Role of earnings management and capital structure in signalling early stage of financial distress: a firm life cycle perspective

Financial Distress, the Severity of Financial Distress and Direction of Earnings Management: Evidences from Indian Economy

“…Altman's Z-score is the most globally recognized and widely used model for measuring financial distress (Charitou et al, 2011;Chhillar, 2016;Ghazali et al, 2015).…”

“…In this context, Agrawal and Chatterjee (2015) noted that the high distressed firms are less inclined towards earnings management than low distressed firms. Chhillar (2016) asserted that distressed firms indulge in earnings management to camouflage their poor financial performance, avoid debt covenant violations, and get better terms in renegotiating debt covenants. Nagar and Sen (2016) argued that companies in their early distress stage resort to real activities and classification shifting-based techniques to enhance profitability and liquidity and during the severe distress phase, they involve in accrual earnings management.…”

“…This has highlighted the ugly fact of firms being involved in unethical practices by camouflaging the unpleasant reality in their annual accounts, thereby pointing out earnings management worldwide, making it a topic of great inquisitiveness among the researchers and practitioners. Several studies have addressed the different aspects of earnings management practices in companies concerning various events, one of which is the firms’ financial health (Chhillar, 2016; Habib et al, 2013; Li et al, 2020; among others).…”

“…Prior studies provide evidence that financially distressed firms indulge both in upward and downward earnings management. Mainly the firms deflate their earnings to highlight their financial difficulties to get better terms while renegotiating debt covenants (Jaggi & Lee, 2002), obtaining government support (DeAngelo et al, 1994), or under the pressure of audit opinion (Etemadi et al, 2013) and inflate their earnings to portray firms as less distressed to avoid default and continue obtaining financing from banks (Chhillar, 2016; DeFond & Jiambalvo, 1994). The reasons behind firms engaging in earnings management is a matter of key importance to the researchers.…”

“…Mostly the studies on earnings management in distressed firms have been carried out in international scenarios and are mainly based on the developed economies. There are limited studies on developing economies like India, where only a few studies exist (Agrawal & Chatterjee, 2015; Chhillar, 2016; Nagar & Sen, 2016; Rakshit & Paul, 2020). Moreover, the researchers have mainly focused on a single model for detecting earnings management and financial distress.…”