The impact of SME’s pre-bankruptcy financial distress on earnings management tools

a r t i c l e i n f o Previous literature finds that situations that put managers under significant levels of pressure (e.g. IPO, upcoming credit rating changes, violation of debt covenant, etc.) might affect the way earnings are manipulated. The aim of this study is to investigate whether the pressure caused by the non-temporary level of financial distress, conditions the choice between real activity and discretionary accrual manipulation. Using a selection of financial distress indexes and pre-bankruptcy data of a sample of bankrupt small companies operating in a code law country, our findings show that, on average, firms with higher levels of financial distress show more extensive signs of upward earnings management through real transaction manipulation rather than accruals and vice versa. Accordingly, real activity earnings management is preferred over accruals when managers are under significant levels of 'pressure' such as being close to face a bankruptcy procedure, despite its implications for the firm in the long term. Managers have different incentives to manipulate earnings that may affect the quality of financial statements and alter their reliability. Especially during a financial crisis, the pressure brought by poor results and/or tough financial situations is an 'ideal' context for managers to expand the alteration of the current performance of firms. For example, extant literature indicates that managers have stronger motivations for manipulating reported earnings during financial distress situations such as the period preceding bankruptcy procedures (e.g. 2014) have also analyzed the effect of economic downturns on financial reporting quality since the former enlarge the number of firms in financial distress situations, especially among small companies. They show that earnings management increases when an economic crisis becomes worse. Hence, it is interesting to analyse the impact of economic downturns at a microeconomic level, i.e. the index of financial distress of each firm, on earnings quality through the study of the two tools of earnings management, real activity and accrual manipulation (Schipper, 1989). Literature that investigates what drives the choice between these two earnings management tools indicates that real activity manipulation is chosen in the presence of 'extreme' circumstances, when managers need immediate results, regardless of the disadvantages and the costs it has for companies in the long term (e. Accordingly, we aim to investigate whether the earnings management tools used by managers of companies that are experiencing 'extreme' financial situations also depend on the level of firms' financial distress. Indeed, …