11Th Auckland Regional Conference, 30Th November 2012, Auckland, New Zealand
Submission to
11th Auckland Regional Conference, 30th November 2012, Auckland, New Zealand
Financial distress, earnings management and market pricing of accruals during the global financial crisis
Ahsan Habib
Associate Professor
Department of Accounting, AUT University
Auckland, New Zealand
Md. Borhan Uddin Bhuiyan
Lecturer
School of Accountancy, Massey University
Auckland, New Zealand
Ainul Islam
Senior Lecturer
School of Accounting and Commercial Law, Victoria University of Wellington
Wellington, New Zealand
Corresponding author
Md. Borhan Uddin Bhuiyan can be contacted at:
Abstract
Purpose - This paper empirically examines managerial earnings management practices for financially distressed firms and whether these practices changed during the recent global financial crisis.
Design - We investigate this topic in New Zealand, which was shaken by a series of finance company collapses recently. We use three distress measures and use discretionary accruals, a popular proxy for earnings management, to investigate the impact of distress on earnings management.
Findings - We find that managers of distressed firms engage more in income-decreasing earnings management practices compared to their healthy firm counterparts. We also document that this effect became more pronounced during the financial crisis period. Finally, we show some evidence of positive market pricing of discretionary accruals in the non-crisis period but a substantial reduction in pricing coefficient during the global financial crisis period.
Research limitations/Implications - We believe that the findings of this study would be useful to current and prospective investors as well as to regulatory authorities who are responsible for monitoring managerial financial reporting quality. Income-decreasing earnings management by the distressed firms as reported in this study distorts the quality of reported information and therefore makes it difficult for investors to adequately predict future firm performance. The findings will also help the regulatory authorities to closely monitor the financial reporting quality of distressed firms.
Originality - This study provides evidence that financially distressed firms manipulate earnings downwards. This association, however, is not significantly changed during the GFC period. New Zealand market considers discretionary accruals to be informative but only during the non-crisis period. During the crisis period the market penalizes discretionary accruals reported by firms
Keywords Financial distress, Earnings management, Global financial crisis, New Zealand
Financial distress, earnings management and market pricing of accruals during the global financial crisis
1.Introduction
The objective of this paper is to empirically examine managerial earnings management behaviour offinancially distressed firmsin New Zealand and whether this behaviour changed during the global financial crisis (hereafter GFC).We also examine the market pricing of discretionary accruals, a popular proxy for earnings management. Financial distress in enterprises has long been an issue of concern to governments and the investing public. Corporate financial performance can deteriorate for a numbers of reasons and in the extreme may cause companies to go bankrupt or be subject to acquisition by other firms. Corporate bankruptcies have significant adverse consequences for an economy since investors and creditors suffer considerable financial loss. If a firm is in financial distress, the company’s managers can expect to have their bonuses cut, be replaced and suffer loss of reputation (Liberty and Zimmerman 1986; Gilson 1989). Therefore, conventional wisdom suggests that managers have incentives to conceal such a deteriorating performance by resorting to accounting choices that increase income. Empirical evidence, however, is not conclusive.
Rosner (2003), for example, documents that firms that become bankrupt ex post but do not appear distressed ex ante, engage in income-increasing earnings manipulation practices. DeAngeloet al. (1994), on the other hand, find that managers reduce income via negative abnormal accruals and discretionary write-offs, instead of inflating income. Other studies that examine accounting policy choice of troubled companies include Burgstahler and Dichev (1997), Charitou et al. (2007a), Charitou et al. (2007b), Charitou et al. (2011), Elliott and Shaw (1984), and Lillien et al. (1988).Although these studies examine samples of firms experiencing some kind of financial difficulty, their sample periods did not include the GFC.
