Earnings management at different stages of financial distress

The purpose of this study is to examine whether earnings are managed upward or downward at the following stages of financial distress; Stage 1. Omitting/reducing dividend payments; Stage 2. Debt covenant violations; Stage 3. Troubled debt restructuring. These stages of financial distress represent an ordinal measure of financial distress of a firm. This paper conducts a stage analysis to provide additional evidence of firms' accounting discretionary behavior at different financial distress stages. Sensitivity analysis has also been conducted to control the effects of confounding factors, such as management changes, auditors' going concern qualifications and accruals reversal effects. Moreover, discretionary accruals as a proxy of earnings management are calculated based on time-series as well as cross-sectional models.; The findings of this study indicate that managers of firms at the dividend reduction/omissions stage have used income decreasing discretionary accruals to remove negative items from the financial statements either to avoid further decline in the financial performance, or to show better performance in the future. Firms with technical default but being successful in obtaining waivers for debt covenant violations have used income-increasing discretionary accruals. If waivers are denied or firms are restructuring their troubled debt, income decreasing discretionary accruals have been used. These results are interpreted to suggest that managers use income-increasing discretionary accruals if technical default is due to temporary financial difficulties and the firm is in fact in a good financial condition. If financial distress is severe that leads to debt restructuring, even if technical default is not declared, or firms are unable to obtain waivers, managers use income decreasing discretionary accruals to highlight financial difficulties, so that they can negotiate better terms for debt contracts. Income decreasing discretionary accruals are also used by firms which significantly reduce dividends to highlight their financial difficulties. The results of this study thus suggest that the use of discretionary accruals depends upon severity of financial distress and on the manager's expectation to obtain waivers for debt covenant violations.