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How firms’ performance mediates Corporate

governance
the relationship between corporate and earnings
quality
governance quality and
earnings quality?
Mohammed Adel Elzahaby Received 17 September 2018
Revised 20 September 2019
Department of Accounting, Faculty of Commerce, Damanhour University, 2 February 2020
Damanhour, Egypt 29 September 2020
8 December 2020
Accepted 19 January 2021
Abstract
Purpose – The purpose of this study is to propose an analytical model that investigates both a direct path
between corporate governance quality and earnings quality and an indirect path, in which firms’ performance
is a mediating variable that is influenced by corporate governance quality and that, in turn, influences earnings
quality.
Design/methodology/approach – The study employs a structural equation modelling (SEM), to a sample of
Egyptian listed firms during 2011–2017, to test the proposed analytical model and to determine the relative
importance of both the direct and indirect paths.
Findings – The findings show a statistically significant evidence of both a direct path from corporate
governance quality to earnings quality, and an indirect path that is mediated by firms’ performance,
suggesting that both corporate governance quality and performance have a complementary effect on earnings
quality. However, the weight of the evidence favouring the direct path is more important in case of accounting-
based performance measures; and the weight of the evidence favouring the indirect path is more important in
case of market-based performance measures.
Research limitations/implications – The current study has some limitations. First, the study focuses
specifically on one proxy for measuring earnings quality which is the absolute value of discretionary accruals.
Other proxies of earnings quality could be examined in future research, such as income smoothing, earnings
persistence and timely loss recognition. Another limitation is that only financial performance measures were
examined, namely, return on assets, return on equity, price-to-earnings ratio and market-to-book value.
Notwithstanding, non-financial performance measures could be investigated in future studies, such as
balanced scorecard (BSC). Furthermore, considering cultural, political and legislative differences among
countries, the results may not be generalised outside the scope of the current sample (i.e. Egyptian listed firms).
Practical implications – The implications of the findings for both theory and practice are discussed.
Originality/value – This study is distinguished by validating an analytical model that has been overlooked
by prior studies. Moreover, it provides a new constructed index for measuring corporate governance quality.
Furthermore, it uses a new sophisticated statistical technique, which is SEM, for testing the proposed model.
Keywords Corporate governance quality, Earnings quality, Performance, Structural equation modelling, Egypt
Paper type Research paper

1. Introduction
A growing body of the accounting literature argued that earnings quality is a central issue
that has been emerged in recent decades, particularly after the bankruptcies of giant firms
(e.g. Enron, WorldCom and Xerox), due to earnings management practices that have resulted
in severe harm to the world economy (Yoon et al., 2006). Firms may have incentives to manage
earnings for various reasons such as maximising management compensations, increasing
the prices of initial public offerings (IPOs) and seasoned offerings, avoiding debt covenants
violations, maintaining earnings stability and reducing tax burdens (DeFond and
Jiambalvo, 1994; Healy, 1985; Jones, 1991; Perry and Williams, 1994; Teoh et al., 1998a,
1998b; Yoon and Miller, 2002). Hence, it is supposed that having high-quality earnings Journal of Accounting in Emerging
Economies
© Emerald Publishing Limited
2042-1168
The author thanks two anonymous reviewers for their constructive feedback and insightful comments. DOI 10.1108/JAEE-09-2018-0100
JAEE represent healthy performance and faithful financial information about the firm, and is thus
beneficial to users of financial reports in general, and to investors in particular. Moreover,
Ball and Brown (1967) contended that high-quality earnings are more informative regarding
the value of the firm in the long-run. In contrast, low-quality earnings may generate inefficient
contracts when used as inputs to design management compensation contracts (Schipper and
Vincent, 2003). In addition, low-quality earnings also introduce an information risk to
investors, and thereby increase the cost of raising capital (Francis et al., 2008).
On one hand, it has been argued that corporate governance could be used as a monitoring
tool to ensure the quality of reported earnings by deterring managers’ ability to manipulate
earnings (Baxter and Cotter, 2009; Bentley et al., 2012; Dey, 2008; Habbash et al., 2013; Kent
et al., 2010; Lo et al., 2010; Saenz Gonzalez and Garcıa-Meca, 2014; Zhong et al., 2007).
