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Assessing the perceptionsof the quality of reported

earnings in EgyptHany Kamel

Business Administration College,Al Ain University of Science and Technology,

Al Ain, United Arab Emirates, and

Said ElbannaCollege of Business and Economics,

United Arab Emirates University, Al Ain, United Arab Emirates

Abstract

Purpose – The purpose of this paper is to assess respondents’ perceptions of the quality of reportedearnings in Egypt. To this end, three main issues are investigated: first, the potential incentivesfor engagement in earnings manipulation; second, the techniques most frequently used inmanipulating earnings; and finally, the actions required to improve the quality of accountinginformation, including the reported earnings.

Design/methodology/approach – A total of 16 semi-structured interviews are conducted in orderto uncover any undisclosed issues and to supplement the results provided by a questionnaire surveydistributed among three groups of respondents, namely, accounting academics, external auditors, andfinancial managers.

Findings – The results indicate that the main incentives for manipulating earnings in Egypt are toenhance the chances of obtaining a bank loan; to sustain last year’s profit performance; to reportprofits and to avoid reporting losses; and to achieve high-share valuation. The results alsodemonstrate that making inadequate provisions; capitalising rather than expensing expenditures; andoverestimating the inventory value are the most frequently used techniques in earnings manipulation.

Practical implications – The results could be of assistance to Egyptian external auditors andregulators in their attempt to limit the incidence of earnings manipulation.

Originality/value – With a few exceptions, most of the literature on earnings management has beenbased on the US data. Therefore, research undertaken in a country such as Egypt, where the environmentin many respects is different, may reveal a different perception of thequality of reported earnings and helpdetermine how preparers in Egypt can further improve the quality of reported earnings.

Keywords Earnings, Financial reporting, Corporate governance, Egypt

Paper type Research paper

1. IntroductionIt is well known that the central role of reported earnings is to assist external users of financial reports in evaluating firms’ economic performance through the use of basicaccounting principles (Financial Accounting Standards Board (FASB), 1978).Nevertheless, because earnings are subject to managerial discretion and potentiallyto manipulation, their contribution to reflecting firms’ underlying economics isquestionable. The Securities and Exchange Commission (SEC) has concluded, after therecent string of accounting scandals that has rocked the US stock markets, that there is

The current issue and full text archive of this journal is available at

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Received 7 January 2008Revised 29 March 2009Accepted 1 July 2009

Managerial Auditing Journal

Vol. 25 No. 1, 2010

pp. 32-52

q Emerald Group Publishing Limited

0268-6902

DOI 10.1108/02686901011007298



a systematic reporting problem in the USA. Many publicly held companies are abusingthe financial reporting process by excessively managing their earnings. Describing thissituation, former SEC chairman, Levitt (1998), declared that “earnings management ison the rise and the quality of financial reporting is on the decline”. In addition, Feltham

and Pae (2000) show that “noisy” earnings management, which garbles, rather thanimproving the informativeness of earnings, results in poorer quality and valuerelevance of earnings reporting. This finding has recently been supported byMarquardt and Wiedman (2004b), who demonstrate that opportunistic earningsmanagement impairs the value relevance of earnings for a sample of firms issuingsecondary shares.

In a comprehensive review of “market-based accounting research” on theinformation content of reported earnings, Lev (1989) concludes that the explanatoryvalue of earnings for share returns and subsequently the usefulness of earningsdisclosures, tends to be very low and sometimes negligible. Lev (1989) attributes thesedisappointing results to the poor quality of reported earnings, because of biasintroduced by accounting measurement practices or creative abuses of the earningsmeasurement process. Therefore, Lev (1989) recommends that research on the motivesand consequences of financial reporting manipulation should be an integral part of thequality of the reported earnings research agenda. Consistent with this view, asubstantial number of earnings management studies have emerged. Most of thesestudies have been conducted in the USA. However, since the propensity to manageearnings may vary internationally, continuous research efforts are still needed in othercountries to explore the opportunities for management to manage, or presumablymanipulate, the level or trend of reported earnings according to its interests.

In the context of Egypt, the government embarked in 1991 on an Economic Reformand Structural Adjustment Programme designed with the assistance of theinternational monetary fund and the World Bank. The main objective of this

programme was to introduce market-oriented economic policies and to create a neweconomic environment in which the private sector takes the lead. The most importantand challenging component for achieving this objective was the privatisation of publicsector enterprises. In doing so, the legal and organisational framework was establishedin 1991 with the Public Business Sector Law No. 203, which paved the way for thetransformation of 314 public sector enterprises into 17 holding companies (laterreduced to ten) in order to facilitate the subsequent transfer of ownership to privateinvestors (Kamel, 2009). Hence, this business environment is expected to create a set of incentives for earnings manipulation by the managers of state-owned enterprises inorder to achieve the performance levels expected by their superiors in the holdingcompanies. Also, it should be noted that since 1997 the Egyptian privatisationprogramme has provided the opportunity for private companies to issue capital in the

stock market. These companies are likely to have a different set of incentives whenthey declare their own figures of reported earnings. Therefore, without further detailedresearch involving direct questions about the earnings management strategies of individual managers, it is impossible to determine the dominant incentives formanipulating earnings in Egypt.

As mentioned earlier, a review of the research on earnings management revealsthat most of the literature, with a few exceptions, has been based on US data. Thereis very little published research on earnings management in developing countries.

The qualityof reported

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Therefore, research undertaken in a country such as Egypt, where the socio-economicenvironment in many respects is different (e.g. the shareholding structures of manyEgyptian companies were concentrated in the hands of the state before going public;there are relatively few sophisticated users of financial reports; and internal corporate

governance tends to be weakly structured), may reveal a different perception of thequality of reported earnings and help determine whether this setting leads to a higheror lower propensity for earnings management. Accordingly, this paper aims todiscover why and how earnings management is practised in Egypt, and if so, how thecountry could tackle this problem. To serve this purpose, the decision was made in thisstudy to examine the perceptions of three different groups of respondents, namely,accounting academics, external auditors and financial managers or senior accountants,regarding the current quality of reported earnings disclosed by Egyptian companies[1].