Extant literature on the effect of economic crises on managers’ earnings management behavior is not conclusive. One analytical model suggests that managers are more likely to manipulate earnings during an economic boom as opposed to a recession (Strobl 2008). However, empirical evidence from the 1997 Asian financial crisis and earnings management studies provide some evidence that managers engaged in more income-decreasing earnings management during the crisis period (Saleh and Ahmed 2005; Ahmedet al.2008). During the GFC, the global credit market experienced severe illiquidity, investors’ confidence significantly declined, and most of the listed firms on world stock exchanges experienced downward pressure on their stock prices (Bartram and Bodnar 2009). Following the increasing uncertainties in business environment, a recent survey in Asia, Europe and North America, documents that the Chief Financial Officers (CFOs) responded to the economic crisis by reducing investments to avoid business risk and financial constraints (Campelloet al.2010).
We use data from New Zealand to shed further light on this issue. Recently, New Zealand experienced a spate of finance company collapses, making the country’s financial system more fragile and vulnerable.[1] Although these collapses come nowhere close to Enron or WorldCom type of collapses, they somewhat contribute indirectly to financial distress experienced by firms. Previous research on the association between financial distress and earnings management has primarily been done in the US. Whether the findings from studies of the accounting choices of troubled firms in the US can also be generalized to New Zealand is an empirical question.The presence of concentrated ownership[2] (Prevostet al.2001), relaxed monitoring by New Zealand regulatory authorities (Habib 2008), and a very low litigation threat may impact on New Zealand corporate managers differently with respect to accounting choices during financial distress. Previous research on accounting choices for troubled companies included firms that went bankrupt, generating possible selection bias. We include firm-year observations that are stressed but non-bankrupt and firm-year observations delisted from the stock exchange.[3]We also contribute to the market pricing of accruals literature by investigating capital market pricing of earnings components including discretionary accruals of the distressed firms, and whether the GFC moderated such pricing.
Using a sample of NZX listed firmsfrom 2000 to 2011, this research documents that financially distressed firms engaged in income-decreasing earnings management strategies which is unaffected by the GFC. With respect to market pricing of the discretionary accruals component of earnings, the evidence shows that the market positively prices discretionary accruals but such a pricing coefficient significantly reduces during the GFC period.
The paper proceeds as follows. Section two provides a brief review of the literature on the association between financial distress and managerial discretionary reporting behaviour and develops testable hypotheses. Section three explains the research methodology employed in this study. Descriptive statistics and regression analysis results are presented in section four, and section five concludes.
2.Literature review and development of hypotheses
Financial distress in enterprises has long been an issue of concern to governments and the investing public. A significant and persistent decline in a company’s financial performance may eventually result in insolvency,making investors and creditors suffer considerable financial loss. Financial distress is costly “…because it creates a tendency for firms to do things that are harmful to debtholders and nonfinancial stakeholders…, impairing access to credit and raising costs of stakeholder relationships. In addition, financial distress can be costly if a firm’s weakened condition induces an aggressive response by competitors seizing the opportunity to gain market share” (Opler and Titamn 1994, 1015). If a firm is in financial distress, the company’s managers can expect to have their bonuses cut, be replaced and suffer loss of reputation (Liberty and Zimmerman 1986; Gilson 1989).
However, financial distress does not necessarily lead to corporate bankruptcy. McKeownet al.(1991),Hopwood et al.(1994), and Mutchleret al.(1997), study bankrupt and nonbankrupt firms and classify them as (i) stressed/bankrupt (SB), (ii) nonstressed/bankrupt (NSB), (iii) stressed/nonbankrupt (SNB), and (iv) nonstressed/nonbankrupt (NSNB). The bankrupt/nonbankrupt classification was easily determined by observing firms’ expost bankruptcy status. The stressed/nonstressed classification was based on ex ante signs in the financial statements of impending bankruptcy.They assigned the SB status to a bankrupt firm that exhibited any one of four symptoms: (i) negative working capital in the current year; (ii) a loss from operations in any of the three years prior to bankruptcy; (iii) a retained earnings deficit in year 3 (where year 1 is the last financial statement date preceding bankruptcy); or (iv) a bottom-line loss in any of the last three pre-bankruptcy years.
