The impact of SME's pre-bankruptcy financial distress on earnings management tools

- Literature suggests that the way earnings are manipulated is conditioned by managers' level of pressure.
- We investigate whether the level of pre-bankruptcy financial distress conditions earnings management tools.
- Highly-distressed firms exhibit more extensive upward earnings management through real activity manipulation.
- Highly-distressed firms exhibit less extensive upward earnings management through accrual manipulation.
- Real activity earnings management is preferred over accruals when managers are under significant levels of 'pressure'

Previous literature finds that situations that put managers under significant levels of pressure (e.g. IPO, upcoming credit rating changes, violation of debt covenant, etc.) might affect the way earnings are manipulated. The aim of this study is to investigate whether the pressure caused by the non-temporary level of financial distress, conditions the choice between real activity and discretionary accrual manipulation. Using a selection of financial distress indexes and pre-bankruptcy data of a sample of bankrupt small companies operating in a code law country, our findings show that, on average, firms with higher levels of financial distress show more extensive signs of upward earnings management through real transaction manipulation rather than accruals and vice versa. Accordingly, real activity earnings management is preferred over accruals when managers are under significant levels of 'pressure' such as being close to face a bankruptcy procedure, despite its implications for the firm in the long term.