Managerial Auditing Journal Volume 32 Issue 1 2017 (Doi 10.1108 - MAJ-01-2016-1304) Mostafa, Wael - The Impact of Earnings Management On The Value Relevance of Earnings PDF

Managerial Auditing Journal
The impact of earnings management on the value relevance of earnings: Empirical

evidence from Egypt
Wael Mostafa
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Wael Mostafa , (2017),"The impact of earnings management on the value relevance of earnings
Empirical evidence from Egypt ", Managerial Auditing Journal, Vol. 32 Iss 1 pp. 50 - 74
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MAJ
32,1
The impact of earnings
management on the value
relevance of earnings
50 Empirical evidence from Egypt
Wael Mostafa
Faculty of Commerce, Ain Shams University, Egypt
Abstract
Purpose – This paper aims to examine the association between earnings management and the value
relevance of earnings (the latter is operationalized by earnings response coefficient). Specifically, this study
examines whether opportunistic earnings management has a negative impact on the value relevance of
earnings for a sample of firms listed on the Egyptian Stock Exchange.
Design/methodology/approach – Different from prior work and due to data limitations in the Egyptian
market, this paper first examines for the existence of earnings management based on the whole operating
performances of the firms by testing whether firms with low/poor operating performance are more likely to
choose income-increasing actions (strategies) than firms with high operating performance. After confirming
that low operating performance firms manage earnings upward, the authors then assess whether this
opportunistic earnings management by these low operating performance firms reduces the value relevance of
earnings. This is performed by estimating a model of the relationship between stock returns and accounting
earnings with a dummy variable that allows parameter shifts for earnings of low operating performance firms.
Findings – The results show that discretionary accruals are positive and significantly higher for firms with
low operating performance than those for firms with high operating performance. These results indicate that
low operating performance firms increase the earnings management practices by probably increasing their
reported earnings opportunistically to mask their low performance. Furthermore, the results show that the
earnings response coefficient is significantly smaller for earnings of low operating performance firms than
that for earnings of high operating performance firms. These results suggest that earnings of firms with low
operating performance (that are engaged in opportunistic earnings management strategies) have less value
relevance than earnings of firms with high operating performance, i.e. the informativeness of managed
earnings is lower than that of non-managed earnings.
Practical implications – Based on these results, it is plausible that the presence of opportunistic earnings
management adversely affects the value relevance of accounting earnings.
Originality/value – Consistent with previous results from developed countries, this study shows that
earnings management is a significant factor that affects value relevance of earnings in Egypt.
Keywords Earnings, Discretionary accruals, Earnings management, Operating performance,
Value relevance, Cash flows from operations
Paper type Research paper
1. Introduction
An issue central to accounting research is the extent to which managers alter reported
earnings to benefit their own interests (Beneish, 2001). When managers seek to manage
earnings opportunistically to increase their personal wealth, earnings management masks
Managerial Auditing Journal the true economic performance of firms and conceals valuable information that financial
Vol. 32 No. 1, 2017
pp. 50-74 statement users ought to see (Dechow and Skinner, 2000). In addition, because managers
© Emerald Publishing Limited
0268-6902
believe that reported earnings influence investor and creditor decisions, they may attempt to
DOI 10.1108/MAJ-01-2016-1304 manage earnings in such a way that the shareholders’ interest will be adversely affected
(Sevin and Schroeder, 2005). Therefore, earnings management has become a great concern Impact of
for the accounting profession in recent decades. earnings
Fraudulent reporting practices by corporate giants such as Enron, WorldCom and Xerox
have resulted in serious harm to the world economy so significantly that financial statement
management
users lost confidence in the financial-reporting process (Yoon et al., 2006). In late 2001 and
early 2002, Enron and WorldCom declared bankruptcy. Later investigation of Enron and
WorldCom by the US Securities and Exchange Commission (SEC) revealed that their
bankruptcies were due to earnings management practices. These events suggested giving
51
greater attention to earnings management activities.
Studies examining the link between earnings management and value relevance of
earnings (Warfield et al., 1995; Christensen et al., 1999; Hunt et al., 2000; Feltham and Pae,
2000; Marquardt and Wiedman, 2004; Habib, 2004; Tucker and Zarowin, 2006; Cheng and Li,
2014) have shown that the presence of earnings management is a factor that affects value
relevance of earnings.
This study, based on Egyptian data, investigates the association between earnings
management and value relevance of earnings. Specifically, this study examines the impact of
opportunistic earnings management on the value relevance of earnings in the context of
Egypt. Previous research (Feltham and Pae, 2000; Marquardt and Wiedman, 2004) found
that opportunistic earnings management decreases the informativeness of earnings.
However, this study differs from previous studies in that we chose to examine the effect of
opportunistic earnings management on the informativeness of earnings in the context of the
low operating performance as a setting (different from these previous studies) in which
opportunistic earnings management is likely to occur. Yoon and Miller (2002) found that
when operating performance is low/poor, firms tend to choose income-increasing strategies.
Consistent with that, we argue that low operating performance provides strong incentive
for opportunistic earnings management. Therefore, we extend prior work on the
informativeness of managed earnings by examining the value relevance of earnings for a
sample of firms that includes firms for which there is evidence of opportunistic earnings
management due to their low operating performance. We first confirm the earnings
management practices for the subset of firms with low operating performance. We then
examine whether earnings management by those firms with low operating performance has
a negative impact on the value relevance of earnings. Thus, our tests are directed toward,
first, detecting earnings management for low operating performance firms and, then
second, determining whether earnings management by those low operating performance
firms reduces the value relevance of earnings, i.e. the extent to which earnings capture or
summarize information that affects firm value. Value relevance of earnings is
operationalized by the earnings response coefficient.
The Egyptian setting provides a valuable opportunity for examining the effect of
earnings management on the informativeness of earnings in a relatively recently established
and rapidly growing capital market. This is because Egypt has many significant differences
from other developed markets, as it is classified as an emerging market. The Egyptian
accounting setting can be characterized by weak corporate governance (Bremer and Ellias,
2007), less importance of the capital market (Moore, 1995) and high conformity of financial
accounting to taxation (Farag, 2009). Conversely, the USA and the UK are considered as
highly developed markets with strong corporate governance, high importance of the capital
market and low conformity of financial accounting to tax (Defond and Hung, 2004; Myring,
2006). These environment differences may lead to different results between countries (Alford
et al., 1993; Amir et al., 1993) (for more details about the motivation of this study within the
Egyptian context, see Section 2).
MAJ With respect to earnings management, most prior studies on earnings management were
32,1 conducted on developed markets, while studies regarding developing markets were much
more less. These studies examined the impact of specific events or incentives (such as
maximizing management compensation, minimizing management buyouts (MBOs)
compensation, gaining import relief, avoiding anti-trust violations, avoiding violating debt
covenants and increasing the prices of equity offers) on management motives to manage
52 earnings (Healy, 1985; DeAngelo, 1986; Jones, 1991; Cahan, 1992; Defond and Jiambalvo,
1994; Perry and Williams, 1994; Teoh et al., 1998a, 1998b; Yoon and Miller, 2002). However,
different from these prior studies and because full data of such events or incentives is not
available in an emerging capital market such as Egypt, we first address the issue of earnings
management based on the whole operating performances of the firms by testing whether
earnings management is associated with the firms’ operating performances[1]. Specifically,
we first examine whether firms with low/poor operating performance manipulate earnings.
Indeed, the majority of the firms may have incentives to manage earnings for various
reasons. The firms will, however, have stronger incentives opportunistically to manage
earnings upward when their operating performances are relatively poor. Based on that, we
argue that low operating performance firms use income-increasing actions (strategies) more
heavily than high operating performance firms to offset their low operating performance.
Following prior studies (McNichols and Wilson, 1988; DeAngelo, 1988; Givoly and Hayn,
2000; Barth et al., 2001; Yoon and Miller, 2002), our proxy for operating performance is cash
flows from operations based on the assumption that cash flows are relatively objective and
difficult to manipulate, and unlikely to consist of transitory components unless cash
accompanying revenues or expenses are deliberately deferred or front-loaded (Yoon and
Miller, 2002). To distinguish between low and high operating performance firms, we classify
the sample firms into two groups with an approximately equal number of firms per group:
low and high cash flows groups. We consider the low cash flows group as firms with low
operating performance and the high cash flows group as firms with high operating
performance.
To examine whether the low operating performance affects a firm’s earnings
management practices, we compare earnings management for low operating performance
firms with high operating performance firms. Earnings management practices of high
operating performance firms are used as a benchmark for our tests regarding whether firms
with low/poor operating performance manipulate earnings upward. In this regard, high
operating performance firms are considered as firms that do not have incentives (or have
fewer incentives) to manipulate earnings. This can serve in comparing earnings
management practices between high and low operating performance firms. If low operating
performance is effective in increasing earnings management, then we may find significant
differences in earnings management practices between low and high operating performance
firms.
Based on the accrual approach used in most prior studies (Healy, 1985; DeAngelo, 1986;
Jones, 1991; Defond and Jiambalvo, 1994; Teoh et al., 1998a, 1998b; Yoon and Miller, 2002), we
use mean and median discretionary accruals difference tests to examine whether
discretionary accruals differ between the low and high operating performance firms. The
discretionary accruals of the low operating performance firms on average should be positive
and higher than those of the high operating performance firms if the low operating
performance firms manage earnings upward. Consistent with our definition for low and high
operating performance firms, these tests are conducted for low cash flows group against high
cash flows group. Discretionary accruals are estimated using the modified Jones model
presented in Dechow et al. (1995). Based on the classification of the Egyptian Stock Exchange
for its listed firms, we categorized the entire sample into eight sectors/industries. The Impact of
modified Jones model was fitted by each industry with a six-year panel data. earnings
Concerning the effect of earnings management on the value relevance of earnings, the
literature indicates that earnings management may be used to enhance the quality of
management
earnings as a measure of a firm’s performance or to manipulate earnings to benefit managers’
own interests (Watts and Zimmerman, 1986; Jiraporn et al., 2008). We assume that the latter
alternative holds for the subset of our sample firms with low operating performance if they
manage their earnings upward to hide their low operating performance. Thus, after we
53
confirm that low operating performance firms are engaged in earnings management
strategies, we investigate whether opportunistic earnings management by those firms with
low operating performance impairs the value relevance of earnings. Prior research has found
that opportunistic earnings management reduces the quality and value relevance of earnings
(Feltham and Pae, 2000; Marquardt and Wiedman, 2004). Similarly, we argue that if
opportunistic earnings management is more likely to occur in low operating performance
firms, then reported earnings of these firms are not appropriate to explain their value, i.e.
earnings of these firms have less value relevance. This is because investors will pay less
attention to earnings of low quality in firm valuation.
In Egypt, as an emerging stock market, there is a lack of alternative information sources
other than published accounting reports (Ragab and Omran, 2006; Ebaid, 2012) such as
earnings forecasts, financial analysis industry and management conference calls. Therefore,
the financial statements are considered the main source of information available to investors,
and most Egyptian capital market transactions are made based on accounting data, especially
earnings. As a result, earnings become highly important for market pricing, and investors are
commonly fixated on earnings for valuation purposes (Ebaid, 2012). This Egyptian
institutional setting is important because our empirical tests necessarily assume that investors
in Egypt are able to discern opportunistic earnings management when it occurs.
To assess the impact of earnings management on the value relevance of earnings, we
examine the regression coefficients obtained from regression of stock returns on unexpected
earnings and a dummy variable for unexpected earnings (where dummy variable ⫽ 1 for low
operating performance firms and ⫽ 0 for high operating performance firms). Under the null
hypothesis of no effect for the opportunistic earnings management on the value relevance of
earnings, we should not observe any significant difference in the estimated slope coefficient
of unexpected earnings between high and low operating performance firms. However, if the
opportunistic earnings management by firms with low operating performance has a
negative impact on the value relevance of earnings, these firms’ earnings will be less
successful in explaining stock returns. Therefore, it is expected to find a smaller slope
coefficient of unexpected earnings in low operating performance firms compared with high
operating performance firms. Hence, we test earnings response coefficients differences
between earnings of low and high operating performance firms.
The results show that firms with low operating performance are associated with positive
and higher discretionary accruals relative to firms with high operating performance, which
is consistent with our expectation that managers of low operating performance firms
opportunistically manage earnings upward to hide the low operating performance. The
finding that low operating performance firms are more likely to have higher accruals to
increase earnings is consistent with the results of the income smoothing literature. Therefore,
Egyptian firms face similar pressures to maintain a smoothed-earnings series as in other
countries. Furthermore, the results show that earnings of firms with low operating
performance are associated with smaller earnings response coefficient relative to earnings of
firms with high operating performance. These results show a smaller impact from earnings
MAJ of low operating performance firms (that are engaged in opportunistic earnings management
32,1 strategies) on security returns which we interpret as a low value relevance of earnings when
opportunistic earnings management is present. Under the assumption that investors are able
to correctly estimate the upward manipulation of earnings, these results suggest that the
informational value of managed earnings is lower than that of non-managed earnings. Thus,
opportunistic earnings management impairs the value relevance of earnings.
54 The paper is organized as follows. The next section shows motivation for the study.
Section 3 reviews prior studies relevant to this study and presents research questions and
hypotheses. Section 4 discusses research method. Section 5 shows variables definition and
data selections. Section 6 provides empirical results, and Section 7 concludes the paper.
2. Motivation of the study

