Impact of Financial Distress on Earnings Management with the Moderating Role of Audit Quality: Evidence from Pakistan

Abstract

The core aim of the financial reports is to provide a firm’s annual results of financial performance and position to stakeholders on time. Several accounting scandals led to the default of many large-scale corporations, leading to investors’ lack of confidence in the reliability of financial information and also putting a question mark on the effectiveness of internal control mechanisms and external audits. Business managers of financially distressed firms use the choice of accrual accounting methods which gives them leverage to misuse their powers and expropriate stakeholders by showing good financial results. So, this study fills this gap by investigating the presence of Financial Distress (FD) and its effect on Earnings Management (EM) with the moderating role of Audit Quality (AQ). The sample of this study contains the data of 96 non-financial listed companies for the period 2017-2022 on the Pakistan Stock Exchange (PSX). This study uses the discretionary accruals as a proxy for the EM and Z-score for FD. The results and analysis find that FD and EM have a significant positive relationship, which reveals that corporate managers of distressed companies do EM while AQ weakens this relationship. This study recommends that professional bodies, regulatory authorities, and corporate governance institutions must design policies that restrict corporate managers from getting involved in earning management practices, especially in the time of FD.