Project Report

Name Roll no

Esha Anjum 20031554-042

Rana Zain-ul-Abideen 20031554-055

Supervisor

Ma’am Marina Afzal

Course

Research project

Department

Commerce 8th

Topic:

Impact of financial distress and earning management on earning quality: a study of

listed companies.

1
ACKNOWLEDGEMENT

We would like to express our heartfelt gratitude to my supervisor, Ms. Marina Afzal for their
invaluable guidance, support, and expertise throughout entire research process. Their unwavering
commitment and insightful feedback have been instrumental in shaping the direction and
improving the quality of this thesis. We would also like to extend our appreciation to the Head
of Department Dr. Muhammad Usman for their valuable insight. We would like to acknowledge
the support of our friends and family for their unwavering encouragement and understanding.

2
DACALARATION

In submitting this thesis, we confirm that the work presented herein is our own and has been
conducted in accordance with the guidelines set forth by University of Gujrat and the academic
standards of BS Accounting & Finance. We have taken great care to ensure the ethical conduct
of my research, including obtaining necessary permissions, maintaining participant
confidentiality, and acknowledging the contributions of others. This thesis has not been
previously submitted for any other degree or qualification, and the research findings presented
are original and have not been replicated or duplicated in any form. We take full responsibility
for the content of this thesis and grant permission for its reproduction for academic and research
purposes, with proper acknowledgment.

Esha Anjum 20031554-042

Rana Zain-ul-Abideen 20031554-055

Ms. Marina Afzal

Lecturer,

University of Gujrat,
Punjab, Pakistan
Dated:

3
 Supervisor’s Certification

I solemnly certify that the/these students Esha Anjum and Rana Zain-ul-Abideen bearing the roll
number# 20031554-042 and 20031554-055 of BS Commerce, semester 8th at Department of
Commerce, University of Gujrat, Pakistan has completed their research project under my
direction and supervision along-with the overhead indicated statement is real as per best of my
knowledge.

Supervisor’s Complete Name: Miss Marina Afzal

Signature Dated:

Supervisor’s Designation: Lecturer

Supervisors

Department of Commerce,

University of Gujrat.

4
 Department Certification

The Department of Commerce, University of Gujrat certify that the students Esha Anjum and
Rana Zain-ul-Abideen bearing the roll number# 20031554-042 and 20031554-055 of BS
Commerce, semester 8th at Department of Commerce, University of Gujrat, Pakistan has
completed their research project with the title Testing the mediating role of trust between
satisfaction and loyalty in customers: A research study of Islamic Banks in Pakistan along-with
all of the requirements set for this purpose including Viva Voce under the supervision and
direction of Miss Marina Afzal.

________________

Dr. Muhammad Usman

Head of Department,

Department of Commerce,

University of Gujarat, Pakistan.

Dated:

5
Contents
ABSTRACT...................................................................................................................................................7

1. Introduction:...............................................................................................................................................8

1.1. Background of the study:....................................................................................................................8

1.2. Research Objective:..........................................................................................................................13

1.3. Research question:............................................................................................................................13

2. Literature review:.....................................................................................................................................14

2.2. Theoretical Framework and Hypotheses..........................................................................................18

2.3. Synthesis and implication:................................................................................................................19

Methodology:...............................................................................................................................................20

Measurements and proxy:........................................................................................................................26

Population and sample:............................................................................................................................26

4. Results and discussion:............................................................................................................................30

4.1. Descriptive analysis:.........................................................................................................................30

4.2. Correlation between all variable:......................................................................................................31

4.3. Regression of variables:....................................................................................................................32

4.4. Multicollinearity:..............................................................................................................................34

4.5. Heteroscedasticity & Hausman test:.................................................................................................35

4.6. GSL estimation:................................................................................................................................36

5. Conclusion and future direction:..............................................................................................................37

5.1. Conclusion:.......................................................................................................................................37

5.2. Limitation and future direction:........................................................................................................37

6. References:...............................................................................................................................................38

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ABSTRACT
Purpose: Discretionary accruals are earnings quality proxies that illustrate that the greater the
value of discretionary accruals, the greater the practice of earnings management and vice versa.
High-quality financial reports (especially earnings quality) are expected to help investors and
potential investors to make decisions. This study analyses the factors that affect earnings quality,
such as financial distress earning management and corporate governance mechanism.
Furthermore, the author identify the controlling role of corporate governance and ROE in non-
financial companies in Pakistan stock exchange (KSE-100).

Design/ methodology/Approach: the study uses 43 non-financial companies of KSE-100 index

period from 2023 to 2016 the data were analyzed using Stata and MS Excel for some test like
findings and descriptive analysis.

Limitation: The study's limitations include the shortage of time and its focus on manufacturing
companies listed on the KSE-100 index, and the relatively small sample size of 43 companies.

Keyword: Earning quality, earning management, financial distress, corporate governance

mechanism, Return on equity (ROE).

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 CHAPTER-01

1. INTRODUCTION:
1.1. Background of the study:

Earnings quality is a fundamental concern for investors and stakeholders relying on financial
statements to gauge a firm's performance and future prospects (Alhadab & Al-Own, 2017). High-
quality earnings are characterized by their ability to reliably predict future earnings, reflecting
the underlying economic realities of a company's operations. Discretionary accruals (DACC), a
widely recognized proxy for earning management, represent adjustments made to financial
statements that do not involve direct cash flows, thereby influencing reported earnings (Dechow
et al., 1995). The manipulation of discretionary accruals (DACC) can distort the transparency
and reliability of earnings, affecting stakeholders' perceptions and decision-making processes.
Higher levels of discretionary accruals often indicate more aggressive earning management
practices, potentially compromising earning quality (Roychowdhury, 2006) In addition to
earning management, financial distress serves as another critical variable impacting earning
quality. Financial distress occurs when a company faces significant challenges in meeting its
financial obligations (Altman, 1968), which can lead to various strategic responses including
aggressive accounting practices to manage reported earnings (Sharma & Panigrahi, 2019). The
presence of financial distress not only signals potential liquidity and solvency issues but also
influences the integrity of financial reporting, as firms under distress may be incentivized to
manipulate earnings to avoid breaching debt covenants or to maintain stakeholder confidence
(Richardson et al., 2011). The relationship between discretionary accruals, financial distress, and
earning quality is complex and multidimensional, impacting how financial information is
interpreted and utilized by stakeholders (Kanagaretnam et al., 2004). The focus of this research is
to explore the relationships between earning management, financial distress and earning quality.
By elucidating these dynamics, this research contributes to a deeper understanding of the factors
shaping financial reporting integrity and corporate governance practices. Earnings management
is the phrase used most commonly in the empirical research to describe manager intervention in
accounting information. The terms cosmetic accounting and accounting manipulation are
frequently used. According to Schipper, earnings management refers to a manager's participation