The remainder of this paper is organised as follows. Section 2 presents a criticalreview of the relevant literature on the subject. Section 3 describes the methodologyemployed in the present paper. Section 4 reports and discusses the empirical results of our study and finally Section 5 draws some conclusions.

2. Literature reviewSince SEC Chairman Arthur Levitt’s “Numbers Game” speech before the New YorkUniversity’s Centre for Law and Business in September 1998, earnings management hasreceived considerable attention from accounting regulators and the investmentcommunity, who are concerned about the negative effects that earnings managementcan have on earnings quality and financial reporting. Meanwhile, attempts have beenmade in the academic literature to examine the many different incentives for engaging inearnings manipulation.

Stolowy and Breton (2004) have recently developed a three-fold classification of managerial incentives which have the aim of manipulating earnings. The first category

covers those incentives that attempt to minimise the cost of capital required by firms.Prior investigations on this category typically include the incentives of managers tomanipulate earnings towards reporting positive profits, sustaining last year’sperformance and meeting management’s expectations. Burgstahler and Dichev (1997),for example, find that earnings management to avoid annual losses and earningsdecreases is common. Also, Degeorge et al. (1999) find that it is crucial for managers toavoid losses, but once profitability is achieved, every effort will be made to reportincreases in earnings, and once increases are achieved, the managers’ goal will beturned to meeting analysts’ earnings forecasts. Furthermore, Dutta and Gigler (2002)indicate that earnings management is more likely to follow high-earnings forecaststhan low-earnings forecasts; and it is easier to prevent managers from manipulatingearnings if they are asked to forecast earnings.

Managers may also have the incentives to manipulate earnings around the time of new share offers in order to influence the offering proceeds. It has been documentedthat firms opportunistically manipulate earnings upwards before they go public, in anattempt to persuade potential investors to form overly optimistic expectationsregarding future post-issue earnings. Consequently, offering firms are able tomaximise their offering prices in the short-run; however, subsequent earnings andshare return performance tend to suffer as a result of such manipulation (Teoh et al.,1998a, b; DuCharme et al., 2001; Roosenboom et al., 2003). In the same vein, there is

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another group of studies asserting that managers may attempt to deceive investors andeven financial analysts, in order to preserve high-share valuation. According to thisclaim, investors are expected to be unable to detect the direction and magnitude of themanaged portion of reported earnings. Hence, investors may tend to over-value firms

practising income-increasing earnings management and under-value firms practisingincome-decreasing earnings management (Sloan, 1996; Chambers, 1999).

Debt contracts are also expected to create an incentive for some corporate managersto manage earnings in order to avoid the violation of these contracts (DeFond andJiambalvo, 1994; Kasanen et al., 1996). The main intention for this type of contract is tolimit management’s ability from benefiting firm’s investors over its creditors. Yet, afterreviewing the empirical research on accounting choices, Fields et al. (2001, p. 275)conclude that “the evidence on whether accounting choices are motivated by debtcovenant concerns is inconclusive”.

The second category of incentives, as reported by Stolowy and Breton (2004),includes all the incentives that are created by compensation agreements. Of course, onegood reason for managers to engage in earnings manipulation would be theirremuneration package. Watts and Zimmerman (1986) argue that managers in firms withearnings-based compensation agreements have an incentive to report accounting resultswhich maximise the value of their bonus awards. Healy (1985) indicates that there is astrong association between accruals and managers’ income-reporting incentives undertheir bonus plan. Nonetheless, Healy’s bonus hypotheses have been recently reexaminedby Holthausen et al. (1995) and Gaver et al. (1995), and their findings are, in part,inconsistent with Healy’s conclusion. In their attempt to investigate whether implicitcompensation contracts have any association with earnings management incentives,DeFond andPark (1997) report evidencethat managers may smooth earnings to enhancetheir reputation or mitigate the threat of displacement.

The third and final category of incentives includes those which are concerned with

the potential impact of political and regulatory requirements on changing accountingmethods, or estimates, or accruals. Key (1997), for example, reports that Cable TV firmsare found to have greater income-decreasing accruals during the period of Congressional scrutiny given the expected relationship between accruals and otherfirms’ financial characteristics. In addition, Han and Wang (1998) provide evidence thatoil companies used income-decreasing accounting policies during the Gulf War toavoid the political consequences of a higher profit coming from increased retail prices.

In general, the wealth of evidence on the most common techniques used tomanipulate earnings in the USA indicates that earnings management is largelydominated by managing recurring rather than non-recurring income statement itemsand is most likely to occur when sales revenue is overstated (Feroz et al., 1991; Dechowet al., 1996; Marquardt and Wiedman, 2004a). Moreover, a study conducted by

PricewaterhouseCoopers (PwC, 2000) reveals that, since the enactment of the PrivateSecurities Litigation Reform Act in the USA, the most commonly alleged method of carrying out accounting fraud has been the manipulation of revenue recognition. Inresponse to this problem, a number of international bodies of corporate governancehave suggested that the presence of strong governance will reduce the likely potentialfor earnings management and related practices which are not in the best interests of investors. The POB of the SEC Practice Section (1993), for example, argues that auditcommittees entirely composed of outside directors would enhance the effectiveness of


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an audit committee to monitor the opportunistic behaviour of managers. In support, agrowing body of empirical research has emerged to examine whether the existence of an audit committee is effective in reducing the incidence of earnings management(Klein, 2002; Xie et al., 2003; Choi et al., 2004; Peasnell et al., 2005; Davidson et al., 2005;

Ebrahim, 2007). This new area of studies relies mainly on accruals-based measures toestimate the degree of manipulation and, in general, its findings demonstrate that thereis a significant negative relationship between the existence of an effective auditcommittee and the likelihood of its company being cited as an earnings manipulator.

