Financial Distress and Earnings Management: Evidence from Malaysia before and during the COVID-19 Pandemic

Abstract

The main objective of this study is to determine the choice of earnings management approach among financially distressed firms in the period before and during the COVID-19 pandemic. The manager may choose either Accrual Earnings Management (AEM) or Real Earnings Management (REM). This study uses the modified Jones, 1991, model for AEM. Whereby for REM is the Abnormal Cash Flow from Operation (AbCFO), Abnormal Production Cost (AbPROD), and Abnormal Discretionary Expenses (AbDISEXP) model by Roychowdhury, 2006. Using a final sample of 672 firms year observation consisting of Malaysian public listed companies for the period of 2018 to 2021, this study reveals that financially distressed firms do manipulate earnings using the REM approach both before and during the pandemic. Further analysis discovers that those firms specifically practice AbCFO and AbDISEXP in managing earnings. This study also finds a significant negative relationship between financial distress and the AEM approach. In addition, some other control variables such as leverage, firm size, ROA and liquidity also have a significant effect on EM. This study contributes to the earnings management literature, notably how managers choose to manipulate earnings at the different levels of financial health, which then can influence the accounting earnings quality.