We examine whether financial distress and its severity have a role to play in managers' decisions with respect to the choice of earnings management strategies. Our results suggests that firms in initial stages of distress engage in real earnings management through a reduction in the spending on selling, general and administrative expenses, and engage in classification shifting to increase profitability and liquidity. When distress becomes severe, firms cut-back on production, engage in income-increasing accruals management, and increase their spending on selling, general and administrative expenses. Initial under-spending on selling, general and administrative expenses is opportunistic with an intention to show improved performance. In extreme distress, increase on such spending is a sound economic decision. Our findings provide insights into how managers of distressed firms trade-off between liquidity, profitability and solvency in both short-run and long-run.
JEL Codes: M41; G33.