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The IUP Journal of Accounting Research and Audit Practices:
Earnings Management Strategies During Financial Distress
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The paper examines whether financial distress and its severity have a role to play in managersí decisions with respect to the choice of earnings management strategies. The results suggest that firms in initial stages of distress engage in real earnings management through a reduction in the spending on selling and general and administrative expenses, and through classification shifting to increase profitability and liquidity. When distress becomes severe, firms cut back on production, engage in income-increasing accruals management, and increase their spending on selling and general and administrative expenses. Initial under-spending on selling and general and administrative expenses is opportunistic with an intention to show improved performance. In extreme distress, increase in such spending is a sound economic decision. The findings provide insights into how managers of distressed firms trade off between liquidity, profitability and solvency both in the short run and the long run.

 
 
 

Financial distress refers to a firmís inability to service its debt or other obligations. Such inability emanates from poor cash flows and profitability. Distress throws new challenges before managers of the firm to take real economic actions, which lead to an improvement in the firmís long-run performance. However, since in these circumstances managers fear debt covenant violations and job loss, and sound economic decisions may give returns only in the long-run, short-term incentives outweigh long-term incentives, and they may indulge in tactics which shows an improved short-term performance in no time.

Managers of companies in distress thus commit fraud to cover up the adverse performanceóin order to get more liquidity from the banks or for their personal benefit.1 They are more likely to indulge in improper revenue recognition and manipulation of expenses, liabilities and accounts receivable (Deloitte Forensic Center, 2008).