Ownership structure and Earnings Management: evidence from Egypt

Abstract

The purpose of this paper is to investigate the relationships between ownership structure and Earnings Management (EM) of Egyptian companies. Discretionary accruals using the modified Jones model is evaluated to calculate the extent of EM. A sample of 50 companies listed on the Egyptian stock market for twelve years is used in the study. Three ownership indicators for concentration are included in the current research: block holder ownership, managerial ownership, and public ownership. A set of control variables are used in the current study: return on assets, firm size, firm age, debt ratio and market to book value. The statistical results indicated that there is a positive relationship between the Block holder ownership and the degree of earning management. However, no relationship was found between the Managerial Ownership and the Public Ownership on level of Earning Management. Corresponding author: Racha El Moslemany Email address for corresponding author: rachaelmoslemany@aast.edu First submission received: 7th January 2019 Revised submission received: 13th March 2019 Accepted: 19th March 2019 1.Introduction In academic literature, the corporate governance mechanism has gained remarkable attention. This is attributed to two main reasons. As a main reason the move toward globalization, the introduction of new technologies, the social and cultural environment encourages good corporate governance and promote financial information transparency. Second, the corporate financial scandals in many companies have led to losing confidence in the financial information provided (Zgarni, 2016). The reliability and accuracy of the financial information provided is required in the business environment in order to be able to make decisions and perform analysis. Earnings are considered the main source of information and would alter any decision (Elham; Salehi; and Vali Pour, 2016). This raised the need to set rules to guide and control the performance by enhancing the quality of the financial reporting and to ensure the transparency of the financial information (Zgarni, 2016). Despite this, accrual basis of accounting encourages managers to engage in earnings management. This is easily detected from the discontinuity in the distribution of earnings. Previous studies have elaborated the ways and methods managers undertake to manage their earnings (El-Sayed, 2012). Several definitions exist for EM. One the definitions is “purposeful intervention in the external financial reporting process with the intent of obtaining private gain” Schipper (1989, p. 92). Another definition is that “EM occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting International Journal of Business and Economic Development, Vol. 7 Number 1 March 2019 www.ijbed.org A Journal of the Academy of Business and Retail Management (ABRM) 19 numbers” Healy and Wahlen (1999, p. 368). (Saleem, 2016 b). However, EMcould also be defined as the process of taking purposeful steps within the limits of Generally Accepted Accounting Principles to bring about a desired level of reported income (Tanewski and Bartholomeusz, 2006; Parveen, Malik, Mahmood, and Ali, 2016). In order to avoid Earnings Management, corporations must have enough control mechanisms to provide information in the best, reliable way. This could be done by reducing the agency coststhat arises from the conflict of interests between the owner and managersto its minimum through a good corporate governance system (Kouaib and Jarboui, 2014; Elham et al., 2016). Most of the recent rules and regulations focus on how to improve the quality of corporate governance (Zgarni, 2016). In the 1990s, the Egyptian economy was liberalized and became a free market economy. The stock market was reopened in 1992 and a privatization program was started. Most transactions in the Egyptian capital market are made based on accounting data from the companies’ financial statements especially, earnings. So, earnings play a great role in determining the market price (Hassan et al., 2009; Ragab and Omran, 2006) In October 2005, Egypt reformed a set of Guidelines and Standards to regulate Corporate Governance. But as the application was not mandatory, this gave the chance to managers to engage in EM in order to meet or exceed earnings target to maintain a good image and hence increase the market value of stocks (El-Sayed, 2012) 2.Literature review and hypotheses development Most of the corporate governance studies were explained by theories such as the resources dependence theory, stakeholder’s theory and agency theory. For the aim of this research, agency theory is used to explain the influence of the degree of ownership concentration on EM (Zgarni, 2016). The Agency theory refers to the relationships established between the owners of a company and its directors, relationships are explained through the concept that managers are working on behalf pf owners and for their benefits. Although the development of agency theory is found only in the 70s, the idea of separating the control government has been highlighted since the 30s by Berle and Means (1932) (Shleifer and Vishny, 1997). The separation between the ownership and management is the main source of conflict, which by turn leads to the costs related to these conflicts. This issue was first highlighted by Berle & Means (1932), Adam Smith (1776) and followed by Ross (1973) (Jensen and Meckling, 1976). Agency theory leads to the need for complying the interests of managers with those of shareholders for the objective of maximizing the company’s value. Furthermore, from the literature, it was found that agency theory would be explained by two things. The first explanation is that it is very simple and divide the company into two parties; managers and shareholders. Moreover, the theory assumes that managers and employees favor their own benefits over that of the owners (Daily, Dalton, and Canella, 2003). Although the agency theory states that the managers and employees are self-interest oriented, it is used deeply in the literature to promote the separation between the ownership and the management and control (Bhimani, 2008). Consequently, this gives a motive to managers to manage their earnings in order to achieve targets, which by turn will have an effect on their bonuses. This is the reason behind the weakness of their financial reporting and statements (Davidson et al., 2005; Habbash, 2010). EM is a main issue of current accounting research. EM takes place when managers misuse financial reporting in in their business environment. It also happens when managers tend to change certain income and expense data to misguide users about the current financial performance of the company (Parveen et al., 2016). Ownership structure is considered a tool of corporate governance that can be used to reduce agency costs that arise from agency problems (Jensen and Meckling, 1976). Two points of views explain this issue. The first one assumes that when managers of the firm own a significant portion of the company’s shares, this will lead to balancing their benefits with that of the owners. This will by turn International Journal of Business and Economic Development, Vol. 7 Number 1 March 2019 www.ijbed.org A Journal of the Academy of Business and Retail Management (ABRM) 20 reduce the costs related to agency problems. The second one assumes that if outside shareholders own a significant portion of the company’s stocks, this will provide good control over managers and will force them to act in favor of owners’ interest (Al-Fayoumi, Abuzayed, and Alexander, 2010) This section discusses three types of ownership, Managerial Ownership, Institutional Ownership and block-holders. A discussion of the relevant prior studies on the effectiveness of these ownership structures on mitigating EM is presented 2.1 Managerial ownership According to the Agency theory managers do perform business in a way that would increase their benefits no matter how this is reflected on stockholders especially if they do not own a remarkable portion of the companies’ shares (Saleem, 2016). Some studies were performed to measure the extent of EM when managers own a good portion of the firm shares, which they manage. According to some of the studies performed, some researchers argued that the higher the managerial ownership percentage, the higher will be the power of managers, leading to a tendency to manage their own wealth rather than the stockholders (Jung and Kwon, 2002; Gul, Fung, and Jaggi, 2003; Peasnell, Pope, and Young, 2005). According to these researchers , when management is separated from ownership, managers do not feel the pressure from financial markets to alter the firms’ earnings and pay less attention to the short-term financial reports (Jensen, 1986; Klassen, 1997) thus, the higher the managerial ownership percentage, the higher the tendency to manipulate earnings, since this would lead managers to make decisions that reflect personal benefits and not firm welfare (SanchezBallesta and Garsa-Meca, 2007). In this context some researchers state that as the managerial ownership increases, the market becomes less effective as managers tend to take own value maximizing decisions. This is because of the higher their ownership percentage the higher will be their voting rights and hence ensure their place as managers high. So according to this statement, as managerial ownership increases, EM may increase (Parveen et al., 2016). On the other hand, managerial ownership was perceived as a method to limit the extent of EM (Jung and Kwon, 2002; Klein, 2002; Sanchez-Ballesta and Garcia-Meca, 2007; Teshima and Shuto, 2008; Jensen and Meckling, 1976). This incentive was explained by the idea that managerial