Earnings Management, Agency Costs and Corporate Governance

283 Pages·2011·3.04 MB·English

THE UNIVERSITY OF HULL

Earnings Management, Agency Costs and Corporate Governance:
Evidence from Egypt
being a Thesis submitted for the degree of
Doctor of Philosophy
in the University of Hull

By
Mohamed Mohamed Mahmoud Khalil

PGDip, Hull University
MSc Accounting, Tanta University, Egypt
B.Com (Hon) Accounting, Tanta University, Egypt

November 2010
Table of contents

List of Tables...................................................................................................................vi
List of Figures................................................................................................................viii
Aknowledgements........................................................................................................... ix
Dedication.........................................................................................................................x
Abstract............................................................................................................................xi
Chapter 1 Introduction .................................................................................................. 1
1.1 Introduction ......................................................................................................... 2
1.2 Research objectives ............................................................................................. 6
1.3 Why Egypt? ........................................................................................................ 7
1.4 The contributions of the thesis ............................................................................ 8
1.5 The structure and findings of the thesis .............................................................. 9
Chapter 2 Measurement of Earnings Management .................................................. 13
2.1 Introduction ....................................................................................................... 14
2.2 Accruals Models before the Jones Model ......................................................... 16
2.2.1 The Healy Model ....................................................................................... 16
2.2.2 The DeAngelo Model ................................................................................ 17
2.2.3 The Industry Model ................................................................................... 18
2.3 The evolution of the Jones Model ..................................................................... 18
2.4 Modifications to the Jones Model ..................................................................... 20
2.4.1 The Modified Jones Model (Discretionary Total Accruals) ...................... 20
2.4.2 The Modified Jones Model (Discretionary Current Accruals) .................. 21
2.4.3 The Forward-Looking Model .................................................................... 22
2.4.4 The Performance–adjusted Models ........................................................... 23
2.4.4.1 The Kang and Sivaramakrishnan Model .......................................... 23
2.4.4.2 The Margin Model ............................................................................ 24
2.4.4.3 The Cash-Flow Models .................................................................... 26
2.4.4.4 The Performance Modified Model ................................................... 27
2.4.4.5 The Synthesis Model ........................................................................ 28
2.5 Alternative Methodologies................................................................................ 29
2.5.1 The Single Account Approach ................................................................... 29

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2.5.2 The Set of Accounts Approach .................................................................. 30
2.5.3 The Distribution Approach ........................................................................ 32
2.5.4 Rounding Earnings per Share (EPS) .......................................................... 33
2.6 Commentary ...................................................................................................... 33
2.7 Conclusion ........................................................................................................ 36
Chapter 3 The Evolution of Corporate Governance and Ownership Structures in
Egypt ................................................................................................................... 37
3.1 Introduction ....................................................................................................... 38
3.2 The legal and regulatory framework ................................................................. 39
3.2.1 The Capital Market Authority (CMA) ....................................................... 40
3.2.2 Overview of the Egyptian Exchange (EGX) ............................................. 41
3.2.3 Egyptian accounting, auditing and financial reporting .............................. 45
3.3 Data collection and sample ............................................................................... 49
3.4 Corporate Governance in Egypt........................................................................ 52
3.4.1 Board characteristics .................................................................................. 54
3.4.1.1 Board composition and size ............................................................. 54
3.4.1.2 CEO-Duality ..................................................................................... 57
3.4.1.3 Board structure ................................................................................. 58
3.5 Ownership structure .......................................................................................... 59
3.5.1 Managerial ownership ................................................................................ 61
3.5.2 Ownership concentration and identity of blockholders ............................. 63
3.6 Conclusion ........................................................................................................ 70
Chapter 4 Firm-Specific Determinants of Earnings Management: Evidence for
Egyptian Companies ......................................................................................... 72
4.1 Introduction ....................................................................................................... 73
4.2 Literature review and empirical hypotheses ..................................................... 76
4.2.1 Executive Bonus Plans Hypothesis ............................................................ 76
4.2.2 Debt Covenants Hypothesis ....................................................................... 78
4.2.3 Political Costs Hypothesis ......................................................................... 81
4.2.4 Income Smoothing Hypotheses ................................................................. 84
4.3 Data and methodology ...................................................................................... 86
4.3.1 Data ............................................................................................................ 86
4.3.2 Discretionary accruals proxies ................................................................... 88

