Real earnings management in bankrupt firms

• Published date: 01 April 2021
• Author: Chunhao Xu,Hongxian Zhang,Jun Hao,Liang Guo
• Date: 01 April 2021
• DOI: http://doi.org/10.1002/jcaf.22483

Received:  July  Revised:  November Accepted:  December 

DOI: ./jcaf.

BLIND PEER REVIEW

Real earnings management in bankrupt firms

Chunhao Xu1Hongxian Zhang2Jun Hao3Liang Guo4

College of Business, University of Texas

of the Permian Basin, Odessa, Texas,USA

Business and Information Technology,

Missouri University of Science and

Technology, Rolla,Missouri, USA

College of Business, University of

Houston-Clear Lake, Houston, Texas,

USA

Department of Accounting and Finance,

Jack H. Brown College Business & Public,

Administration, California State

University atSan Bernardino, San

Bernardino, California, USA

Correspondence

ChunhaoXu, Department of Accounting,

TheUniversity of Texas of the Permian

Basin, E. University, Odessa, TX

-,USA.

Email:xu_c@utpb.edu

Abstract

We investigate: () whether managers in bankrupt firms manipulate earnings

through real earnings management (REM); () the incentives and tradeoff strate-

gies to engage in REM; () how REM influences the subsequent firm perfor-

mance and bankruptcy probability. We find that bankrupt firms are more likely

to manipulate earnings via REM than continuous firms. There is an increas-

ing trend of REM activities in the -year window before bankruptcy. The major

incentive for bankrupt firms to engage in REM is the issuance of new debt.

Bankrupt firms treat REM and accrual-based earnings management (AEM) as

complementary tools for earnings management. We further find that REM is

associated with low future firm performance. The REM score defined in this

study can more accurately predict bankruptcy than the Altman Z score by %.

Overall, the findings in this paper will help investors, regulators, and academics

identify REM activities and understand the incentives and consequences of

REM.

KEYWORDS

accrual-based earnings management, bankrupt firms, firm performance, real earnings man-

agement

1 INTRODUCTION

Real earnings management (REM) is defined as sub-

optimal operation activities (e.g., sales manipulation,

overproduction, cutting research, and development [R&D]

expenditures etc.) that deliberately influence the reported

earnings in the financial statements (Roychowdhury,

;Vorst). In contrast to accrual-based earnings

management (AEM), REM alters underlying economic

activities, thereby having a real economic impact on firm

performance. Graham et al. () surveyed  executives

and find that % of the managers are willing to engage in

REM activities, even though the managers are aware that

REM activities have negative long-term consequences on

firm performance. A confounding issue in defining REM

relates to the extent to which the real transaction activities

diverge from optimal operational practices. Furthermore,

the intention to perform REM activities (e.g., cutting R&D

to reduce expenses) varies under different conditions

(Roychowdhury, ;Zang,). For example, firms

cut R&D expenses in response to a constrained budget

or a shift in business interests. However, firms may boost

earnings numbers by cutting R&D expenses when they

have the resources and interests to invest in R&D. It is

difficult to distinguish between optimal operational activ-

ities and REM activities in manipulating earnings (Vorst

). Since managers have an information advantage

relative to external stakeholders, it is very challenging

for auditors, investors, and regulators to detect REM

(Roychowdhury, ). In this study, new empirical

evidence of REM in bankrupt firms, before bankruptcy,

can shed some light on the identifying REM. Bankrupt

firms provide a unique setting in which to study REM, as

limited financial flexibility may push managers to aggres-

sively manipulate earnings (Dutzi & Rausch, ;García

Lara et al., ).

22 ©  Wiley Periodicals LLCJ Corp Account Finance. ;:–.wileyonlinelibrary.com/journal/jcaf

XU  .23

When firms file for bankruptcy, under Chapter , a

reorganization plan is discussed among committees of

different investor classes. Once the court confirms the

bankruptcy of a failing firm, the stocks of those bankrupt

firms become worthless (Kadapakkam & Zhang, ).

