The Role of Earnings Management in Theoretical Development and Improving the Efficiency of Accounting-Based Financial Distress Prediction Models

Examining the theoretical foundations of earnings management shows that companies have stronger incentive to use earnings management at the prebankruptcy stage. Consequently, accounting-based determinants retrieved from financial statements may be biased factors for financial distress. In this paper, we investigate whether taking into account real earnings management improves the specification of accounting-based financial distress prediction models. We test whether the inclusion of such attributes in financial distress prediction models improves their predictive ability. We use a sample of listed manufacturing companies in the Iran Stock Exchange during 2008 - 2017. Our findings suggest that the inclusion of earnings management significantly increases the predictive ability of accounting-based financial distress prediction models. Our results show that the real earnings management can provide predictive signals concerning financial distress and that an abnormal cash flow which proxies for real earnings management can play a relevant role in early warnings of financial distress. These results are of interest to market participants, auditors, regulating authorities, banks and other financial institutions that are interested in financial distress assessment.