Earnings Management to Meet or Beat Earnings Thresholds

Purpose – The purpose of the study is to examine whether Egyptian listed firms engage in earnings management to meet or beat earnings thresholds, particularly, earnings level (avoiding losses) threshold and earnings change (avoiding earnings decreases) threshold.

Design/methodology/approach – The study uses the distribution of reported earnings approach similar to Burgstahler and Dichev (1997) to examine discontinuities around earnings thresholds as evidence on earnings management to meet or beat earnings thresholds.

Findings – The findings of the study reveal that there is a discontinuity in the distribution of reported earnings and earnings changes of Egyptian listed firms surrounding zero. Too few observations immediately below zero and too many observations immediately above zero. These results suggest that Egyptian listed firms tend to engage in earnings management to avoid reporting losses and avoid reporting earnings decreases.

Research limitations/implications – The study’s main limitation is relatively small sample size given the thinness of the Egyptian capital market, therefore, the findings of the study should be interpreted with caution.

Originality/value – This study contributes to the literature by examining earnings management to meet or beat earnings thresholds in Egypt as one of emerging markets.

Keywords – Earnings management, Earnings Distributions, Earnings thresholds, Egypt.

Paper typ e- Research paper

Introduction

The fundamental objective of accounting is to provide information that is useful to present and potential investors in making investment decisions. However, accrual accounting provides managers with discretion in the reporting of earnings and, thus, provides opportunity for managers to engage in earnings management. Prior research has documented a discontinuity in the distribution of earnings around the thresholds of three earnings benchmarks: zero earnings, previous year’s earnings, and analysts’ earnings forecasts (e.g., Degeorge et al., 1999; Burgstahler and Dichev, 1997; Hayn, 1995). This discontinuity in the distribution of earnings has been widely interpreted as evidence that managers tend to manage earnings to meet or beat these earnings benchmarks. Prior research suggests a broad set of mechanisms that managers use to manage earnings to meet or beat earnings benchmarks. The first mechanism is earnings management through real operating decisions such as delaying investment in R&D, cutting selling, general, and administration expenses, overproduction to reduce cost of goods sold, and cutting prices or extending credit terms at the end of the period to accelerate sales (e.g., Roychowdhury, 2006). The second mechanism is to manage working capital accruals to manage earnings upward (e.g., Caylor, 2010; Phillips et al., 2003; Burgstahler and Dichev, 1997; Healy, 1985). The third mechanism is classification shifting of core expenses to non- recurring item to inflate core earnings (McVay, 2006).

The “meet or beat” phenomenon has spawned a considerable research in recent years. The key argument underlying this phenomenon is that managers benefit in some way by meeting or beating the thresholds. Healy (1985) suggests that managers have the incentive to meet or beat earnings targets to maximize their executive compensations. Matsunaga and Park (2001) document a significant negative effect on the CEO’s cash bonuses when a firm misses the analysts’ forecasts or last period’s earnings. Burgstahler and Dichev (1997) and Degeorge et al. (1999) argue that firms manage reported earnings to meat or beat earnings thresholds because various stakeholder groups use earnings thresholds as reference points or heuristics to evaluate the firm’s financial condition and evaluate the probability will fulfill its implicit claims. McVay et al. (2006) find that the likelihood of just meeting versus just missing the analyst forecast is strongly associated with subsequent managerial stock sales. Xue (2005) suggests that managers of firms facing severe information asymmetry signal the firm’s superior future performance by managing earnings to exceed thresholds. In a survey conducted by Graham et al. (2005), over 80% of CFOs agreed that meeting earnings thresholds helped them to build credibility with the capital market and maintain or increase stock prices. Also, prior research provides empirical evidence that the market tends to react positively to firms that meet or beat earnings thresholds and negatively to firms that fall short of these earnings thresholds. Barth et al. (1999) show that firms reporting continuous growth in annual earnings are priced at a premium, and this premium increases with the length of the string and decreases when the string is broken. Brown and Caylor (2005) find that the highest returns accrue to firms that meet or beat earnings expectations. Other research also documents market rewards for meeting or beating earnings benchmarks (e.g., Dopuch et al., 2008; Bartov et al., 2002; Lopez and Rees, 2002; Kasznik and McNichols, 2002).

