Firm Performance and Earnings Management

Wael Mostafa, Mukdad Ibrahim

Abstract

This study examines whether firms with low performance are more engaged in earnings management practices than firms with high performance in an emerging market; namely, Egypt. We estimate a model of the relationship between earnings and cash flows from operations with a dummy variable that allows parameter shifts for cash flows of low performance firms. Thus, the model captures whether the strength of the relationship between earnings and cash flows differs between low and high performance firms. The results show that, compared to firms with high performance, firms with low performance have smaller regression coefficient of earnings on cash flows. These results can be interpreted as indicating that low performance firms engage in more earnings management (increase their earnings management practices) than high performance firms. Overall, these results suggest that firm performance is a critical determinant of earnings management. Given the current weakness of shareholder protection and regulatory enforcement in Egypt, these results encourage policymakers to improve considerably corporate-governance mechanisms in Egypt. This study contributes not only to the limited research on earnings management in the emerging market of Egypt, but also in other emerging economics.