Rosner (2003) employed this classification and finds that firms that become bankrupt ex post but do not appear distressed ex ante (NSB), use income-increasing earnings management techniques. DeAngelo et al. (1994), on the other hand, find that managers use income-decreasing earnings management techniques via negative abnormal accruals and discretionary write-offs, rather than attempts to inflate reported income. Charitou et al. (2007a) use a sample of 859 US bankruptcy-filing firms over the period 1986-2004, and find evidence that managers of highly distressed firms shift earnings downwards prior to the bankruptcy filing. The findings may be attributed to earnings bath choices adopted by new management teams during the distress period. This evidence is particularly pronounced for companies with low levels of institutional ownership. Charitou et al. (2007b) also find evidence of downwards earnings management,one year prior to the bankruptcy-filing. When a specific context of debt covenant violations is examined, results are consistent with managers increasing reported income via positive abnormal accruals in the year prior to covenant violation (DeFond and Jiambalvo 1994; Sweeney 1994). Chenet al.(2010) find that distressed firms in China employ income-increasing earnings management techniques to avoid a delisting threat and special monitoring treatment from the government. Given the inconclusive evidence on the association between firm distress and earnings management strategies we develop the following null hypothesis:
H1: There is no association between financial distress and earnings management proxied by discretionary accruals.
Our second set of analysis examines whether the GFC has any incremental impact on the association between firm distress and earnings management. An analytical model proposes that earnings management is most prevalent during economic booms (Strobl 2008). Cohen and Zarowin (2007) find empirical support for this proposition. When business conditions are good, most firms have high earnings. Investors thus correctly believe that few firms have an incentive to manipulate their accounting statements. However, this is exactly when the incentive for a manager of a low-value firm to issue an upwardly biased report is highest since investors, in general, are not questioning the integrity of the reporting system. In bad times, on the other hand, incentives for earnings management are low because investors expect a large number of firms to manipulate their earnings and, hence, put less emphasis on the observed reports.
However,empirical evidence from research using the 1997 Asian financial crisis suggests otherwise. For example, Saleh and Ahmed (2005) find that during an economic downturn in Malaysia, managers undertook income-reducing earnings management during debt renegotiation, perhaps hoping to benefit from government support or improved borrowing terms. Alternatively, managers may have recognized that the market tolerates poor performance during an external shock (crisis) environment, so they may have depressed earnings further, via accruals, to enable greater post-shock performance improvements to the benefit of managers’ reputations (a ‘bigbath’ argument). Chiaet al.(2007) find that service-oriented companies in Singapore engage in income-decreasing earnings management during the crisis period.
Conventional wisdom suggests that an economic crisis should encourage managers to adopt big bath accounting for at least two reasons. First, since investors expect companies to report losses during bad times, big bath accounting is a rational managerial response during bad times, and second, big bath accounting during the crisis period allows companies to report positive earnings in the post-crisis period since accruals reverse. Whether such an association will be more pronounced for distressed firms during the crisis is open to empirical examination since non-distressed firms, too, can engage in income-decreasing earnings management practices. The following hypothesis, therefore, is developed in null form:
H2: There is no incremental association between firm distress and earnings management during the crisis period.
Finally, we examine the market pricing of earnings components for distressed firms and whether the relation is changed during the GFC. The accruals component of earnings is composed of discretionary accruals and non-discretionary accruals. The discretionary accruals component of accruals is under managerial discretion and managers can use such discretion to convey useful information or they can use it opportunistically. If managers use discretionary accruals to convey private information about firm value then such accruals are perceived positively by the market (informativeness view). On the other hand, if managers use discretionary accruals for opportunistic reasons, then rational managers discount such accruals (opportunistic view). Contrary to the conventional wisdom that discretionary accruals represent managerial opportunism, empirical findings from the market pricing test suggests an informative role of discretionary accruals (Subramanyam 1996; Guayet al.1996; Krishnan 2003; Chunget al.2004).