This paper examines the association between earnings management and value relevance of
accounting earnings published by listed Egyptian firms during the year 2003-2008. Egypt is
an important and influential country in the Middle East. Egypt has traditionally played a
pivotal role in Middle Eastern politics. The examination of the relationship between earnings
management and value relevance of earnings data within the Egyptian context is interesting
for the following two reasons. The first is related to value relevance of earnings, and the
second is associated with earnings management practices.
First, Egypt has a different institutional context from that of the USA and the UK, the
countries where the relation between earnings management and value relevance of
accounting information was initially examined and tested. This is because Egypt has a
developing and emerging economy in transition and can be classified as a code law origin
country in which there is high politicization of its accounting system (Ball et al., 2000).
Specifically, the Egyptian institutional setting can be characterized by the insignificant role
of the capital market to raise capital (Moore, 1995), high conformity of accounting earnings to
taxable income (Farag, 2009), weak level of a sound regulatory system and control
mechanisms for monitoring compliance with accounting standards or for punishing firms
for violation (Ebaid, 2012) and noncompliance with disclosures requirements of obligatory
Egyptian Accounting Standards (EASs) (Abdelsalam and Weetman, 2007).
According to Ball et al. (2000), these characteristics of Egyptian accounting data are
comparable and of similar features to those presented by firms in code-law countries and
suggest that firms in Egypt tend to report lower quality local accounting data than common
law countries, despite the mandating adoption of high-quality accounting standards (IFRS).
Furthermore, these characteristics suggest that, compared with more mature markets, the
Egyptian financial market is probably less efficient, and its demand for timely and relevant
information is possibly lower. Consequently, the financial market of Egypt should exhibit a
lower level of value relevance than those of Western countries (a similar argument has been
made by Filip and Raffournier, 2010, with respect to the value relevance of earnings in the
emerging market of Romania).
Second, the first Egyptian Code of Corporate Governance was introduced in 2005 by the
Ministry of Investment based on Organization for Economic Cooperation and Development
principles of corporate governance. However, there is difference between corporate
governance environment in Egypt and other developed countries (e.g. the USA and the UK).
This difference is that the Egyptian rules on corporate governance are neither mandatory nor
legally binding; rather, they encourage and regulate responsible and transparent behavior in
managing corporations according to international best practices to ensure that directors
manage the firm in the best interest of the owners and other stakeholders. This significant
difference suggests that the Egyptian market lacks a sufficient level of corporate governance
(Bremer and Ellias, 2007) such as independent directors, audit committee and external Impact of
auditors, which increases earnings management practices. As a result, earnings earnings
management can be seen as pervasive, problematic and actively practiced (Kamel and
Elbanna, 2010) in the Egyptian emerging market as compared to mature markets, i.e.
management
earnings management is common in Egypt. Kamel (2012) argue that Egyptian managers of
state-owned enterprises who undertake initial public offers (IPOs), as implementation of the
privatization program, may have contradictory incentives to engage in either income
increasing or income decreasing practices of earnings management. However, the incentives 55
to overstate earnings outweigh, on average, the incentives to understate earnings.
Collectively, these two reasons suggest that both value relevance of earnings and
earnings management are likely to differ in Egypt. Thus, the above-stated different
institutional characteristics may yield significant differences in the impact of earnings
management on the value relevance of earnings in Egypt compared to what is the case in
other developed markets. Therefore, based on Egyptian data, the objective of this study is to
investigate whether the value relevance of earnings is related to earnings management.

