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MAJ
25,1
32
Received 7 January 2008
Revised 29 March 2009
Accepted 1 July 2009
Managerial Auditing Journal
Vol. 25 No. 1, 2010
pp. 32-52
q Emerald Group Publishing Limited
0268-6902
DOI 10.1108/02686901011007298
Assessing the perceptions
of the quality of reported
earnings in Egypt
Hany Kamel
Business Administration College,
Al Ain University of Science and Technology,
Al Ain, United Arab Emirates, and
Said Elbanna
College of Business and Economics,
United Arab Emirates University, Al Ain, United Arab Emirates
Abstract
Purpose – The purpose of this paper is to assess respondents’ perceptions of the quality of reported
earnings in Egypt. To this end, three main issues are investigated: first, the potential incentives
for engagement in earnings manipulation; second, the techniques most frequently used in
manipulating earnings; and finally, the actions required to improve the quality of accounting
information, including the reported earnings.
Design/methodology/approach – A total of 16 semi-structured interviews are conducted in order
to uncover any undisclosed issues and to supplement the results provided by a questionnaire survey
distributed among three groups of respondents, namely, accounting academics, external auditors, and
financial managers.
Findings – The results indicate that the main incentives for manipulating earnings in Egypt are to
enhance the chances of obtaining a bank loan; to sustain last year’s profit performance; to report
profits and to avoid reporting losses; and to achieve high-share valuation. The results also
demonstrate that making inadequate provisions; capitalising rather than expensing expenditures; and
overestimating the inventory value are the most frequently used techniques in earnings manipulation.
Practical implications – The results could be of assistance to Egyptian external auditors and
regulators in their attempt to limit the incidence of earnings manipulation.
Originality/value – With a few exceptions, most of the literature on earnings management has been
based on the US data. Therefore, research undertaken in a country such as Egypt, where the environment
in many respects is different, may reveal a different perception of the quality of reported earnings and help
determine how preparers in Egypt can further improve the quality of reported earnings.
Keywords Earnings, Financial reporting, Corporate governance, Egypt
Paper type Research paper
1. Introduction
It is well known that the central role of reported earnings is to assist external users of
financial reports in evaluating firms’ economic performance through the use of basic
accounting principles (Financial Accounting Standards Board (FASB), 1978).
Nevertheless, because earnings are subject to managerial discretion and potentially
to manipulation, their contribution to reflecting firms’ underlying economics is
questionable. The Securities and Exchange Commission (SEC) has concluded, after the
recent string of accounting scandals that has rocked the US stock markets, that there is
a systematic reporting problem in the USA. Many publicly held companies are abusing The quality
the financial reporting process by excessively managing their earnings. Describing this of reported
situation, former SEC chairman, Levitt (1998), declared that “earnings management is
on the rise and the quality of financial reporting is on the decline”. In addition, Feltham earnings
and Pae (2000) show that “noisy” earnings management, which garbles, rather than
improving the informativeness of earnings, results in poorer quality and value
relevance of earnings reporting. This finding has recently been supported by 33
Marquardt and Wiedman (2004b), who demonstrate that opportunistic earnings
management impairs the value relevance of earnings for a sample of firms issuing
secondary shares.
In a comprehensive review of “market-based accounting research” on the
information content of reported earnings, Lev (1989) concludes that the explanatory
value of earnings for share returns and subsequently the usefulness of earnings
disclosures, tends to be very low and sometimes negligible. Lev (1989) attributes these
disappointing results to the poor quality of reported earnings, because of bias
introduced by accounting measurement practices or creative abuses of the earnings
measurement process. Therefore, Lev (1989) recommends that research on the motives
and consequences of financial reporting manipulation should be an integral part of the
quality of the reported earnings research agenda. Consistent with this view, a
substantial number of earnings management studies have emerged. Most of these
studies have been conducted in the USA. However, since the propensity to manage
earnings may vary internationally, continuous research efforts are still needed in other
countries to explore the opportunities for management to manage, or presumably
manipulate, the level or trend of reported earnings according to its interests.
In the context of Egypt, the government embarked in 1991 on an Economic Reform
and Structural Adjustment Programme designed with the assistance of the
international monetary fund and the World Bank. The main objective of this
programme was to introduce market-oriented economic policies and to create a new
economic environment in which the private sector takes the lead. The most important
and challenging component for achieving this objective was the privatisation of public
sector enterprises. In doing so, the legal and organisational framework was established
in 1991 with the Public Business Sector Law No. 203, which paved the way for the
transformation of 314 public sector enterprises into 17 holding companies (later
reduced to ten) in order to facilitate the subsequent transfer of ownership to private
investors (Kamel, 2009). Hence, this business environment is expected to create a set of
incentives for earnings manipulation by the managers of state-owned enterprises in
order to achieve the performance levels expected by their superiors in the holding
companies. Also, it should be noted that since 1997 the Egyptian privatisation
programme has provided the opportunity for private companies to issue capital in the
stock market. These companies are likely to have a different set of incentives when
they declare their own figures of reported earnings. Therefore, without further detailed
research involving direct questions about the earnings management strategies of
individual managers, it is impossible to determine the dominant incentives for
manipulating earnings in Egypt.
As mentioned earlier, a review of the research on earnings management reveals
that most of the literature, with a few exceptions, has been based on US data. There
is very little published research on earnings management in developing countries.
MAJ Therefore, research undertaken in a country such as Egypt, where the socio-economic
25,1 environment in many respects is different (e.g. the shareholding structures of many
Egyptian companies were concentrated in the hands of the state before going public;
there are relatively few sophisticated users of financial reports; and internal corporate
governance tends to be weakly structured), may reveal a different perception of the
quality of reported earnings and help determine whether this setting leads to a higher
34 or lower propensity for earnings management. Accordingly, this paper aims to
discover why and how earnings management is practised in Egypt, and if so, how the
country could tackle this problem. To serve this purpose, the decision was made in this
study to examine the perceptions of three different groups of respondents, namely,
accounting academics, external auditors and financial managers or senior accountants,
regarding the current quality of reported earnings disclosed by Egyptian companies[1].
The remainder of this paper is organised as follows. Section 2 presents a critical
review of the relevant literature on the subject. Section 3 describes the methodology
employed in the present paper. Section 4 reports and discusses the empirical results of
our study and finally Section 5 draws some conclusions.

