This study investigates whether financially distressed firms exploit the pension actuarial assumptions of the Statement of Financial Accounting Standards No. 87 (Employers’Accounting for Pension) as a tool for earnings management. For a sample of 587 firm-year observations over the period of 1988-2002, the solution for detecting earnings management is
the use of a system of four simultaneous equations. By using three-stage-least-square (3SLS),this study demonstrates that taking account of simultaneity is important for three of the seven modelled incentives, namely, the discount rate, expected rate of return on plan assets, and
salary progression rate. All three behave as if they are used to manipulate pension costs, and discretion in each of these incentives depends on the levels of the other two. In contrast, the remaining four incentives are used as control variables in this study, namely: debt covenant,bonus plan, cash flow, and funding status incentives, which appear to be determined independently of the other incentives. The parameter estimates indicate that the discount rate and the expected rate of return on plan assets are used to manage earnings, and salary
progression rate is used, perhaps secondarily, to offset the total pension costs. Therefore,managers of financially distressed firms may have smoothed reported earnings by jointly changing the pension rates to change the corresponding pension costs and cash requirements.