Specifically, the current study examines whether opportunistic earnings management has a
negative impact on the value relevance of earnings in listed Egyptian firms. Prior studies
(Feltham and Pae, 2000; Marquardt and Wiedman, 2004) found evidence that opportunistic
earnings management decreases value relevance of earnings. In this study, we identify a
different setting (namely, the low operating performance) in which opportunistic earnings
management is likely to occur, and we examine the effect of opportunistic earnings
management on the informativeness of earnings. We choose to examine our research
question in the context of the low operating performance because prior research (Yoon and
Miller, 2002) has documented evidence of income-increasing strategies when operating
performance is low. This is consistent with the opportunistic earnings management by low
operating performance firms to hide their low operating performance. Therefore, we extend
existing research on the informativeness of managed earnings by examining the value
relevance of earnings for a sample of firms that includes a group of firms that are likely to
manage earnings opportunistically because of their low operating performance. We first
present evidence of earnings management for the subset of low operating performance firms.
We then examine the impact of earnings management by those firms with low operating
performance on the value relevance of earnings. Value relevance of earnings is proxied by
earnings response coefficient.
3. Previous research, research questions and hypotheses

Recently, earnings management has received considerable attention from both academics
and practitioners. Various definitions have attempted to explain the concept of earnings
management. For example, Davidson et al. (1987) defined earnings management as “a
process of taking deliberate steps within the constraints of generally accepted accounting
principles to bring about a desired level of reported earnings”. Schipper (1989, p. 92) defined
earnings management as:
[…][…] a purposeful intervention in the external financial reporting process, with the intent of
obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the
process) […][…]
These definitions reveal that the objective of earnings management is to mislead
stakeholders about the firm’s real performance by increasing or decreasing its reported
earnings.
The most common approach used in the literature as a proxy for (to detect) earnings
management is the accrual approach that focuses on the potential use of accruals
MAJ management with the intention of obtaining some private gain. Total accruals that are the
32,1 difference between earnings and cash flows from operations can be separated into
nondiscretionary accruals and discretionary accruals. Nondiscretionary accruals are
accounting adjustments to cash flows from operations as required by the accounting
standards setting body, whereas discretionary accruals are accounting adjustments to cash
flows from operations subject to management discretion. Generally accepted accounting
56 principles provide managers with the opportunity to choose discretionary accruals to
manipulate earnings to benefit their own interests. Thus, the discretionary accruals are
believed to represent the degree of earnings management. Hence, the accrual approach tests
whether patterns of discretionary accruals are consistent with specific incentives (Healy and
Wahlen, 1999). Earnings are said to have been managed upward (income-increasing) if
discretionary accruals are significantly positive; and earnings are said to have been managed
downward (income-decreasing) if discretionary accruals are significantly negative.
Given that discretionary accruals are used as a proxy for earnings management, a model
is needed to isolate the discretionary accruals component from total accruals. There are
several models used in the literature to separate accruals into discretionary and
non-discretionary components. Examples of these models include the Healy (1985) Model,
the DeAngelo (1986) Model, the Jones (1991) Model, the cross-sectional Jones Model (Defond
and Jiambalvo, 1994; Subramanyam, 1996), the modified Jones Model (Dechow et al., 1995),
the industry Model (Dechow et al., 1995) and the Kang and Sivaramakrishnan (1995) Model.
With respect to the effect of earnings management on the value relevance of earnings,
Warfield et al. (1995) found evidence that earnings management renders earnings reports
less informative. However, Hunt et al. (2000) arrived at a different conclusion, namely, that
managerial discretion can render earnings more informative to investors. Christensen et al.
(1999) showed that the greater managers’ incentives for earnings management, the less
informative the earnings announcement to investors. Feltham and Pae (2000) showed that
noisy earnings management that garbles rather than improves informational value of
earnings decreases the value relevance and quality of earnings announcement, whereas
earnings management that provides a credible signal about future cash flows improves the
value relevance and quality of earnings announcement. Marquardt and Wiedman (2004)
found decreased value relevance of earnings in the year of secondary equity offering when
managers are selling their own shares in the offering. This finding is consistent with the idea
that opportunistic earnings management impairs the value relevance of earnings. Habib
(2004) showed that earnings management is significantly negatively associated with both
the combined value relevance of book values of equity and earnings, and value relevance of
earnings. Tucker and Zarowin (2006) found that income smoothing improves earnings
informativeness. However, the analysis of the China market by Cheng and Li (2014) indicates
that income smoothing has little impact on earnings informativeness.
In summary, previous research (mostly from the developed economies, e.g. the USA and
the UK) has found that earnings management that intends to communicate a manager’s
private value relevant information increases the value relevance of earnings, but
opportunistic earnings management decreases (negatively affects) the value relevance of
earnings. Using data from the emerging market of Egypt, the objective of this study is to
examine whether opportunistic earnings management reduces the value relevance of
earnings.
Regarding earnings management, academic literature has examined whether
management actively seek to manipulate earnings opportunistically under specific events or
incentives. For example, Healy (1985) examined earnings management in the context of
management compensation, DeAngelo (1986) and Perry and Williams (1994) investigated
earnings management prior to MBOs, Jones (1991) examined earnings management in the Impact of
context of import relief, Cahan (1992) explored earnings management in the context of earnings
anti-trust, Defond and Jiambalvo (1994) examined earnings management in the context of
debt covenants, Teoh et al. (1998a) explored earnings management prior to IPOs, Teoh et al.
management
(1998b) examined earnings management prior to seasoned equity offers, Burgstahler and
Eames (1998) examined earnings management in the context of analysts earnings forecasts,
Han and Wang (1998) examined earnings management in the context of political costs issues
and Yoon and Miller (2002) investigated the relation between the operating performance and
57
the degree of earnings management. However, different from these prior studies and due to
data limitations in the Egyptian market which does not allow considering whether earnings
management is related to the occurrence of a specific event (or incentive) similar to those
events (or incentives) considered in prior studies of developed markets, we first investigate
earnings management based on the whole operating performances of the firms rather than a
specific event or incentive by examining whether low/poor operating performance firms are
assumed to have incentives to manage earnings. More specifically, the first research question
is as follows.
RQ1. Do firms that experience low operating performance attempt to manipulate their
accounting earnings to report higher earnings?
Prior research on earnings management found that the patterns of discretionary accruals are
consistent with specific incentives. In this study, we consider low operating performance as
an incentive for earnings management. We argue that low operating performance firms are
assumed to have more incentives to manage earnings opportunistically than high operating
performance firms by adopting income increasing strategies. This is to improve their low
operating performance. To be able to determine whether low operating performance firms
manage earnings upward, we use the earnings management practices of high operating
performance firms as a benchmark. In this regard, we consider firms with high operating
performance as firms that do not have incentives (or have fewer incentives) to manage
earnings[2]. Therefore, the comparison of earnings management practices between low and
high operating performance firms may provide a good measure of the degree of earnings
management in low operating performance firms. Thus, RQ1 (above) is resolved by testing
the following first research hypothesis, stated in alternative form, as follows.
H1. There is income-increasing opportunistic earnings management when operating
performance is low.
Concerning the impact of earnings management on value relevance of earnings, there are two
competing arguments on earnings management (Jiraporn et al., 2008). One is that managers
use earnings management opportunistically to benefit their own interests. In this case,
earnings management reduces the quality of earnings in representing a firm’s performance
(Lev, 1989). The other is that managers use earnings management beneficially to reflect more
accurately the financial condition of the firms. In this case, earnings management enhances
the quality of earnings as a measure of a firm’s performance. Subramanyam’s (1996)
argument takes the second view in that managers want to signal to the capital market that
accruals are used for efficient contracting purposes. However, if the subset of our sample
firms with low operating performance increase earnings to mask the low operating
performance, this would indicate that these firms generally use earnings management
opportunistically. This is consistent with the first view on earnings management. Therefore,
after we confirm the earnings management practices by low operating performance firms,
we then investigate the second research question:
MAJ RQ2. Does opportunistic earnings management due to the low operating performance
32,1 reduce the value relevance of earnings?
Previous studies show that opportunistic earnings management affects the value relevance
of earnings adversely (Feltham and Pae, 2000; Marquardt and Wiedman, 2004). Moreover, as
indicated above, opportunistic earnings management reduces the quality of earnings to
represent firm’s performance (Lev, 1989). We therefore predict that earnings play a less
58 important role in explaining stock returns (i.e. earnings have less value relevance) when
opportunistic earnings management is present because of the low operating performance.
This is because investors will give less importance to earnings of poor quality in the
formulation of stock prices. Based on that, the above-stated RQ2 is resolved by testing the
following second research hypothesis, stated in alternative form.
H2. Value relevance of earnings (measured by earnings response coefficient) is less in
the presence of opportunistic earnings management due to the low operating
performance.
4. Research method
4.1 Distinguish between low and high operating performance firms
As stated, this study first examines whether the low operating performance firms manage
earnings as compared to high operating performance firms. It seems that, the first logical
step in developing our methodology is to define the operating performance. We define “the
operating performance” as the economic performance of the firm for the period that reflects
economic results as they are. Following prior work (McNichols and Wilson, 1988; DeAngelo,
1988; Givoly and Hayn, 2000; Barth et al., 2001; Yoon and Miller, 2002), we use cash flows
from operations as a proxy for operating performance. This is based on the premise that cash
flows are relatively objective and “hard” to manipulate, and unlikely to contain transitory
components. This is unless managers intentionally delay or front load the recognition of cash
accompanying revenues or expenses. Therefore, cash flows from operations typically should
be a good measure for the firms’ operating performance (Yoon and Miller, 2002).
To distinguish between low and high operating performance firms, the full data set is
divided into two groups with an approximately equal number of firms per group, i.e. a low
and a high cash flows group. We rank the full data sample from the lowest to the highest by
their ending-of-year cash flows from operations scaled by total assets of the beginning of
year t. Then, we classify firms in the top group as low cash flows group and firms in the
bottom group as high cash flows group. The low cash flows group represents firms with low
operating performance, whereas the high cash flows group represents firms with high
operating performance.
4.2 Detecting earnings management – testing H1