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4.3.3 Independent and control variables ............................................................. 90
4.3.4 Methodology .............................................................................................. 94
4.3.5 Sample characteristics ................................................................................ 95
4.4 Empirical results ............................................................................................... 98
4.4.1 Univariate analysis ..................................................................................... 98
4.4.2 Multivariate analysis ................................................................................ 102
4.5 Robustness checks .......................................................................................... 109
4.5.1 Alternative discretionary accruals proxies: current discretionary accruals ..
................................................................................................................. 109
4.5.2 Managerial ownership: piecewise and nonlinearity tests ........................ 110
4.5.3 Prior period accruals ................................................................................ 111
4.5.4 Size effect ................................................................................................ 112
4.6 Summary and concluding remarks.................................................................. 113
Chapter 5 Board Characteristics, Audit Quality and Earnings Management ..... 116
5.1 Introduction ..................................................................................................... 117
5.2 Prior research and hypotheses development ................................................... 121
5.2.1 Board characteristics ................................................................................ 121
5.2.1.1 The proportion and ownership of non-executive directors ............ 121
5.2.1.2 CEO-duality .................................................................................... 123
5.2.1.3 Board size ....................................................................................... 124
5.2.2 Audit committee composition .................................................................. 125
5.2.3 Executive ownership ................................................................................ 128
5.2.4 Audit quality ............................................................................................ 129
5.3 Research design .............................................................................................. 130
5.3.1 Corporate governance variables ............................................................... 130
5.3.2 Control variables ...................................................................................... 131
5.3.3 Regression models ................................................................................... 136
5.3.3.1 Discretionary accruals tests ............................................................ 136
5.3.3.2 Earnings benchmarks tests ............................................................. 137
5.4 Sample characteristics ..................................................................................... 138
5.5 Empirical results ............................................................................................. 143
5.5.1 Univariate analysis ................................................................................... 143
5.5.2 Multivariate analysis ................................................................................ 145

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5.5.2.1 Absolute discretionary accruals ...................................................... 145
5.5.2.2 Signed discretionary accruals ......................................................... 155
5.5.2.3 Earnings benchmark tests ............................................................... 156
5.6 Robustness checks .......................................................................................... 159
5.6.1 Alternative specifications of discretionary accruals ................................ 159
5.6.2 Tests of non-linearity of executive directors ownership .......................... 160
5.6.3 Firm size .................................................................................................. 160
5.7 Summary and concluding remarks.................................................................. 160
Chapter 6 Agency Costs, Ownership Structure and Corporate Governance
Mechanisms ...................................................................................................... 163
6.1 Introduction ..................................................................................................... 164
6.2 Literature review and hypothesis development .............................................. 170
6.2.1 Managerial ownership and agency costs ................................................. 170
6.2.2 Ownership concentration and agency costs ............................................. 172
6.2.3 Board of directors and agency costs ........................................................ 174
6.2.3.1 Board composition ......................................................................... 174
6.2.3.2 CEO-Chairperson Duality .............................................................. 175
6.2.3.3 Board size ....................................................................................... 177
6.2.4 Debt maturity and growth opportunities .................................................. 178
6.2.5 Dividends and growth opportunities ........................................................ 179
6.3 Empirical models and methodology ............................................................... 180
6.4 Data ................................................................................................................. 181
6.5 Agency costs measurement ............................................................................. 182
6.6 Independent variables ..................................................................................... 182
6.6.1 Ownership structure variables ................................................................. 182
6.6.2 Board characteristics variables ................................................................ 183
6.6.3 Debt maturity, dividends and growth opportunities variables ................. 183
6.6.4 Control variables ...................................................................................... 183
6.7 Sample characteristics ..................................................................................... 186
6.8 Empirical results ............................................................................................. 190
6.8.1 Univariate analysis and preliminary analyses .......................................... 190
6.8.2 Multivariate analysis ................................................................................ 194
6.9 Further checks ................................................................................................. 204

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6.9.1 Agency costs as measured by the SG&A ratio ........................................ 204
6.9.2 Concern about endogeneity ..................................................................... 206
6.9.3 Identity of controlling shareholders ......................................................... 206
6.10 Summary and concluding remarks.................................................................. 207
Chapter 7 Conclusions ............................................................................................... 211
7.1 The findings of the thesis ................................................................................ 212
7.2 The contributions of the thesis ........................................................................ 216
7.3 The major limitations of the thesis.................................................................. 217
7.4 The implications of the thesis ......................................................................... 218
7.5 Avenues for future research ............................................................................ 219
Appendices ................................................................................................................... 222
Appendix 4.1 .......................................................................................................... 223
Appendix 5.1 .......................................................................................................... 233
Appendix 6.1 .......................................................................................................... 237
Bibliography ................................................................................................................ 243