The internal audit function is also expected to assist audit committees in carryingout their expanded responsibilities (KPMG Audit Committee Institute, 2003). In thisrespect, a few recent studies highlight the unique importance of the internal auditfunction in achieving audit committee effectiveness, including the association betweeninternal audit support and a lower incidence of financial statement fraud. Beasley et al.(2000), for example, report that companies in three industries (technology, healthcareand financial services) which experienced fraud were less likely to have an internalaudit function. In addition, Cohen et al. (2002) find that 90 per cent of their respondentsindicated that the internal audit function could improve corporate governance butexpressed concerns over the strength of many internal audit departments.

Additionally, the role of independent directors in the protection of shareholders haslong been debated in the literature (Fama, 1980; Fama and Jensen, 1983).The accumulated evidence in this regard is rather mixed. While some authorsdemonstrate that earnings management is negatively associated with the percentage of outside directors on the board (Klein, 2002; Davidson et al., 2005; Ebrahim, 2007), othershave found no association between earnings management and board independence(Chtourou et al., 2001; Abdul Rahman and Ali, 2006). The competence of non-executiveboard members is also expected to have special importance for the monitoringeffectiveness of the board of directors. This expectation has been greatly supported by

the results of Chtourou et al. (2001), Xie et al. (2003) and Park and Shin (2004), whoprovide empirical evidence that boardroom members with a corporate or financialbackground are associated with firms which have lower levels of earnings management.

3. Research methodology3.1 Questionnaire surveyJudgment sampling should be used when a limited category of people has the requiredinformation (Sekaran, 1992); and also when the purpose of the study is to gain deeperunderstanding rather than to be generalised to a larger population (Neuman, 2000).Hence, it was decided that judgement sampling should be used in this case and thequestionnaire was accordingly distributed among accounting academics, external

auditors and financial managers or senior accountants. The principal rationale forselecting these groups is based on two factors. First, we assumed that these groupswould have sufficient knowledge and expertise from their daily work regarding theissues of accounting manipulation and earnings management. Second, it was expectedthat these groups would have considerable influence over the accountability of management and the integrity of financial reporting. Thus, identifying the perceptionsof these three key constituents was likely to enhance our understanding of the differentaspects of the problem of earnings management in Egypt.

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The self-administered questionnaire was presented to the respondents, the purposeof the enquiries was explained and then the respondents were left to complete thequestionnaire. A snowball sampling strategy was only used with the first and secondgroups of respondents;, i.e. the initial respondents were requested to distribute the

questionnaires among their colleagues. However, this responsibility of distributingthe questionnaire survey was not left without further control. This was reflected in theresponses to some factual questions about the respondents’ qualifications andexperience. In unreported results, more than one-third of the respondents indicated thatthey have prior work experience in their field of more than ten years. Also, the majorityof academics (86.4 per cent) held a PhD, while 37.5 per cent of external auditors held aprofessional accounting degree other than their Bachelor degree. The professionalaccounting degrees included a Diploma in Accounting; the Modern AccountingCertificate from the American University in Cairo; Membership of the Egyptian Societyof Accountants and Auditors; the Certified Internal Auditor and Certified PublicAccountant from the USA. Consequently, having highly qualified and experiencedrespondents in the area of financial reporting is expected to result in more reliable andvalid responses.

One week after administering the questionnaire, the respondents were contacted bytelephone and were asked whether they had any problems in understanding orcompleting the questionnaire. In general, 464 questionnaires were initially sent out topotential respondents and 217 usable questionnaires were returned (a response rate of 46.8 per cent). This response rate compares favourably with other studies in the samesetting, which have indicated that the average response rate to questionnaire surveysin Egypt tends to be low, ranging between 30 and 50 per cent (Elbanna, 2007; Elbannaand Child, 2007). The distribution of respondents and their response rates are providedin Table I. Unsurprisingly, the response rate from the financial managers or senioraccountants was much lower than for the other two groups.

Given that the success of any questionnaire survey entirely depends on widespreadagreement about the meaning of the terms involved (Seale, 1999), our questionnairewas developed as follows. It was initially drafted in English and sent out to fourbilingual academics at Cardiff Business School. On the basis of the feedback received,several changes were made to the original questionnaire. Second, the questionnairewas translated into Arabic by the first author and then given to three fellow researchstudents at Cardiff Business School (all Arabic speakers) in order to ensure that thetranslation was equivalent. Third, the modified Arabic version of the questionnairewas sent for piloting to representatives from each group of respondents (i.e. threeaccounting academics; two external auditors; and one senior accountant). A numberof questions were redrafted, amended and translated back again into English,

IssuedReceivedand used

No. % No. % Response rate (%)

1. Accounting academics 115 24.8 59 27.2 51.32. External auditors 171 36.8 104 47.9 60.83. Financial managers or senior accountants 178 38.4 54 24.9 30.3Total 464 100 217 100 46.8

Table I.Responses to the

questionnaire survey


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as suggested by the pilot respondents. Finally, both versions had the same layout,paper, order of questions and number of pages. It is worth noting that in order tocompensate for the inability to probe for more information, open-ended questions wereincluded so that the respondents could explain their answers.

For test-retest reliability purposes, seven respondents completed the questionnairetwice. The Pearson correlation coefficients between the answers of the samerespondents to the same questions, using the identical questionnaire on two differentoccasions, ranged between 0.87 and 0.98, which indicates a high degree of stability of the measures used in this study (Kline, 1993). Finally, Kruskal-Wallis test was used fordata analysis because our data did not meet the conditions required for parametrictests (Balian, 1982; Siegel, 1956).