8
in the external financial reporting process for their own benefit not for the company benefit
(Katherine Schipper, 1989). This definition demonstrates how managers' opportunistic behavior
is caused by earnings management. Research in positive accounting theory and agency theory led
to the development of earnings management, a managerial technique that arose in the context of
information asymmetry between managers and other business partners. The efficient market
hypothesis can also be used to analyze earnings management. From this angle, managers are
driven to inflate profits in order to provide more detailed information(Watts & Zimmerman,
1990) A widespread occurrence in financial reporting is earnings management. The goal of
earnings management is to demonstrate a sufficient level of earnings quality that satisfies both
the needs of gaining necessary authorization from regulators and the expectations of
shareholders. When evaluating a company's financial health, it shares many similarities with
earnings quality, persistence, predictability, and smoothness. A genuine view of the company
without any irregularities or accounting gimmicks is provided by Quality of Earnings. It provides
a thorough analysis of the business's finances. It speaks of the money the business makes from its
core business operations. Net income frequently appears to be an inaccurate indicator of a
company's underlying financial situation. A corporation may declare a large net income even
while its actual cash flows are negative. The corporation cannot be considered financially sound
in the situation. In these situations, determining the genuine status requires calculating the
quality of earnings. The quality of earnings is closely related to earnings management. All
managed profits are often of low quality. It does not follow that high earnings or high-quality
accounting statistics can be guaranteed by a lack of earnings management. The quality of profits
is influenced by an enormous number of other factors(Khanh & Thu, 2019; Khuong et al., 2020).

Earning management is a most researched and discussed topic by practitioner, accounting and
institution over last few decades. It is not only in develop countries like (ENRON and
WorldCom suffers in earning management and at the end these companies face default) where
system is strong but also in developing countries like Pakistan where system is not strong. Due to
big financial scandals of large companies such as ENRON and WorldCom etc increase the
importance of making effective system to produce qualitative financial reports, by targeting
specifically earning quality report because which companies show better level of earning are

9
linked with high economic performance in capital market and money market. The importance
toward quality of financial reports and firms earning management is still relevant.

In order to make decisions and conduct analyses related to their financial matters, users must
always have access to correct and trustworthy information. Consequently, a deficiency of
pertinent and appropriate information may influence their choices. A significant portion of the
data and information needed for this process are thought to be the financial reports and figures.
Several experimental investigations have demonstrated that decision makers view earnings as the
primary source of information and depend on them above all other considerations (.Ahmadpor,
2013),
when companies encounter financial distress, this assumption of going concern is challenged,
and the quality of their earnings reports comes under scrutiny, making it essential to investigate
the impact of financial distress on earnings quality and its implications for stakeholders,
Nevertheless, poor financial management decisions can lead to a company's financial downfall,
potentially culminating in insolvency and, in extreme cases, making it an attractive target for
acquisition or takeover by rival firms(El Deeb & Ramadan, 2020) , the ability of companies to
manage their finances effectively and maintain high-quality earnings is crucial for their survival
and independence, making the investigation of the impact of earnings management and financial
distress on earnings quality a vital area of research with significant implications for corporate
governance, investor decision-making, and overall market efficiency. In the face of financial
adversity, company managers may resort to earnings manipulation as a desperate measure to
maintain stakeholder confidence and project a rosy financial picture. This deceptive tactic aims
to convince lenders of their creditworthiness, staving off the looming threats of bankruptcy and
delisting from the capital market. Earnings management, a form of financial misrepresentation,
can have far-reaching consequences, including reputational damage, legal repercussions, and
erosion of investor trust. Despite its prevalence, the motivations and mechanisms underlying
earnings manipulation require further exploration (Purba, 2022, 2011). Failing to disclose early
warning signs of bankruptcy to stakeholders can leave them vulnerable to financial losses and
societal consequences. Bankruptcy can have far-reaching impacts, affecting not only the
company but also its executives, investors, lenders, and employees. The lack of transparency can
lead to unforeseen risks, exacerbating the severity of financial losses and social burdens. This

10
research aims to investigate the consequences of nondisclosure of initial bankruptcy indicators,
exploring the financial and societal implications for various stakeholders and examining the
ethical and regulatory implications of transparent disclosure(Hassanpour & Ardakani, 2017).

Following Enron and WorldCom, the two most prominent examples of earnings management
entered into for opportunistic purposes, policymakers, investors, academics and practising
accountants are cognizant that managers have manipulated or “managed” earnings—in these
cases to create what were in effect the largest bankruptcies ever witnessed in the United
States(Jiraporn et al., 2008). Financial distress can create stress for managers, influence their
cognitive functioning and form a basis for them to initiate operating or accounting earnings
management methods in all cases particularly following the change of managerial incentives
under financial distress (Almubarak et al., 2023)

Discretionary accrual is a proxy for earning quality, it is simply an adjustment in the profit and
loss accounting rules by not involving direct cash flows, higher the discretionary accrual lower
the earning quality and vice versa (Riyan Harbi Valdiansyah, 2022). earning quality is a earning
that have an ability to predict future earning, higher earning quality reflect an ability to predict
high future earning and vice versa, Earning management develop the uncertainty about both firm
value and earning quality (Anne Beyer, 2018). Earning quality is significant tool that evaluating
the company going concern of firm besides improving the decision making process in the firm.
Several attempts have been made to examine the consequences of earning quality on firm value
(e.g. Dang et al, 2020; Nuris and Juliardi, 2017).

The importance of earnings quality has been highlighted in various studies (Dechow et al., 2020;
Francis et al., 2020). Earnings quality is a critical attribute of financial reporting, as it reflects the
accuracy, reliability, and transparency of a company's reported earnings (Healy & Wahlen,
1999). However, earnings quality can be compromised by various factors, including earnings
management and financial distress (Beneish, 1998; DeAngelo et al., 1994).

