Efficiently monitoring the ship of financially distressed companies sinking in Iron law of earnings management: Evidence from Pakistan

Abstract

The purpose of this study is to validate the relationship between earnings management and financial distress. Further, it will explore the moderating role of ownership structure for the relationship between earnings management and financial distress which is missing in the current literature. Agency theory and the iron law of earnings management are utilized to develop the framework for this study. Data have been collected from 156 companies listed on the Pakistan Stock Exchange for the period of 2004 to 2017. All the reported results are on a log-odds matric because our dependent variable is binary. The results of the study proved that there exists a positive relationship between earnings management and financial distress and this relationship is negatively moderated by ownership structure. The results of this study are beneficial for investors as well as regulators regarding control mechanisms of ownership structure.

Keywords:

• Earnings management
• financially distressed companies
• financially healthy companies
• ownership structure
• agency theory
• iron law
• logit analysis
• moderation
• entrenchment behavior
• efficient monitoring

PUBLIC INTEREST STATEMENT

Each investor wants to know the detailed financial conditions of companies before choosing to invest in them. And if it is about investing in financially distressed companies, it requires more insights and financial analysis of such firms. In this way, they can avoid the myopic investments thus safeguarding their profits form plummeting because of the wrong choice of company. However, companies may get involved in window dressing their earnings, i.e., earnings management, to attract investments and also to avoid financial distress. The present study has well explained that companies engaging in earnings management to avoid the state of financial distress, however, ultimately are faced with increased financial distress. Conversely, a strong ownership structure in financially distressed companies can control their earnings management activities. The present study demonstrates that investors can analyze a financially distressed firm regarding its earnings and ownership structure before investing in it.

Additional information

Funding

The authors received no direct funding for this research.

Notes on contributors

Muqaddas Khalid

Muqaddas Khalid is a Ph.D. scholar in Department of Management Sciences, COMSATS University Islamabad, Lahore Campus, Punjab 54000, Pakistan. She has completed her MS in 2013. She is the author of several publications in well-reputed journals and has presented her work in several national and international conferences. Her area of interest is corporate governance, corporate finance, earnings management and financial distress. Currently, she is carrying out her research on different aspects of corporate finance that can affect financial distress status of a company.