However, prior literature examining earnings management to meet or beat earnings thresholds has conducted in developed markets (especially, USA). Extension of prior research findings to thin/emerging capital markets is not a straightforward task. Thin and emerging capital markets have different characteristics from those of mature capital markets. Thin and emerging capital markets have fewer numbers of registrants, less mature investors, less efficient processing of information, less demanding disclosure requirements, and less enforcement of established disclosures. In addition, local accounting rules are in a transition from serving national planning purposes to being useful for investment decisions. As a result of these differences in characteristics, one would be cautious in generalizing research findings in developed markets to thin and emerging ones. Therefore, examining earnings management to meet or beat earnings thresholds in emerging markets is of particular interest.

The main purpose of the study is to contribute to the literature by examining earnings management to meet or beat earnings thresholds in Egypt as one of emerging markets. In fact, Egypt is an interesting case for three reasons. First, accounting information (especially earnings) in Egypt has high value relevance due to the lack of alternative information sources in Egyptian capital market such as earnings forecasts, firm research by financial analysts, management conference call, etc. (Hassan et al., 2009; Ragab and Omran, 2006). Therefore, investors and financial media in Egypt focus their attention on reported earnings as a single most important item in evaluating the firm’s financial performance. This higher value relevance of earnings due to the lack of informational efficiency of the Egyptian capital market creates an incentive for managers in Egyptian listed companies to engage in earnings management to meet or beat earnings thresholds in order to enjoy positive market performance. Second, CEOs compensation in Egyptian listed companies depends only on earnings- based cash bonus. This compensation scheme creates an incentive for managers in Egyptian listed companies to engage in earnings management to meet or beat earnings thresholds in order to protect their wealth on their bonus scheme. Third, due to poor corporate governance practices, Egyptian executives are able to exercise much greater discretion in financial reporting process. Most of corporate governance mechanisms such as audit committee, independent board of directors, sufficient investor protection typically found in developed markets to restrain managers’ discretion over financial reporting do not exist in Egypt.

By examining earnings distributions for discontinuities around thresholds, similar to Burgstahler and Dichev (1997) and Degeorge et al. (1999), for a sample of Egyptian listed companies for the period 1997-2005, the findings of the study reveal that there is a discontinuity in the distribution of reported earning and earnings change of Egyptian listed firms surrounding zero earnings. Too few observations immediately below zero and too many observations immediately above zero. These results suggest that Egyptian listed companies tend to engage in earnings management to avoid reporting losses and avoid reporting earnings decreases.

The remainder of the study is organized as follows. Second section provides a summary review of prior literature. Third Section describes the institutional setting in Egypt and development of research hypotheses. The fourth section deals with the research method and analysis of research results. The final section provides a summary conclusion.

Literature Review

Earnings management to meet or beat earnings thresholds has spawned a considerable research in recent years, especially, in USA. Hayn (1995) documents that there is a point of discontinuity around zero. Specifically, there is a concentration of cases just above zero, while are fewer than expected cases just below zero (small losses). These results suggest that firms whose earnings are expected to fall just below the zero earnings point engage in earnings manipulation to help them cross the “red line” for the year. In subsequent research, Burgstahler and Dichev (1997) provide evidence that 8% to 12% of the firms with small pre- managed earnings decreases exercise discretion to report earnings increases. Similarly, 30% to 44% of the firms with slightly negative pre- managed earnings exercise discretion to report positive earnings. They also find that two components of earnings, cash flow from operations and changes in working capital, have been used to manage earnings. Degeorge et al. (1999) extend the work of Burgstahler and Dichev (1997) by introducing financial analysts’ forecasts as further threshold and find that the need to avoid reporting losses is the primary threshold, once a profit has been achieved then the need to report increases in earnings and the desire to meet analysts’ forecasts become relevant. Brown and Caylor (2005) apply a Burgstahler and Dichev (1997) type methodology to quarterly data and find that since the mid- 1990s, but not before then, managers seek to avoid negative quarterly earnings surprises more than to avoid either quarterly losses or quarterly earnings decrease.

