Does the life cycle affect earnings management and bankruptcy?

Abstract

Research background: Deteriorating economic conditions and a negative outlook increase the pressure on financial management and the need to show high financial performance. According to Positive Accounting Theory, the growing risk of bankruptcy is associated with the phenomenon of earnings management. Bankruptcy risk and the quality of reported profits, along with other aspects of financial performance, vary throughout the company's life cycle. Nevertheless, these factors or their interactions are investigated only to a very small extent. Purpose of the article: The aim of this study is to clarify the impact of corporate life cycle and bankruptcy on earnings management, in order to describe behaviour of companies at different stages of corporate life cycle. Methods: A hierarchical mixed model with a random time and industry effect was chosen as appropriate because it allows the investigation of multilevel data that is not independent. The sample covers the financial indicators of more than 33,000 Central European companies from 2015–2019. The non-sequential Dickinson model, company age, and three models of accrual earnings management were used as proxies for the company's life cycle and quality of reported profit. Findings & value added: Earnings management and bankruptcy risk have a U-shape, indicating that financially distressed firms reduce reported accounting profit at the Introduction, Decline and, to a lesser extent, at the Growth stage. Slovak and Czech companies manipulate profits to a similar extent, Hungarian companies increase accounting profit to a greatest extent than the surveyed countries by controlling bankruptcy — life cycle effect; however, the variability of accounting manipulations across industries has not been demonstrated. These findings imply that start-ups and declining businesses provide crooked financial statements to obtain more favourable debt covenants, and estimating discretionary accruals using life-cycle subsamples can improve the predictive power of accrual earnings management models.