Earnings Management Strategies During Financial Distress: Evidence on Incentives and Trade-Off Between Accrual and Real Earnings Management

The surge in insolvency filings in India has garnered significant scholarly interest due to the substantial cost associated with financial distress. Firms facing financial downturns have strong incentives to manipulate financial reporting through various earnings management strategies. This study aims to assess the extent of earnings management in financially distressed companies, identify incentives for such practices, and explore the trade-off between accrual and real earnings management. Using the data from NSE-listed firms and those undergoing insolvency from 2008 to 2022, the findings indicate a prevalence of real earnings management over accrual earnings management among distressed firms, with overproduction and sales manipulations being favored over cutting discretionary expenses. Further, the study also underscores that the choice between accrual and real earnings management is influenced by the relative cost of each strategy. The findings offer valuable insights for regulators and auditors, shedding light on the earnings manipulation strategies employed by distressed firms and contributing to enhanced financial reporting quality.