Damage Control: Earnings Management by Firms Facing Product Harm Crises

Product harm crises have the potential to undermine a firm’s reputation as well as its managers’ career perspectives. An ethical dilemma arises during a PHC as to whether managers choose to be transparent about the crisis’ economic implications or camouflage them to neutralize in an unethical manner the crisis’ negative impact. Our evidence suggests that managers choose to increase income via earnings management when their firms experience a crisis. Such unethical action reduces the potential for customer losses and for a firing of the CEO. However, in the longer-run, it carries negative consequences in the form of a greater probability of a financial statement restatement. Moreover, there is less unethical earnings management by crisis firms that are subject to stricter external monitoring as well as by firms with proactive ethical policies.

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