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LIST OF TABLES
Table 3.1 Main Egyptian capital market indicators 44
Table 3.2 Auditor type by sectors 48
Table 3.3 Sample size by sector and year 50
Table 3.4 Variables definition 51
Table 3.5 Average board composition 55

Table 3.6 Board size 56

Table 3.7 Companies privatized and/or liquidated from inception of 60
privatization programme up to 31/12/2009
Table 3.8 Average percentage of shares held by board members 61
Table 3.9 Frequency distribution for board ownership 62
Table 3.10 Top five largest shareholders by year 63
Table 3.11 Frequency distribution of number of blockholders 65
Table 3.12 Distribution of large shareholders by sector 66
Table 3.13 Percentage and identity of large shareholders by year 67
Table 3.14 Identity of large shareholders 69
Table 4.1 Variables definition 93
Table 4.2 Descriptive statistics 95
Table 4.3 Pearson correlation matrix 97
Table 4.4 Univariate analyses 99
Table 4.5 Cross sectional regressions using discretionary total accruals as 103
measured by the MJTDA
Table 4.6 Cross sectional regressions using discretionary total accruals as 105
measured by the PATDA
Table 4.7 Pooled regressions using the MJTDA and PATDA 107
Table 5.1 Variables definition 135
Table 5.2 Descriptive statistics 139
Table 5.3 Pearson correlation matrix 141
Table 5.4 Univariate results 144
Table 5.5 Regressions of discretionary accruals on board characteristics, audit 146
quality and control variables

Table 5.6 Regressions of discretionary accruals on board characteristics, audit 151

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quality, and control variables using interaction terms
Table 5.7 Regressions of discretionary accruals on board characteristics, audit 152
quality, and control variables partitioned by executive s‘ ownership
Table 5.8 Regressions of signed discretionary accruals on board monitoring, 157
audit quality, and control variables
Table 5.9 Regressions of discretionary accruals on board monitoring, audit 158
quality, and control variables partitioned by whether earnings is
below or above earnings benchmarks
Table 6.1 Variables definition 185
Table 6.2 Descriptive statistics 187
Table 6.3 Pearson correlation matrix 189
Table 6.4 Univariate results 191
Table 6.5 Determinants of agency costs 195
Table 6.6 Determinants of agency costs partitioned by growth opportunities 200

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LIST OF FIGURES
Figure 3.1 Market capitalization end of year (LE billion) 42
Figure 3.2 Figure 3.2 Average board compositions by sector 55
Figure 3.3 Figure 6.1 Agency costs and managerial ownership 193
Figure 3.4 Figure 6.2 Agency costs and ownership concentration 194

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ACKNOWLEDGEMENTS

First of all, all praise and thanks are Allah‘s, the Lord of the mankind, The Most
Gracious and the Most Merciful for giving me the power to complete this work.
I gratefully acknowledge the significant contribution of several people to this
thesis. First among these are my supervisors, Mr. Jon Simon and Professor Aydin
Ozkan. I would like to express my sincerest appreciation to them for their guidance,
encouragement and support throughout the development of this thesis. Their insights
comments, understanding and suggestions often provoked superior quality in my
research work. With their office door open for me, they were always happy to talk about
my research and spend countless hours encouraging me to develop my ideas and to
think critically. I cannot adequately express my gratitude to them.
Most of all, I am forever sincerely grateful to my parents for their unconditional
love and support throughout my often seemingly endless educational years. I will be
forever grateful for their considerable sacrifices and all they have done to ensure my
success in my study and in life. I would like to thank them especially for instilling in me
the importance of knowledge and hard work.
This work could not have possible without the exceptional patience and
unwavering support I have received from my wife, my daughters, Basant and Malak,
and my son, Omar. They are a constant source of encouragement and support. My
family gave me the strength to pursue this seemingly endless task. I am grateful to all of
them for their tremendous confidence in my potential and for always providing the love
that inspired me. Their emotional support and encouragement is directly responsible for
overcoming hard times throughout my doctoral journey. My brother and sisters, too,
have all been a great support and I deeply thank them for always being there.
Generous financial support from the Egyptian Ministry of Higher Education is
also greatly appreciated. I want to thank the staff in Department of Accounting and
Finance at the University of Hull for their useful comments. I am indebted to my friends
and colleagues for their moral support and encouragement that helped me to overcome
many obstacles in the process of completing my thesis. My special appreciation also
goes to all my professors at the Faculty of Commerce in the University of Tanta for
their continuous encouragement.

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