2. Literature review
Since SEC Chairman Arthur Levitt’s “Numbers Game” speech before the New York
University’s Centre for Law and Business in September 1998, earnings management has
received considerable attention from accounting regulators and the investment
community, who are concerned about the negative effects that earnings management
can have on earnings quality and financial reporting. Meanwhile, attempts have been
made in the academic literature to examine the many different incentives for engaging in
earnings manipulation.
Stolowy and Breton (2004) have recently developed a three-fold classification of
managerial incentives which have the aim of manipulating earnings. The first category
covers those incentives that attempt to minimise the cost of capital required by firms.
Prior investigations on this category typically include the incentives of managers to
manipulate earnings towards reporting positive profits, sustaining last year’s
performance and meeting management’s expectations. Burgstahler and Dichev (1997),
for example, find that earnings management to avoid annual losses and earnings
decreases is common. Also, Degeorge et al. (1999) find that it is crucial for managers to
avoid losses, but once profitability is achieved, every effort will be made to report
increases in earnings, and once increases are achieved, the managers’ goal will be
turned to meeting analysts’ earnings forecasts. Furthermore, Dutta and Gigler (2002)
indicate that earnings management is more likely to follow high-earnings forecasts
than low-earnings forecasts; and it is easier to prevent managers from manipulating
earnings if they are asked to forecast earnings.
Managers may also have the incentives to manipulate earnings around the time of
new share offers in order to influence the offering proceeds. It has been documented
that firms opportunistically manipulate earnings upwards before they go public, in an
attempt to persuade potential investors to form overly optimistic expectations
regarding future post-issue earnings. Consequently, offering firms are able to
maximise their offering prices in the short-run; however, subsequent earnings and
share return performance tend to suffer as a result of such manipulation (Teoh et al.,
1998a, b; DuCharme et al., 2001; Roosenboom et al., 2003). In the same vein, there is
another group of studies asserting that managers may attempt to deceive investors and The quality
even financial analysts, in order to preserve high-share valuation. According to this of reported
claim, investors are expected to be unable to detect the direction and magnitude of the
managed portion of reported earnings. Hence, investors may tend to over-value firms earnings
practising income-increasing earnings management and under-value firms practising
income-decreasing earnings management (Sloan, 1996; Chambers, 1999).
Debt contracts are also expected to create an incentive for some corporate managers 35
to manage earnings in order to avoid the violation of these contracts (DeFond and
Jiambalvo, 1994; Kasanen et al., 1996). The main intention for this type of contract is to
limit management’s ability from benefiting firm’s investors over its creditors. Yet, after
reviewing the empirical research on accounting choices, Fields et al. (2001, p. 275)
conclude that “the evidence on whether accounting choices are motivated by debt
covenant concerns is inconclusive”.
The second category of incentives, as reported by Stolowy and Breton (2004),
includes all the incentives that are created by compensation agreements. Of course, one
good reason for managers to engage in earnings manipulation would be their
remuneration package. Watts and Zimmerman (1986) argue that managers in firms with
earnings-based compensation agreements have an incentive to report accounting results
which maximise the value of their bonus awards. Healy (1985) indicates that there is a
strong association between accruals and managers’ income-reporting incentives under
their bonus plan. Nonetheless, Healy’s bonus hypotheses have been recently reexamined
by Holthausen et al. (1995) and Gaver et al. (1995), and their findings are, in part,
inconsistent with Healy’s conclusion. In their attempt to investigate whether implicit
compensation contracts have any association with earnings management incentives,
DeFond and Park (1997) report evidence that managers may smooth earnings to enhance
their reputation or mitigate the threat of displacement.
The third and final category of incentives includes those which are concerned with
the potential impact of political and regulatory requirements on changing accounting
methods, or estimates, or accruals. Key (1997), for example, reports that Cable TV firms
are found to have greater income-decreasing accruals during the period of
Congressional scrutiny given the expected relationship between accruals and other
firms’ financial characteristics. In addition, Han and Wang (1998) provide evidence that
oil companies used income-decreasing accounting policies during the Gulf War to
avoid the political consequences of a higher profit coming from increased retail prices.
In general, the wealth of evidence on the most common techniques used to
manipulate earnings in the USA indicates that earnings management is largely
dominated by managing recurring rather than non-recurring income statement items
and is most likely to occur when sales revenue is overstated (Feroz et al., 1991; Dechow
et al., 1996; Marquardt and Wiedman, 2004a). Moreover, a study conducted by
PricewaterhouseCoopers (PwC, 2000) reveals that, since the enactment of the Private
Securities Litigation Reform Act in the USA, the most commonly alleged method of
carrying out accounting fraud has been the manipulation of revenue recognition. In
response to this problem, a number of international bodies of corporate governance
have suggested that the presence of strong governance will reduce the likely potential
for earnings management and related practices which are not in the best interests of
investors. The POB of the SEC Practice Section (1993), for example, argues that audit
committees entirely composed of outside directors would enhance the effectiveness of
MAJ an audit committee to monitor the opportunistic behaviour of managers. In support, a
25,1 growing body of empirical research has emerged to examine whether the existence of
an audit committee is effective in reducing the incidence of earnings management
(Klein, 2002; Xie et al., 2003; Choi et al., 2004; Peasnell et al., 2005; Davidson et al., 2005;
Ebrahim, 2007). This new area of studies relies mainly on accruals-based measures to
estimate the degree of manipulation and, in general, its findings demonstrate that there
36 is a significant negative relationship between the existence of an effective audit
committee and the likelihood of its company being cited as an earnings manipulator.
The internal audit function is also expected to assist audit committees in carrying
out their expanded responsibilities (KPMG Audit Committee Institute, 2003). In this
respect, a few recent studies highlight the unique importance of the internal audit
function in achieving audit committee effectiveness, including the association between
internal audit support and a lower incidence of financial statement fraud. Beasley et al.
(2000), for example, report that companies in three industries (technology, healthcare
and financial services) which experienced fraud were less likely to have an internal
audit function. In addition, Cohen et al. (2002) find that 90 per cent of their respondents
indicated that the internal audit function could improve corporate governance but
expressed concerns over the strength of many internal audit departments.
Additionally, the role of independent directors in the protection of shareholders has
long been debated in the literature (Fama, 1980; Fama and Jensen, 1983).
The accumulated evidence in this regard is rather mixed. While some authors
demonstrate that earnings management is negatively associated with the percentage of
outside directors on the board (Klein, 2002; Davidson et al., 2005; Ebrahim, 2007), others
have found no association between earnings management and board independence
(Chtourou et al., 2001; Abdul Rahman and Ali, 2006). The competence of non-executive
board members is also expected to have special importance for the monitoring
effectiveness of the board of directors. This expectation has been greatly supported by
the results of Chtourou et al. (2001), Xie et al. (2003) and Park and Shin (2004), who
provide empirical evidence that boardroom members with a corporate or financial
background are associated with firms which have lower levels of earnings management.