3.2 Semi-structured interviewsSince it has long been recognised that questionnaire surveys suffer from the inability togain detailed insights into respondents’ perceptions, efforts were made to conduct anumber of interviews in order to uncover any undisclosed issues and to supplement the

results obtained from the questionnaire survey.To determine whom to interview, we were attracted by the idea of theoretical

sampling. This approach to sampling and selection was first introduced by Glaser andStrauss (1967). Theoretical sampling is an approach to selecting people which givespriority to a theoretical basis for their inclusion rather than a statistical one. Thus,rather than specifying in advance that n number of people should be interviewed inorder to achieve the aims of the research, the approach of theoretical sampling requiresonly enough people for a certain question and then moves on to related issues. Inprinciple, we used three criteria to select the interviewees:

(1) they should be drawn from those respondents who had been questioned in thequestionnaire survey;

(2) they should have comprehensive knowledge and experience in the accountingand auditing fields; and

(3) they should be willing to be interviewed.

On the basis of these criteria, 16 respondents were chosen for the semi-structuredinterviews, comprising seven accounting academics, seven external auditors and fivefinancial managers or senior accountants.

Each interview usually began by a five-minute introduction to the aims of theresearch in which the interviewees were thanked for their time, with a view to puttingthe interviewee in “question-answering mode” (Oppenheim, 1992). Then the firstauthor asked more detailed questions on the quality of reported earnings in Egypt.In this respect, it should be noted that interviewees in the developing countries,

including Egypt, usually refuse to have their interviews tape-recorded and, therefore,notes were taken and written up, using the 24 hour rule (Eisenhardt, 1989; Elbanna andChild, 2007). Since this study consisted of only 16 interviews and the amount of datawas manageable, our data were coded and analysed manually.

4. Results and discussionWith the aim of assessing respondents’ perceptions of the quality of reported earningsin Egypt, we attempt in this section to investigate three main issues:

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(1) Why might firms manipulate their reported earnings in Egypt?

(2) What techniques are most frequently used in this manipulation?

(3) What actions might be taken to improve the quality of reporting earnings in

Egypt?

The responses to these questions are presented and analysed in order.

4.1 The potential incentives for earnings manipulation in Egypt A list of 11 incentives for perpetrating earnings manipulation was prepared and ispresented in Table II on the basis of the ongoing debate in the literature. It can be seenfrom this table that over 80 per cent of the respondents agreed or strongly agreed withthe existence of the first four incentives for manipulating earnings in Egypt. For each of these incentives there were no significant differences in the responses, indicating a highdegree of consensus. The next five incentives (incentives from No. 5 to No. 9) also enjoy ahigh degree of agreement (means range between 3.97 and 3.61). However, the levels of

agreement were much lower for the last two incentives (incentives No. 10 and No. 11) andthis was reflected in their overall mean scores of only 3.38 and 3.32, respectively.

Significant differences (at the 1 per cent level) between the three groups of respondents were found twice. First, 96.6 per cent of financial managers or senioraccountants agreed or strongly agreed that managers might tend to manipulate thefigure of reported earnings in Egypt in order to “mitigate the threat of displacement”.However, this agreement was found to be much lower in the responses of academics(77.8 per cent) and external auditors (64.4 per cent). This significant difference wasexpected, since financial managers or senior accountants would normally be moreconcerned about their job security than the two other groups. Second, financialmanagers or senior accountants showed much lower levels of agreement than the othertwo groups that the purpose of manipulation was “to meet financial analysts’predictions”. This is possibly due to their belief that there is a limit to the ability of accounts preparers to manipulate earnings to this extent.

During the interview stage of this study, one financial manager drew our attentionto the fact that we should distinguish between the incentives for manipulating earningsin public sector companies and those in the private sector, in particular in familybusiness companies. On this point, the interviewee remarked that:

With regard to companies that have been offered to the public under the privatisationprogramme and are still controlled by the same financial managers, the main incentives formanipulating earnings are most likely to be: (i) reporting profits and avoiding the report of losses; (ii) meeting predetermined budgets; and (iii) mitigating the threat of displacement,whilst the primary incentive for committing earnings manipulation in the family-controlled

companies that have been partially offered to the public would be either to sustain last year’sprofit performance or to preserve high share valuation in the stock market.

This comment is, to some extent, consistent with Kamel (2009) who reports that privatecompanies seemed to have a strong incentive to manipulate earnings before goingpublic in order to get the highest possible offer price. In contrast, state-ownedenterprises were found to have no systematic pattern of earnings manipulation, whichsuggests that these companies have other incentives to manipulate earnings beforegoing public than maximising their offering proceeds.


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Additionally, two senior officers in the Egyptian stock market authority stated anotherimportant incentive for manipulating earnings in Egypt, notably in the public sectorcompanies which had been privatised. One of these officers commented that:

Some companies may attempt to overstate their reported earnings by adopting illegitimateways in order to use these overstated earnings to increase their capital by issuing new sharesin the stock market, taking into account the provisions of article (17) of the executive

Level of agreement (%)Managers might tend tomanipulate the figure of reportedearnings in order to 1 2 3 4 5

Overallmean score

OverallSD Sig.

1. Enhance the chances of – 10.2 – 57.6 32.2 4.21 0.937 – obtaining a bank loan ( – ) (8.7) (9.6) (31.7) (50.0)

[1.9] [7.4] [7.4] [29.6] [53.7]2. Sustain last year’s profit – 6.8 – 67.8 25.4 4.17 0.788 –

performance ( – ) (6.7) (2.9) (60.6) (29.8)[ – ] [9.3] [1.9] [40.7] [48.1]

3. Report profits and to avoid 1.7 1.7 – 59.3 37.3 4.12 0.915 – reporting losses (3.8) (5.8) (2.9) (49.0) (38.5)

[1.9] [11.1] [1.9] [63.0] [22.2]4. Achieve high share valuation – 8.5 5.1 50.8 35.6 4.09 0.850 –

(1.0) (6.7) (7.7) (47.1) (37.5)[ – ] [7.4] [7.4] [66.7] [18.5]

5. Mitigate the threat of – 11.1 11.1 25.9 51.9 3.97 1.04*

displacement (2.9) (18.3) (14.4) (37.5) (26.9)[ – ] [3.4] [ –] [59.3] [ 37.3]

