Earnings Management and Default: The Case of the Plastics Sector in Portugal

Introduction

International financial scandals, such as Enron (USA 2001), Parmalat (Italy 2003), WorldCom (USA 2003), Pescanova (Spain, 2020), among others, call the need to understand earnings management practices. Managers sometimes feel pressure to change the reported financial information to influence the company’s main stakeholders and obtain private benefits.

In Portugal, the main purpose to engage in earnings management practices is related to both contractual and regulatory incentives (Moreira, 2006). Companies with losses or low profits, tend to show a sustainable financial situation to meet debt covenants (contractual incentive) and avoid an increase in financial costs or have access to new loans with low interest rates. On another side, companies with high profits may try to reduce earnings to pay less income taxes (regulatory incentive) at the end of the year.

Rosner (2003) and García-Lara, Osma and Neophytou (2009) found that default companies (the ones unable to fulfill their obligations) tend to engage more in earnings management practices to maintain their economic relationships with stakeholders and to hide their financial difficulties. Lin, Lo and Wu (2016), Nagar and Sen (2018), and Wu, Lin and Lo (2018) found that earnings management increases companies' financial distress, as information is less reliable and misleads stakeholders' decisions. Similar conclusions were found by Ashraf, Félix and Serrasqueiro (2020) and Costa, Lisboa and Gameiro (2022) when analyzing the impact of financial report quality and companies’ probability of default.

This chapter aims to understand the differences between compliant and default companies and the impact of earnings management practices on companies’ probability of default. An unbalanced panel data of Portuguese companies operating in the plastics industry is analyzed, from 2012 to 2018. The plastic sector is a relevant sector to analyze due to the challenge in environmental sustainability. In 2018, the European Commission presented a strategy for this sector based not only on promoting the reuse of plastics but also on promoting investment in innovative solutions, to transform current challenges into opportunities (Gabinete de Estratégia e Estudos do Ministério da Economia, 2019). To do new investments, companies operating in the plastic sector may need external financing, which means that may present a stable financial situation to reduce the cost of debt. Therefore, these companies may engage in earnings management practices which, in turn, may increase their probability of default.

We analyze non-listed companies, whether most of the works in the area analyze listed companies (Lin et al., 2016; Wu et al., 2018; Ashraf et al., 2020). Moreover, the sample comprises micro, small, medium, and large size companies. We analyze the sample as a whole and by companies’ size to understand if companies’ size impact results.