THE IMPACT OF IMPENDING CORPORATE FAILURE ON THE INCIDENCE AND MAGNITUDE OF DISCRETIONARY ACCOUNTING POLICY CHANGES

Abstract

This paper investigates the influence of impending corporate failure on income and asset increasing discretionary accounting policy changes (DAPCs) and discusses its implications for failure prediction model development and use. Deriving hypotheses from the ‘opportunistic behaviour’ perspective, the paper argues that management of failing firms have a greater incentive than management of non-failing firms to select accounting policies that will mask performance problems. The results of the study support the hypotheses in that: (1) management of failing firms tend to adopt a greater number of favourable DAPCs than management of non-failing firms; (2) failing firms are more likely than non-failing firms to adopt favourable DAPCs and (3) failing firms are more likely than non-failing firms to adopt DAPCs for a combined material net favourable effect on income and total assets. The results imply that failure prediction model accuracies may be influenced by the frequency and magnitudinal effect of DAPCs adopted by failing firms. Thus, model developers and users should not ignore or assume that the effects of potential manipulation of financial information is either negligible or will be randomly distributed.