Recent papers have emphasized the significance of earnings management and financial distress
in affecting earnings quality. For instance, a study by Ahmed et al. (2022) found that earnings
management practices, such as accrual manipulation, can lead to low-quality earnings. Similarly,
a study by Ibrahim et al. (2023) revealed that financial distress can result in aggressive earnings

11
management, which can compromise earnings quality. A series of research examined the
relationship between earning quality and financial distress (zedan, Azzam and EIBasuony, 2023).
A series of research examine the relationship between earning management and financial
distress.

Audit committee is seen as an entity within an organization that provides the assurance to third
party that the business is run ethically. The internal and external audit is the first line of defense
that reflect the good corporate governance apply in the firm (Abbott et al., 2010). Audit
committee play a significant role in society, the main goal of audit committee to complete the
governance in which company protect the interest of stakeholders, institutional shareholder and
minority shareholders (Rezaee et al., 2003). Audit committee is the tool of corporate governance
that whose goal is to increase the questioning of the board of management and to increase the
role of audit committee and its independence. Furthermore, audit committee is to increase the
interest of organizations and it’s of the major role is to prepare financial reports during the past
few years (Ali, 2024). Furthermore, (Ali, 2024) audit committee would be more active in the
process of monitor financial statement and limiting the difference between management and
external auditor. Financial reports are no longer reflect the exact financial position of a company
because some time CFO is a negative in amount but net income in positive in amount as a result
a result to attempt manipulation in the information through earning management (Nuzulia, 1967;
Zgarni et al., 2016).

As a result misuse of information is harmful for the interested parties has made the analysis of
financial statements a major problem, because of this information does not correspond to the
actual term of the company, the technique of smooth earning and income maximization can
control the earning(Hertz, 2012). Earning management is carried out by management (agent).
According to (Ibrani et al., 2019) is to raise the value of firm that mean firm value also increase
the in the eyes of investor. The audit committee's attributes need to be given more consideration
because its mere existence does not guarantee that it will be a helpful monitoring body. Because
of this, corporate governance rules set forth particular requirements for the makeup and
organization of the audit committee in order to ensure its effectiveness.

12
Thus, by reducing earnings management, enhanced audit quality can lessen the ambiguity
surrounding reported profits. Because there are less earnings management techniques used,
investors are better able to determine a company's true value(Alsayani et al., 2023).

1.2. Research Objective:

This study aims to examine the factors that influence earning quality with the role of earning
management, financial distress, audit committee effectiveness and its independence:

1. To check the impact of earning management on earning quality.

2. Examine the impact of financial distress on earning quality.
3. Control for the influence of audit committee, audit quality, board independence and ROE
on the relationship between the earning management, financial distress and earning
quality.

1.3. Research question:

RQ1: what is impact of earning management on earning quality?

RQ2: what is the impact of financial distress on earning quality?

RQ3: what is the impact of audit committee on earning quality?

RQ4: what is the relationship between audit committee meeting and earning quality?

RQ5: what is the relationship between audit meeting frequency and earning quality?

RQ6: what is the relationship between audit committee independence and earning quality?

RQ7: what is the relationship between return on equity (ROE) and earning quality?

This study shows that the relationship between earning management and financial distress with
earning quality with the role of corporate governance in which this study most focused on audit
committee independence and ROE then there is a still gap for study.

13
 CHAPTER-02

2. Literature review:
Earning quality is a critical metric in assessing the reliability and sustainability of reported
earnings. Researchers have investigated various factors that influence earning quality, including
earning management and financial distress. Additionally, the role of audit committees and return
on equity (ROE) has been studied as potential control variables affecting earning quality.

Earnings Quality and Earnings Management:

Earnings quality refers to the accuracy and reliability of financial information presented in a
company's reports. High earnings quality implies that the financial statements fairly represent the
company's financial performance and position. Conversely, earnings management involves
strategic manipulation of financial reports to achieve specific goals, such as meeting earnings
targets or presenting a favorable image to stakeholders. This manipulation can include using
aggressive accounting practices like premature revenue recognition or understating expenses.

Research by Healy & Wahlen (1999) and Dechow & Skinner (2000) has highlighted that
earnings management can compromise earnings quality. Companies may resort to such practices
to artificially boost reported earnings, which can mislead investors and creditors about the true
financial health of the organization. In contrast, companies with high earnings quality adhere to
accounting principles rigorously, ensuring transparency and reliability in their financial
reporting. This reduces the temptation and necessity for earnings management practices.

Audit committee and earning quality:

14
The audit committee of a company's board of directors plays a pivotal role in safeguarding
earnings quality. Its primary responsibility is to oversee the financial reporting process, ensuring
compliance with accounting standards and regulatory requirements. Klein (2002) underscores the
importance of an effective audit committee in enhancing earnings quality by preventing and
detecting earnings management practices.

Research by Carcello & Neal (2000) has demonstrated that robust audit committees can mitigate
the risk of earnings management. This is achieved through diligent oversight and scrutiny of
financial reporting practices, including the independence and expertise of committee members.
Independent audit committee members, as noted by DeZoort et al. (2003), are less likely to
succumb to pressures that might compromise the accuracy and transparency of financial
statements. Their expertise allows them to effectively evaluate financial information and
challenge management decisions when necessary, thereby upholding the integrity of earnings
quality.

Earning Quality and financial distress:

The link between earnings quality and financial distress highlights how the reliability of financial
reporting can impact corporate solvency and investor confidence. Earnings management
practices, aimed at masking financial weaknesses or boosting short-term performance metrics,
can mislead stakeholders about a company's true financial health (DeFond & Jiambalvo, 1994).
Huang et al. (2014) found empirical evidence suggesting that firms engaging in earnings
management are more likely to experience subsequent financial distress, including bankruptcy.

Companies in financial distress may face pressures to manipulate earnings to avoid breaching
debt covenants or to maintain access to capital markets (Beneish et al., 2013). This exacerbates
the risk of financial instability, as the true extent of financial difficulties becomes obscured by
manipulated financial statements. Effective regulatory oversight and robust corporate governance
practices, such as stringent audit committee supervision, are crucial in mitigating these risks and
promoting accurate financial reporting (Beasley et al., 2000).

