before bankruptcy filing in Table 2. We attempt to capture the firm s liquidity position before default, and therefore we measure interest coverage as the ratio of annual operating cash flows to interest expense before default. We use the three-year average before default to mitigate timing problems inherent in cash flows. 21

24 Additionally, we control for litigation-prone industries, macroeconomic conditions before default, and industry and Fama-French 12 industry fixed effects. Standard errors are clustered by year. The results of this analysis are presented in Table 7. In column 1 of Panel A, the dependent variable, Int Coverage, measures the average interest coverage over the three years before default. The coefficient on All Conservatism is positive and significant at the 10% level. In column 2, the results confirm our expectation that conservatism is positively related to asset productivity prior to default. Overall, the results in Table 7 are consistent with the hypothesis that conservatism preserves firm value by improving the timeliness of bankruptcy filing. [Insert Table 7 here] The relation between accounting conservatism and the likelihood of emergence from bankruptcy Higher creditor recovery for conservative firms may result either from wealth transfers from shareholders to creditors or from improvement of efficiency during bankruptcy. We study emergence from bankruptcy conditional on pre-bankruptcy performance to understand which explanation the data supports. Emergence from bankruptcy resolution, conditional on pre-filing ROA, is a measure of performance improvement. If creditors hollow out the firm for their private benefit, we expect a lower probability of emergence. Table 1 presents descriptive statistics for firms emerging from bankruptcy in our sample. Approximately 68% of firms in our initial sample (541 firms) emerge from financial distress. Only 24% of sample firms in Hotchkiss (1995) emerge from bankruptcy, while 44% of firms reorganize and emerge from bankruptcy in Kalay et al. (2007). We test the relation between accounting conservatism and the likelihood of emergence from bankruptcy using the following probit model: 22

25 Prob(Emerge i =1) = α Conservatism i + 2 Size it + 3 Leverage it Prior ROA it + 5 Litigation i + k Default Macroeconomic Controls+ k Emerge Macroeconomic Controls + ε it (4) The dependent variable in this model, Emerge, is a dummy variable equal to 1 if a firm emerged from bankruptcy or completed its debt exchange or restructuring and 0 otherwise. All other variables are defined in Appendix C. If conservatism improves creditor recovery rates by wealth transfers, then it should not be systematically associated with the likelihood of emergence. However, if conservatism improves the overall efficiency by allowing creditors to take valuemaximization actions or reduce deadweight losses by mitigating information asymmetry between shareholders and creditors, we anticipate that accounting conservatism will be positively associated with the firm s probability of emergence from bankruptcy. Table 8 presents the results of estimating model (6) using a probit model. The results show that accounting conservatism is loaded with a positive coefficient and is statistically significant at the 10% level after controlling for accounting performance before default. The coefficient estimates on other control variables indicate that larger firms and firms with higher leverage and ROA have higher likelihood of emergence. The marginal effect of accounting conservatism on the probability of emergence is 3.3%. [Insert Table 8 here] V. ROBUSTNESS TESTS Our results suggest that accounting conservatism benefits lenders. However, one might argue that conservative financial reporting gives too much power to creditors, who can force healthy firms into bankruptcy to achieve higher recovery. We illustrate this issue in Figure 1 by drawing the URD circle so that it is not a proper subset of the darker circle. Note the Heckman 23

26 two-stage procedure discussed in Section 4.3 potentially addresses this selection bias since accounting conservatism is included as a predictor in the first-stage regression. To illuminate this issue, we investigate whether a disproportionally high percentage of conservative (less conservative) firms lies in very high (low) creditor recovery rate region. Finding such evidence would suggest that conservatism induces unnecessary liquidation. We partition our sample into high and low conservative firms based on sample median of All Conservatism and plot the cumulative distribution of recovery rate of high and low conservative firms separately. The distribution reflects the probability that a realized recovery rate is less than or equal to a specified threshold. For example, approximately 40% of firms in the High Conservatism subsample have recovery rates less than 50%. If conservatism pushes healthy firms into bankruptcy unnecessarily, we would expect the cumulative distribution of recovery rates of High Conservatism firms to experience a jump in the high creditor recovery rates region (i.e., above 80%). However, the figure shows that there is no difference in the frequency of distribution between high conservative and low conservative firms in the high creditor recovery rates region (i.e., above 80%). Furthermore, the frequency difference between the two groups of firms mainly lies in the relatively low recovery rates region. We perform a Kruskal Wallis test to determine whether the recovery rate distribution differs between high and low conservative firms. Untabulated results indicate no statistically significant difference between the two groups (pvalue = 0.15), and the observed difference between the two groups mainly resides in the low recovery rate region. Thus conservatism does not appear to push healthy firms into bankruptcy. [Insert Figure 3 here] Furthermore, we check the relation between stock-price reaction at bankruptcy filing announcements and accounting conservatism. If conservatism allows creditors to push healthy 24

