Economic Recession, Corporate Distress and Income Increasing Accounting Policy Choice

In late 1997 much of the Asian region experienced a major economic downturn. Such economic conditions can give rise to external pressure on corporate managers, so that they react to this pressure by changing accounting policy choice.The present paper is set in a time period in Australian corporate history when there was also a substantial economic downturn. In that context, the present study examines the use of income increasing policy choice by stock exchange listed companies. In particular, we look at whether companies experiencing financial distress are more inclined to use income increasing policy choice than ‘healthy’ companies. Prior research supports the view that managers of ‘financially troubled’ firms try to lift reported income, thereby disclosing more favourable performance measurements and avoiding default of loan agreements and/or enhancing their own wealth.The results show the use of income increasing policy choice does not increase monotonically with the level of financial distress. In particular, we show that firms classified as ‘distressed’ which do not subsequently fail in the short term, show a significant tendency to increase reported income using changes in accounting policy. However, firms which subsequently fail within the short term do not select income increasing techniques more frequently than ‘healthy’ firms.One reason why firms that fail in the short term may not engage in income increasing policy choice is the clear prospect of imminent ex post settling up (including litigation against former directors, auditors and others) which can occur following corporate failure. Such costs are not widely recognized in the tests of accounting policy choice which rely on indicators of financial health such as leverage or interest coverage.