Earnings management refers to the deliberate efforts by a firm’s management to organize and concoct financial statements within the confines acceptable by accounting principles with the intention of the manager's private interests (Suryandari, Yuesti, & Suryawan, 2019). Earnings management can also be described as the “active manipulation of earnings toward a predetermined target, which may be set by management, a forecast made by analysts, or an amount that is consistent with a smoother, more sustainable earnings stream” (Yadav, 2013). The two definitions point out that earnings management involves purposive manipulation of earnings, and in effect the financial statements, for a motivation other than the shareholders’ interests.
Financial distress refers to the twilight phase of corporate decline that paves the way for more devastating events such as insolvency or bankruptcy (Platt & Platt, 2002). A financially distressed firm satisfies three simple conditions: negative growth in the average market value; its income from operations is less than its financial expenses; and its operating cash flow is less than its financial expenses (Gupta & Chaudhry, 2018). This implies that financial distress is associated with declining profits or increasing losses, operating cashflow snags, and a general decline in firm market value. These are conditions that lead to the bankruptcy and collapse of firms.
Evidence that a firm is approaching distress can lead to swift managerial actions to prevent problems before they take place. One of the possible decisions includes mergers or takeover by a more solvent or stable firm or organization (Platt & Platt, 2002). This only happens when the management is brave enough to take the bull by its horns. Earnings management may be designed to remove crests and dales from a normal earnings series by reducing profits during peak years and using it during slower years. This action is commonly referred to as income smoothing (Yadav, 2013). Some managers may result in actions aimed at concealing the actual distress position; such actions include earnings management in the form of income smoothing.
Financial distress also affects households just as it affects businesses. Financially distressed households are usually faced with choices over consumption, wealth, credit, and debt repayment (Athreya, Mustre-del-Río, & Sánchez, 2019). This element of choices can be extrapolated to the firms. Companies with high debt ratios tend to perform earnings management in relation to the high burden that the company bears so that it will reduce its profitability. The element of low profitability is the driving force for management to exercise earnings management to entice investors to invest (Suryandari, Yuesti, & Suryawan, 2019). Debt covenants are a key component of positive accounting theories and have always been associated with creative accounting and, by extension, earnings management (Kamau, Namusonge, & Bichanga, 2016).
The tax shield has a positive and significant effect on earnings growth, while financial distress has a negative significant effect on earnings growth. The tax shield may be perceived as a mediator between earnings growth and financial distress (Sitorus & Christian, 2019). Taxation has been observed as one of the reasons behind creative accounting practice. Management may desire to represent diminutive earnings to reduce the tax burden (Kamau, Mutiso, & Ngui, 2012). Income smoothing in insurance firms and tax hypotheses are closely linked (Alford, Luchtenberg, & Reddie, 2018). Taxes that form part of the political cost hypothesis in positive accounting theories are linked to earnings management.
Corporate governance may be used as a tool to deter earnings management. Confirmation of income decreasing or increasing accruals in the findings implies EM still exists among the listed firms in Kenya. Policymakers should therefore consider drastic arrangements, including unconventional approaches, to improve the efficiency of corporate governance (Outa, Eisenberg, & Ozili, 2017). Audit and audit committees are key elements of corporate governance. Financially distressed firms tend to incur higher audit costs but have a greater likelihood of receiving a going-concern opinion. Financially nondistressed firms, on the other hand, are likely to incur fewer audit costs with a greater probability of receiving a going‐concern opinion. However, the prospect of a going‐concern opinion is stronger for nondistressed compared to distressed firms (Bhaskar, Krishnan, & Yu, 2017). Active monitoring by audit committees who are experts in finance may help reduce earnings management. This is because they are able to understand the financial records necessary to help them oversee the firm’s corporate actions (Suryandari, Yuesti, & Suryawan, 2019).
Financial stability does not have an effect on earnings management. Therefore, the level of financial stability of a firm does not form a basis for management to practice earnings management (Suryandari, Yuesti, & Suryawan, 2019). Earnings management negatively influences financial performance. Earnings manipulations lead to the degeneration of firm performance (Nisansala & Menike, 2018). On the other hand, financial targets have a negative influence on earnings management. A higher financial target realized by the firm attracts greater monitoring by investors; therefore, the firm tends to be more cautious in deciding what actions to take, especially in regard to fraud (Suryandari, Yuesti, & Suryawan, 2019).
Organizational structure has no effect on earnings management. Likewise, changes in the board of directors have no effect on earnings management and fraudulent activities (Suryandari, Yuesti, & Suryawan, 2019). On the other hand, “executive structure power, ownership power and expert power have positive effects on earnings management, while prestige power has negative effects on earnings management” (Wang, Wang, Zhang, & Hu, 2017). Different forms of organizational structure surface after firms experience financial distress. Additionally, manager qualifications and experience are significant during financial distress (Rakhmayil, 2018). Both organizational structure and capital structure play a key role in both financial distress and earnings management. This explains perhaps why restructuring is one of the strategies adopted by firms experiencing financial distress.