Thus, detecting earnings management and decrypting the

real financial condition of a firm is essential for stockhold-

ers to avoid immense investment losses (Dutzi & Rausch,

). Prior literature suggests that, when firms are under

financial distress, managers tend to manipulate earnings

more aggressively (García Lara et al., ). As bankruptcy

approaches, there is usually limited flexibility for man-

agers to engage in AEM activities. Relative costliness and

scrutiny of the auditing environment can influence man-

agers to choose different earnings management tools (Gar-

cíaLaraetal.,;Rosner,;Zang,). Earnings

management behaviors in distressed firms, in the period

before bankruptcy, are still ambiguous. The unclear direc-

tions (i.e., upward and downward) of earnings manage-

ment are found in prior research (Dutzi & Rausch, ).

Prior research finds that smooth earnings could help

firms improve credibility and reputation in order to obtain

better credit terms from debt holders (Gunny, ;Liu

et al., ). The primary cost of REM is the replacement of

pursuing valuable investment opportunities by suboptimal

operation activities (Zang, ). Hence, REM could have

more severe consequences on long-term firm performance

than AEM (Chan et al., ; Cohen & Zarowin, ;

Zang, et al., ). In a highly competitive industry, firms

that engage in REM may lose significant market share

and competitive advantage by cutting R&D investment,

thereby negatively affecting their future performance and

financial health (Zang, ). Vorst () found that firms

will reverse REM transactions when there are no benefits

from REM activities. Because of the unclear net effect of

the benefits and costs of REM, no consensus exists in prior

studies regarding the impact of REM on future firm perfor-

mance (Vorst, ).

In this study, we select a large sample of bankrupt firms

that were publicly traded at the United States stock mar-

ket to examine () whether managers in bankrupt firms

manipulate earnings through real earnings management

(REM); () the incentives and tradeoff strategies to engage

in REM; () how REM influences the subsequent firm per-

formance and bankruptcy probability. Zang () points

out that managers switch between AEM and REM based

on the relative cost of each manipulation strategy. To our

knowledge, this paper will be the first study to investigate

the incentives to engage in REM and the tradeoff between

AEM and REM in bankrupt firms.

We find that bankrupt firms manipulate income-

increasing REM at a higher level than control firms.

Bankrupt firms have a significantly higher level of discre-

tionary production costs and discretionary expense cuts,

but lower discretionary cash flow from operations, than

continuous firms. However, there is no significant differ-

ence in discretionary accruals between bankrupt firms and

control firms. This indicates that the bankrupt firms do not

engage in a higher level of AEM than continuous firms. In

the post-SOX period, AEM is highly regulated and easily

detected by auditors (Cohen et al., ). This shows that

managers in bankrupt firms mainly manipulate earnings

through REM to conceal their poor performance. When

a firm is approaching bankruptcy, we find that there is

an increasing trend of aggregated REM activities in the

-year window before bankruptcy. However, the control

firms do not exhibit such a trend in earnings management.

Due to exhausting financial flexibility, managers have to

engage in more costly REM to avoid debt covenant vio-

lations (DeFond & Jiambalvo, ). However, deteriorat-

ing future performance, caused by REM, can affect the

chances of emerging from bankruptcy.If a manager under-

estimates the consequences of REM and does not reverse

REM activities in later periods, the firm may have a high

possibility of bankruptcy. We define a REM score and find

that it can more accurately predict bankruptcy than the

Altman Z score by %.

We also find that bankrupt firms treat REM and AEM

as complementary tools for earnings management in US

firms. This extends a prior study that REM is a substi-

tute for AEM when there is limited flexibility for accrual

manipulation as failure approaches in UK bankrupt firms

(García Lara et al., ). Further, the main incentive of

REM activities for bankrupt firms, in our sample, is to

gain capital market incentives through theissuance of new

debt. We further find that REM is associated with low

future performance in bankrupt firms. Since the detection

of REM is less likely under current accounting guidelines,

bankrupt firms tend to resort to REM activities to manipu-

late earnings. The findings in this study have implications

for investors, researchers,andregulators to understand the

incentives and costs of REM and the monitoring of earn-

ings management activities of bankrupt firms.

This paper contributes to the extant literature on

earnings management in terms of identifying REM and

understanding the consequences of REM activities. We

provide new empirical evidence of REM in the setting of

ex-post bankrupt firms. Specifically, we find that bankrupt

firms treat AEM and REM as complementary tools for

earnings management. Because of financial distress,

managers in ex-post firms are more likely to resort to REM

to boost reported earnings. We further find that REM is

negatively associated with future firm performance. The

consequences of REM found here could help the market

efficiently process earnings information in the financial

statements of financially distressed firms. Furthermore,