Earnings Quality and Return on Equity (ROE):

Return on Equity (ROE) measures a company's profitability relative to shareholders' equity and
serves as a key performance metric for investors assessing financial performance. High earnings

15
quality is associated with more reliable ROE figures, reflecting sustainable earnings generation
and efficient capital utilization (Burgstahler & Dichev, 1997).

Research suggests that firms with higher earnings quality tend to exhibit more stable and
predictable ROE over time (Sloan, 1996). Transparent financial reporting practices, including
conservative accounting policies and comprehensive disclosure practices, contribute to enhanced
investor confidence and support valuation metrics based on ROE (Penman, 2007). Conversely,
firms engaging in earnings management practices to artificially inflate earnings may experience
volatile ROE figures, undermining investor trust and long-term financial stability (Healy &
Wahlen, 1999).

Earning quality refers to the degree to which reported earnings reflect the true economic
performance of a company. Higher earning quality indicates earnings that are less likely to be
influenced by accounting manipulations or financial distress. Studies by Dechow and Dichev
(2002) and Roychowdhury (2006) emphasize the importance of accurate financial reporting and
its impact on earning quality. They argue that firms with higher earning quality exhibit more
consistent and transparent financial statements, leading to greater investor confidence and market
trust. Earning Management and Financial Distress as Independent Variables in Earning
management involves the strategic manipulation of financial reports to achieve specific financial
outcomes. Scholars like Healy and Wahlen (1999) and Jones (1991) have explored how earning
management practices can adversely affect earning quality. They highlight that aggressive
earning management practices can distort financial results, leading to lower earning quality.
Financial distress, on the other hand, refers to a firm's inability to meet its financial obligations.
Beaver (1966) and Altman (1968) pioneered research on financial distress, demonstrating its
negative impact on financial health and, consequently, earning quality. Firms in financial distress
may resort to earnings manipulation to mask underlying weaknesses, further compromising
earning quality. The most influential factors are Audit Committee and ROE as Control Variables
Audit committees play a crucial role in overseeing financial reporting processes and ensuring the
accuracy and reliability of reported earnings. Research by Bedard and Johnstone (2004) and
Klein (2002) suggests that effective audit committees enhance earning quality by providing
independent oversight and reducing the likelihood of earning management practices.

16
Return on equity (ROE) measures a company's profitability relative to shareholders' equity and is
often used as an indicator of financial performance. While not directly influencing earning
quality, studies by Myers (1999) and Palepu (1986) argue that ROE can reflect management
effectiveness and operational efficiency, which indirectly impact earning quality. 2,000,000
Earning quality is a fundamental concept in accounting and finance, reflecting the extent to
which reported earnings accurately represent a firm's true economic performance. High earning
quality implies that reported earnings are reliable and transparent, providing stakeholders with a
trustworthy basis for decision-making (Dechow & Dichev, 2002; Roychowdhury, 2006).
However, earning quality can be influenced by various factors, including earning management,
financial distress, and the effectiveness of governance mechanisms such as audit committees.
This literature review explores these relationships, with a focus on understanding how earning
management and financial distress impact earning quality, while considering the roles of audit
committees and return on equity (ROE) as control variables. Earning quality is commonly
assessed through metrics that evaluate the reliability and sustainability of reported earnings.
Scholars emphasize the importance of earning quality in enhancing investor confidence and
market trust (Dechow & Dichev, 2002; Roychowdhury, 2006). High earning quality indicates
that reported earnings reflect actual economic performance, free from distortions or
manipulations. Dechow and Dichev (2002) define earning quality as the degree to which
reported earnings reflect true underlying performance. They argue that high earning quality
reduces information asymmetry between managers and investors, leading to more efficient
capital allocation. Similarly, Roychowdhury (2006) suggests that earning quality is critical for
financial statement users to assess a firm's financial health accurately.

Earning Management and Financial Distress as Independent Variables Earning management

involves deliberate actions by management to manipulate financial reports, often to achieve
specific financial outcomes (Healy & Wahlen, 1999; Jones, 1991). While earning management is
not inherently illegal, aggressive practices can compromise earning quality by distorting
financial results (Healy & Wahlen, 1999). Researchers argue that firms engaging in excessive
earning management may mislead stakeholders about their true financial condition, thereby
reducing earning quality (Jones, 1991).

17
Financial distress refers to a firm's inability to meet its financial obligations, indicating
underlying financial instability (Beaver, 1966; Altman, 1968). Firms experiencing financial
distress may face pressures to manage earnings to avoid negative perceptions or potential default
(Altman, 1968). This can lead to earnings manipulation tactics that artificially inflate earnings,
masking underlying financial weaknesses and compromising earning quality (Beaver, 1966).
Empirical studies by DeFond and Jiambalvo (1994) and Dechow et al. (1995) provide evidence
of a negative relationship between earning management and earning quality. They find that firms
engaging in aggressive earning management practices tend to exhibit lower earning quality, as
indicated by increased earnings volatility and lower persistence of earnings. Similarly, research
on financial distress by Altman (1968) and Ohlson (1980) suggests that firms under financial
distress may resort to earnings manipulation to mitigate negative perceptions and maintain
financial stability. This manipulation can distort earnings quality metrics, making it challenging
for stakeholders to assess the true financial health of the firm (Altman, 1968). Audit Committee
and ROE: Audit committees play a crucial role in corporate governance, overseeing financial
reporting processes and ensuring the integrity of financial statements (Bedard & Johnstone,
2004; Klein, 2002). Effective audit committees enhance earning quality by providing
independent oversight and reducing the likelihood of earnings manipulation (Bedard &
Johnstone, 2004). Research indicates that firms with strong audit committees tend to exhibit
higher earning quality, as these committees enhance transparency and accountability in financial
reporting practices (Klein, 2002). Return on equity (ROE) measures a firm's profitability relative
to shareholders' equity and is often used as an indicator of financial performance (Myers, 1999;
Palepu, 1986). While ROE itself does not directly influence earning quality, it reflects
management effectiveness and operational efficiency (Myers, 1999). Studies suggest that firms
with higher ROE may demonstrate better overall financial health, indirectly contributing to
higher earning quality through improved operational performance and financial stability (Palepu,
1986).

Research gap:

While existing studies have examined the impact of audit committee and board characteristics on
earnings quality, no research has investigated the simultaneous effects of audit committee
independence, frequency of audit meetings, board composition, and board independence on the

18
relationship between earnings quality and financial distress, with earnings management as a
moderator, while controlling for Return on Equity (ROE) in the context of emerging markets."