27 firms into bankruptcy or otherwise transfer wealth from shareholders, we expect a negative relation between accounting conservatism and share price changes. We fail to find a systematic relation, suggesting that shareholders do not expect to be harmed by greater conservatism. Moreover, shareholders are able to anticipate payouts (Gilson et al. 1990). We find a significant, positive relation between stock reactions at bankruptcy filings and subsequent creditor recovery rates. This evidence again reinforces the view that higher creditor recovery results from reduced losses in reorganization rather than at the expense of shareholders. Last, we exclude firms with creditor recovery rates above 80% from the sample and reestimate model (1) based on this smaller sample. The firms excluded are relatively healthier and thus may have been pushed by a creditor into bankruptcy resolution inefficiently. All results are qualitatively similar. Robustness tests Validation of the measures of accounting conservatism To validate our measures of accounting conservatism, we correlate our composite measure with post-bankruptcy filing asset write-downs. By law and rule, within 15 days of the filing of a bankruptcy petition, firms must file schedules of the debtor s assets and liabilities with the bankruptcy court. Failure to file the appropriate schedules quickly results in dismissal of the bankruptcy filing. 23 A reasonable conjecture is that court supervision and creditor pressure force firms to more conservative reporting during bankruptcy proceedings. Thus bankruptcy filing can cause firms that were less conservative before bankruptcy to write down assets. If so, we predict that higher (lower) levels of accounting conservatism before bankruptcy filing are associated 23 Bankrupt publicly traded companies are not relieved of their SEC-related financial reporting requirements. However, the SEC generally will accept the monthly reports a public company must file with the bankruptcy court in lieu of its quarterly and annual reports (Form 10-K and Form 10-Q), respectively. The company must file each monthly report with the SEC using Form 8-K within 15 calendar days after the monthly report is due to the bankruptcy court. 25

28 with lower (higher) asset write-downs during bankruptcy proceedings. Such correlation will support the internal validity of our accounting conservatism measures. 24 We measure ex post write-downs in two ways: (i) by searching for the cumulative loss reported in the monthly operating report or SEC filing available on Compustat and (ii) by examining the change in the firm s total assets following bankruptcy filing. First, we measure Ex-Post Loss as (-1) multiplied by the firm s net income scaled by total assets after default. We also scale the total loss by the number of days over the write-down measurement period, because each monthly operating report filed with the bankruptcy court is not standardized with respect to the number of days covered in each report. 25 Second, we measure Ex-Post Asset WD as (-1) multiplied by the percentage change in the firm s total assets from the last balance sheet before default to the first balance sheet following default. Total write-downs are then scaled by the number of days between the default date and the post-filing balance sheet date, because firms with a greater lag between the default date and the balance sheet date are more likely to record greater asset write-downs. Table 9 reports the results of this analysis with ex post asset write-downs as the dependent variable, with All Conservatism as the variable of interest. In both columns, the coefficient on our composite measure of accounting conservatism is negative and statistically significant at conventional levels. The evidence suggests that more conservative firms experience lower asset write-downs after bankruptcy filing and provides validation to our measures of conservatism. 24 To conduct this test, we hand-collect monthly operating reports filed with the bankruptcy courts from public disclosures available in firms Form 10-K, Form 10-Q, and Form 8-K during the bankruptcy resolution period using Morningstar s 10-K Wizard for the URD sample for firms whose first SEC filing is unavailable on Compustat following default and before emergence from bankruptcy. This procedure results in a total sample of 217 firms with sufficient financial data to compute asset write-downs following default. 25 The average length between the bankruptcy filing date and the date of first monthly operating or quarterly financial report is approximately 48.3 days. The short period means that write-downs recorded following bankruptcy filings reflect pre-bankruptcy losses. 26

29 [Insert Table 9 here] Control for growth opportunities, prepackaged bankruptcy, and alternative measure of bankruptcy risk We employ several robustness tests using additional control variables and econometric designs to ensure that our results are not driven by correlated omitted variables. We first include the firm s growth opportunities prior to bankruptcy. Untabulated results indicate that high growth opportunities (MTB) are insignificantly associated with creditor recovery rates. Most importantly, the coefficient on our conservatism measures remains positive and statistically significant at the 10% level or better except for the skewness measure, and our composite measure of conservatism remains significant at the 5% level. Under a prepackaged bankruptcy agreement, the firm and its creditors jointly determine the allocation of firm value to claimants and specify this allocation in a contract before the firm enters Chapter 11. Prepackaged bankruptcies may significantly improve the efficiency of resolution by eliminating negotiations during the proceedings and may result in higher creditor recovery rates than standard Chapter 11 proceedings. We include prepackaged bankruptcy as a dummy variable in estimating model (1). 26 The untabulated results show that prepackaged bankruptcies are significantly positively associated with creditor recovery rates. Yet the impact of conservatism on recovery rates remains quantitatively and qualitatively similar after controlling for prepackaged bankruptcy. Finally, we include additional control variables MTB and Prepackage at the same time in estimating model (1). Our results are robust to this estimate. In untabulated analysis, we employ an alternative measure to firm leverage, distance to default, to estimate a volatility adjusted measure of the remaining slack the firm has in its 26 We first identify prepackaged bankruptcy filings using the UCLA Bankruptcy Research Database (BRD). We can match 342 firms from our sample to the BRD data; for the remaining 215 firms in our sample, we assume a prepackaged filing if the firm s resolution period is less than four months (excluding successful distressed exchanges), following Ayotte and Morrison (2009). 27