Under the null hypothesis of no earnings management, we should not observe any
significant difference in the mean accruals between the low and high operating performance
firms. However, under alternative hypothesis of earnings management, low operating
performance firms would actively seek to increase accruals to increase earnings. Hence, we
expect to find positive and higher mean accruals in the low operating performance firms
compared with high operating performance firms, if these low operating performance firms
manage earnings upward.
As indicated before, earnings management is captured by discretionary accruals. Given
that our proxy for operating performance is cash flows from operations, tests of the first
hypothesis are directed toward comparing discretionary accruals of low cash flows group
(low operating performance firms) with high cash flows group (high operating performance
firms). Specifically, we assess whether discretionary accruals of low cash flows group are Impact of
positive and higher than those of high cash flows group. We test this hypothesis against a earnings
one-tailed alternative which permits rejection of the null hypothesis only if discretionary
accruals are higher in the low cash flows group compared to the high cash flows group. A
management
one-tailed alternative is used, as it is difficult to imagine circumstances under which low cash
flows group would seek to reduce discretionary accruals. This is because, as argued before,
increasing discretionary accruals, and especially producing positive accruals, to increase
reported earnings will be an objective which will be adopted by the low cash flows group to 59
offset the low operating performance.
For testing the above-stated H1, we use the test statistics for the difference between
means and medians (a t-statistic for the difference between means and a Wilcoxon z-statistic
for the difference between medians) for the low cash flows group against the high cash flows
group to see whether the two means or medians of discretionary accruals for the two groups
are different from each other.
To estimate discretionary accruals, we use the cross-sectional version of the modified

Jones (1991) model presented by Dechow et al. (1995). The cross-sectional modified Jones
(1991) model is estimated separately each year for all firms in the same industry. The
advantage of using the cross-sectional approach is that it automatically adjusts for the
effects of the specific year changes in economic conditions that influence expected accruals in
each year (Teoh et al., 1998a). However, due to the small sample sizes of the Egyptian data
and hence in this study in comparison to other studies (especially studies that are conducted
on developed markets), we estimate the modified Jones (1991) model by using pooled
cross-sectional and time-series regression for each industry (pooled cross-sectional for each
industry category). This is to have sufficient observations available in each industry to
estimate discretionary accruals. The modified Jones (1991) model is described as follows.
TAit /Ait⫺1 ⫽ ␣[1/Ait⫺1 ] ⫹ ␤[(⌬REVit ⫺ ⌬ARit )/Ait⫺1 ] ⫹ ␥[PPEit /Ait⫺1 ] ⫹ ␧it
where:
TAit ⫽ is total accruals for firm i in year t;
Ait-1 ⫽ is total assets for firm i at the beginning of year t;
⌬REVit ⫽ is the change in revenues for firm i in year t;
⌬ARit ⫽ is the change in receivables for firm i in year t;
PPEit ⫽ is the gross property, plant and equipment for firm i in year t; and
␧it ⫽ is residuals.
The above-stated modified Jones model with no intercept regresses total accruals on the
inverse of total assets at the beginning of year t, the change in revenues minus the change in
trade receivables, as in Dechow et al. (1995), deflated by total assets at the beginning of year
t, and the gross property, plant and equipment deflated by total assets at the beginning of
year t. Discretionary accruals (abnormal accruals) are obtained by subtracting fitted values
of total accruals (non-discretionary accruals) from total accruals. Therefore, discretionary
accruals are considered to be the residuals of the model (the unexplained components of total
accruals).
Based on the classification of the Egyptian Stock Exchange for its listed firms into eight
major industry categories, we estimate the modified Jones model for each of the eight
industries with a six-year panel data. It should be noted that, in this study, the modified Jones
model is estimated using data over the period 2003-2008 (the estimation period) which
corresponds to the event period.
MAJ As discussed in Section 3, the accrual approach focuses on the detection of discretionary
32,1 accruals because they can be manipulated by managers. However, the models of estimating
discretionary accruals are subject to mis-specification problems which lead to measuring
discretionary accruals with error (Healy and Wahlen, 1999). We therefore, and as a
robustness check, also examine total accruals (between the low and high operating
performance firms) because they should be free from error.
60
4.3 Measuring value relevance of earnings – testing H2
For the sake of completeness, before examining the effect of earnings management upon the
value relevance of earnings, the value relevance of earnings was first addressed for the whole
sample. Consistent with prior research (Easton and Harris, 1991; Strong, 1993; Lev and
Zarowin, 1999; Francis and Schipper, 1999; Hellström, 2006; Ragab and Omran, 2006; Filip
and Raffournier, 2010), we examine the value relevance of earnings, using the following
pooled regression model (Model 1) to estimate the association between annual stock returns
and the level and change of earnings.
Rit ⫽ ␣0t ⫹ ␣1t ⌬Eit ⫹ ␣2t Eit ⫹ ␧it (Model 1)
where Rit is annual market adjusted returns or annual raw returns (where Model 1 is
estimated under both market adjusted returns and raw returns as a dependent variable) for
firm i in year t accumulated from the fourth month of fiscal year t to the third month of fiscal
year t ⫹ 1. ⌬Eit is the change in earnings and Eit is the level of earnings for firm i in year t.
Change and level of earnings are deflated by the beginning-of-the fiscal year market value of
equity as suggested by Christie (1987) to reduce the potential problems of heteroskedasticity.
The sum (␣1 ⫹ ␣2) that combines the estimated coefficients of the change and level of
earnings represents earnings response coefficient. A positive and significant value of
(␣1 ⫹ ␣2) means that earnings have value relevance.
For testing the above-stated H2 (assessing the effect of earnings management on value
relevance of earnings), we estimate the following nonlinear regression model (Model 2) which
is an extension of Model (1). Model 2 uses a slope dummy that identifies differences in the
coefficients of earnings between low and high operating performance firms. The nonlinear
model (Model 2) has the following structure.
Rit ⫽ ␣0t ⫹ ␣1t ⌬Eit ⫹ ␣2t Eit ⫹ ␣3t Dit ⫻ ⌬Eit ⫹ ␣4t Dit ⫻ Eit ⫹ ␧it (Model 2)
where, Dit is an indicator (dummy) variable (0, 1) to determine high and low operating
performance firms, respectively. Dit takes the value of 0 when the firm belongs to high
operating performance firms (high cash flows group) and takes the value of 1 when the firm
belongs to low operating performance firms (low cash flows group). (␣1 ⫹ ␣2) is the sum of
the estimated coefficients of the change and level of earnings of high operating performance
firms. The sum (␣1 ⫹ ␣2 ⫹ ␣3 ⫹ ␣4) combines the estimated coefficients of the change and
level of earnings of low operating performance firms. A positive and significant value of
(␣1 ⫹ ␣2) and (␣1 ⫹ ␣2 ⫹ ␣3 ⫹ ␣4) implies that earnings of both high and low operating
performance firms, respectively, have value relevance. The sum (␣3 ⫹ ␣4) combines the
difference in the estimated slope coefficients of the level and change in earnings between high
and low operating performance firms. To test the above-stated H2, we hypothesize a
negative and significant value for the sum (␣3 ⫹ ␣4). A negative and significant value for the
sum (␣3 ⫹ ␣4) implies that the earnings response coefficient (value relevance of earnings) will
be significantly smaller in low operating performance firms than that for high operating
performance firms, i.e. the earnings response coefficient will be significantly smaller when Impact of
earnings management is present. earnings
As our proxy for operating performance is cash flows from operations, tests of the
above-stated H2 are directed toward comparing the sum of the estimated slope coefficients of
management
the level and change in earnings of low cash flows group to high cash flows group.
Specifically, we assess whether the sum of the estimated slope coefficients of the level and
change in earnings of low cash flows group is smaller than that of high cash flows group. We
test this hypothesis against a one-tailed alternative which permits rejection of the null 61
hypothesis only if the sum of the estimated slope coefficients of the level and change in
earnings is significantly smaller in low cash flows group compared to high cash flows group.
A one-tailed alternative is used as it is difficult to imagine circumstances under which stock
returns will be more affected by earnings of low cash flows group than those of high cash
flows group. This is because, as stated earlier, opportunistic earnings management by low
operating performance firms will lead to low marginal stock returns response to earnings.
5. Data and sample