Prior research suggests a broad set of earnings management’s mechanisms that can use to meet or beat earnings thresholds. The first mechanism is earnings management through real operating decisions. Roychowdhury (2006) finds evidence suggesting price discounts to temporarily increase sales, overproduction to report lower cost of goods sold, and reduction of discretionary expenditures to avoid reporting annual losses. Dechow and Shakespeare (2009) find that managers are more likely to engage in securitization transaction at quarter- end to report gains sufficient to beat two earnings benchmarks, reporting a profit and reporting an increase over last year’s earnings. The second mechanism is to manage working capital accruals, Beatty et al. (2002) find that, relative to private banks, public banks report fewer small earnings declines, are more likely to use the loan loss provision and security gain realization to eliminate small earnings decreases, and report longer strings of consecutive earnings increases. Beaver et al. (2003) find that property- casualty insurers with small positive earnings understate loss reserves relative to insurers with small negative earnings. Matsumoto (2002) reports that firms with higher transient institutional ownership, greater reliance on implicit claims with their stakeholders, and higher value- relevance of earnings are more likely to meet or exceed expectations at the earnings announcement date. He also finds that managers use both of abnormal accruals and forecast guidance to avoid negative surprises. Phillips et al. (2003) provide evidence that deferred tax expense generally being incrementally useful beyond that total accruals and abnormal accruals in detecting earnings management to avoid an earnings decline and to avoid a loss while total accruals is incrementally useful only in detecting earnings management to meet analysts’ earnings forecasts. Also, Dhaliwal et al. (2004) find that firms lower their projected effective tax rates (ETRs) when they miss the consensus forecast, which is consistent with firms decreasing their tax expense if non- tax sources of earnings management are insufficient to achieve targets. Caylor (2010) finds that managers use discretion in both accrued revenue (i.e., accounts receivable) and deferred revenue (i.e., advances from customers) to avoid negative earnings surprises, but finds little evidence that discretion is used to avoid losses or earnings decreases. The third mechanism is classification shifting of core expenses to non- recurring item to inflate core earnings. McVay (2006) finds that managers shift expenses from core expenses (cost of goods sold and selling, general, and administrative expenses) to special items to manage core earnings upward and that managers use this earnings management tool to meet the analyst forecast earnings benchmark, as special items tend to be excluded from both pro forma and analyst earnings definitions.

Prior research also examines managerial incentives that explain earnings management to meet or beat earnings thresholds. Graham et al. (2005) find that more than 80% of CFOs agree that meeting earnings benchmarks helps maintain or increase the stock price and build credibility with capital markets and 78% of CFOs also believe that missing a benchmark creates uncertainty about the firm’s future prospects. Cheng and Warfield (2005) find that managers with high equity incentives, arising from stock- based compensation and stock ownership-incentives, are more likely to manage earnings to meet or just beat analysts’ forecasts. McVay et al. (2006) find that the likelihood of just meeting versus just missing the analyst forecast is strongly associated with subsequent managerial stock sales. McAnally et al. (2008) find that firms that miss earnings targets have larger and more valuable subsequent stock- option grants and the likelihood of missing earnings targets for firms that manage earnings downward increases with stock- option grants.

Earnings management to meet or beat earnings thresholds has also examined in other countries. Using UK data, Gore et al. (2007) find that earnings are distributed discontinuously around basic targets: earnings levels, earnings changes and analyst forecasts, and that discretionary accruals are significant cause of the discontinuity observed in the distribution of earnings relative to basic targets. Athanasakou et al. (2009) find no evidence of a positive association between income- increasing abnormal working capital accruals and the probability of meeting analyst forecasts. In contrast, they find that firms shifting core expenses to other non- recurring items to just hit analyst expectations with core earnings. Based on a sample of New Zealand firms, Bennett and Bradbury (2007) find an asymmetry in the distribution of earnings associated with the dividend- cover earnings threshold and that an asymmetry exists for the zero earnings threshold. Habib and Hossain (2008) examine whether managers manage earnings to ‘just meet or beat’ analyst forecasts in Australia and find no significant difference in unexpected accruals of the “just meet or beat” group against the “just miss” group. Based on a sample of firms from Taiwan, Tung et al. (2008) find that managers are likely to grant extended credit at the end of the fiscal year to accelerate customer purchases and thus avoid reporting losses. Shuto (2009) finds that earnings management to avoid earnings decreases is more pronounced in parent-only earnings, compared to consolidated earnings, in Japanese firms for the period 1980-1999.