3. Research methodology
3.1 Questionnaire survey
Judgment sampling should be used when a limited category of people has the required
information (Sekaran, 1992); and also when the purpose of the study is to gain deeper
understanding rather than to be generalised to a larger population (Neuman, 2000).
Hence, it was decided that judgement sampling should be used in this case and the
questionnaire was accordingly distributed among accounting academics, external
auditors and financial managers or senior accountants. The principal rationale for
selecting these groups is based on two factors. First, we assumed that these groups
would have sufficient knowledge and expertise from their daily work regarding the
issues of accounting manipulation and earnings management. Second, it was expected
that these groups would have considerable influence over the accountability of
management and the integrity of financial reporting. Thus, identifying the perceptions
of these three key constituents was likely to enhance our understanding of the different
aspects of the problem of earnings management in Egypt.
 The self-administered questionnaire was presented to the respondents, the purpose The quality
of the enquiries was explained and then the respondents were left to complete the of reported
questionnaire. A snowball sampling strategy was only used with the first and second
groups of respondents;, i.e. the initial respondents were requested to distribute the earnings
questionnaires among their colleagues. However, this responsibility of distributing
the questionnaire survey was not left without further control. This was reflected in the
responses to some factual questions about the respondents’ qualifications and 37
experience. In unreported results, more than one-third of the respondents indicated that
they have prior work experience in their field of more than ten years. Also, the majority
of academics (86.4 per cent) held a PhD, while 37.5 per cent of external auditors held a
professional accounting degree other than their Bachelor degree. The professional
accounting degrees included a Diploma in Accounting; the Modern Accounting
Certificate from the American University in Cairo; Membership of the Egyptian Society
of Accountants and Auditors; the Certified Internal Auditor and Certified Public
Accountant from the USA. Consequently, having highly qualified and experienced
respondents in the area of financial reporting is expected to result in more reliable and
valid responses.
One week after administering the questionnaire, the respondents were contacted by
telephone and were asked whether they had any problems in understanding or
completing the questionnaire. In general, 464 questionnaires were initially sent out to
potential respondents and 217 usable questionnaires were returned (a response rate of
46.8 per cent). This response rate compares favourably with other studies in the same
setting, which have indicated that the average response rate to questionnaire surveys
in Egypt tends to be low, ranging between 30 and 50 per cent (Elbanna, 2007; Elbanna
and Child, 2007). The distribution of respondents and their response rates are provided
in Table I. Unsurprisingly, the response rate from the financial managers or senior
accountants was much lower than for the other two groups.
Given that the success of any questionnaire survey entirely depends on widespread
agreement about the meaning of the terms involved (Seale, 1999), our questionnaire
was developed as follows. It was initially drafted in English and sent out to four
bilingual academics at Cardiff Business School. On the basis of the feedback received,
several changes were made to the original questionnaire. Second, the questionnaire
was translated into Arabic by the first author and then given to three fellow research
students at Cardiff Business School (all Arabic speakers) in order to ensure that the
translation was equivalent. Third, the modified Arabic version of the questionnaire
was sent for piloting to representatives from each group of respondents (i.e. three
accounting academics; two external auditors; and one senior accountant). A number
of questions were redrafted, amended and translated back again into English,

Received
Issued and used
No. % No. % Response rate (%)

1. Accounting academics 115 24.8 59 27.2 51.3

2. External auditors 171 36.8 104 47.9 60.8 Table I.
3. Financial managers or senior accountants 178 38.4 54 24.9 30.3 Responses to the
Total 464 100 217 100 46.8 questionnaire survey
MAJ as suggested by the pilot respondents. Finally, both versions had the same layout,
25,1 paper, order of questions and number of pages. It is worth noting that in order to
compensate for the inability to probe for more information, open-ended questions were
included so that the respondents could explain their answers.
For test-retest reliability purposes, seven respondents completed the questionnaire
twice. The Pearson correlation coefficients between the answers of the same
38 respondents to the same questions, using the identical questionnaire on two different
occasions, ranged between 0.87 and 0.98, which indicates a high degree of stability of
the measures used in this study (Kline, 1993). Finally, Kruskal-Wallis test was used for
data analysis because our data did not meet the conditions required for parametric
tests (Balian, 1982; Siegel, 1956).

