Abstract

This study explores the association between the Covid-19 outbreak, corporate financial distress and earnings management practices in China. We investigate whether firms took advantage of the downturn in economic conditions during the pandemic to adjust their earnings using different earnings management techniques. Utilising a sample of 1832 listed firms and underlying theoretical frameworks (i.e., positive accounting and signalling theory), we find that firms were more inclined to manage earnings during the pandemic period. They favoured using the accrual-based rather than the real activity-based earnings management technique. We also find that firms engaged more in income-increasing practices in the shadow of the outbreak. In addition, our results further demonstrate that financially distressed firms were involved in earnings management, particularly accrual-based earnings management. However, compared to privately-owned firms, state-owned enterprises seem to be involved less in earnings management during the Covid-19 pandemic. Findings from this study raise some concerns for policymakers about the credibility of financial reporting information during Covid-19.

Introduction

The global coronavirus (i.e., Covid-19) pandemic and the associated economic recession brought many severe challenges to companies around the world, posing a profound threat to the viability of many businesses (Barai and Dhar, 2021). The crisis is regarded as the century’s largest health, economic and social crisis so far (The New Yorker, 2020). In addition to the human losses and the disease itself, Covid-19 slowed down global economic activities due to its extensive impacts and the different measures implemented by countries to control the disease’s spread. It caused a significant negative impact on employment (high unemployment rate), reduced economic activity and created uncertainties in many financial markets (Zhang, Hu, and Ji, 2020). Consequently, many firms faced financial distress and bankruptcy due to operational disruption (Lassoued & Khanchel, 2021).

The Covid-19 lockdowns had a profound effect on financial markets and corporate financial performance (Ruiz, Koutronas, and Lee, 2020; Zhang et al., 2020). Managerial behaviours were inevitably affected by the pandemic. In response to the poor market environment during the pandemic, many managers were under high pressure; hence, they may have manipulated earnings or polished their financial statements by using accounting discretion to achieve their targets (Ali, Amin, Mostafa, and Mohamed, 2022; Choi, Kim, and Lee, 2011; Liu & Sun, 2022). Their firms may make use of accounting techniques to improve their deteriorating income statements and balance sheets during a crisis (Arnold, 2009; Laux and Leuz, 2010) or possibly during a pandemic (Ali et al., 2022; Chen, Liu, Liu, and Wang, 2022; He and Jianqun, 2021; Liu & Sun, 2022; Ozili, 2021; Rahman, Ding, Hossain, & Khan, 2022). Earnings management can be done through accrual-based earnings management (hereafter, AEM), and real activity-based earnings management (hereafter, REM) (Graham, Harvey, and Rajgopal, 2005; Kim, Udawatte, and Yin, 2018). AEM occurs when executives manage the accrual component of earnings, while REM can be conducted by changing business operational activities, which has a direct influence on a company’s cash flow (Cimini, 2015). The financial report is an important basis for investors, analysts and stakeholders to make decisions, so it should be able to reflect the actual situation of firms. Arguably, there are numerous gaps in financial reporting that can provide space for executives to take part in earnings management (Azizah, 2021), especially because of the impact of Covid-19 social distancing on audit quality (Albitar, Gerged, Kikhia, & Hussainey, 2020). This leads to a lack of authenticity of accounting information and a lack of stability of enterprise development (Chen et al., 2022).

Conclusion

The Covid-19 pandemic had a catastrophic impact on global health and economic systems. Businesses saw a drop in profitability because of the pandemic, as most economic activities were suspended during lockdown measures. This paper examines the impact of the Covid-19 pandemic on the earnings management practices in a sample of listed companies in China. This is an important issue, given the relevance of the authenticity and reliability of accounting information to stakeholders during troubling periods.

Based on a sample of 1832 companies listed on the Shanghai and Shenzhen stock exchanges during the pre-pandemic period, from 2015 to 2019, and the pandemic period (2020−۲۰۲۱), with 8590 firm-year observations conducted, we examined the earnings management practice using both accrual earnings management and real earnings management techniques. Our findings reveal that the quality of financial reporting by Chinese companies tended to be lower during the pandemic. Listed companies affected by the pandemic were more likely to engage in AEM than REM. In particular, the results indicate that Chinese listed companies were more likely to engage in upward earnings management during the Covid-19 pandemic, which can be explained by the argument that businesses tried to show acceptable levels of losses and thus mitigate the impact of the pandemic in the eyes of investors and stakeholders. This is consistent with the finding of Lassoued & Khanchel (2021) that companies manage earnings upward by mitigating the reported losses level to rebuild the confidence of stakeholders and thus support economic recovery. Furthermore, the results also indicate that financially distressed firms engaged in earnings manipulation, especially accrual-based earnings management. However, this behaviour seems to be less prevalent during the Covid-19 pandemic, especially in the case of state-owned enterprises. The findings were robust after considering the factors that may influence the incentives and behaviours of earnings management. In detail, we used the corresponding company-level variables, such as debt performance, opportunity growth, board independence and audit quality. Furthermore, we also used other alternative proxies as dependent variables and panel data fixed effects to ensure the robustness of our results.