Firms' financial performance and earnings management : the case of Egypt

Abstract EN

The present study examines the relation between firms‟ financial performance and earnings management in an emerging market; namely, Egypt.We examine the associa-tion between firms‟ financial performance and earnings management from three per-spectives.

First, we investigate whether a firm‟s financial performance affects earnings management.

Second,we examine whether firms with ineffective financial performance engage in earnings management practices more than firms with effective financial per-formance.

Third, we test whether firms with ineffective financial performance manipu-late their earnings to report greater earnings.

Earnings management is captured by discretionary accruals.

Cash flows from opera-tions are used to indicate the level of a firm‟s financial performance, thus allowing the categorisation of the sample group of Egyptian firms into two sub-samples: firstly, those characterized by low cash flows (demonstrating ineffective financial performa-nce, i.e.

underperforming or low performing firms); and secondly, those characterized by high cash flows (demonstrating effective financial performance, i.e.

high perform-ing firms).

We use the ordinary least square regression model of the relation between discre-tionary accruals and a firm‟s financial performance to examine whether a firm‟s finan-cial performance affects earnings management.To assess whether firms with ineffective financial performance are more prone to manage earnings than their higher performing counterparts,we employ a contextual model (of the relation between discretionary ac-cruals and a firm‟s financial performance) with a dummy variable approach that allows parameter shifts for underperforming firms.

Finally, to test for income increasing ac-cruals by underperforming firms, we test whether discretionary accruals are positive and significantly greater for underperforming firms than those for high performing firms.

The results show that, first, earnings management is negatively associated with a firm‟s financial performance.

Second, underperforming firms are engaged in more ea-rnings management practices than their high performing counterparts.

Third, underper-forming firms have positive and considerably greater discretionary accruals than their effectively performing counterparts to elevate their reported earnings in order to hide their low financial performance.

Overall, these results suggest that an Egyptian firm‟s financial performance may serve as a fundamental determinant of its likelihood of en-gaging in earnings management.

Moreover, these results suggest that listed Egyptian firms utilize earnings management practices opportunistically as a way to conceal their ineffective/poor financial performance.

Given the current weakness of investor protec-tion and legal enforcement in Egypt, these results encourage policymakers to improve considerably corporate-governance mechanisms in Egypt.

This study contributes to the limited research on earnings management in emerging markets, and specifically, Egypt.