3.2 Semi-structured interviews

Since it has long been recognised that questionnaire surveys suffer from the inability to
gain detailed insights into respondents’ perceptions, efforts were made to conduct a
number of interviews in order to uncover any undisclosed issues and to supplement the
results obtained from the questionnaire survey.
To determine whom to interview, we were attracted by the idea of theoretical
sampling. This approach to sampling and selection was first introduced by Glaser and
Strauss (1967). Theoretical sampling is an approach to selecting people which gives
priority to a theoretical basis for their inclusion rather than a statistical one. Thus,
rather than specifying in advance that n number of people should be interviewed in
order to achieve the aims of the research, the approach of theoretical sampling requires
only enough people for a certain question and then moves on to related issues. In
principle, we used three criteria to select the interviewees:
(1) they should be drawn from those respondents who had been questioned in the
questionnaire survey;
(2) they should have comprehensive knowledge and experience in the accounting
and auditing fields; and
(3) they should be willing to be interviewed.

On the basis of these criteria, 16 respondents were chosen for the semi-structured
interviews, comprising seven accounting academics, seven external auditors and five
financial managers or senior accountants.
Each interview usually began by a five-minute introduction to the aims of the
research in which the interviewees were thanked for their time, with a view to putting
the interviewee in “question-answering mode” (Oppenheim, 1992). Then the first
author asked more detailed questions on the quality of reported earnings in Egypt.
In this respect, it should be noted that interviewees in the developing countries,
including Egypt, usually refuse to have their interviews tape-recorded and, therefore,
notes were taken and written up, using the 24 hour rule (Eisenhardt, 1989; Elbanna and
Child, 2007). Since this study consisted of only 16 interviews and the amount of data
was manageable, our data were coded and analysed manually.

4. Results and discussion

With the aim of assessing respondents’ perceptions of the quality of reported earnings
in Egypt, we attempt in this section to investigate three main issues:
 (1) Why might firms manipulate their reported earnings in Egypt? The quality
(2) What techniques are most frequently used in this manipulation? of reported
(3) What actions might be taken to improve the quality of reporting earnings in earnings
Egypt?

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

39
4.1 The potential incentives for earnings manipulation in Egypt
A list of 11 incentives for perpetrating earnings manipulation was prepared and is
presented in Table II on the basis of the ongoing debate in the literature. It can be seen
from this table that over 80 per cent of the respondents agreed or strongly agreed with
the existence of the first four incentives for manipulating earnings in Egypt. For each of
these incentives there were no significant differences in the responses, indicating a high
degree of consensus. The next five incentives (incentives from No. 5 to No. 9) also enjoy a
high degree of agreement (means range between 3.97 and 3.61). However, the levels of
agreement were much lower for the last two incentives (incentives No. 10 and No. 11) and
this was reflected in their overall mean scores of only 3.38 and 3.32, respectively.
Significant differences (at the 1 per cent level) between the three groups of
respondents were found twice. First, 96.6 per cent of financial managers or senior
accountants agreed or strongly agreed that managers might tend to manipulate the
figure of reported earnings in Egypt in order to “mitigate the threat of displacement”.
However, this agreement was found to be much lower in the responses of academics
(77.8 per cent) and external auditors (64.4 per cent). This significant difference was
expected, since financial managers or senior accountants would normally be more
concerned about their job security than the two other groups. Second, financial
managers or senior accountants showed much lower levels of agreement than the other
two groups that the purpose of manipulation was “to meet financial analysts’
predictions”. This is possibly due to their belief that there is a limit to the ability of
accounts preparers to manipulate earnings to this extent.
During the interview stage of this study, one financial manager drew our attention
to the fact that we should distinguish between the incentives for manipulating earnings
in public sector companies and those in the private sector, in particular in family
business companies. On this point, the interviewee remarked that:
With regard to companies that have been offered to the public under the privatisation
programme and are still controlled by the same financial managers, the main incentives for
manipulating earnings are most likely to be: (i) reporting profits and avoiding the report of
losses; (ii) meeting predetermined budgets; and (iii) mitigating the threat of displacement,
whilst the primary incentive for committing earnings manipulation in the family-controlled
companies that have been partially offered to the public would be either to sustain last year’s
profit performance or to preserve high share valuation in the stock market.
This comment is, to some extent, consistent with Kamel (2009) who reports that private
companies seemed to have a strong incentive to manipulate earnings before going
public in order to get the highest possible offer price. In contrast, state-owned
enterprises were found to have no systematic pattern of earnings manipulation, which
suggests that these companies have other incentives to manipulate earnings before
going public than maximising their offering proceeds.
MAJ
Level of agreement (%)
25,1 Managers might tend to
manipulate the figure of reported Overall Overall
earnings in order to 1 2 3 4 5 mean score SD Sig.