Accounting data of this study that are reported under current EASs, an Arabic translation of
International Accounting Standards (IASs)[3], are extracted from the financial statements of
the sample firms. Consistent with previous research, the variables used to examine the value
relevance of earnings (Section 4.3) are defined as follows. First, earnings are defined as net
income available to stockholders which is the so-called “bottom line”. It represents income
before preferred and common dividends, but after operating and non-operating income and
expenses, provisions, extraordinary items, income taxes and minority interest[4]. Second,
raw returns are computed for the 12 months ending 3 months after the fiscal year-end. This
calculation of raw returns is based on that the Egyptian Companies’ Law (CL 159/1981)
obligates all firms to publish their financial statements within three months from the fiscal
year-end. Therefore, the annual raw return inclusive of dividends for stock i in year t is
defined as the natural log of closing stock price for firm i at the last day of the third trading
month after the firm’s fiscal year-end plus cash dividends divided by closing stock price for
firm i at the last day of the third trading month after the beginning of firm’s fiscal year. Third,
the annual market-adjusted return is defined as the difference between the annual raw return
on each firm’s stock and annual raw return on the EGX 30 Index (return on the EGX 30 Index
is calculated the same as the return on each firm’s stock), and both are measured over the
12-month period, beginning on the fourth month of each firm’s fiscal year. Our calculation of
the annual percentage change in each stock is adjusted for stock dividends and splits as well
as cash dividends. Fourth, the market value of equity is defined as the market closing
price-year end multiplied by the number of common shares outstanding. As stated before, we
use cash flows from operations to distinguish between low and high operating performance
firms. Cash flows are defined as cash flows from operations (net cash flows from operating
activities). It represents the net cash receipts and disbursements resulting from the
operations of the firm.
The variables required by the modified Jones model to estimate discretionary accruals
(Section 4.2) are defined similarly to previous studies that examined earnings management
under specific events (McNichols and Wilson, 1988; Jones, 1991; Defond and Jiambalvo, 1994;
Han and Wang, 1998; Yoon and Miller, 2002). First, total accruals are defined as earnings less
cash flow from operations. Second, revenues are defined as gross sales and other operating
revenue less discounts, returns and allowances (net sales). Third, receivables are defined as
trade receivables minus the allowance for doubtful accounts (net trade receivables). Fourth,
the gross property, plant and equipment are defined as gross property, plant and equipment
MAJ less accumulated provisions for depreciation, depletion and amortization (net property, plant
32,1 and equipment). Fifth, total assets are defined as the sum of total current assets, advances
payments on fixed assets or investments, investment in unconsolidated subsidiaries, other
long-term investments, goodwill, net property plant and equipment and other assets.
The accounting data are collected from the database of MISR Information Services &
Trading Corporation (MIST Corporation) and Mubasher Corporation database covering the
62 period from 2002 to 2008. MIST and Mubasher corporations are specialized in the field of
real-time, on-line, financial and stock market information dissemination services in Egypt.
MIST and Mubasher databases include financial statements, financial market data, news
and other data for almost all listed Egyptian firms. Full accounting data have been collected
from Mubasher database. As MIST data are not available in the post-2006 period, data from
before 2006 have also been collected from MIST database. Then, to ascertain the accuracy of
the data, data items from Mubasher database are compared with those from MIST database
of the same firms for years before 2006. Monthly share prices data and market value of
equity are collected from the Egyptian Capital Market Authority. Corporate actions data,
such as cash dividends, stock dividends and stock split, etc., which are necessary and
required to estimate annual stock returns, are collected from MISR for Central Clearing,
Depository and Registry.
The sample of this study consists of listed Egyptian firms included in the EGX 30 Index
from 2003 to 2009[5]. The EGX 30 is a price index commonly used to monitor the performance
of the Egyptian capital market. The EGX 30 is considered to include the leading and most
active top 30 listed Egyptian firms, with respect to their liquidity and activity, in the
Egyptian Stock Exchange. Therefore, the EGX 30 does not include small firms having
limited interest to investment community. Accordingly, our sample is not represented by a
random sample of listed Egyptian firms but contains a large percentage of the Egyptian
market in terms of market capitalization. Initially, we collected all the lists of the top 30 listed
Egyptian firms that make up the EGX 30 over the period from 2003 to 2009. This resulted
into the identification of 13 lists[6]. A check was made carefully to identify the firms across
those 13 lists[7]. The result was an identification of 72 firms where each firm is counted only
once, regardless of whether it was included in only one list or more. The sample firms
selected from those 72 firms met the following criteria. First, firms should present their
financial statements in Egyptian pound (L.E.). Second, firms should have corporate actions
data for calculating stock returns. Third, firms should have accounting or share prices data
for at least one year over the period of the study (2002 to 2008). Fourth, firms should not
belong to the financial sector. After imposing these four criteria, the sample size is reduced
into 52 firms. Table I shows the initial sample size of the study.
Data for those 52 firms are collected over the period from 2002 to 2008, but the study
begins with the 2003 fiscal year because we use changes in accounting items as independent
variables. The result was the identification of 312 firm year observations over the period
No. of firms
Table I.
Initial sample 72
Initial sample of the
study for listed Less
Egyptian firms that 1. Firms presenting their financial statements in currency other than Egyptian pound (L.E.) (3)
were included in the 2. Firms without corporate actions data (6)
EGX 30 index over the 3. Firms without accounting or share prices data through entire period 2002-2008 (2)
period from 2003 to 4. Financial firms (9)
2009 Sample size before excluding firms with insufficient data to calculate the study variables 52
from 2003 to 2008. In an emerging capital market like Egypt, one would expect that some Impact of
stocks are traded infrequently, hence including them in the analysis affects the inferences earnings
from our tests. To control the possible effects of stocks that are traded infrequently, we
removed from the study sample all observations having number of trading days less than
management
120 days during the year. After considering missing observations (84 firm-year
observations) and excluding observations falling above 99 per cent and below 1 per cent of
the distribution of the study variables (23 firm-year observations), the final sample size was
reduced to 205 firm-year observations for a sample of 52 firms covering the period 2003-2008. 63
An individual year’s estimation may be noisy and generate inconsistent results across the
years of study in case if it is based on small number of observations like the Egyptian market
data in this study. Hence, we estimate all empirical models in this study by pooling
observations across all years of the study (from 2003 through 2008).
Table II provides the distribution of the study sample according to industrial
classification based on the classification of the Egyptian Stock Exchange. The industrial
classification names on the Egyptian Stock Exchange are chemicals, construction, consumer
and household goods, entertainment, food and beverages, manufactured products, real estate
and telecommunications[8]. To separate the sample into industry categories to estimate
discretionary accruals, we use the classification of the Egyptian Stock Exchange. Therefore,
we separate the sample firms into eight major industry categories, and the modified Jones
model was run by industry category over six-year periods (2003-2008). As stated before,
estimating the modified Jones model by pooling observations across all years of the study
(instead of performing year-by-year regression) to estimate a single regression for each
industry is applied to have sufficient degree of freedom in each industry category. Table II
shows that there are insufficient observations in the entertainment sector to estimate
discretionary accruals for that sector; hence, this sector is dropped from the sample (three
firm-year observations). Therefore, the final sample is further reduced to 202 firm-year
observations for a sample of 49 firms covering the period 2003-2008.
6. Empirical results
6.1 Descriptive statistics
As stated before, from the full data set (202 firm-year observations), we construct two groups
based on the cash flows from operations ranks: low- and high-cash flows group. Descriptive
statistics of cash flows from operations and earnings for the low cash flows group (101
observations, 50 per cent), the high cash flows group (101 observations, 50 per cent) and the
entire sample (202 firm-year observations, 100 per cent) are reported in Table III.
On the level of firm year

observations from 2003 to
On the level of firms 2008
Industry Frequency (%) Frequency (%)
Chemicals 8 0.15 38 0.18

Construction 12 0.23 51 0.25
Consumer and household goods 10 0.19 45 0.22 Table II.
Entertainment 3 0.06 3 0.01 Distribution of the
Food and beverages 4 0.08 14 0.07 sample by industrial
Manufactured products 3 0.06 7 0.04 classification based on
Real estate 6 0.115 23 0.11 the Egyptian stock
Telecommunications 6 0.115 24 0.12 exchange
Total 52 1 205 1 classification
MAJ Entire sample Low cash flows group High cash flows group
32,1 Mean Median SD Mean Median SD Mean Median SD
Earnings 0.119 0.093 0.107 0.058 0.053 0.057 0.179 0.15 0.111
Cash flows from operations 0.132 0.091 0.15 0.02 0.032 0.061 0.244 0.21 0.126
Total accruals ⫺0.013 ⫺0.017 0.111 0.039 0.018 0.088 ⫺0.065 ⫺0.051 0.108
64 Discretionary accruals ⫺0.002 ⫺0.001 0.092 0.034 0.026 0.073 ⫺0.037 ⫺0.038 0.096
Notes: Cash flows from operations and earnings are deflated by total assets at the beginning of year t; The
whole sample is split into two groups with an approximately equal number of firms per group: low and high
cash flows groups. The whole sample is ranked in an ascending order by their ending-of-year cash flows from
operations deflated by total assets at the beginning of year t. Then, firms in the top group are classified as low
cash flows group and firms in the bottom group as high cash flows group. Low cash flows group represents
firms with low operating performance, whereas high cash flows group represents firms with high operating
performance; Total accruals deflated by total assets at the beginning of year t are defined as earnings minus
cash flows from operations; Discretionary accruals deflated by total assets at the beginning of year t are
Table III. defined as the residuals of the modified Jones model; The number of firm-year observations for a sample of 49
Descriptive statistics Egyptian firms over 6-year periods (2003 to 2008) for entire sample, low cash flows group and high cash flows
of the variables group are, respectively, as follows: 202, 101 and 101
For the entire sample, cash flows from operations have a mean value of 0.132. Earnings have
a mean value of 0.119. These results indicate that cash flows have a larger mean than do
earnings. This means that, on average, total accruals have a negative value. The standard
deviation of earnings is 0.107; and the standard deviation of cash flows from operations is
0.15. These results show that earnings have a lower standard deviation than that of cash
flows. This is expected because managers can use accruals to smooth out the variations in
cash flows across years. Overall, these results are consistent with US studies (Jones, 1991;
Subramanyam, 1996; Sloan, 1996).
Regarding both the low and high cash flows groups, cash flows from operations have a mean
(median) value of 0.02 (0.032) and 0.244 (0.21) for the low cash flows group and the high cash flows
group, respectively. Earnings have a mean (median) value of 0.058 (0.053) and 0.179 (0.15) for the
low cash flows group and the high cash flows group, respectively. These results show that
earnings have a higher mean and median than cash flows for the low cash flows group, whereas
cash flows have a higher mean and median than earnings for the high cash flows group. These
results indicate that the low cash flows group (low operating performance firms) has on average
a positive value for total accruals, whereas the high cash flows group (high operating
performance firms) has on average a negative value for total accruals. The positive value for total
accruals in low operating performance firms reveal that low operating performance firms are
engaged in earnings management by using accounting procedures that increase reported
earnings. The negative value for total accruals in high operating performance firms is expected,
as total accruals in industrial firms are normally expected to be negative. As argued before, in this
study, we consider firms with high performance as neutral firms; hence, they do not have any
incentive (or they have fewer incentives) to manage earnings[9]. This is to be able to compare
earnings management practices between low and high operating performance firms. It is worthy
of note that we checked the distribution of the industries for both the low and the high cash flows
groups, and the results showed that industry clustering is not likely to be a problem for this
study[10].
Table III also shows the descriptive statistics of total accruals and discretionary accruals
for the low cash flows group, the high cash flows group and the entire sample. The following
results are based on the figures of discretionary accruals; however, these results are also
applicable to total accruals. This is because a similar pattern of results for discretionary
accruals is observed for total accruals. The mean (median) of discretionary accruals is 0.034 Impact of
(0.026) for low cash flows group, compared to ⫺0.037 (⫺0.038) for high cash flows group and earnings
⫺0.002 (⫺0.001) for entire sample. These results show that the low cash flows group
produces the highest discretionary accruals; and the high cash flows group is the lowest,
management
with the entire sample lying in between. Moreover, the mean and median discretionary
accruals are positive for the low cash flows group (the low operating performance firms) and
negative for the high cash flows group (the high operating performance firms). This means
that firms with low operating performance are increasing earnings in comparison to firms 65
with high operating performance.
6.2 Results of earnings management test