30 covenants. 27 Higher distance to default levels implies lower default likelihood, and thus we expect a positive relation between distance to default and creditor recovery rates. The results for the accounting conservatism measures are qualitatively similar when we replace leverage with distance to default. Finally, our results continue to hold when we cluster standard errors by industry or industry-year. VI. CONCLUSION We examine the relation between accounting conservatism and creditor recovery rates. We hypothesize that accounting conservatism preserves firm value by facilitating timely transfers of decision rights from shareholders to creditors through covenant violations. We also hypothesize that conservative financial reporting improves the efficiency in bankruptcy resolution by mitigating information asymmetry between shareholders and creditors and facilitating agreement on a reorganization plan among these parties. We find evidence that accounting conservatism is positively associated with creditor recovery rates. We also find that conservative firms have shorter bankruptcies, consistent with our argument that conservative reports mitigate information asymmetry. Next, we show that conservative firms have a higher likelihood of violating debt covenants before default and file for bankruptcy sooner after negative economic shocks. We also demonstrate that conservative firms have better solvency and asset productivity before default. Therefore we not only demonstrate the robustness of the findings in Zhang (2008) for defaulted firms but also suggest that timely covenant violation, quicker default, and higher asset productivity are likely to be the mechanisms through which creditors of conservative borrowers improve collections upon default. We also find that conservative firms have higher likelihood of emergence from bankruptcy, further 27 We thank Tyler Shumway for SAS code used to calculate distance to default for all sample firms available at 28

31 suggesting that conservatism improves the efficiency of resolution. Finally, our results are robust to a number of alternative estimation procedures such as Heckman two-stage estimation. They also hold after controlling for additional factors that might be correlated omitted variables. Overall, our study suggests that conservative accounting benefits creditors of borrowers in financial distress and improves the efficiency of bankruptcy resolution, which likely benefits all stakeholders of the firm. 29

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35 Figure 1: Populations Examined This figure illustrates the population of firms we wish to study. This population is shown as the darker inner circle. The lighter outer circle represents the population of firms studied by Zhang (2008). Inferential issues are illustrated by fact that the dashed circle from which we draw our data does not perfectly coincide with the population of firms unable to make current or future promised payments on debt. It could contain firms forced by creditors into bankruptcy at the expense of shareholders (A) and could exclude firms unable to make current or future payments, omitted from the URD database either because of Moody s data collection procedures or because these firms still maintain liquidity to avoid default (B). Firms that experience a negative shock Firms unable to make current and/or future promised debt payments Firms in Moody s URD database B A 33

36 Figure 2: Sample Composition This figure describes sample composition over the period of Panel A shows the initial sample comes from Moody s Ultimate Recovery Rates dataset (URD) of 987 firms and UCLA Bankruptcy Research Database (BRD) of 886 firms. The intersection of these two datasets holds 381 sample observations. Panel B shows that, after deleting all firms without financial data and conservatism measures available for the empirical analysis, the final sample holds 896 firms; 557 firms are in the URD dataset, and 681 are in the BRD dataset, with an intersection of 342 firms. Panel A: Initial full sample Moody s URD (N = 987) N= 381 UCLA BRD (N=886) B: Final sample with available financial data Moody s URD (N = 557) N= 342 UCLA BRD (N=681) N =

37 Figure 3: Cumulative distribution of recovery ratess for high and low conservative firms This figure plots the cumulative distribution function of recovery rates of sample firms in bankruptcy over the period of , identified from Moody s URD database. The sample is partitioned into Highh Conservatism and Low Conservatism firms based on the sample median of the composite measure of accounting conservatism: All Conservatism. The composite measure is created based onn the average quintile rank of the individual conservatism measures: Cons_r2, Cons_Basu, Cons_BS, Skewness, and Special Items Ratio. The distribution reflects the probability that a realized recovery rate is less than or equal to a specified threshold within eachh conservatism grouping. A difference in the distribution of recovery ratess for High Conservatism and Low Conservatism firms, specifically, a discontinuity in the high end (i.e., above 80%) of the creditor recovery rate distribution for High Conservatism firms, is i consistent with accounting conservatism forcing healthy firms into bankruptcy unnecessarily. The observed difference in the recoveryy rates for High Conservatism and Low Conservatism firms lies mainly in thee lower end off the distribution, reflecting that accountingg conservatism does not force healthy firms into unnecessary bankruptcy. 35