1. Enhance the chances of – 10.2 – 57.6 32.2 4.21 0.937 –

40 obtaining a bank loan (–) (8.7) (9.6) (31.7) (50.0)
[1.9] [7.4] [7.4] [29.6] [53.7]
2. Sustain last year’s profit – 6.8 – 67.8 25.4 4.17 0.788 –
performance (–) (6.7) (2.9) (60.6) (29.8)
[–] [9.3] [1.9] [40.7] [48.1]
3. Report profits and to avoid 1.7 1.7 – 59.3 37.3 4.12 0.915 –
reporting losses (3.8) (5.8) (2.9) (49.0) (38.5)
[1.9] [11.1] [1.9] [63.0] [22.2]
4. Achieve high share valuation – 8.5 5.1 50.8 35.6 4.09 0.850 –
(1.0) (6.7) (7.7) (47.1) (37.5)
[–] [7.4] [7.4] [66.7] [18.5]
5. Mitigate the threat of – 11.1 11.1 25.9 51.9 3.97 1.04 *
displacement (2.9) (18.3) (14.4) (37.5) (26.9)
[–] [3.4] [ –] [59.3] [37.3]
6. Maintain stable dividends – 15.3 3.4 50.8 30.5 3.93 0.933 –
(–) (8.7) (17.3) (53.8) (20.2)
[1.9] [7.4] [18.5] [29.6] [42.6]
7. Reduce the amount of income 1.7 22.0 8.5 39.0 28.8 3.89 1.22 –
taxes (5.8) (14.4) (6.7) (31.7) (41.3)
[1.9] [14.8] [9.3] [18.5] [55.6]
8. Maximise the value of their – 16.9 15.5 28.8 38.8 3.72 1.12 –
compensation (1.0) (19.2) (22.1) (39.4) (18.3)
[5.6] [14.8] [16.7] [29.6] [33.3]
9. Meet their predetermined 1.7 28.8 13.6 42.4 13.6 3.61 1.03 –
expectations (budgets) (2.9) (18.3) (10.6) (50.0) (18.3)
[1.9] [7.4] [9.3] [68.5] [13.0]
10. Meet financial analysts’ – 20.3 15.3 54.2 10.2 3.38 0.950 *
predictions (–) (19.2) (28.8) (39.4) (12.5)
[3.7] [20.4] [50.0] [18.5] [7.4]
11. Reduce the buyout 3.4 32.2 10.2 40.7 13.6 3.32 1.05 –
compensation (2.9) (22.1) (21.2) (42.3) (11.5)
[1.9] [18.5] [40.7] [29.6] [9.3]
Notes: *Distribution of responses among the three groups of respondents is statistically significantly
different at the 1 per cent level using the Kruskal-Wallis test; level of agreement on a scale of:
1 ¼ strongly disagree, 2 ¼ disagree, 3 ¼ do not know, 4 ¼ agree, 5 ¼ strongly agree; for each
Table II. incentive, three rows of figures are reported under the level of importance; the first row represents the
The potential incentives perceptions of accounting academics, the figures in parentheses (second row) represent the perceptions
for earnings of external auditors, and the figures between square parenthesis (third row) represent the perceptions
manipulation in Egypt of financial managers or senior accountants

Additionally, two senior officers in the Egyptian stock market authority stated another
important incentive for manipulating earnings in Egypt, notably in the public sector
companies which had been privatised. One of these officers commented that:
Some companies may attempt to overstate their reported earnings by adopting illegitimate
ways in order to use these overstated earnings to increase their capital by issuing new shares
in the stock market, taking into account the provisions of article (17) of the executive
 regulations of the capital market law 95/1995. This will lead to an increase in the issued The quality
capital by unrealised and illusive earnings and will be associated with two dangerous
repercussions: (1) the market value of companies’ capital will contain shares that do not of reported
represent any real ownership in these companies and (2) these manipulative companies will earnings
enjoy the advantage of tax exemption which is calculated as a percentage of the paid capital
multiplied by the annual interest rate in the central bank of Egypt. This loophole will, of
course, lead to a “legal” scam against paying the owed taxes to the state.
41
4.2 The commonly techniques used to manipulate earnings in Egypt
The Egyptian capital market authority (ECMA) has recently discovered and noted
certain accounting and auditing malpractices and disclosure issues among certain
companies, either to present an untrue picture of their financial position and operation
results, or because of lack of understanding of the applicable accounting standards.
Accordingly, our respondents were given a list of nine techniques which could be used
to manipulate the figure of reported earnings in Egypt. This list was mainly derived
from the practices of earnings management detected by ECMA and also from the
related accounting research (McNichols and Wilson, 1988; Dechow et al., 1996;
Marquardt and Wiedman, 2004a).
It can be seen from Table III that at least 58 per cent of all three groups of
respondents viewed the first three techniques (i.e. making inadequate provisions;
capitalising rather than expensing expenditures; and overestimating the inventory
value) as either frequently used or very frequently used. In contrast, Table III shows
that the least frequent techniques for manipulating earnings in Egypt were the last
three techniques (i.e. accelerating/deferring the recognition of maintenance expenses;
accelerating/deferring the recognition of research and development costs; and
manipulating depreciation figures). This was reflected in overall mean scores of only
3.03, 2.90 and 2.83, respectively. It is interesting to note that there were significant
differences (at the 1 per cent level) among the three groups of respondents with regard
to the frequency of occurrence of these three techniques. For example, 57.7 per cent of
the academic respondents perceived that manipulating depreciation figures occurred
either frequently or very frequently, compared to 20.2 and 18.5 per cent of external
auditors and financial managers or senior accountants, respectively. These differences
could be due to the level of experience of each group of respondents in the practical
field. The remaining three techniques (techniques from No. 4 to No. 6) were believed to
be moderately used since their means range from 3.18 to 3.40.
Discussions with respondents participating in the interview survey revealed further
ways of perpetrating earnings management in Egypt. One interviewee, for example,
referred to the concerns documented in the corporate governance assessment report in
Egypt (Report on the Observance of Standards and Codes (ROSC), 2004), with
particular regard to the accounting treatment of foreign currency exchange gains and
losses. This report states that:
[. . .] some companies do not adhere to the requirement that foreign currency exchange gains
and losses arising from balance sheet date revaluations should be shown in the income
statement. Some companies show currency exchange gains under a special account in the
liability section of the balance sheet. Some companies capitalise the currency exchange losses
as part of fixed assets, even if all the necessary conditions for such capitalisation are not met
(ROSC, 2004, Annex F, p. 4).
MAJ
Level of frequency (%)
25,1 Managers might manipulate Overall Overall
earnings through 1 2 3 4 5 mean score SD Sig.