Table IV reports t-statistics and p-values for tests of the significance of the differences
between the means of total accruals and discretionary accruals of low and high cash flows
groups. As we have predicted the direction of the expected differences between the two
groups, the t-statistics and p-values are one-tailed (Section 4.2). The comparison between the
low and high cash flows groups shows that the means for the low cash flows group are
positive and significantly higher than those of the high cash flows group at the 0.0000 level.
The difference between the means for the two sample groups is 0.104 (t-stat ⫽ 7.492) and
0.071 (t-stat ⫽ 5.893) for the total accruals and discretionary accruals, respectively.
The above-stated results provide strong support for H1 of earnings management in low
operating performance firms. Hence, the evidence in Table IV supports the hypothesis that
there is income-increasing opportunistic earnings management when operating performance
is low. This is because the total and discretionary accruals of low cash flows group (low
operating performance firms) are positive and significantly higher than those of high cash
flows group (high operating performance firms). This means that low operating performance
firms are taking earning-increasing strategies to mask their low operating performance. This
result is consistent with Yoon and Miller (2002). However, Yoon and Miller’s (2002) major
findings are that, when operating performance is poor, the firms tend to choose
income-increasing strategies, and, when operating performance is extremely poor, firms tend
to take “a big bath”, while some of the exceptionally well-performing firms tend to select
income-decreasing strategies. In general, our finding is consistent with prior studies that
indicate that earnings management occurs for a variety of reasons (Healy, 1985; Jones, 1991;
Defond and Jiambalvo, 1994; Teoh et al., 1998a, 1998b; Yoon and Miller, 2002). Consequently,
our finding shows that low operating performance is also a reason for earnings management.
Table V reports z-statistics and p-values for tests of the significance of the differences
between the medians of total accruals and discretionary accruals for the low and high cash
Mean
(1) Low cash (2) High cash
Accruals flows group flows group Difference (1-2) T-stat p-value
Total accruals 0.039 ⫺0.065 0.104 7.492 0.0000

Discretionary accruals 0.034 ⫺0.037 0.071 5.893 0.0000
Notes: Total accruals deflated by total assets at the beginning of year t are defined as earnings minus cash
flows from operations; Discretionary accruals deflated by total assets at the beginning of year t are defined as Table IV.
the residuals of the modified Jones model; Low and high cash flows groups are defined as in Table III; The Mean accruals (total
number of firm-year observations for a sample of 49 Egyptian firms over 6-year periods (2003 to 2008) for low accruals and
cash flows group and high cash flows group, respectively, are as follows: 101 and 101; t-stat is the t-statistic discretionary accruals)
along with p-value (one-tailed test) of the corresponding difference difference tests
MAJ flows groups. The results have not changed and were identical to those derived from testing
32,1 the significance of the differences between the means of total and discretionary accruals (as
reported in Table IV and as discussed above). Again, these findings support H1.
Overall, the possible interpretation of all the above-stated results is that, given that
the magnitude of accruals (total accruals and discretionary accruals) tends to vary
between low- and high-operating performance firms where firms with low operating
66 performance have positive and larger magnitude of accruals than firms with high
operating performance, then low operating performance firms are engaged in
opportunistic earnings management strategies by adopting income increasing actions to
hide their low operating performance[11].
6.3 Impact of earnings management on value relevance of earnings

Model 1 is used to examine the value relevance of earnings (without addressing the effect of
earnings management) through regressing stock returns on earnings changes and levels.
Table VI shows coefficients and t-statistics along with p-values for two-tailed of regression
Median
(1) Low cash (2) High cash
Accruals flows group flows group Difference (1-2) Z-stat p-value
Total accruals 0.018 ⫺0.051 0.069 8.498 0.0000f

Discretionary accruals 0.026 ⫺0.038 0.064 6.622 0.0000
Notes: Total accruals deflated by total assets at the beginning of year t are defined as earnings minus cash
Table V. flows from operations; Discretionary accruals deflated by total assets at the beginning of year t are defined as
Median accruals (total the residuals of the modified Jones model; Low and high cash flows groups are defined as in Table III; The
accruals and number of firm-year observations for a sample of 49 Egyptian firms over 6-year periods (2003 to 2008) for low
discretionary accruals) cash flows group and high cash flows group, respectively, are as follows: 101 and 101; Z-stat is the Z-statistic
difference tests along with p-value (one-tailed test) of the corresponding difference
Coefficients (t-statistics and p-values)

␣0 ␣1 ␣2 Sum of (␣1 ⫹ ␣2 ) Adj.R2
Panel A: Pooled cross-sectional time-series regression with market-adjusted returns