6. Maintain stable dividends – 15.3 3.4 50.8 30.5 3.93 0.933 – ( – ) (8.7) (17.3) (53.8) (20.2)[1.9] [7.4] [18.5] [29.6] [42.6]

7. Reduce the amount of income 1.7 22.0 8.5 39.0 28.8 3.89 1.22 – taxes (5.8) (14.4) (6.7) (31.7) (41.3)

[1.9] [14.8] [9.3] [18.5] [55.6]8. Maximise the value of their – 16.9 15.5 28.8 38.8 3.72 1.12 –

compensation (1.0) (19.2) (22.1) (39.4) (18.3)[5.6] [14.8] [16.7] [29.6] [33.3]

9. Meet their predetermined 1.7 28.8 13.6 42.4 13.6 3.61 1.03 – expectations (budgets) (2.9) (18.3) (10.6) (50.0) (18.3)

[1.9] [7.4] [9.3] [68.5] [13.0]10. Meet financial analysts’ – 20.3 15.3 54.2 10.2 3.38 0.950 *

predictions ( –) (19.2) (28.8) (39.4) (12.5)[3.7] [20.4] [50.0] [18.5] [7.4]

11. Reduce the buyout 3.4 32.2 10.2 40.7 13.6 3.32 1.05 – compensation (2.9) (22.1) (21.2) (42.3) (11.5)

[1.9] [18.5] [40.7] [29.6] [9.3]

Notes: *Distribution of responses among the three groups of respondents is statistically significantlydifferent at the 1 per cent level using the Kruskal-Wallis test; level of agreement on a scale of:1 ¼ strongly disagree, 2 ¼ disagree, 3 ¼ do not know, 4 ¼ agree, 5 ¼ strongly agree; for eachincentive, three rows of figures are reported under the level of importance; the first row represents theperceptions of accounting academics, the figures in parentheses (second row) represent the perceptionsof external auditors, and the figures between square parenthesis (third row) represent the perceptions

of financial managers or senior accountants

Table II.The potential incentivesfor earnings

manipulation in Egypt

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regulations of the capital market law 95/1995. This will lead to an increase in the issuedcapital by unrealised and illusive earnings and will be associated with two dangerousrepercussions: (1) the market value of companies’ capital will contain shares that do notrepresent any real ownership in these companies and (2) these manipulative companies will

enjoy the advantage of tax exemption which is calculated as a percentage of the paid capitalmultiplied by the annual interest rate in the central bank of Egypt. This loophole will, of course, lead to a “legal” scam against paying the owed taxes to the state.

4.2 The commonly techniques used to manipulate earnings in Egypt The Egyptian capital market authority (ECMA) has recently discovered and notedcertain accounting and auditing malpractices and disclosure issues among certaincompanies, either to present an untrue picture of their financial position and operationresults, or because of lack of understanding of the applicable accounting standards.Accordingly, our respondents were given a list of nine techniques which could be usedto manipulate the figure of reported earnings in Egypt. This list was mainly derived

from the practices of earnings management detected by ECMA and also from therelated accounting research (McNichols and Wilson, 1988; Dechow et al., 1996;Marquardt and Wiedman, 2004a).

It can be seen from Table III that at least 58 per cent of all three groups of respondents viewed the first three techniques (i.e. making inadequate provisions;capitalising rather than expensing expenditures; and overestimating the inventoryvalue) as either frequently used or very frequently used. In contrast, Table III showsthat the least frequent techniques for manipulating earnings in Egypt were the lastthree techniques (i.e. accelerating/deferring the recognition of maintenance expenses;accelerating/deferring the recognition of research and development costs; andmanipulating depreciation figures). This was reflected in overall mean scores of only3.03, 2.90 and 2.83, respectively. It is interesting to note that there were significant

differences (at the 1 per cent level) among the three groups of respondents with regardto the frequency of occurrence of these three techniques. For example, 57.7 per cent of the academic respondents perceived that manipulating depreciation figures occurredeither frequently or very frequently, compared to 20.2 and 18.5 per cent of externalauditors and financial managers or senior accountants, respectively. These differencescould be due to the level of experience of each group of respondents in the practicalfield. The remaining three techniques (techniques from No. 4 to No. 6) were believed tobe moderately used since their means range from 3.18 to 3.40.

Discussions with respondents participating in the interview survey revealed furtherways of perpetrating earnings management in Egypt. One interviewee, for example,referred to the concerns documented in the corporate governance assessment report inEgypt (Report on the Observance of Standards and Codes (ROSC), 2004), with

particular regard to the accounting treatment of foreign currency exchange gains andlosses. This report states that:

[. . .] some companies do not adhere to the requirement that foreign currency exchange gainsand losses arising from balance sheet date revaluations should be shown in the incomestatement. Some companies show currency exchange gains under a special account in theliability section of the balance sheet. Some companies capitalise the currency exchange lossesas part of fixed assets, even if all the necessary conditions for such capitalisation are not met(ROSC, 2004, Annex F, p. 4).


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In support of the previous concerns, the interviewee mentioned the following casewhich he had encountered in his practical work as an external auditor:

A transportation company failed to recognise a foreign exchange loss of L.E. 871K fromrevaluation of liabilities denominated in a foreign currency. The company capitalised therevaluation difference to its assets although these assets were unqualified for capitalisation inaccordance with the relevant Egyptian Accounting Standard[2].

Additionally, our interviewees drew our attention to other possible ways of practisingearnings management in Egypt such as:

. Overstating the value of the inventory by not deducting obsolete andslow-moving inventory from the ending balance.

Level of frequency (%)Managers might manipulateearnings through 1 2 3 4 5

Overallmean score

OverallSD Sig.