This research gap highlights the need to explore the interplay between audit committee and board
characteristics, earnings quality, financial distress, and earnings management in the specific
context of emerging markets, which has not been previously investigated.

2.2. Theoretical Framework and Hypotheses

Based on the literature reviewed, the following hypotheses can be formulated:

Hypothesis 1: Earning management is negatively associated with earning quality.

Hypothesis 2: Financial distress is negatively associated with earning quality.

Hypothesis 3: Audit committee effectiveness is positively associated with earning quality.

Hypothesis 4: ROE is positively associated with earning quality.

2.3. Synthesis and implication:

Synthesis:

The findings from this study provide important insights into the factors that influence earnings
quality. The results suggest that both earnings management and financial distress have a
significant impact on earnings quality, even after controlling for other relevant factors.

The analysis indicates that higher levels of earnings management are associated with lower
earnings quality. This is consistent with prior research showing that earnings management
practices, such as accounting manipulations or the use of discretionary accruals, can reduce the
reliability and in formativeness of reported earnings.

Additionally, the results reveal that firms experiencing financial distress tend to have lower
earnings quality compared to more financially stable firms. This finding underscores the idea that
financial difficulties can create incentives for opportunistic reporting behavior and the distortion
of true underlying performance.

19
In terms of the control variables, the study finds that certain corporate governance mechanisms,
such as audit committee independence and the frequency of audit committee meetings, are
positively associated with earnings quality. This suggests that stronger oversight and monitoring
by the audit committee can help enhance the reliability of financial reporting.

Implications:

The findings from this research have important implications for several stakeholders: Investors
and analysts: The results highlight the importance of considering both earnings management and
financial distress when assessing the quality and reliability of a firm's reported earnings.
Investors and analysts should be attuned to these factors when making investment decisions and
valuations. Regulators and policymakers: The study provides evidence that supports the need for
robust corporate governance regulations and guidelines, particularly with respect to audit
committee structure and oversight. Strengthening these mechanisms can help improve the
transparency and integrity of financial reporting. Company management: The findings suggest
that managers should be mindful of the impact of earnings management and financial distress on
earnings quality. Prudent financial management and the implementation of strong internal
controls can help maintain high-quality financial reporting, which is crucial for building investor
trust and confidence.

CHAPTER-03

3. Methodology:
The type of data is secondary data that is obtained by annual reports of companies while the data
source were annual reports of companies that is listed in Pakistan stock exchange (PSX), these
companies are the top 100 companies of Pakistan (KSE-100 index). The data is obtained from
the official data portal site of stock exchange that is dps.psx and companies official website.
Panel data is used in this study. In this paper, stata and excel mostly use.

Model:

Dependent Variable:

 Earnings Quality

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Independent Variables:

 Earnings Management
 Financial Distress

Control Variables:

 Audit Committee Independence

 Board Composition
 Frequency of Audit Committee Meetings
 Return on Equity (ROE)

The model can be represented as follows:

Earnings Quality = f (Earnings Management, Financial Distress, Audit Committee

Independence, Board Composition, Frequency of Audit Committee Meetings, Return on Equity)

EQLTY= f (EM, FD, ACI, BC, BI, FAM, ROE)

Where:

 Earnings Quality is the dependent variable.

 Earnings Management and Financial Distress are the independent variables.
 Audit Committee Independence, Board Composition, Frequency of Audit Committee
Meetings, and Return on Equity are the control variables.

This model examines the relationship between earnings quality (the dependent variable) and
earnings management, financial distress (the independent variables), while controlling for the
impact of audit committee independence, board composition, frequency of audit committee
meetings, and return on equity.

3.1 Dependent variable:

Earnings quality reflects the extent to which a company's reported earnings provide a faithful
representation of its underlying economic performance. High earnings quality indicates that the
company's financial statements, including the income statement and balance sheet, are reliable
and accurately depict the firm's true financial position. Low earnings quality suggests that the
21
reported earnings may be distorted or manipulated, reducing the usefulness of the financial
information for decision-making. Earnings quality is related to the persistence and predictability
of a company's earnings over time. High-quality earnings are more likely to be sustainable, as
they are closely tied to the firm's cash flows and operational performance. Consistent, high-
quality earnings provide investors and analysts with a better understanding of the company's
long-term earning potential, which is crucial for valuation and investment decisions(Zahid, n.d.).
Companies with high earnings quality are generally perceived as less risky investments, as their
financial reporting is more transparent and trustworthy. This lower perceived risk can translate
into a lower cost of capital for the company, as investors are willing to accept a lower rate of
return. Conversely, low earnings quality may increase a company's cost of capital, as investors
demand higher returns to compensate for the higher perceived risk. Earnings quality can be an
indicator of a company's operational efficiency and the effectiveness of its management team.
High earnings quality is often associated with strong internal controls, effective risk
management, and sound operational practices. Low earnings quality, on the other hand, may
suggest underlying operational challenges or a lack of effective management oversight.
Maintaining high earnings quality is essential for complying with accounting standards and
regulatory requirements, such as those set by the Securities and Exchange Commission of
Pakistan (SECP). Failure to uphold high earnings quality can lead to regulatory scrutiny, legal
consequences, and damage to the company's reputation among stakeholders, including investors,
lenders, and the general public. A strong reputation for high-quality financial reporting can be a
competitive advantage for a company, as it can enhance stakeholder trust and confidence.

Earning predictability= SQRT (Net income/ beg. of total assets)

3.2 Independent variable:

3.2.1. Earnings Management:

Earnings management refers to the deliberate intervention in the financial reporting process by
managers to achieve a desired earnings outcome, often for personal or organizational benefit. As
an independent variable, earnings management represents the extent to which a company's
managers engage in practices that manipulate or distort the reported earnings figures(Taha et al.,

22
2024). This could include techniques such as income smoothing, big bath accounting, or the
strategic timing of accruals and asset recognition.

TACC/ Beg. Of TA= B0 (1/Beg. of TA) + B1 (change in revenue/ beg. of TA) + B 2 (PPE/ beg.
of TA) + e

TACC= total accrual.

Beg. Of total assets= previous year assets.

Change in revenue= current year revenue- previous year revenue.

PPE= property plant and equipment.

