Self-fulfilling prophecies of failure: The endogenous balance sheets of distressed companies

Abstract

This article analyses a problem at the intersection of accounting, law, and economics: the economically efficient operation of legal arrangements for company failure is undermined because valuations of assets and liabilities become unstable once a firm is distressed. The paper draws on the three disciplines to show the pivotal role of asset and liability valuations in answering the legal question, whether the firm is insolvent, and the economic question, whether the firm should fail and its assets be redeployed to an alternative use. U.S. and U.K. evidence reveals a disconcerting indeterminacy in these processes: the probability that a firm will fail affects significantly the valuations assigned to assets and liabilities; but at the same time the valuation of assets and liabilities itself determines the probability of failure. This balance sheet endogeneity is then shown to delay economically efficient management changes under debtor-oriented U.S. Chapter 11, and to induce unnecessary costly bankruptcy with creditor-oriented U.K. receivership/administration. Recent cases trace this endogeneity in failures involving often controversial countermanding of huge financial claims. © 2008 Accounting Foundation.