1. Making inadequate provisions 1.7 – 22.0 33.9 42.4 4.22 0.931 – (1.0) (4.8) (8.7) (36.5) (49.0)[3.7] [3.7] [14.8] [25.9] [51.9]

2. Capitalising rather than 3.4 3.4 25.4 40.7 27.1 3.91 1.07 – expensing expenditures (5.8) (4.8) (17.3) (42.3) (29.8)

[1.9] [13.0] [7.4] [29.6] [48.1]3. Overestimating the inventory – 8.5 13.6 44.1 33.9 3.81 1.79 –

value (2.9) (12.5) (26.0) (32.7) (26.0)[9.3] [3.7] [13.0] [40.7] [33.3]

4. Manipulating the amount of sales 1.7 6.8 37.3 37.3 16.9 3.40 1.09 – revenue (5.8) (21.2) (17.3) (37.5) (18.3)

[7.4] [20.4] [29.6] [37.0] [5.6]5. Accelerating/deferring the 3.4 1 0.2 32.2 37.3 1 6.9 3.30 1.21 –

recognition of loan interest (8.7) (24.0) (24.0) (23.1) (20.2)[14.8] [14.8] [20.4] [37.0] [13.0]6. Accelerating/deferring the 3.4 10.2 28.8 44.1 13.6 3.18 1.12 *

recognition of capital gains or (9.6) (26.9) (28.8) (26.0) (8.7)capital losses [9.3] [20.4] [22.2] [37.0] [11.1]

7. Accelerating/deferring the 3.4 6.8 42.4 37.3 10.2 3.03 0.954 *

recognition of maintenance (5.8) (25.0) (44.2) (21.2) (3.8)expenses [9.3] [25.9] [44.4] [16.7] [3.7]

8. Accelerating/deferring the 6.8 11.9 35.6 33.9 11.9 2.90 1.07 *

recognition of research and (10.6) (22.1) (43.3) (18.3) (5.8)development costs [14.8] [40.7] [24.1] [18.5] [1.9]

9. Manipulating depreciation 3.4 15.3 23.7 42.4 15.3 2.83 1.16 *

figures (14.4) (34.6) (30.8) (14.4) (5.8)[18.5] [40.7] [22.2] [11.1] [7.4]

Notes: *Distribution of responses among the three groups of respondents is statistically significantlydifferent at the 1 per cent level using the Kruskal-Wallis test; level of frequency on a scale of: 1 ¼ rarelyused, 2 ¼ occasionally used, 3 ¼ moderately used, 4 ¼ frequently used, 5 ¼ very frequently used; foreach technique of earnings management, three rows of figures are reported under the level of agreement;the first row represents the perceptions of accounting academics, thefiguresin parentheses (second row)represent the perceptions of external auditors, and the figures between square parenthesis (third row)represent the perceptions of financial managers or senior accountants

Table III.The commonlytechniques used tomanipulate earnings inEgypt

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. Overstating the value of the inventory by disclosing inventory at the higherfigure of either cost or market value.

. Overstating the value of sales revenue before the end of the fiscal year in order toget higher bonuses and then re-recording these fake transactions as sales returnsin the subsequent fiscal year.

. Manipulating the percentage at which the work-in-process can be consideredrevenue, especially in construction companies.

. Not disclosing loan interest in interim reports and including this later under thecost of goods sold at the end of the fiscal year. (In this respect, it should be notedthat the external auditor of this particular case was referred by the ECMA forinvestigation in the Commercials’ Syndicate).

4.3 Necessary actions to improve the quality of reported earningsFollowing Naser (1993), we provided our respondents with a number of actions whichmight improve the quality of reported earnings in Egypt and asked them to indicate

their level of agreement with each of these actions. Generally, Table IV reveals that“greater reliance on the existence of an effective audit committee” elicited the greatestlevel of agreement, with at least 94 per cent of the three groups of respondentsindicating that they either agree or strongly agree (mean ¼ 4.64). It is important tohighlight that the support for this particular action was only marginally higher thanthat for “greater disclosure” and “greater reliance on the existence of an effectiveinternal audit function” (with overall mean scores of 4.58 and 4.54, respectively, andover 92 per cent of all three groups of respondents agreeing or strongly agreeing). Foreach of these three actions there were no significant differences in the responses of thethree groups of respondents.

In contrast, the action of “stricter standards” elicited the lowest level of agreementfrom respondents (mean ¼ 3.37). It can also be seen that the level of disagreement was

much higher for financial managers or senior accountants than for the two othergroups of respondents and the difference in responses was significant at the 1 per centlevel. The following comment from a senior accountant provides a possible explanationfor the relatively low support given by the group of financial managers or senioraccountants to this action:

Alternatives should be allowed as long as their effects are being disclosed in the notes tofinancial statements and therefore there is no need to change the current existing standardsand make them stricter than they are.

Also, it should be observed that Table IV provides support for most of the presentedactions and this was reflected in the overall mean scores of more than four for six of theidentified seven actions. This finding suggests that respondents felt that reliance on

internal corporate governance mechanisms (in terms of the existence of an effectiveaudit committee; the existence of an effective internal audit function and the existenceof an independent and competent board of directors) is not the only way to improve thequality of reported earnings and eliminate the use of earnings management in Egyptiancompanies. But instead these mechanisms should be used collectively with the otheridentified actions reported in Table IV. In this sense, these results seem to besupportive, to some extent, of those critics who argue that the existence of a strongsystem of internal corporate governance has been demonstrably ineffective in


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mitigating corporate irregularity hitherto and is unlikely to be any more effective in thefuture unless the factors which act to limit the effectiveness of the present paradigm of corporate governance are controlled. For example, based on a study of six majorcorporate failures (i.e. Enron, WorldCom, Tyco, Xerox, Shell, Hollinger), Gwilliam andMarnet (2008) conclude that a number of factors are likely to weaken the ability of auditcommittee members, internal auditors and external auditors to fulfil the role ascribed tothem by regulators and others. These factors are classified under three main categories:fee dependence; sociological and psychological dependence; and lack of expertise and

an independent knowledge base. Gwilliam and Marnet (2008) warn that without dueconsideration of these three factors, any efforts to create or improve the structure of internal corporate governance mechanisms are likely to be costly and ineffective.