1. Making inadequate provisions 1.7 – 22.0 33.9 42.4 4.22 0.931 –

(1.0) (4.8) (8.7) (36.5) (49.0)
42 [3.7] [3.7] [14.8] [25.9] [51.9]
2. Capitalising rather than 3.4 3.4 25.4 40.7 27.1 3.91 1.07 –
expensing expenditures (5.8) (4.8) (17.3) (42.3) (29.8)
[1.9] [13.0] [7.4] [29.6] [48.1]
3. Overestimating the inventory – 8.5 13.6 44.1 33.9 3.81 1.79 –
value (2.9) (12.5) (26.0) (32.7) (26.0)
[9.3] [3.7] [13.0] [40.7] [33.3]
4. Manipulating the amount of sales 1.7 6.8 37.3 37.3 16.9 3.40 1.09 –
revenue (5.8) (21.2) (17.3) (37.5) (18.3)
[7.4] [20.4] [29.6] [37.0] [5.6]
5. Accelerating/deferring the 3.4 10.2 32.2 37.3 16.9 3.30 1.21 –
recognition of loan interest (8.7) (24.0) (24.0) (23.1) (20.2)
[14.8] [14.8] [20.4] [37.0] [13.0]
6. Accelerating/deferring the 3.4 10.2 28.8 44.1 13.6 3.18 1.12 *
recognition of capital gains or (9.6) (26.9) (28.8) (26.0) (8.7)
capital losses [9.3] [20.4] [22.2] [37.0] [11.1]
7. Accelerating/deferring the 3.4 6.8 42.4 37.3 10.2 3.03 0.954 *
recognition of maintenance (5.8) (25.0) (44.2) (21.2) (3.8)
expenses [9.3] [25.9] [44.4] [16.7] [3.7]
8. Accelerating/deferring the 6.8 11.9 35.6 33.9 11.9 2.90 1.07 *
recognition of research and (10.6) (22.1) (43.3) (18.3) (5.8)
development costs [14.8] [40.7] [24.1] [18.5] [1.9]
9. Manipulating depreciation 3.4 15.3 23.7 42.4 15.3 2.83 1.16 *
figures (14.4) (34.6) (30.8) (14.4) (5.8)
[18.5] [40.7] [22.2] [11.1] [7.4]
Notes: *Distribution of responses among the three groups of respondents is statistically significantly
different at the 1 per cent level using the Kruskal-Wallis test; level of frequency on a scale of: 1 ¼ rarely
Table III. used, 2 ¼ occasionally used, 3 ¼ moderately used, 4 ¼ frequently used, 5 ¼ very frequently used; for
The commonly each technique of earnings management, three rows of figures are reported under the level of agreement;
techniques used to the first row represents the perceptions of accounting academics, the figures in parentheses (second row)
manipulate earnings in represent the perceptions of external auditors, and the figures between square parenthesis (third row)
Egypt represent the perceptions of financial managers or senior accountants

In support of the previous concerns, the interviewee mentioned the following case
which he had encountered in his practical work as an external auditor:
A transportation company failed to recognise a foreign exchange loss of L.E. 871K from
revaluation of liabilities denominated in a foreign currency. The company capitalised the
revaluation difference to its assets although these assets were unqualified for capitalisation in
accordance with the relevant Egyptian Accounting Standard[2].
Additionally, our interviewees drew our attention to other possible ways of practising
earnings management in Egypt such as:
.
Overstating the value of the inventory by not deducting obsolete and
slow-moving inventory from the ending balance.
 .
Overstating the value of the inventory by disclosing inventory at the higher The quality
figure of either cost or market value. of reported
.
Overstating the value of sales revenue before the end of the fiscal year in order to earnings
get higher bonuses and then re-recording these fake transactions as sales returns
in the subsequent fiscal year.
.
Manipulating the percentage at which the work-in-process can be considered
revenue, especially in construction companies. 43
.
Not disclosing loan interest in interim reports and including this later under the
cost of goods sold at the end of the fiscal year. (In this respect, it should be noted
that the external auditor of this particular case was referred by the ECMA for
investigation in the Commercials’ Syndicate).

4.3 Necessary actions to improve the quality of reported earnings

Following Naser (1993), we provided our respondents with a number of actions which
might improve the quality of reported earnings in Egypt and asked them to indicate
their level of agreement with each of these actions. Generally, Table IV reveals that
“greater reliance on the existence of an effective audit committee” elicited the greatest
level of agreement, with at least 94 per cent of the three groups of respondents
indicating that they either agree or strongly agree (mean ¼ 4.64). It is important to
highlight that the support for this particular action was only marginally higher than
that for “greater disclosure” and “greater reliance on the existence of an effective
internal audit function” (with overall mean scores of 4.58 and 4.54, respectively, and
over 92 per cent of all three groups of respondents agreeing or strongly agreeing). For
each of these three actions there were no significant differences in the responses of the
three groups of respondents.
In contrast, the action of “stricter standards” elicited the lowest level of agreement
from respondents (mean ¼ 3.37). It can also be seen that the level of disagreement was
much higher for financial managers or senior accountants than for the two other
groups of respondents and the difference in responses was significant at the 1 per cent
level. The following comment from a senior accountant provides a possible explanation
for the relatively low support given by the group of financial managers or senior
accountants to this action:
Alternatives should be allowed as long as their effects are being disclosed in the notes to
financial statements and therefore there is no need to change the current existing standards
and make them stricter than they are.
Also, it should be observed that Table IV provides support for most of the presented
actions and this was reflected in the overall mean scores of more than four for six of the
identified seven actions. This finding suggests that respondents felt that reliance on
internal corporate governance mechanisms (in terms of the existence of an effective
audit committee; the existence of an effective internal audit function and the existence
of an independent and competent board of directors) is not the only way to improve the
quality of reported earnings and eliminate the use of earnings management in Egyptian
companies. But instead these mechanisms should be used collectively with the other
identified actions reported in Table IV. In this sense, these results seem to be
supportive, to some extent, of those critics who argue that the existence of a strong
system of internal corporate governance has been demonstrably ineffective in
MAJ
Level of agreement (%)
25,1 To improve the quality of reported
earnings in Egypt it is necessary to Overall Overall
have 1 2 3 4 5 mean score SD Sig.

