Bankruptcy Audits Reveal Deception — and Confusion

Accounting is usually associated with corporations. “In accounting, we traditionally think more about the firm and less about the household,” says Fabian Nagel, an assistant professor of accounting at Stanford Graduate School of Business.

That perspective has shifted as it’s become easier to study ordinary people’s finances. “We’ve seen this great rise in micro-level data about households and their credit situation, which opens doors to areas we previously couldn’t study,” explains Nagel, who is particularly interested in the long-term impacts of personal financial choices. “Whether it’s a mortgage, a car loan, or bankruptcy, these are consequential decisions that shape people’s lives.”

More than half a million Americans file for bankruptcy each year, and roughly 10% will declare bankruptcy at some point. In a recent paper, Nagel looked at random audits of bankruptcy filings to see how many filers are telling the truth — and what happens when they get caught lying or making a mistake.

The research focused on Chapter 7 bankruptcies, the most common kind, where filers can get their debts wiped out. Random “debtor audits” of Chapter 7 filings started after Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005. Under the law, auditors hired by the Department of Justice compare what people report in their bankruptcy filings with their tax returns, bank statements, and other records. If they find a significant discrepancy, it’s flagged as a “material misstatement.”

Nagel explains that his research is the first large academic study of the program. “It’s a massive pain to get the data,” he says. The Justice Department is reluctant to share records with researchers, and court records are expensive and hard to search. Nagel once showed up at the Chicago bankruptcy court to seek a fee exemption. “It took a bit of persistence,” he says.

Honest Mistakes and Strategic Misreporting

In the end, Nagel obtained data from more than 16,000 audits done between 2007 and 2020 and hand-collected and read roughly 3,800 individual audit reports. He found that between 20% and 30% of audited bankruptcy filings contained at least one material misstatement.

The most common problem was misreported income, with filers understating their monthly income by as much as 50%.

The gaps in reported assets were even more striking. When filers made misstatements, they reported an average of $917 in their bank accounts; auditors found around $19,000. Vehicles and real estate followed a similar pattern, with audited values dwarfing reported values.

Nagel wanted to figure out whether filers were lying or simply thrown off by complicated paperwork. “There’s a lot of confusion among people who are just in a pretty turbulent financial state,” he says. Yet the audit data suggested more than just innocent confusion. Income misreporting was low when filers didn’t have the capacity to repay, but climbed above 30% among those who appeared able to pay something back. A second clue came from Chapter 7 eligibility cutoffs. Reported income claims piled up just below the cutoff, suggesting that some people were nudging their numbers to land on the safe side of the line.

Among those who understated their income below the eligibility threshold, however, 44% turned out to be genuinely confused: Even after auditors corrected their numbers, their income still fell below the cutoff. The rest were acting strategically; their corrected incomes crossed the line, suggesting they knew they would face higher hurdles to obtain debt relief had they reported truthfully.

The debtor audit program has been controversial. Bankruptcy attorneys argue that audits are burdensome, while creditors and oversight advocates say they’re essential. Nagel’s analysis suggests that audits are accomplishing their goal of identifying misreporting.

In Chapter 7 cases, being audited increased the likelihood that a bankruptcy filing would be dismissed without any debts forgiven. Among audited cases, around two-thirds of misconduct-related dismissals would not have happened without an audit. Audited cases were also more likely to be converted from Chapter 7 to Chapter 13, which requires paying creditors over three to five years. Dismissals were concentrated among strategic misreporters; filers who made honest mistakes saw no increase in dismissals. Those effects suggest that audits reveal issues previously unknown to the courts.

A Powerful Enforcement Tool

To track the longer-term consequences of debtor audits, Nagel followed people’s credit scores for up to four years after they filed for bankruptcy. He found that even those caught with misstatements didn’t end up with meaningfully worse credit scores than those of similar filers who weren’t audited. Even after their bankruptcies were dismissed, their financial trajectory looked roughly the same. The exception was people who refused to cooperate with audits, whose credit scores dropped about 30 points in the first year after filing.

When Nagel compared audits to the effect of getting a stricter trustee — the court-appointed official who oversees each case — he found audits were dramatically more powerful, which he attributes to the fact that Chapter 7 trustees are paid based on the assets they find but obtain little reward when cases are simply dismissed.

In a back-of-the-envelope calculation, he estimated that increasing the audit rate by 1 percentage point (about 6,500 more audits per year) would cost $6.5 million while reducing improperly discharged debt by roughly $33 million. The bottom line: Bankruptcy audits look like a powerful enforcement tool.

However, Nagel notes that aggressive audits impose an administrative burden on filers. “They are working in that they flag misstatements,” he says. “But many misstatements are just too small to matter.” The demands of compliance can be heavy as well. “It should be easier to comply with an audit,” he says, especially around document requests.

Even modest tweaks to a program that touches millions of Americans a year could meaningfully change who gets relief and who doesn’t. “There does seem to be some fine-tuning needed,” Nagel says.