3.2.2. Financial Distress:

Financial distress is a condition in which a company experiences difficulty meeting its financial
obligations or maintaining its operational viability. Financial distress captures the degree of
financial strain or pressure that a company is experiencing, which can be measured using various
financial ratios or indicators(El Deeb & Ramadan, 2020). This could include factors such as high
debt-to-equity ratios, low profitability, or cash flow challenges. In research model, these two
variables (Earnings Management and Financial Distress) are hypothesized to have an influence
or impact on the dependent variable, which is Earnings Quality. Earnings management practices
can undermine the reliability and credibility of a company's reported earnings, thereby reducing
the overall quality of its financial reporting. By examining the relationship between earnings
management and earnings quality, you can gain insights into the extent to which managerial
discretion and manipulation can impact the quality of a company's financial information.
Companies experiencing financial distress may be more inclined to engage in earnings
management or other practices that compromise the quality of their reported earnings(Feni et al.,
2022). Financial distress can create incentives for managers to "manage" earnings in an attempt
to mask the company's true financial condition or meet certain performance targets. Investigating
the relationship between financial distress and earnings quality can help elucidate how a
company's financial health influences the reliability and transparency of its financial reporting.

Z-score = 1.2X1+ 1.4X2+ 3.3X3+ .6X4+ 1.00X5

Where:

23
X1= Working capital/ total assets

X2= retained earnings/ total assets

X3= EBIT/ total assets

X4= market value of equity/ total liabilities

X5= Sales/ total assets

3.3. Control variable:

Audit Committee Independence:

The audit committee is a critical governance body within a company, responsible for overseeing
the financial reporting process, internal controls, and the work of the external auditors. Audit
committee independence refers to the degree to which the members of the committee are free
from undue influence by management or other insiders. Independent audit committees, with a
majority of outside, non-executive directors, are better able to provide objective and impartial
oversight, as they are less likely to be beholden to the company's management. A highly
independent audit committee is associated with higher-quality financial reporting, as independent
members are more likely to challenge management's accounting practices, scrutinize financial
disclosures, and ensure compliance with relevant regulations and standards. This independence
enhances the committee's ability to identify and address potential issues related to earnings
management, financial misstatements, or other irregularities that could compromise the quality
of the company's reported earnings.

Board Composition:

The composition of the company's board of directors is another important control variable, as the
board is responsible for setting the overall strategic direction and oversight of the company's
operations, including financial reporting and risk management. A board with a higher proportion
of independent, non-executive directors is generally considered more effective in monitoring
management and ensuring the integrity of the company's financial information. Independent
directors are less likely to be influenced by the company's management and are better positioned
to provide objective and impartial oversight. A well-balanced board, with a mix of executive,

24
non-executive, and independent directors, can enhance the board's ability to challenge
management, exercise effective control, and ensure the quality and reliability of the company's
financial reporting.

Frequency of Audit Committee Meetings:

The frequency of audit committee meetings is a measure of the committee's engagement and
diligence in overseeing the company's financial reporting processes. More frequent audit
committee meetings, particularly when combined with a high degree of independence, can
indicate a stronger commitment to financial oversight and a greater ability to identify and address
potential issues related to earnings quality, internal controls, and compliance. Regular and well-
documented audit committee meetings, with detailed discussions of accounting policies,
financial disclosures, and risk management, can contribute to higher-quality financial reporting
and a stronger control environment within the company.

Return on Equity (ROE):

ROE is a measure of a company's profitability and efficiency in generating returns for its
shareholders. It is calculated as net income divided by shareholders' equity. ROE can provide
insights into the overall financial health and performance of the company, which may be related
to the quality of its earnings and financial reporting. Companies with consistently high ROE are
typically better managed, have more robust financial systems and controls, and may be less
likely to engage in earnings management or other practices that compromise the quality of their
reported earnings. Conversely, companies with low or declining ROE may face greater financial
pressures and incentives to engage in earnings management or other accounting manipulations to
mask their underlying performance challenges.

Measurements and proxy:

Variables Measurement/ proxy

Earning predictability Square root of net income divided by
beginning of total assets.

25
 Financial distress Altman z-score = 1.2X1 + 1.4X2 + 3.3X3
+ .6X4 + 1.00X5.

Earning management Jones model 1991

Audit committee independence No. of independent director/ total audit

committee member
Frequency of audit meeting Natural log of audit meeting

Board composition No. of non-executive director/ total director

Return on equity(ROE) Net income/ total equity

Population and sample:

Population: KSE-100 Index The population for research is the KSE-100 Index, which is a
benchmark index of the Pakistan Stock Exchange (PSX). The KSE-100 Index is composed of the
100 largest and most liquid companies listed on the PSX, representing a significant portion of the
overall market capitalization. The KSE-100 Index is widely considered to be the most
comprehensive and representative index of the Pakistani equity market, as it encompasses a
diverse range of sectors and industries. The index is designed to provide a broad and accurate
representation of the performance of the Pakistani stock market, making it a suitable population
for research.

Sample: 43 Manufacturing Companies from the PSX-100 Index population, you have selected a
sample of 43 manufacturing companies to include in research. The manufacturing sector is a
crucial component of the Pakistani economy, and understanding the factors that influence the
earnings quality of these companies can provide valuable insights. The sample size of 45
companies represents a significant portion of the overall PSX-100 Index population, which
typically consists of around 100 companies. This sample size is considered adequate for the
purposes of your research, as it provides a sufficiently large and representative subset of the
population to enable meaningful analysis and draw reliable conclusions. By focusing on the

26
manufacturing sector, your research is likely to provide insights into the specific challenges and
factors that impact the earnings quality of these companies, which may differ from other
industries. This targeted approach allows you to delve deeper into the nuances of the
manufacturing sector and potentially identify industry-specific trends or patterns.

The type of data is secondary data that is obtained by annual reports of companies while the data
source were annual reports of companies that is listed in Pakistan stock exchange (PSX). These
companies are top 100 companies of Pakistan (PSX-100 index). The data is obtained from the
official data portal site of stock exchange that is Dps.psx and other data source in company’s
official website.