In contrary to findings mentioned above, some prior studies have questioned the validity of evidence on earnings management to meet or beat earnings thresholds. Dechow et al. (2003) suggest that earnings management is not the key driver of the kink in the earnings distribution. Alternatively, they suggest that exchange listing selection bias and scaling by market value of equity may explain the discontinuity in the distribution of earnings. Durtschi and Easton (2005) provide evidence that the shapes of the frequency distributions of earnings are affected by deflation (i.e., scaling by market value of equity), sample selection criteria, and difference between the characteristics of observations to the left of zero and observations to the right of zero. Ayers et al. (2006) find that the positive associations between discretionary accrual measures and beating the profit and earnings increase benchmarks hold for comparisons of groups segregated at other points, referred to as pseudo targets, in the distributions of earnings and earnings changes. These results suggest that positive associations between discretionary accrual measures and beating the profit and earnings increase benchmarks is not sufficient to conclude that the discretionary accruals detect earnings management. Beaver et al. (2007) argue that the asymmetric effects of certain earnings components for profit and loss firms contribute to the discontinuity of the distribution of earnings. Specifically, effective tax rates, which are higher for profit firms, draw profit observations towards zero, while negative special items, which are greater in magnitude and more frequent for loss firms, pull loss observations away from zero.

Overall, prior literature documents significant discontinuities in earnings distribution around three earnings thresholds: zero in earnings, earnings change, and analysts’ earnings forecasts. These discontinuities provide compelling evidence that firms manage earnings to meet or beat these thresholds. The purpose of this study is to extend the literature by examining whether managers in Egyptian listed companies engage in earnings management to meet or beat earnings thresholds, particularly, earnings level (avoiding losses) threshold and earnings change (avoiding earnings decreases) threshold.

Institutional Background and hypotheses development

During the 1960s, with the move to economic management based on central planning, nationalization, and rapid expansion of the public sector, the Unified Accounting System which issued by a president Decree in 1966 became the mandatory accounting system for Egyptian companies. This Unified Accounting System was not capital- market oriented but followed the principles of macro- accounting with strong government intervention to control the economy, and was closely connected with accounting for tax purposes. In the mid- 1970s, the Egyptian government introduced an “open- door” policy to liberalize the national economy and encourage the private sector. Subsequently, Egyptian government issued the Company Law 159/1981 which regulates shareholding joint stock, partnerships, and limited liability companies that belong to private sector. The Company Law 159/1981 did not include accounting standards. It provided a framework for the establishment and operation of the companies in Egypt. Article 196 of the Company Low 159/1981 states that executives should be compensated in terms of cash bonus that should not less than 10 % of company’s annual earnings provided that these cash bonuses do not exceed the total of annual salaries of those executives.

In the 1990s Egyptian government introduced the economic liberalization to move the economy to free market economy. Privatization program was initiative and the stock exchange reopened in 1992 in order to help firms raise capital for growth and investment opportunities and provides local investors with the opportunity to invest their savings and participate in the privatization process through ownership of stocks of listed firms. Another goal of the reopening of the stock exchange was to attract foreign direct investment to help in the economic development and growth. In order to enhance the reliability of the market, the Egyptian Government issued the Capital Market Law 95/1992. The L95-1992 established the Capital Market Authority (CMA), a controlling body resembling the Securities and Exchange Commission in the United States. The CMA controls the registration and disclosure of firms. CMA also oversees the behavior of security brokers and enforces transactions law. Under the L95-1992 registrants are required to file their audited financial statements with the CMA within three months from the fiscal year end. In fact, accounting information (especially earnings) disclosed in audited financial statements is the only information source available to investors in the market due to the lack of alternative information sources in Egyptian capital market such as earnings forecasts, firm research by financial analysts, management conference call, etc. Therefore, investors and financial media in Egypt focus their attention on reported earnings as a single most important item in evaluating the firm’s financial performance.

