Evaluating the Effectiveness of Corporate Governance Mechanisms and External Audit on Earnings Management: Empirical Study of Companies listed in the Egyptian Stock Market

This thesis aims to examine the effects of corporate governance (CG) attributes and external auditing on accrual-based earnings management (EM) and real EM (REM) activities in the Egyptian context. CG attributes are divided into ownership structure, the board of directors (BOD) and audit committee (AC) mechanisms. EM activity based on discretionary accruals (DAs) is measured using the modified Jones model (1995), Kasznik (1999), Kotahri, Leon and Wasely’s (2005) model and Raman and Shahrur’s (2008) model. By contrast, REM activities are measured using Roychowdhury’s (2006) abnormal operating cash flow (ABCFO), abnormal production cost (ABPROD), abnormal discretionary expenditures (ABDISX) and aggregate proxies.

This study finds that a theory explaining the general pattern of association between CG attributes and EM practice has not since been established. CG–EM relationship is based on various conflicting theoretical perspectives, such as agency theory, institutional theory, stewardship theory and resource dependence theory. Thus, these conflicting theories have resulted in inconsistent empirical findings on CG–EM relationship.

The dynamic panel system-generalized method of moments (§) estimator is used as the main analysis to alleviate dynamic endogeneity concerns between the CG mechanisms and EM. Furthermore, this study selected a sample of 78 Egyptian Exchange (EGX)-listed companies for the period 2008–2017 representing a total of 780 observations. Organisations in the mining, financial and insurance and regulated industries are eliminated from the sample because of distinctive accrual options and valuation processes. Furthermore, Seo and Shin’s (2016) dynamic panel threshold analysis is used to demonstrate the existence of a non-linear association between CG mechanisms and EM and CG attributes’ optimal threshold that can achieve the minimum level of EM.

On one hand, results from SYSTEM GMM reveal that managerial and institutional ownership, the board’s size, independence and diversity, AC meetings and external audit negatively significantly correlated with DAs. On the other hand, family and government ownership and AC size positively significantly related to DAs. In the terms of REM, the results from SYSTEM GMM reveal that managerial and family ownership, AC independence and meeting and the board’s size and diversity negatively significantly correlated with REM proxies, except for ABCFO measure. Whereas, board meetings and AC size are positively and significantly related to REM except for ABCFO. By contrast, government and institutional ownership, board independence, CEO duality and external audit provided varying results due to different REM proxies.

Dynamic panel threshold proposes the presence of a non-linear relationship between ownership structure, BOD’s characteristics and AC, except AC independence with DAs. This finding supports the alignment–entrenchment hypothesis. The findings from almost of studies that are conducted in developed markets may not be generalized to developing countries due to different institutional settings. Hence, this work contributes to the literature in developing countries to determine whether CG compliance constrains EM. EGX participants and policymakers and stock markets similar to the Egyptian context can benefit from the results of this study. That is, they can identify essential CG attributes and their optimal threshold value that can enhance the quality of published information and achieve the minimum level of EM, respectively. Moreover, this study sheds light on the importance of firm-based determinants and characteristics of institutional settings in monitoring REM and DA-based EM based on the sample of Egyptian firms.