1. Greater reliance on the existence 1.7 – 3.4 28.8 66.1 4.64 0.674 –
44 of an effective audit committee (– ) (1.9) (1.0) (32.7) (64.4)
[1.9] [1.9] [– ] [9.3] [87.0]
2. Greater disclosure – 1.7 1.7 20.3 76.3 4.58 0.642 –
(– ) (2.9) (4.8) (36.3) (56.0)
[– ] [–] [– ] [24.1] [75.9]
3. Greater reliance on the existence of 3.4 1.7 – 35.6 59.3 4.54 0.757 –
an effective internal audit function (1.0) (3.8) (1.0) (32.7) (61.5)
[– ] [–] [1.9] [24.1] [74.1]
4. More standards aimed at specific – 3.4 10.2 44.1 42.4 4.24 0.798 –
problem areas (1.9) (2.9) (3.8) (44.2) (47.1)
[– ] [5.6] [5.6] [64.8] [24.1]
5. More detailed accounting legislation 3.4 11.9 6.8 52.5 25.4 4.06 0.869 –
(– ) (9.6) (2.9) (48.1) (39.4)
[– ] [1.9] [3.7] [77.8] [16.7]
6. Greater reliance on the existence 1.7 3.4 8.5 49.2 37.3 4.02 0.986 *
of an independent and competent (– ) (15.4) (15.4) (44.2) (25.0)
board of directors [1.9] [7.4] [7.4] [25.9] [57.4]
7. Stricter standards 3.4 22.0 1.7 44.1 28.8 3.37 1.28 *
(3.8) (29.8) (9.6) (32.7) (24.0)
[9.3] [46.3] [11.1] [16.7] [16.7]
Notes: *Distribution of responses among the three groups of respondents is statistically significantly
different at the 1 per cent level using the Kruskal-Wallis test; level of agreement on a scale of:
1 ¼ strongly disagree, 2 ¼ disagree, 3 ¼ do not know, 4 ¼ agree, 5 ¼ strongly agree; for each action,
Table IV. three rows of figures are reported under the level of agreement; the first row represents the perceptions
Necessary actions to of accounting academics, the figures in parentheses (second row) represent the perceptions of external
improve the quality of auditors, and the figures between square parenthesis (third row) represent the perceptions of
reported earnings financial managers/senior accountants

mitigating corporate irregularity hitherto and is unlikely to be any more effective in the
future unless the factors which act to limit the effectiveness of the present paradigm of
corporate governance are controlled. For example, based on a study of six major
corporate failures (i.e. Enron, WorldCom, Tyco, Xerox, Shell, Hollinger), Gwilliam and
Marnet (2008) conclude that a number of factors are likely to weaken the ability of audit
committee members, internal auditors and external auditors to fulfil the role ascribed to
them by regulators and others. These factors are classified under three main categories:
fee dependence; sociological and psychological dependence; and lack of expertise and
an independent knowledge base. Gwilliam and Marnet (2008) warn that without due
consideration of these three factors, any efforts to create or improve the structure of
internal corporate governance mechanisms are likely to be costly and ineffective.
In general, our interviewees supported the above argument. An external auditor, for
instance, expressed his view on this particular issue as follows:
In my personal opinion, the following actions will collectively guarantee good quality
financial reporting in Egypt. (1) Issuing new Egyptian accounting and auditing standards to
cover those subjects that have not been addressed yet in the current Egyptian standards.
 (2) Reorganising the accounting and auditing profession in Egypt in order to increase the The quality
professionalism of the accountants and auditors and to guard their independence and
impartiality. (3) Establishing a specific mechanism to penalise those auditors who affirm of reported
financial statements that are prepared in contradiction with the Generally Accepted earnings
Accounting Principles (GAAP).
The last part of the previous comment was extremely supported by the different
groups of interviewees, to the extent that most of them have urged the legislator to 45
prosecute any auditor or any person on the board of directors, audit committee, or in
the internal auditing department who deliberately makes a false entry in the financial
statements or deliberately manipulates the figure of reported earnings.
Another interviewee (an accounting academic) also suggested that the following
actions would greatly assist in improving the quality of accounting information,
including the reported earnings, in Egypt:
.
Enhancing external auditors’ independence by protecting them from being
changed unless there are plausible reasons for doing so.
.
Issuing the new Accounting Practices Law to replace Law No. 133 of 1951 in
regulating the profession of accounting and auditing in Egypt.
.
Preventing auditors from providing their clients with consultation services
unless they receive approval from the Capital Market Authority.
.
Publishing common accounting problems and ways of tackling them in
accordance with the Egyptian and International Accounting Standards in a
scientific periodical for accountants and auditors.

5. Conclusion
This paper investigates respondents’ perceptions of the current quality of reported
earnings in Egypt. In doing so, we relied on the assumption that the engagement in
earnings manipulation can be attributed to three broad factors:
(1) the existence of motivations and pressures to engage in financial statement
fraud;
(2) the availability of earnings management techniques; and
(3) the presence of weak corporate governance which encourages the practice of
earnings manipulation.

Based on 217 usable questionnaires and 16 semi-structured interviews, our results

indicate that the overriding incentives for manipulating earnings in Egypt are: “to
enhance the chances of obtaining a bank loan”; “to sustain last year’s profit
performance”; “to report profits and to avoid reporting losses” and “to achieve high
share valuation”. More interestingly, while earnings manipulation is largely committed
in the USA by overstating sales revenue, the results of this paper suggest that “making
inadequate provisions”; “capitalising rather than expensing expenditures” and
“overestimating the inventory value” are most common in Egypt.
Finally, the results reveal a consensus among respondents on the importance of
combating earnings management in Egypt through greater reliance on internal
corporate governance mechanisms. However, these results and discussions with the
respondents participating in the interview survey also indicate that greater reliance on
MAJ corporate governance cannot alone completely solve the problem. To reduce the
25,1 prevalence of earnings management, other important actions (such as greater
accounting disclosure and penalties for auditors who affirm financial statements which
are prepared in contradiction with GAAP) should be also taken in addition to greater
reliance on internal corporate governance mechanisms.
In the light of the above results, our paper contributes to the accounting research
46 literature in several areas. First, this paper could be of assistance to regulators and external
auditors in Egypt by identifying the potential incentives for engaging in earnings
manipulation and the techniques which are most frequently used in practice and therefore
should receive more attention during the audit process. Second, this paper highlights the
importance of combating the problem of earnings management through having greater
accounting disclosure and harsher auditor penalty. Thus, our paper encourages future
research to empirically investigate the potential impacts of these two actions on the
credibility of financial reporting in general and reported earnings in particular. Third, this
paper addresses the importance of certain governance mechanisms which are extremely
important to a country such as Egypt, where the capital market is less developed and
where governance mechanisms are still evolving. Finally, research on the reported
earnings quality in Egypt may be of interest to domestic and overseas investors in
Egyptian firms. However, our results should be interpreted with caution given the
limitation of the employed snowball sampling strategy.
It should be acknowledged that some loss of control over the sample frame has
resulted from leaving the responsibility of distributing the questionnaire survey to the
initial respondents in the academics and external auditors groups. Also, since we were
not able to employ any accruals-based model in this paper due to the unavailability of
data, it is highly recommended in the future that the existence of earnings management
in Egypt should be reexamined around the date of certain types of corporate events
(such as the dates for reporting losses or declines in earnings) by investigating the
distribution of reported earnings around these dates (Burgstahler and Dichev, 1997;
Degeorge et al., 1999; Holland and Ramsay, 2003).

