Abstract

This study investigates the impact of the degree of financial distress on the earnings management activities of Italian non-listed firms using a linear regression model proxied by the Altman Z-Score which controls the heteroscedasticity and autocorrelation using the Petersen method. The extant literature provides mixed evidence on this relationship for listed firms. In this study we find a positive (negative) relationship between financial distress risk and income-decreasing (income-increasing) earnings management, suggesting that firms tend to manage earnings downward as financial distress risk increases. In two robustness tests, we test the power of the Kothari model and we also analyse a reduced firm sample representing over 80% of the population, though the results are qualitatively the same. Our research has several implications for academics, practitioners, lenders, and national standard setters, showing that, in contrast to the extant literature, non-listed firms are more likely to manage earnings downward as their financial situation deteriorates. Furthermore, our findings are of interest to national standard setters and professional accountants who are concerned with advanced warning indicators of firm financial problems such as Altman’s Z-score, especially in recent years in which countries are focused on developing robust empirical models to detect firm financial difficulties.

Key words: Financial distress, Altman’s Z-score, accrual-based earnings management, non-listed firms, Italian context.