New Perspective of Earnings Management: The Effect of Outsiders' Requirements on Managerial Choice of Earnings Management Mechanisms

Abstract

This paper aims at studying the relationship between the existence of a particular set of motivational parties in firms' context, and the executives' choice of certain earnings management (EM) mechanisms. Analysing 34 interviews with executives, financial analysts, external auditors and regulators, and the official documents help to find that the possible existence of a group of sophisticated outsiders in the Egyptian context, including: capital and credit markets, and the regulatory rules of Egyptian Stock Exchange constitutes influential EM motives; and that these parties appreciate and place more emphasis on the long-term operational results of the firms. The paper also finds that managers' intention to achieve compliance between the financial requirements of these motivating factors and the reported earnings necessitates using operational EM mechanisms, including: sales activities, overproduction, and advertising expenses which do not lead to outsiders' suspicion in a firm's performance and value. This paper contributes to literature by giving new perspective for EM by revealing that some of firm's interested parties care about long-term operational profits and cash flows instead of short-term profits; by highlighting the importance of identifying EM motives, and their unique requirements and expectations to accurately determine EM techniques; by building a theoretical framework for better understanding of the study; and by collecting first hand information through adopting interpretive approach.

Earnings management in global background

“…[5] The author McKee has a different view of earnings management, who thinks it is more of a purposeful and legal decision-making and reporting management with a view to achieving stable and predictable results. [6] Earnings management in an international environment is also defined as a strategic way to exercise discretion in managerial decision-making to influence profits that have been reported to external users or as a conscious intervention in the external financial reporting process for personal benefit. [7] Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial statements because of misleading some partners with respect to the economic performance of the company.…”

The effect of political-economic reform on the quality of financial reporting in Egypt

“…Literature has investigated other external factors that can negatively affect accounting and the quality of financial reporting, implying outside factors that motivate firms to manage profits upward including: attracting skilled employees and beating an earnings target (Makhaiel and Sherer, 2017); meeting the industrial norms (Makhaiel, 2016); credit markets and debt covenants (Bartov, 1993;Beneish et al, 2001;Burgstahler and Dichev, 1997;Dechow et al, 1996;DeFond and Jiambalvo, 1994;Dhaliwal et al, 1994;Graham et al, 2005;Makhaiel, 2015;Roychowdhury, 2006;Trueman and Titman, 1988;Watts and Zimmerman, 1990); and stock markets which overprices the stock of firms, succeeding in managing the reported earnings when they intend to sell their stock to the public during certain corporate events, i.e. initial public offers (IPO) or seasoned equity offers (SEO), or firms, succeeding in beating financial analysts' expectations (Cohen et al, 2010;Darrough and Rangan, 2005;DuCharme et al, 2004;Kamel, 2006;Makhaiel, 2015;Marquardt and Wiedman, 2004;Rangan, 1998;Teoh et al, 1998aTeoh et al, , 1998b.…”