Variable capacity description duration Expected

impact
EQTLY Dependent Square root of 2016-2023
variable earning
persistence
FM Independent TA is a proxy of 2016-2023 (-)
variable EM(DACC)
EM Independent Altman z-score 2016-2023 (-)
variable
ACI Control variable No. of 2016-2023 (+)
independent
director in AC
divided by total
no. audit director
BI Control variable Independent 2016-2023 (+)
director divided
by total director
in a board
FAM Control variable Natural log of 2016-2023 (+)

27
 audit meeting
BCO Control variable Independent and 2016-2023 (+)
non- executive
director in a
board

Variable: This column lists the names of the variables included in our study.

Capacity: Indicates the role or nature of each variable in our analysis:

Dependent variable: EQTLY.

Independent variables: FM, EM

Control variables: ACI, BI, FAM, and BCO

EQTLY (Dependent variable): Square root of earning persistence. This suggests EQTLY
represents a measure related to the square root of how earnings persist over time. FM
(Independent variable): TA is a proxy of EM (DACC). FM serves as an independent variable,
likely using TA (possibly Total Assets) as a proxy for EM (possibly Earnings Management)
using some specific methodology or metric (DACC). EM (Independent variable): Altman z-
score. EM is another independent variable, representing the Altman z-score, which is commonly
used to predict financial distress or bankruptcy risk. ACI (Control variable): No. of independent
directors in AC divided by total no. audit directors. ACI is a control variable measuring the
proportion of independent directors in the audit committee relative to total audit directors. BI
(Control variable): Independent directors divided by total directors in a board. BI is a control
variable measuring the proportion of independent directors to total directors on a board. FAM
(Control variable): Natural log of audit meeting. FAM is a control variable representing the
natural logarithm of the number of audit meetings, which could indicate the frequency or depth
of audit committee activities. BCO (Control variable): Independent and non-executive directors
in a board. BCO is a control variable measuring the presence of independent and non-executive
directors on a board, which may influence governance and oversight. Duration: Specifies the
timeframe or period during which data for each variable is considered:

28
2016-2023: This indicates that data or observations for each variable span from the year 2016 to
2023.

Expected Impact: Provides an indication of the anticipated direction of impact of each variable
on the outcomes of interest:

(+): Indicates a positive expected impact. An increase in the variable is expected to lead to
positive changes or outcomes in the dependent variable or other variables of interest.

(-): Indicates a negative expected impact. An increase in the variable is expected to lead to
negative changes or outcomes in the dependent variable or other variables of inter

CHAPTER -04

4. Results and discussion:

4.1. Descriptive analysis:

Standard
Variable Mean Deviation Minimum Maximum

EQTLY 0.302304525 0.15865352 -0.1796 1.051935984

ACI 0.414113095 0.206191317 0 1

FD 3.758176304 4.014274529 1.11019532 26.85903046

BI 0.75139966 0.174635074 0 1

FAM 1.460358464 0.049445107 0 2.302585093

ROE 0.193310869 0.185040043 0.35381954 1.049444866

EM 0.005129389 0.134556554 0.44639346 1.101374984

29
EQTLY: Mean is 0.302, with a relatively small SD (0.159), indicating less variability. The
values range from -0.179 to 1.052. ACI: Mean is 0.414, with a moderate SD (0.206), indicating
some variability. The values range from 0 to 1. FD: Mean is 3.758, with a large SD (4.014),
indicating significant variability. The values range from 1.11 to 26.86. BI: Mean is 0.751, with a
moderate SD (0.175), indicating some variability. The values range from 0 to 1. FAM: Mean is
1.460, with a small SD (0.049), indicating relatively little variability. The values range from 0 to
2.303. ROE: Mean is 0.193, with a moderate SD (0.185), indicating some variability. The values
range from 0.354 to 1.049. EM: Mean is 0.005, with a moderate SD (0.135), indicating some
variability. The values range from 0.446 to 1.101.

4.2. Correlation between all variable:

Correlation coefficients (r) between the dependent variable Earning Quality (EQTLY) and the
independent variables Financial Distress (FD), Earnings Management (EM), and the control
variables Audit Committee Independence (ACI), Board Independence (BI), Frequency of Audit
Meetings (FAM), Board Composition (BCO), and Return on Equity (ROE). The correlation
between EQTLY and FD is -0.5470, indicating a moderate negative relationship between earning

30
quality and financial distress. This suggests that as financial distress increases, earning quality
tends to decrease. The correlation between EQTLY and EM is -0.9055, indicating a strong
negative relationship between earning quality and earnings management. This suggests that as
earnings management increases, earning quality tends to decrease significantly. The correlations
between EQTLY and the control variables are relatively weak, indicating minimal relationships
between earning quality and these variables. The correlation between FD and EM is 0.3952,
indicating a moderate positive relationship between financial distress and earnings management.
This suggests that companies experiencing financial distress may be more likely to engage in
earnings management. The correlations between the control variables themselves are mostly
weak, except for a moderate positive correlation between ACI and BCO (0.5583), indicating that
companies with more independent audit committees tend to have more independent boards.
Overall, this table suggests that earning quality is negatively related to financial distress and
earnings management, and that these relationships are more pronounced than the relationships
between earning quality and the control variables. The table also highlights the interrelationships
between the independent variables and control variables, which can be useful in understanding
the underlying dynamics of the data.

4.3. Regression of variables:

Dependent Variable and Independent Variables:

Dependent Variable: EQTLY (presumably Equity to Total Liabilities ratio or a similar financial
metric). Independent Variables: FD, EM, ACI, BI, BCO, ROE. FD: This variable has a

31
coefficient of −0.4588 (−0.4588 with a very low p-value (0.000), indicating that a one-unit
increase in FD is associated with a 0.4588) 0.4588 decrease in EQTLY, holding other variables
constant. EM: The coefficient is -0.2593 (−0.2593 with a significant p-value (0.000), suggesting
that EM negatively influences EQTLY as well.) ACI: It has a coefficient of 0.0517 with a p-
value of 0.004, indicating a positive but weak impact on EQTLY. BI: The coefficient is 0.0453
with a significant p-value (0.000), showing a positive effect on EQTLY. BCO: The coefficient is
0.01982 with a p-value of 0.125, suggesting a positive effect, but the statistical significance is
marginal (p > 0.05). ROE: It has a coefficient of 0.2326 with a very low p-value (0.000),
indicating a strong positive impact on EQTLY.