However, empirical evidence on the ‘opportunism versus informativeness’ role of discretionary accruals during an economic crisis is very limited. To the best of our knowledge, Ahmed et al. (2008) and Choi et al. (2011) are the only published studies that have examined the effect of the 1997 Asian financial crisis on the pricing of earnings components including discretionary accruals. Ahmed et al. (2008) find that negative discretionary accruals for debt renegotiating firms are associated with higher market values of equity and are not related to a firm’s future earnings. These findings imply that investors place a positive value on the probability that negative accruals increase the likelihood that concessions can be extracted from lenders during renegotiation. In contrast, discretionary accruals for a control sample of non-debt renegotiating firms are not significantly associated with stock prices but are positively associated with future earnings. Investors’ confidence on financial reporting quality during a crisis naturally declines, as they tend to associate discretionary accruals more with managerial opportunism rather than efficient signaling. Managerial opportunism-induced discretionary accruals have lower predictability with respect to future cash flows and hence investors attach a negative information value to this discretionary earnings component (Choi et al. 2011). However, Jenkins, Kane, and Velury (2009) report that accounting conservatism and value relevance of earnings are higher during economic contractions because firms generally report more conservatively to avoid sharp increases in litigation risk and regulatory scrutiny during recession. In addition, investors place great reliance on firms’ current earnings in their prediction of future earnings during a period characterized by increased uncertainty. Whether firm distress has any moderating effect on the market pricing of discretionary accruals during economic crisis has not been examined before. We, therefore, develop the following null hypothesis:
H3: The market pricing of discretionary accrualsfor the distressed firms during the GFCare not different from their non-distressed counterparts.
3.Research design and measurement of variables
3.1Sample selection
We begin with an initial sample of 1,200 firm-year observations from 1999 to 2011 with required information to estimate the regression equations. We delete 302 firm-year observations pertaining to finance, investment, and equity trust and funds because of the different regulatory environments for which the standard accruals estimation technique is not useful. We also lost 85 firm-year observations because we need lagged total assets data to deflate the accruals variables. This leaves us with 813 firm-year observations. We then eliminated industries with less than six observations in a year as we ran industry-year discretionary accruals regressions. The choice of six observations is consistent with Rosner (2003) and also allows us to retain more observations. We derive a final usable sample of 767 firm-year observations from 2000 to 2011. It should be noted that our sample includes a broad group of firms that are SNB as well as NSNB observations,as per Hopwood et al.’s (1994) and Mutchler et al.’s (1997) classifications. The sample selection procedure is explained in Table 1.
[TABLE 1 ABOUT HERE]
3.2 Measurement of financial distress
We now explain the measurement of financial distress, our independent variable of primary interest. We adapt the distress/non-distress classification of McKeown et al.(1991),Hopwood et al. (1994), and Mutchler et al. (1997), and classify a company as stressed if it exhibits at least one of the following financial distress signals:
- Negative working capital in the most recent year;
- A bottom line net loss in the most recent year;
- BOTH negative working capital and net loss experienced in the most recent years.
We assign a value of 1 for firm-year observations that meet any one of the above three criteria, and 0 otherwise. Rosnser(2003) also uses a classification similar to this one although her focus was on failing firms. Rosner (2003, 373), however, expresses concern about these classifications schemes. Rosner argues that:
“…the stressed / nonstressed state can change from year to year. For example, a firm that overstatesearnings three years prior to bankruptcy…may not appear stressed and thus should be classified in that year as [non-stressed bankrupt]. However, as the firm approaches bankruptcy, the auditor may discover the firm’s distressed state and misstatements in year -2 or -1, insist on their reversal, and render a going- concern opinion. Thus, using the [McKeown et al. (1991) classification] criteria, thefirm would likely be classified as [stressed bankrupt], and the nonstressed state and earnings overstatements occurring in year -3 would be ignored.