Unveiling the Connection among ESG, Earnings Management, and Financial Distress: Insights from an Emerging Market

Abstract

Earnings management continues to be a critical ethical concern faced by companies. The management that conducts earnings manipulation may adopt environmental, social, and governance (ESG) activities to safeguard themselves from stakeholders. Engagement in ESG is sometimes viewed as a type of managerial misconduct and as a means to cover up manipulative practices. Thus, the key aim of our study is to investigate the association between ESG disclosure and earnings management levels in the context of listed companies in Saudi Arabia. We also investigate the influence of financial distress on the above association. Data were obtained from 304 company-year observations for the years 2014–2021. The results showed that ESG disclosure had a positive and statistically significant effect on earnings management. In addition, financial distress significantly and positively enhanced this effect. This shows that financially distressed companies tend to disclose more ESG practices and engage in earnings management. Moreover, through the division of the three ESG components—environmental, social, and governance—the impacts of both environmental and social factors on earnings management were found to be positive and robust, while the governance score was negative. The results obtained using diverse regression techniques and further tests were robust. This study makes several contributions to the ESG and earnings management literature. It also minimizes the literature gap by focusing on the influences of financial distress on the ESG–earnings management relationship. The study findings have implications for several stakeholder groups, including regulators, decision makers, investors, and auditors. In particular, it warns policymakers that some practices focused on ESG enhancements may be a tool for preventing other questionable practices.