Model Characteristics:

Observations: 326, Firms: 43, Years: 8, R-Square: 0.8864. The high R-squared value (88.64%)
suggests that the independent variables collectively explain a substantial portion of the variation
in EQTLY. Hausman Test: 0.763. The Hausman test compares the efficiency of fixed effects
versus random effects models. A p-value of 0.763 indicates that the null hypothesis (random
effects model is preferred) cannot be rejected at the conventional significance level (p > 0.05).

Significance of Findings:

FD, EM, BI, BCO, and ROE are statistically significant factors influencing EQTLY based on
their low p-values (0.000). These variables have been found to have significant impacts on the
equity to total liabilities ratio of the firms studied. ACI and FAM, while included in the model,
show weaker statistical significance (p-values of 0.004 and 0.125 respectively). ACI has a
positive impact on EQTLY, whereas FAM's impact is less clear due to its higher p-value

.4.4. Multicollinearity:

32
To detect the issue of multicollinearity variance inflation factor (VIF) is used. If the value of VIF
is greater than 10 it is an indication of multicollinearity that may results in biased estimation
(Gujrati, 2003). This table shows the results of VIF values that revealed that there is no issue of
multicollinearity. ROE: VIF = 2.92, 1/VIF = 0.3419 ROE has a moderate VIF, suggesting
moderate multicollinearity with other variables in the model. However, its 1/VIF value indicates
that approximately 34% of its variance is not explained by the other predictors. EM: VIF = 2.08,
1/VIF = 0.4811 Earning Management also shows moderate VIF, indicating moderate
multicollinearity. About 48% of its variance is independent of other predictors. FD: VIF = 1.67,
1/VIF = 0.5973 Financial Distress has a relatively low VIF, indicating low multicollinearity with
the other variables. Approximately 60% of its variance is independent. BCO and ACI: VIF =
1.58, 1/VIF = 0.6330 to 0.6338 Board Composition and Audit Committee Independence have
similar VIF values, suggesting low multicollinearity with other predictors. Around 63% of their
variance is independent. FAM: VIF = 1.10, 1/VIF = 0.9117 Frequency of Audit Meetings has a
very low VIF, indicating minimal multicollinearity with other variables. About 91% of its
variance is independent. BI: VIF = 1.07, 1/VIF = 0.9338 Board Independence also shows very
low VIF, suggesting minimal multicollinearity. Around 93% of its variance is independent. The
mean VIF across all variables is 1.71, which is relatively low. This indicates that
multicollinearity is not a significant concern in your model, as all VIF values are well below the
threshold of 5.

4.5. Heteroscedasticity & Hausman test:

The variance of residuals should be homogeneous is one of the important assumption of
regression for adequate fitness of model. Assumption of heteroskedasticity is checked by using
Breusch-Pagan/Cook-Weisberg test. The results in Table 10 showed the issue of

33
heteroskedasticity in the data. In the presence of heteroskedasticity the standard errors are biased
which affects t-test and significance of model. So, the robust approach is applied for the remedy
of heteroskedasticity an unbiased estimation of the regression model. The null hypothesis (Ho) in
this case is that the residuals have constant variance (there is no heteroskedasticity). The chi-
squared test statistic (chi2 (3)) compares the observed data with the expected data under the null
hypothesis. The p-value (0.5411) is higher than the typical significance level of 0.05 (or 5%).

The p-value (0.0697) is greater than 0.05, we fail to reject the null hypothesis that the difference
in coefficients is not systematic. This suggests that the random effects model is more appropriate.
However, if the p-value were less than 0.05, we would reject the null hypothesis, indicating that
the fixed effects model is more appropriate. In this case, the random effects model is preferred,
suggesting that the individual specific effects are uncorrelated with the independent variables,
and the random intercept term is sufficient to control for unobserved heterogeneity.

4.6. GSL estimation:

34
FD (Financial Distress): The coefficient (-0.0058828) indicates a negative relationship between
earning predictability and financial distress. For every unit increase in financial distress, earning
predictability decreases by 0.0058828 units. The z-value (-6.34) and p-value (0.000) indicate a
highly significant relationship. EM (Earning Management): The coefficient (-0.059349) indicates
a negative relationship between earning predictability and earning management. For every unit
increase in earning management, earning predictability decreases by 0.059349 units. The z-value
(-25.83) and p-value (0.000) indicate a highly significant relationship. Financial Distress (FD): A
one-unit increase in financial distress leads to a 0.0058828 unit decrease in earning
predictability, significant at the 1% level. Earning Management (EM): A one-unit increase in
earning management leads to a 0.059349 unit decrease in earning predictability, significant at the
1% level. Audit Committee Independence (ACI): A one-unit increase in audit committee
independence leads to a 0.0051743 unit increase in earning predictability, significant at the 5%
level. Board Independence (BI): A one-unit increase in board independence leads to a 0.0045358
unit increase in earning predictability, significant at the 5% level. Frequency of Audit Meetings
(FAM): No significant relationship with earning predictability. Board Composition (BCO):
Significant relationship with earning predictability. Return on Equity (ROE): A one-unit increase
in ROE leads to a 0.184868 unit increase in earning predictability, significant at the 1% level.

CHAPTER -05

5. Conclusion and future direction:

5.1. Conclusion:
This study investigated the relationship between earning quality and financial distress, earnings
management, and corporate governance attributes among manufacturing companies listed on the
KSE-100 index. The results show that financial distress and earnings management have a
significant negative impact on earning quality, indicating that companies experiencing financial
difficulties or engaging in earnings manipulation tend to have lower earning quality. The study
also found that audit committee independence, frequency of audit meetings, board composition,
and board independence have a positive impact on earning quality, suggesting that effective

35
corporate governance mechanisms can improve earning quality. Additionally, return on equity
(ROE) was found to be positively related to earning quality, indicating that companies with
higher profitability tend to have better earning quality. The findings of this study have important
implications for investors, regulators, and companies listed on the KSE-100 index. They
highlight the need for companies to maintain high earning quality, avoid financial distress and
earnings management, and establish effective corporate governance mechanisms to ensure
transparency and accountability. The results also suggest that investors should consider earning
quality as a key metric when making investment decisions, and that regulators should strengthen
regulations and oversight to prevent earnings management and promote transparency.

5.2. Limitation and future direction:

The study's limitations include the shortage of time and its focus on manufacturing companies
listed on the KSE-100 index, and the relatively small sample size of 43 companies. Future
research should aim to expand the sample size and explore the generalizability of the findings to
other industries and markets.

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