Value relevance of troubled debt restructurings and policy implications

This paper investigates the beneficial economic consequences and market and accounting based valuation effects of troubled debt restructurings (TDR) in financially distressed debtor firms. Relying on the implications of prior research and extant valuation theories, some empirical evidence on the beneficial outcomes and informativeness of TDR is first provided: significantly positive restructuring interval excess returns and higher excess returns to subsequently consummated restructurings and subsequent survivors. The market reaction to “full-settlement” and “modification of terms” types of TDR are also measured to evaluate the consistency of the FASB's binary classification and recognition criteria with the market participants' assessments. Finally, a valuation model conditional on book values and earnings is used to test the value relevance of the reported financial statement bottom lines and TDR related disclosure. The findings suggest that modifications are at least as beneficial and informative as full settlements. Hence, the recognition of the reduction in the liability and the related gain in the financial statements of firms that undertake modifications would be more congruent with the valuation effects assessed by market participants. Key words: Private workouts, Financial distress, Debt restructuring, Valuation, Capital markets, SFAS No.15. JEL: G14, G33, G38, M4