Notes
1. Some critics may argue that analysing the financial statements directly can be a better
method of determining whether or not a company is engaged in some form of earnings
management. However, this was not possible in the case of Egyptian companies because of
the poor disclosures contained in the financial statements or because of the inability to
employ any accruals-based models in the Egyptian environment, with only one exception
setting which is the initial public offering market (Kamel, 2009).
2. As a consequence of the decision to liberate the foreign exchange market issued on
28 January 2003, the Minister of Foreign Trade in Egypt issued decree No. 156 for 2003,
which included some new interpretations of the Egyptian Accounting Standards regarding
ways of treating any currency exchange losses resulting from foreign currency debts which
were used for financing the acquisition of fixed assets. Under these new interpretations, an
exchange loss on foreign currency debt used to finance the acquisition of an asset can be
added to the carrying amount of the asset if there is still 50 per cent at least of the estimated
useful life of that asset and that the loss has resulted from a severe devaluation of the
Egyptian pound against all other foreign currencies (10 per cent at least in the fiscal year).
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MAJ Appendix 1
25,1 (1) Please indicate, according to the Egyptian business environment, the extent to which you
agree or disagree with the following statements by circling the appropriate number on
the following five-point scale.

50
Strongly Strongly
disagree (SD) Disagree (D) Do not know (NK) Agree (A) agree (SA)

Table AI. 1 2 3 4 5

Managers might tend to manipulate the figure of

reported earnings in order to SD D NK A SA

1. Report profits and to avoid reporting losses 1 2 3 4 5

2. Sustain last year’s profit performance 1 2 3 4 5
3. Achieve high share valuation 1 2 3 4 5
4. Meet financial analysts’ predictions 1 2 3 4 5
5. Maximise the value of their compensation 1 2 3 4 5
6. Maintain stable dividends 1 2 3 4 5
7. Meet their predetermined expectations (budgets) 1 2 3 4 5
8. Enhance the chances of obtaining a bank loan 1 2 3 4 5
9. Reduce the amount of income taxes 1 2 3 4 5
10. Mitigate the threat of displacement 1 2 3 4 5
11. Reduce the buyout compensation 1 2 3 4 5
12. Other(s), please specify:
Table AII. ................................. 1 2 3 4 5

(2) How do you rate the frequency of using the following ways of earnings management by
Egyptian companies? Please indicate your answer by circling the appropriate number on
the following scale from one to five:

Rarely used Occasionally used Moderately used Frequently used Very frequently used
(RU) (OU) (MU) (FU) (VFU)

Table AIII. 1 2 3 4 5
 The quality
Managers might manipulate earnings through RU OU MU FU VFU
of reported
1.
Manipulating the amount of sales revenue 1 2 3 4 5 earnings
2.
Overestimating the inventory value 1 2 3 4 5
3.
Making inadequate provisions 1 2 3 4 5
4.
Manipulating depreciation figures 1 2 3 4 5
5.
Accelerating/deferring the recognition of loan 51
interests 1 2 3 4 5
6. Accelerating/deferring the recognition of
maintenance expenses 1 2 3 4 5
7. Accelerating/deferring the recognition of capital
gains or capital losses 1 2 3 4 5
8. Accelerating/deferring the recognition of
research and development costs 1 2 3 4 5
9. Capitalising rather than expensing expenditures 1 2 3 4 5
10. Other(s), please specify:
................................ 1 2 3 4 5 Table AIV.

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

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

1 2 3 4 5 Table AV.

To improve the quality of reported earnings in Egypt

it is necessary to have SD D NK A SA

1. More detailed accounting legislation 1 2 3 4 5

2. Stricter standards 1 2 3 4 5
3. More standards aimed at specific problem areas 1 2 3 4 5
4. Greater disclosure 1 2 3 4 5
5. Greater reliance on the existence of an effective
audit committee 1 2 3 4 5
6. Greater reliance on the existence of an effective
internal audit function 1 2 3 4 5
7. Greater reliance on the existence of an independent
and competent board of directors 1 2 3 4 5
8. Other(s), please specify:
...................................... 1 2 3 4 5 Table AVI.

Appendix 2
Interview survey questions
(1) How do you see the quality of reported earnings in Egypt? (i.e. does the figure of reported
earnings reflect the real profitability of Egyptian companies?) Explain.
(2) Do you agree that some Egyptian managers tend to manipulate earnings in order to
achieve their own objectives?
If yes, what are these objectives? And please give examples of how manipulation can
be made.
MAJ (3) What are the necessary actions that should be taken in order to improve the quality of
reported earnings in Egypt? Discuss the following actions:
25,1 .
More detailed accounting legislation.
.
Stricter standards.
.
More standards aimed at specific problem areas.
.
Greater disclosure.
52 .
Greater reliance on the internal corporate governance mechanisms which are closely
related to the area of financial reporting quality.
.
Others.

Corresponding author
Said Elbanna can be contacted at: selbanna@uaeu.ac.ae

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