Abstract
Purpose– The purpose of this paper is to examine whether the contracting incentives (i.e. bonus plans, debt covenants, political costs hypotheses), and income smoothing can explain accounting choices in an emerging country, Egypt.Design/methodology/approach– The paper uses the ordinary least square regression model to examine the relationship between earnings management and reporting objectives. A sample of 438 non-financial firms listed on the Egyptian Exchange over the period 2005-2007 is used.Findings– The paper finds that the contracting objectives explain little of the variations in accounting choices (i.e. discretionary accruals) in the Egyptian context. However, the paper finds that mangers are likely to smooth the reported earnings by managing the accrual component in an attempt to reduce the fluctuation in reported earnings by increasing (decreasing) earnings when earnings are low (high) in attempt to reduce the variability of the reported earnings.Research limitations/implications– The empirical results rely on the ability of earnings management proxies to adequately capture earnings manipulation activities.Practical implications– The findings of the study should be of substantial interest to regulators and policy makers. The results implicitly contribute to the ongoing argument in relation to the optimal flexibility permitted by standard setting and the argument that tightening the accounting standards and mandating International Financial Reporting Standards are likely to improve reporting quality and reduce opportunistic earnings management. The results reveal that many of the weaknesses related to corporate reporting in emerging countries may result from the inadequate enforcement of the law and the weak legal protection of minority shareholders. The results also highlight the crucial role of understanding the reporting incentives, which is mainly shaped by institutional and market forces and the legal environment, in explaining accounting choices.Originality/value– Unlike previous studies that tested an individual objective, this study examines the trade-offs among various reporting objectives in an emerging economy.
Highlights
The efficient contracting perspective of accounting choices provides evidence consistent with the idea that managers exercise accounting discretion to increase their compensation, avoid debt covenants violation, and reduce the chance of exposure to political or governmental intrusions in its business’s affairs
Proxies for earnings management We employ the cross-sectional approach of the modified Jones model suggested by Dechow et al (1995), and the performance-adjusted Jones model suggested by Kothari et al (2005) to isolate discretionary accruals, which are used as proxies for earnings management
The results of the regression analysis lend credence to the idea that the traditional costly contracting incentives provide little explanation for discretionary accruals choices in Egypt, while income smoothing activity explains much of the cross sectional variation in managerial choices
Summary
The efficient contracting perspective of accounting choices provides evidence consistent with the idea that managers exercise accounting discretion to increase their compensation, avoid debt covenants violation, and reduce the chance of exposure to political or governmental intrusions in its business’s affairs. While recognizing the role of timely financial statements in channelling information, the information asymmetry problem in emerging countries is more likely resolved by closer personal channels and private communications with dominant shareholders (Ball et al, 2000). The majority of Egyptian board members are considered weak because they are usually chosen from family, close relatives, and friends who lack adequate financial knowledge (Sourial 2004). This is, in turn, more likely encourage resource expropriation and allow controlling shareholders to more manage the firm’s reported earnings (e.g., Guthrie and Sokolowsky, 2010)
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