The role of leverage on real earnings management in financially distress firms before and during the Covid-19

Abstract

Previous research has identified poor industry performance, weak firm performance, and high leverage as significant factors contributing to financial distress, which can subsequently influence the manipulation of earnings. Therefore, this study aims to examine the role of financial leverage in shaping earnings management behaviours in distressed firms with varying leverage conditions across different time periods, both prior to and during the COVID-19 pandemic. Utilizing Roychowdhury's (2006) REM model, which includes measurements of Abnormal Cash Flow from Operations, Abnormal Production Costs, and Abnormal Discretionary Expenses, this study analyzes a sample of 672 firm-year observations from Malaysian publicly listed companies covering the years 2018 to 2021. First, the findings show a significant positive relationship between financially distressed firms and REM practices, both before and during the pandemic. Then, it also highlighted that financially distressed firms may strategically choose certain REM components, where low-leverage firms are more likely to engage in upward earnings management compared to their high-leverage counterparts both before and during the pandemic. Furthermore, we observe a significant negative relationship between leverage and REM, suggesting that higher leverage correlates with lower levels of earnings management. This study contributes to the earnings management literature by demonstrating how leverage acts as a constraining factor on earnings manipulation and by revealing patterns of managerial behaviour across different levels of financial distress.