0.128 0.934 0.955 1.889 0.122
t-statistics 0.767 4.747 4.255 5.655
p-value 0.4442 0.0000 0.0000 0.0000
Panel B: Pooled cross-sectional time-series regression with raw returns
⫺0.119 0.884 0.396 1.28 0.079
t-statistics ⫺1.482 4.408 1.646 4.071
p-value 0.1401 0.0000 0.1013 0.0000
Notes: Model 1 Rit ⫽ ␣0t ⫹ ␣1t⌬Eit ⫹ ␣2tEit ⫹ ␧it; Rit is the annual market-adjusted returns or annual raw
returns of firm i in year t. Both are measured over the fourth month of year t to the third month of year t ⫹ 1,
where Model 1 is estimated under both market-adjusted return and raw return as a dependent variable; ⌬Eit
is the change in earnings and Eit is the level of earnings for firm i in year t. These variables are deflated by the
market value of equity at the beginning of year t; The sample size is 202 of firm year observations for a sample
Table VI. of 49 listed Egyptian firms over 6-year periods from 2003 to 2008; (␣1 ⫹ ␣2) combines the estimated coefficients
Pooled sample results of the change and level of earnings; White cross-section method is used to control for the potential effects of
for value relevance of heteroskedastic and autocorrelation in the errors; t-stat is the t-statistic along with two-tailed p-value of the
earnings corresponding estimation
results for Model 1 under both market adjusted returns and raw returns as a dependent Impact of
variable. Value relevance of earnings is assessed by examining the statistical significance of earnings
the sum of the two slope coefficients on the change and level of earnings. In Panel (A) of
Table VI, with market-adjusted returns as a dependent variable, the summed coefficients of
management
the level and change in earnings is significantly positive at the 1 per cent level (1.889, t ⫽
5.655). In Panel (B), similar results are presented with raw returns as a dependent variable.
These results suggest that earnings have value relevance. These results are consistent with
the findings of prior research (Easton and Harris, 1991; Strong, 1993; Hellström, 2006; Ragab
67
and Omran, 2006; Filip and Raffournier, 2010; Mostafa, 2014).
As discussed, this study investigates whether the opportunistic earnings
management decreases the value relevance of earnings. Section 6.2 confirms the
opportunistic earnings management practices by low operating performance firms.
Therefore, here we examine the impact of such opportunistic earnings management
practices on the value relevance of earnings. Model 2 examines the value relevance of
earnings of low and high operating performance firms via regressing stock returns on
earnings changes and levels and a slope dummy for earnings changes and levels of firms
with low operating performance. Hence, Model 2 estimates the coefficients parameters
that form the sum of the coefficients of the level and change in earnings (earnings
response coefficients) of low and high operating performance firms. Moreover, Model 2
identifies differences in the coefficients of the level and change in earnings between low
and high operating performance firms. As discussed in Section 4.3, to assess whether
opportunistic earnings management reduces the value relevance of earnings, we test the
significance of the difference in earnings response coefficients between low and high
operating performance firms. As we have predicted the direction of the expected
difference, the t-statistics and p-values are one-tailed (Section 4.3).
Table VII shows coefficients and t-statistics along with p-values for one-tailed of
regression results for Model 2 under both market-adjusted returns and raw returns as a
dependent variable. In Panel A, with market-adjusted returns as a dependent variable, the
summed coefficients of the change and level of earnings of high operating performance firms
(high cash flows group) (␣1 ⫹ ␣2) is 2.223 (t ⫽ 11.939). The value 2.223 is significantly
positive at the 1 per cent level. The summed coefficients of the change and level of earnings
of low operating performance firms (low cash flows group) (␣1 ⫹ ␣2 ⫹ ␣3 ⫹ ␣4) is 1.59 (t ⫽
4.742). The value 1.59 is significantly positive at the 1 per cent level. These results suggest
that earnings of both low and high operating performance firms have value relevance. The
difference in the summed slope coefficients of the level and change in earnings as we move
from the earnings of high operating performance firms [with slope coefficients (␣1 ⫹ ␣2)] to
the earnings of low operating performance firms [the slope coefficients being (␣1 ⫹ ␣2 ⫹
␣3 ⫹ ␣4)] is ⫺0.633 (␣3 ⫹ ␣4) (t ⫽ ⫺1.939). The value ⫺0.633 is significantly negative at the
5 per cent level. These results show that the earnings response coefficient is significantly
smaller for earnings of low operating performance firms than that for earnings of high
operating performance firms. This means that the marginal price response to earnings of low
operating performance firms is significantly smaller than that to earnings of high operating
performance firms. In other words, this result suggests a smaller impact from earnings of
firms with low operating performance (that manage earnings) on returns and a greater
impact from earnings of firms with high operating performance (that do not manage
earnings) on returns. In Panel (B), similar results are presented with raw returns as a
dependent variable. However, in the case of raw returns, the difference in informativeness of
earnings between low and high operating performance firms is more prominent where
(␣3 ⫹ ␣4) is significantly negative at the 1 per cent level (⫺1.389, t ⫽ ⫺2.769)[12].
MAJ Coefficients (t-statistics & P-values)
32,1 Sum Sum Sum
␣0 ␣1 ␣2 ␣3 ␣4 (␣1⫹␣2) (␣3⫹ ␣4) (␣1⫹␣2 ⫹ ␣3⫹ ␣4 ) Adj.R2
Panel A: Pooled cross-sectional time-series regression with market-adjusted returns