In mid- 1990s, Egyptian government began to reform the accounting system to improve decision- making, attract investment, and enhance the level of confidence of foreign investors in Egyptian capital market. As a part of reform process, Egyptian government pursued a policy of harmonization between Egyptian Accounting Standards (EAS) and International Accounting Standards (IAS). As a result, Decree No.503 in October 1997 of the Minister of Economics was issued to establish 24 EAS based on IAS with some adaptation for local conditions. As from 1998, all listed companies in Egypt were required to comply with this new set of EAS. In the late 2006, a new set of EAS was issued pursuant to the Decree No.243 of the Minister of Investment and, thus, replace the old set issued under the Decree No.503/1997. This new set of EAS includes 35 EAS based on International Financial Reporting Standards IFRS (2005 version) with some adaptation for local conditions. As from 2007, all listed companies in Egypt were required to comply with this new set of EAS. While financial reforms in Egypt have positively impacted efforts to encourage adoption of IFRS, there are many implementation weaknesses such as insufficient institutional knowledge of IFRS, lack of implementation guidelines and weak enforcement (Hassan et al., 2009; Dahawy et al. 2002). In addition, the current EAS were mostly prepared on the basis of the 2005’s IFRS version. The translation into Arabic has been lengthy; as a result there existed a potential gap between the set of EAS that is currently in effect and the most recent IFRS.

Egypt, among other countries, has responded to the growing attention with corporate governance by reforming the” Egypt Code of Corporate Governance: Guidelines and Standards” in October 2005 which issued by the Center of Managers, the agency authorized by the ministry of investment in Egypt. The code includes a number of rules to be considered in addition to the company-related provisions stated under other laws (i.e., law 159/1981 and law 95/1992). The rules included in this code focus on various aspects of corporate governance especially board of directors, audit committee, internal audit department, external auditor, disclosure of social policies and avoiding conflict of interests. In contrary with corporate governance reforms in developed markets, the rules of corporate governance included in Egypt Code of Corporate Governance are neither mandatory nor legally binding, the purpose of these rules is to promote responsible and transparent behavior in managing companies according to international best practices and means that strike equilibrium between various party interests.

In summery, the Egyptian capital market has especial attributes that signify the importance of examining of earnings management to meet or beat earnings thresholds.

First, accounting information (especially earnings) is the single most important item in evaluating the firm’s financial performance due to the lack of other information sources. Second, CEOs compensation depends only on earnings- based cash bonus. Third, poor corporate governance practices due to the voluntary nature of Egypt code of corporate governance. These attributes create an incentive for managers in Egyptian listed companies to engage in earnings management to meet or beat earnings thresholds in order to enjoy positive market performance, protect their wealth on their bonus scheme. This leads to the following two research hypotheses (in alternative form):

H:1 Egyptian listed companies tend to manage earnings to avoid reporting losses

H:2 Egyptian listed companies tend to manage earnings to avoid reporting earnings decreases

Research Method

Sample and data

Given the thinness of the Egyptian capital market, this study uses all publicly traded firms on Egyptian stock exchange during the period of 1997 to 2005. Misr Information Services & Trading (MIST) is a data base agency that keeps records of financial statements and market data of all Egyptian firms that are listed on Egyptian stock exchange, and that are subject to the regulations by the Capital Market Authority in Egypt. Listed firms were then screened against several factors: financial services institutions (banks and insurance firms) were deleted from sample, remaining firms were then tested for availability of financial data during the test period (1997-2005). This screening yielded a final sample of 74 firms. The firms included in the sample cover ten of non-financial industries. Table 1 provides the distribution of the sample by industry.

{Insert Table 1 about here}

Prior research has identified three earnings thresholds toward which a firm can strive: avoiding losses, avoiding earnings decreases, analysts’ earnings forecasts (Degeorge et al., 1999; Burgstahler and Dichev, 1997). This study focuses on two of these thresholds, avoiding losses and avoiding earnings decreases because Egyptian capital market suffers from the lack of analysts’ earnings forecast. The firm’s financial statements are the only information source available to investors in Egypt. Burgstahler and Dichev (1997) and Degeorge et al. (1999) consider avoiding losses and avoiding earnings decreases as important thresholds. Graham et al. (2005) ask CFOs which earnings benchmarks are important to them and find that zero earnings (avoiding losses) and earnings change (avoiding earnings decreases) are important earnings benchmarks along with analysts’ forecasts. Similar to Burgstahler and Dichev (1997), the study uses annual net income reported in income statement as a measure of earnings. Since the observations are obtained from a broad rang of firm sizes, the earnings measures (earnings levels and earnings changes) are scaled by the market value of equity at the beginning- of- the- year.