In general, our interviewees supported the above argument. An external auditor, forinstance, expressed his view on this particular issue as follows:

In my personal opinion, the following actions will collectively guarantee good qualityfinancial reporting in Egypt. (1) Issuing new Egyptian accounting and auditing standards tocover those subjects that have not been addressed yet in the current Egyptian standards.

Level of agreement (%)To improve the quality of reportedearnings in Egypt it is necessary tohave 1 2 3 4 5

Overallmean score

OverallSD Sig.

1. Greater reliance on the existence 1.7 – 3.4 28.8 66.1 4.64 0.674 – of an effective audit committee (–) (1.9) (1.0) (32.7) (64.4)

[1.9] [1.9] [ – ] [9.3] [87.0]2. Greater disclosure – 1.7 1.7 20.3 76.3 4.58 0.642 –

(–) (2.9) (4.8) (36.3) (56.0)[ – ] [ – ] [ – ] [24.1] [75.9]

3. Greater reliance on the existence of 3.4 1.7 – 35.6 59.3 4.54 0.757 – an effective internal audit function (1.0) (3.8) (1.0) (32.7) (61.5)

[ – ] [ – ] [1.9] [24.1] [74.1]4. More standards aimed at specific – 3.4 10.2 44.1 42.4 4.24 0.798 –

problem areas (1.9) (2.9) (3.8) (44.2) (47.1)[–] [5.6] [5.6] [64.8] [24.1]

5. More detailed accounting legislation 3.4 11.9 6.8 52.5 25.4 4.06 0.869 – (–) (9.6) (2.9) (48.1) (39.4)[–] [1.9] [3.7] [77.8] [16.7]

6. Greater reliance on the existence 1.7 3.4 8.5 49.2 37.3 4.02 0.986 *

of an independent and competent (– ) (15.4) (15.4) (44.2) (25.0)board of directors [1.9] [7.4] [7.4] [25.9] [57.4]

7. Stricter standards 3.4 22.0 1.7 44.1 28.8 3.37 1.28 *

(3.8) (29.8) (9.6) (32.7) (24.0)[9.3] [46.3] [11.1] [16.7] [16.7]

Notes: *Distribution of responses among the three groups of respondents is statistically significantlydifferent at the 1 per cent level using the Kruskal-Wallis test; level of agreement on a scale of:1 ¼ strongly disagree, 2 ¼ disagree, 3 ¼ do not know, 4 ¼ agree, 5 ¼ strongly agree; for each action,three rows of figures are reported under the level of agreement; the first row represents the perceptions

of accounting academics, the figures in parentheses (second row) represent the perceptions of externalauditors, and the figures between square parenthesis (third row) represent the perceptions of financial managers/senior accountants

Table IV.Necessary actions toimprove the quality of reported earnings

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(2) Reorganising the accounting and auditing profession in Egypt in order to increase theprofessionalism of the accountants and auditors and to guard their independence andimpartiality. (3) Establishing a specific mechanism to penalise those auditors who affirmfinancial statements that are prepared in contradiction with the Generally Accepted

Accounting Principles (GAAP).The last part of the previous comment was extremely supported by the differentgroups of interviewees, to the extent that most of them have urged the legislator toprosecute any auditor or any person on the board of directors, audit committee, or inthe internal auditing department who deliberately makes a false entry in the financialstatements or deliberately manipulates the figure of reported earnings.

Another interviewee (an accounting academic) also suggested that the followingactions would greatly assist in improving the quality of accounting information,including the reported earnings, in Egypt:

. Enhancing external auditors’ independence by protecting them from beingchanged unless there are plausible reasons for doing so.

.

Issuing the new Accounting Practices Law to replace Law No. 133 of 1951 inregulating the profession of accounting and auditing in Egypt.

. Preventing auditors from providing their clients with consultation servicesunless they receive approval from the Capital Market Authority.

. Publishing common accounting problems and ways of tackling them inaccordance with the Egyptian and International Accounting Standards in ascientific periodical for accountants and auditors.

5. ConclusionThis paper investigates respondents’ perceptions of the current quality of reportedearnings in Egypt. In doing so, we relied on the assumption that the engagement inearnings manipulation can be attributed to three broad factors:

(1) the existence of motivations and pressures to engage in financial statementfraud;

(2) the availability of earnings management techniques; and

(3) the presence of weak corporate governance which encourages the practice of earnings manipulation.

Based on 217 usable questionnaires and 16 semi-structured interviews, our resultsindicate that the overriding incentives for manipulating earnings in Egypt are: “toenhance the chances of obtaining a bank loan”; “to sustain last year’s profitperformance”; “to report profits and to avoid reporting losses” and “to achieve high

share valuation”. More interestingly, while earnings manipulation is largely committedin the USA by overstating sales revenue, the results of this paper suggest that “makinginadequate provisions”; “capitalising rather than expensing expenditures” and“overestimating the inventory value” are most common in Egypt.

Finally, the results reveal a consensus among respondents on the importance of combating earnings management in Egypt through greater reliance on internalcorporate governance mechanisms. However, these results and discussions with therespondents participating in the interview survey also indicate that greater reliance on


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corporate governance cannot alone completely solve the problem. To reduce theprevalence of earnings management, other important actions (such as greateraccounting disclosure and penalties for auditors who affirm financial statements whichare prepared in contradiction with GAAP) should be also taken in addition to greater

reliance on internal corporate governance mechanisms.In the light of the above results, our paper contributes to the accounting research

literature in several areas.First, this paper could be of assistance to regulators andexternalauditors in Egypt by identifying the potential incentives for engaging in earningsmanipulation and the techniques which are most frequently used in practice and thereforeshould receive more attention during the audit process. Second, this paper highlights theimportance of combating the problem of earnings management through having greateraccounting disclosure and harsher auditor penalty. Thus, our paper encourages futureresearch to empirically investigate the potential impacts of these two actions on thecredibility of financial reporting in general and reported earnings in particular. Third, thispaper addresses the importance of certain governance mechanisms which are extremely

important to a country such as Egypt, where the capital market is less developed andwhere governance mechanisms are still evolving. Finally, research on the reportedearnings quality in Egypt may be of interest to domestic and overseas investors inEgyptian firms. However, our results should be interpreted with caution given thelimitation of the employed snowball sampling strategy.