0.123 1.087 1.136 ⫺0.26 ⫺0.373 2.223 ⫺0.633 1.59 0.12
68 t-statistics 0.698 2.407 1.938 ⫺0.442 ⫺0.669 11.939 ⫺1.939 4.742
p-value 0.2430 0.0085 0.0271 0.3296 0.2522 0.0000 0.0269 0.0000
Panel B: Pooled cross-sectional time-series regression with raw returns
⫺0.109 1.745 0.31 ⫺1.142 ⫺0.247 2.055 ⫺1.389 0.666 0.099
t-Statistics ⫺1.129 4.657 0.886 ⫺1.946 ⫺0.417 7.188 ⫺2.769 2.400
p-value 0.1302 0.0000 0.1883 0.0266 0.3385 0.0000 0.0031 0.0087
Notes: Model 2 Rit ⫽ ␣0t ⫹ ␣1t⌬Eit ⫹ ␣2tEit ⫹ ␣3tDit ⫻ ⌬Eit ⫹ ␣4tDit ⫻ Eit ⫹ ␧it; Rit is the annual
market-adjusted returns or annual raw returns of firm i in year t. Both are measured over the fourth month of
year t to the third month of year t ⫹ 1, where Model 2 is estimated under both market adjusted return and raw
return as a dependent variable; ⌬Eit is the change in earnings and Eit is the level of earnings for firm i in year
t. These variables are deflated by the market value of equity at the beginning of year t; The sample size is 202
of firm year observations for a sample of 49 listed Egyptian firms over 6-year periods from 2003 to 2008; White
cross-section method is used to control for the potential effects of heteroskedastic and autocorrelation in the
errors; t-stat is the t-statistic along with one-tailed p-value of the corresponding estimation; The whole sample
is split into two groups with an approximately equal number of firms per group: low and high cash flows
groups. The whole sample is ranked in an ascending order by their ending-of-year cash flows from operations
deflated by total assets at the beginning of year t. Then, firms in the top group are classified as low cash flows
group and firms in the bottom group as high cash flows group. Dit ⫽ 0 for high cash flows group and Dit ⫽ 1
Table VII. for low cash flows group. Low cash flows group represents firms with low operating performance, whereas
Pooled sample results high cash flows group represents firms with high operating performance; (␣1 ⫹ ␣2) combines the estimated
for value relevance of coefficients of the change and level of earnings of high operating performance firms; (␣1 ⫹ ␣2 ⫹ ␣3 ⫹ ␣4)
earnings in high and combines the estimated coefficients of the change and level of earnings of low operating performance firms;
low operating (␣3 ⫹ ␣4) combines the difference in the estimated coefficients of the change and level of earnings between
performance firms high and low operating performance firms
Overall, these findings indicate that earnings of low operating performance firms (that
are engaged in opportunistic earnings management) have less value relevance than
earnings of high operating performance firms[13]. These results suggest that earnings
have decreased value relevance when income-increasing opportunistic earnings
management is present among low operating performance firms. These findings are
consistent with prior studies which have examined the impact of opportunistic earnings
management on value relevance of earnings in different contexts (Christensen et al.,
1999; Marquardt and Wiedman, 2004).
The above-stated results provide strong support for H2 of the effect of the opportunistic
earnings management on the value relevance of earnings. Hence, the evidence in Table VII
supports the hypothesis that value relevance of earnings (measured by earnings response
coefficient) is less in the presence of opportunistic earnings management due to the low
operating performance. Under the assumption that investors are wary of the upward
manipulation of earnings by low operating performance firms, these results suggest that
earnings that are subject to managerial manipulation are not particularly informative (or
that they are less informative) for investors, whereas investors’ belief that earnings that are
not subject to managerial manipulation are largely informative. The possible interpretation
of these results is that the presence of opportunistic earnings management impairs the value
relevance of earnings.
7. Concluding remarks Impact of
Based on data from Egypt, this study has examined whether the value relevance of earnings earnings
(measured by earnings response coefficient of return earnings relation) is affected by the
opportunistic earnings management. Different from prior research and due to data
management
limitations in the Egyptian market, our analysis focuses on the whole operating
performances of the firms, rather than a specific event or incentive, by examining the impact
of low operating performance on management’s incentive to manage earnings, and then the
effect of earnings management due to this low operating performance on value relevance of
69
earnings. Therefore, we extend prior research by examining the effect of opportunistic
earnings management on the informativeness of earnings in a different setting (low
operating performance) in which opportunistic earnings management is likely to occur.
We first present evidence that low operating performance firms increase discretionary
accruals to manage their reported earnings opportunistically upward (increase their reported
earnings) to conceal their low operating performance as compared to high operating
performance firms. These results reveal that operating performance affects earnings
management practices. Specifically, these results suggest that low operating performance
firms have a tendency to increase reported earnings compared to high operating
performance firms. There are several incentives that may be applied to the case of
income-increasing strategy when operating performance is low. These incentives include, for
example, first, managers may want to get higher compensation from increase reported
earnings when their compensation is linked to earnings. They may want to report higher
earnings than actual when their operating performance is below the expected or tolerated
level. This will lead them to manage income. Second, they will also have an incentive to
increase earnings, if they want to boost their firm’s stock prices.
After confirming the opportunistic earnings management practices by low operating
performance firms, we then investigate whether the value relevance of earnings differs in the
low operating performance firms compared to high operating performance firms. We find
that the earnings response coefficient of earnings of low operating performance firms is
lower than that of earnings of high operating performance firms. This result shows that there
is a decreased value relevance of earnings when opportunistic earnings management is
present by low operating performance firms, i.e. the earnings of firms with low operating
performance (that are engaged in opportunistic earnings management) are less value
relevant than the earnings of firms with high operating performance. Under the assumption
that the users of financial statements are generally wary of earnings management practices
by low operating performance firms, these results suggest that earnings that are subject to
managerial manipulation are particularly less informative for investors, whereas investors’
belief that earnings that are not subject to managerial manipulation are largely informative.
Therefore, opportunistic earnings management has a negative impact on the value relevance
of earnings communicated to users of financial statements. The fact that corporate
governance affects earnings management is well established in the literature. Therefore, given
the current weak shareholder protection and regulatory enforcement regime in Egypt, the
results of this study that show that opportunistic earnings management reduces the value
relevance of earnings would/should encourage policy makers in Egypt to improve corporate
governance mechanisms generally.
This study finds evidence consistent with the premises that managers of low operating
performance firms do manage earnings upward, and these earnings management practices
reduce the value relevance of earnings. Given that we address earnings management based
on the whole operating performances of the firms, this evidence gives only a general idea
about the existence of earnings management and its effect on the value relevance of earnings
MAJ in the listed Egyptian firms. This is because this study does not examine the effect of
32,1 earnings management under specific incentives or events, similar to those examined in
developed countries, on the value relevance of earnings. Therefore, future research in Egypt
regarding this area could, for example, consider the following issues as more data becomes
available.
It is assumed that the incentives for earnings managements are similar. However, new
70 studies in Egypt (with very different cultures and political structures) should explore similar
(as in developed countries) or other incentives for earnings management, when trying to
interpret the behavior of management in Egypt, and then the impact of earnings
management due to these incentives on the value relevance of earnings or accounting
information. Therefore, it would be interesting to choose a specific incentive and examine
whether discretionary accruals are consistent with this incentive, and then examine the
impact of earnings management because of this incentive on the value relevance of earnings
or accounting information. Examples of such incentives include debt covenants,
management compensation, import relief and political cost. If such incentives are reasons for
earnings management practices and if that adversely affect value relevance of earnings or
accounting information, this would indicate that Egyptian corporations allow managers to
make short-term profits at the expense of their current shareholders. This suggests that
corporate governance mechanisms should be improved, and there might be a call for more
oversight. Additionally, future research in Egypt could also be expanded to include, in
addition to such incentives, corporate events as well. Examples of such events are equity
offerings, debt offerings and takeovers.
Notes
1. We define “the operating performance” as the economic performance of the firm for the period that
reflects economic results as they are. In this study, our proxy for the operating performance is cash
flows from operations.
2. However, high operating performance firms may generally have incentives to manage earnings
downward by using income-decreasing policies to reduce their reported earnings when these firms
are driven by such incentives as political costs reduction and/or tax expenses reduction.
3. In 1997, all firms listed on the Egyptian Stock Exchange were obligated by the Egyptian
government to comply with the EASs based on the IASs.
4. Most previous studies on earnings management defined earnings as net income before extraordinary
items because earnings that exclude extraordinary items are a less volatile measure than earnings after
extraordinary items. However, in this study that begins with the year 2003, we define earnings as net
income after extraordinary items because earnings before extraordinary items are not available in the
financial statements of the firms from 2003 onward. This is because in 2003, the last amendment of IAS
No. 1 “Presentation of Financial Statements” entails no disclosure of operating income in the income
statement and forbids the distinction between ordinary and extraordinary items.
5. The empirical work of this study starts from 2003 onwards because the EGX 30 index has been
disseminated from February 2003 onwards. However, EGX 30 was calculated back until 1998.
6. The 13 lists of the EGX 30 Index are acquired from Egypt for Information Dissemination
Corporation (EGID Corporation).
7. The EGX 30 Index is revised semi-annually (in February and August each year). Based on that,
there are two different lists from firms making the EGX 30 Index for each year.
8. The Egyptian Stock Exchange categorized all its listed firms into 12 sectors. Eight of these sectors
have already been mentioned above. The remaining four sectors are financial services, banking,
basic materials and pharmaceuticals and health care. As shown above, the financial services and
banking industry sectors are excluded in the sampling process. Due to the homogeneous
characteristics between the basic materials and construction industry sectors, the firms of the basic
materials industry sector are included with the firms of the construction industry sector because the Impact of
number of firms in the basic materials sector is very limited. This is to have sufficient degrees of
freedom when estimating discretionary accruals for each major industry categories. Finally, for the
earnings
same reasons, we have included the pharmaceuticals and health care industry sector with the management
chemicals industry sector.
9. As indicated above, total accruals in industrial firms are normally expected to be negative due to their
large non-cash expenses. However, this could also indicate that firms are engaged in earnings
management by using income-decreasing policies. However, high operating performance firms are not 71
expected to reduce their reported earnings unless these firms are driven by such incentives as political
costs reduction and/or tax expenses reduction. The circumstances that create such incentives to reduce
earnings deliberately not addressed in the current study. This is because a large percentage of our sample
firms is privatized public firms in which there is considerable state ownership, and thus managers of these
privatized public firms are inclined to use accruals opportunistically to bias earnings upwards (not
downwards) to get higher compensation and to boost their firm’s stock prices. This argument is consistent
with Noronha et al. (2008) with respect to earnings management in the Chinese emerging market. As a
result, it is unlikely that our sample firms include firms with high operating performance that use earnings
management to reduce earnings.
10. This means that both low and high cash flows groups contain firms from the all eight major
industry categories used in this study.
11. As a sensitivity test, we estimate discretionary accruals using the cross-sectional version of the Jones
model, modified by Kothari et al. (2005). The Jones model modified by Kothari et al. (2005) is almost the
same as the Jones (1991) model. However, in Kothari et al. (2005), return on assets is added as an
additional control variable because previous research found that the Jones model is mis-specified for
well-performing or poorly performing firms (Dechow et al., 1995; Kothari et al., 2005). The results are
similar to those derived from using the modified Jones model presented in Dechow et al. (1995) which are
reported in Sections 6.1 and 6.2.
12. For robustness checks to the results of Model 2, an alternative method for distinguishing between
low and high operating performance firms was used. The data set is classified into two sub-groups.
The first sub-group includes firms that report negative cash flows, whereas the second includes
firms that report positive cash flows. The negative cash flows group represents firms with low
operating performance, whereas the positive cash flows group represents firms with high operating
performance. The total accruals and discretionary accruals of the negative cash flows group were
positive and significantly higher than those of positive cash flows group. After we confirm the
earnings management practices of low operating performance firms (the negative cash flows
group), we then re-estimate Model 2 where Dit ⫽ 1 when the firm belongs to negative cash flows
group, and equals 0 when the firm belongs to positive cash flows group. The results show that the
earnings response coefficient is significantly smaller for earnings of low operating performance
firms (negative cash flows group) than that for earnings of high operating performance firms
(positive cash flows group). Thus, the results have not changed and were identical to those derived
from using low and high cash flows groups for identifying low and high operating performance
firms as reported in Section 6.3.
13. Model 2 used a dummy variable approach to examine the value relevance of earnings of low and
high operating performance firms. For a robustness check to the results of Model (2), the regression
results of Model (1) (i.e., Rit ⫽ ␣0t ⫹ ␣1t⌬Eit ⫹ ␣2tEit ⫹ ␧it) were separately generated for low
operating performance firms (low cash flows group) and high operating performance firms (high
cash flows group), and then the values of adjusted R2 across the two sub-groups were compared.
The results show that adjusted R2 of low operating performance firms (0.055 and 0.016) is
substantially lower than that of high operating performance firms (0.233 and 0.182) for
market-adjusted returns and raw returns, respectively. These results are consistent with the results
of Model 2 (reported in Section 6.3) and confirm that the market places less weight on earnings of
low operating performance firms than on earnings of high operating performance firms. Hence, the
presence of opportunistic earnings management by low operating performance firms reduces the
value relevance of earnings.
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About the author

Wael Mostafa holds a PhD in Accounting and Finance from the University of Durham, UK. He is an
Associate Professor of Accounting at Faculty of Commerce, Ain Shams University, Egypt. His main
area of research is related to the information content of accounting information, earnings management
and accounting conservatism. He has published several research papers in international referred
journals such as Review of Accounting & Finance, Management Research Review, Managerial Finance
and International Research Journal of Finance and Economics. Wael Mostafa can be contacted at:
waelsedik@hotmail.com
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Managerial Auditing Journal

The impact of earnings management on the value relevance of earnings: Empirical

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2. Motivation of the study

investigate whether the value relevance of earnings is related to earnings management.

3. Previous research, research questions and hypotheses

4.2 Detecting earnings management – testing H1

To estimate discretionary accruals, we use the cross-sectional version of the modified

TAit /Ait⫺1 ⫽ ␣[1/Ait⫺1 ] ⫹ ␤[(⌬REVit ⫺ ⌬ARit )/Ait⫺1 ] ⫹ ␥[PPEit /Ait⫺1 ] ⫹ ␧it

Rit ⫽ ␣0t ⫹ ␣1t ⌬Eit ⫹ ␣2t Eit ⫹ ␧it (Model 1)

5. Data and sample

On the level of firm year

Chemicals 8 0.15 38 0.18

6.2 Results of earnings management test

Total accruals 0.039 ⫺0.065 0.104 7.492 0.0000

6.3 Impact of earnings management on value relevance of earnings

Total accruals 0.018 ⫺0.051 0.069 8.498 0.0000f

Coefficients (t-statistics and p-values)

Panel A: Pooled cross-sectional time-series regression with market-adjusted returns

Panel A: Pooled cross-sectional time-series regression with market-adjusted returns

About the author

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