Firms’ Financial Performance and Earnings Management: the Case of Egypt

The present study examines the relation between firms’ financial performance and earnings management in an emerging market; namely, Egypt.We examine the association between firms’ financial performance and earnings management from three perspectives. 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 performance. Third, we test whether firms with ineffective financial performance manipulate their earnings to report greater earnings.
Earnings management is captured by discretionary accruals. Cash flows from operations 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 subsamples: firstly, those characterized by low cash flows (demonstrating ineffective financial performance, i.e. underperforming or low performing firms); and secondly, those characterized by high cash flows (demonstrating effective financial performance, i.e. high performing firms).
We use the ordinary least square regression model of the relation between discretionary accruals and a firm’s financial performance to examine whether a firm’s financial 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 accruals and a firm’s financial performance) with a dummy variable approach that allows parameter shifts for underperforming firms. Finally, to test for income increasing accruals 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 earnings management practices than their high performing counterparts. Third, underperforming 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 engaging 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 protection and legal enforcement in Egypt, these results encourage policymakers to improve considerably corporategovernance mechanisms in Egypt. This study contributes to the limited research on earnings management in emerging markets, and specifically, Egypt.