It should be acknowledged that some loss of control over the sample frame hasresulted from leaving the responsibility of distributing the questionnaire survey to theinitial respondents in the academics and external auditors groups. Also, since we werenot able to employ any accruals-based model in this paper due to the unavailability of data, it is highly recommended in the future that the existence of earnings managementin Egypt should be reexamined around the date of certain types of corporate events(such as the dates for reporting losses or declines in earnings) by investigating the

distribution of reported earnings around these dates (Burgstahler and Dichev, 1997;Degeorge et al., 1999; Holland and Ramsay, 2003).

Notes

1. Some critics may argue that analysing the financial statements directly can be a bettermethod of determining whether or not a company is engaged in some form of earningsmanagement. However, this was not possible in the case of Egyptian companies because of

the poor disclosures contained in the financial statements or because of the inability toemploy any accruals-based models in the Egyptian environment, with only one exceptionsetting which is the initial public offering market (Kamel, 2009).

2. As a consequence of the decision to liberate the foreign exchange market issued on28 January 2003, the Minister of Foreign Trade in Egypt issued decree No. 156 for 2003,which included some new interpretations of the Egyptian Accounting Standards regarding

ways of treating any currency exchange losses resulting from foreign currency debts whichwere used for financing the acquisition of fixed assets. Under these new interpretations, anexchange loss on foreign currency debt used to finance the acquisition of an asset can be

added to the carrying amount of the asset if there is still 50 per cent at least of the estimateduseful life of that asset and that the loss has resulted from a severe devaluation of theEgyptian pound against all other foreign currencies (10 per cent at least in the fiscal year).

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Appendix 1

(1) Please indicate, according to the Egyptian business environment, the extent to which you

agree or disagree with the following statements by circling the appropriate number on

the following five-point scale.

(2) How do you rate the frequency of using the following ways of earnings management by

Egyptian companies? Please indicate your answer by circling the appropriate number on

the following scale from one to five:

Stronglydisagree (SD) Disagree (D) Do not know (NK) Agree (A)

Stronglyagree (SA)

1 2 3 4 5Table AI.

Managers might tend to manipulate the figure of reported earnings in order to SD D NK A SA

1. Report profits and to avoid reporting losses 1 2 3 4 52. Sustain last year’s profit performance 1 2 3 4 53. Achieve high share valuation 1 2 3 4 54. Meet financial analysts’ predictions 1 2 3 4 55. Maximise the value of their compensation 1 2 3 4 56. Maintain stable dividends 1 2 3 4 57. Meet their predetermined expectations (budgets) 1 2 3 4 58. Enhance the chances of obtaining a bank loan 1 2 3 4 59. Reduce the amount of income taxes 1 2 3 4 5

10. Mitigate the threat of displacement 1 2 3 4 511. Reduce the buyout compensation 1 2 3 4 5

12. Other(s), please specify:. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5Table AII.

Rarely used(RU)

Occasionally used(OU)

Moderately used(MU)

Frequently used(FU)

Very frequently used(VFU)

1 2 3 4 5Table AIII.

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(3) In your opinion, which of the following actions might improve the quality of reported

earnings in Egypt?

Appendix 2Interview survey questions

(1) How do you see the quality of reported earnings in Egypt? (i.e. does the figure of reportedearnings reflect the real profitability of Egyptian companies?) Explain.

(2) Do you agree that some Egyptian managers tend to manipulate earnings in order toachieve their own objectives?

If yes, what are these objectives? And please give examples of how manipulation canbe made.

Strongly disagree (SD) Disagree (D) Do not know (NK) Agree (A) Strongly agree (SA)

1 2 3 4 5 Table AV.

To improve the quality of reported earnings in Egyptit is necessary to have SD D NK A SA

1. More detailed accounting legislation 1 2 3 4 52. Stricter standards 1 2 3 4 53. More standards aimed at specific problem areas 1 2 3 4 54. Greater disclosure 1 2 3 4 55. Greater reliance on the existence of an effective

audit committee 1 2 3 4 56. Greater reliance on the existence of an effective

internal audit function 1 2 3 4 57. Greater reliance on the existence of an independent

and competent board of directors 1 2 3 4 58. Other(s), please specify:

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 Table AVI.

Managers might manipulate earnings through RU OU MU FU VFU

1. Manipulating the amount of sales revenue 1 2 3 4 52. Overestimating the inventory value 1 2 3 4 5

3. Making inadequate provisions 1 2 3 4 54. Manipulating depreciation figures 1 2 3 4 55. Accelerating/deferring the recognition of loan

interests 1 2 3 4 56. Accelerating/deferring the recognition of

maintenance expenses 1 2 3 4 57. Accelerating/deferring the recognition of capital

gains or capital losses 1 2 3 4 58. Accelerating/deferring the recognition of

research and development costs 1 2 3 4 59. Capitalising rather than expensing expenditures 1 2 3 4 5

10. Other(s), please specify:. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 Table AIV.


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(3) What are the necessary actions that should be taken in order to improve the quality of reported earnings in Egypt? Discuss the following actions:

. More detailed accounting legislation.

. Stricter standards.

. More standards aimed at specific problem areas.

. Greater disclosure.

. Greater reliance on the internal corporate governance mechanisms which are closelyrelated to the area of financial reporting quality.

. Others.

Corresponding authorSaid Elbanna can be contacted at: [email protected]

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