Earnings Management and Financial Distress: Evidence from India

Abstract

This article makes an attempt to empirically examine the relationship between financial distress and earnings management with reference to selected Indian firms. Our sample consists of 150 financially distressed firms during the post-recession period from 2009 to 2014. The present study uses discretionary accruals (DA) as a proxy for earnings management. Multiple regression analysis has been used for this purpose. The study uses cross-sectional modified Jones model to estimate DA, a proxy for earnings management. Altman’s Z-score ( Z-score) and distance-to-default (DD) have been used as two alternative measures for financial distress. The study finds that less distressed firms are engaged in higher earnings management. Cash flow coverage (CFC) is found to have a significant negative relationship with earnings management implying that firms with higher CFC have lesser incentive to manage their earnings through DA. The findings are consistent with several prior studies. The findings of the study have important implications for lenders, investors and managers. Lenders and investors need to be wary of the fact that firms experiencing even low levels of distress might be more prone to concealing their true financial condition. This provides deeper insights into the reliability of accounting information in assessing the creditworthiness of a firm.