Results

McNichols (2000) distinguishes three main research designs commonly used in earnings management literature: those based on aggregate accruals, those based on specific accruals, and those based on the distribution of earnings after management. Similar to Burgstahler and Dichev (1997) and Degeorge et al. (1999), the study provides graphical evidence in the form of histograms of the pooled cross- sectional empirical distributions of scaled earnings level and scaled earnings changes. The study examines earnings distributions for discontinuities around thresholds. This approach relies on the assumption that, without earnings management, one would expect that the distribution of earnings to be relatively smooth around thresholds. Unusually low numbers of observations just below thresholds and unusually high numbers of observations just above thresholds are considered as indicator of earnings management to meet or beat the thresholds.

Earnings Management to avoid Losses

To test the first hypothesis that companies manage earnings to avoid loses, the study examines the distribution of net income of Egyptian listed firms. Earnings management to avoid losses is likely to be reflected in cross- sectional distribution of earnings in the form of unusually low frequencies of small losses and unusually high frequencies of small positive earnings. Table 2 presents descriptive statistics for scaled earnings level. As shown in Table 2, the total number of firm- year observations is 666, the mean and median earnings both decrease throughout the sample period except for 2005 with the median always greater than the mean.

{Insert Table 2 about here}

Figure 1 is a histogram of scaled earnings variable with histogram interval widths of 0.005 for scaled earnings ranging from -0.25 to + 0.35 similar to Burgstahler and Dichev (1997). As shown in Figure 1, earnings slightly less than zero occur much less frequently than would be expected given the smoothness of the remainder of the distribution and earnings slightly greater than zero occur much more frequently than would be expected. This discontinuity of earnings around zero suggests that Egyptian listed firms tend to manage earnings to avoid reporting losses. To test the significance of the irregularity near zero, the study applies the standardization differences test developed by Burgstahler and Dichev (1997). Under the assumption of no earnings management, the cross- sectional distributions of earnings levels are relatively smooth. Burgstahler and Dichev (1997) define smoothness in terms of the expected number of observations in any given interval is the average of the number of observations in the two immediately adjacent intervals. The test statistic used to test the smoothness is the difference between the actual number of observations in an interval and the expected number of observations in the interval divided by the estimated standard deviation of the difference. Under the assumption of no earnings management, these standardization differences will be distributed approximately normal with mean 0 and standard deviation 1. Therefore, in the presence of earnings management to avoid losses, the standardization difference of the interval directly to the left of zero will have a negative value and the standardization difference of interval directly to the right of zero will have a positive value. In this study, the standardization difference for the interval immediately to the left of zero is -3.438 and the standardization difference for the interval immediately to the right of zero is

{Insert Figure 1 about here}

2.872. Thus, under the assumption that the standardization differences are approximately normal, the test statistics are significant suggesting that companies manage reported earnings to avoid losses. Accordingly, the results mentioned above support the first hypothesis that Egyptian listed companies tend to manage earnings to avoid reporting losses.

Earnings Management to avoid Earnings Decreases

To test the second hypothesis that firms manage earnings to avoid earnings decreases, the study examines the distribution of earnings changes of Egyptian listed firms. Earnings management to avoid earnings decreases is likely to be reflected in cross- sectional distributions of scaled earnings changes in the form of unusually low frequencies of small earnings decreases and unusually high frequencies of small earnings increases. Table 3 presents descriptive statistics for the scaled earnings changes variable. As shown in Table 3, the total number of firm- year observations is 592, the mean and median earnings changes are positive throughout the sample period except for 2004 with the median always greater than the mean.

{Insert Table 3 about here}

Figure 2 is histogram of scaled earnings changes variable with histogram interval widths of 0.0025 for the range from -0.15 to + 0.15 similar to Burgstahler and Dichev (1997). As shown in Figure 2, earnings changes slightly less than zero occur less frequently than would be expected given the smoothness of the remainder of the distribution and earnings changes slightly greate