Earnings management of distressed firms during debt renegotiation

Abstract

Empirical evidence on earnings management by financially distressed firms is very limited. This study examines discretionary accruals in distressed firms that have undertaken debt contract renegotiation subsequent to debt covenant violation with a view to determining whether managers adopt income-decreasing accruals during debt renegotiation. Using four established models for detecting discretionary accruals during the recent financial crisis in Malaysia, we find evidence that distressed firms manipulate earnings downward. The results show that the magnitude of discretionary accruals is statistically significantly negative during the year surrounding renegotiations with lenders, and that these accruals are significantly more negative than those of a control sample of firms which have not undertaken debt renegotiation during the same period but experienced similar financial performance. The results are robust after controlling for changes in top management, audit qualifications, audit firm size, as well as traditional measures such as firm size, performance, liquidity and leverage.