Therefore, corporate governance quality has a direct relationship with earnings quality. On
the other hand, it has also been posited that good performance firms have less incentives to
engage in earnings management practices (Dechow et al., 2010; Dechow, 2000; Dechow and
Dichev, 2002; Dechow and Schrand, 2004; Habib et al., 2013; Kumari and Pattanayak, 2017;
Lee et al., 2006; Mostafa, 2017; Peasnell et al., 2005; Rosner, 2003; Skinner and Sloan, 2002).
Thus, beside the direct effect of corporate governance quality on earnings quality, the level of
firm’s performance could also directly influence earnings quality.
Importantly, it has been claimed that effective corporate governance mechanisms are
supposed to ensure the proper management of resources required to enhance the
effectiveness and efficiency of firms’ performance (Arouri et al., 2014; Chauhan et al., 2016;
Florio and Leoni, 2017; Karuna, 2007; Kumari and Pattanayak, 2017; Larmou and Vafeas,
2010; Mueller, 2006; Spira and Page, 2003; Victoria, 2006; Wagenhofer, 2015). Hence,
corporate governance quality has a direct effect on the level of performance. Recalling the
direct relationship between performance and earnings quality, it is therefore suggested that
performance potentially exerts a mediating effect on the relationship between corporate
governance quality and earnings quality (i.e. corporate governance quality affects the level of
performance, which in turn affects earnings quality, sequentially).
It is worthy to note that the literature on corporate governance quality, earnings quality
and performance has focused on: (1) the direct effect of corporate governance quality on
earnings quality; (2) the direct effect of corporate governance quality on performance and
(3) the direct effect of performance on earnings quality, separately. Yet, existing studies
have not investigated the potential indirect relationship between corporate governance
quality and earnings quality, through performance. Therefore, the current study proposes
an analytical model to further investigate whether the level of performance exerts a
mediating effect on the relationship between corporate governance quality and earnings
quality. Also, it aims to examine whether the direct relationship between corporate
governance quality and earnings quality dominates the indirect relationship mediated by
performance, or vice versa.
In the context of the Egyptian business environment, Bremer and Ellias (2007) have
provided evidence on the presence of earnings management practices. Moreover, Farag
(2009) pointed out that Egyptian firms are willing to manipulate earnings downward for tax
issues due to high conformity of financial accounting (book) to the Egyptian tax system. In
addition, Kamel and Elbanna (2010) argued that managers are more likely to engage in
opportunistic income-increasing practices to avoid debt covenants violations, meeting or
beating analysts’ earnings forecasts and achieve their compensation targets. Furthermore,
Kamel (2012) found that Egyptian firms tend to manage earnings upward to increase the
prices of IPOs. Also, Manzalawy and Rwegasira (2013) concluded that most Egyptian firms
pursue manipulative earnings practices for maintaining high stock prices and for avoiding
debt violation. In a similar vein, Mostafa (2017) exhibited that the Egyptian managers of poor
operating performance firms attempt to manage earnings upward to conceal their low
performance. Apparently, these arguments revealed that the quality of earnings reported by Corporate
Egyptian firms is questionable. Accordingly, the Egyptian context provides an interesting governance
research setting for investigating whether the reported earnings faithfully represent the
actual level of performance of Egyptian firms.
and earnings
Moreover, the Egyptian business environment has undergone corporate governance quality
reform by the ministry of investment and international cooperation, in which the code of
corporate governance that was published in October 2005 has been updated in March 2011
[1]. However, the implications of applying the newly issued corporate governance principles
have not been examined yet. Therefore, the current study contributes considerably to fill the
gap in the corporate governance literature in general and in the context of Egyptian business
environment in particular.
The Egyptian setting also motivated the current study in which Egypt has a rapidly
growing capital market, particularly during the last few years. More specifically, Egypt
became a market-based economy since the increased volume of foreign direct investments
since 2013 (Mostafa, 2017). Also, most transactions in the Egyptian capital market are taken
place based on financial accounting data, especially earnings (Ebaid, 2013). This requires
providing relevant and reliable accounting information in general, and earnings-related
information in particular, which help stakeholders in predicting the expected future cash
flows and reducing uncertainties; hence, increasing the stakeholders’ confidence when
making their economic decisions, which in turn enhancing the efficiency of the Egyptian
capital market (HassabElnaby et al., 2003). Moreover, Egypt has many significant differences
compared to other developed countries such as US and UK, in which the Egyptian regulatory
setting is characterised by weak corporate governance and law enforcement (Fawzy, 2003;
Bremer and Ellias, 2007), low level of compliance with disclosure requirements mandated by
Egyptian accounting standards (EASs) (Abdelsalam and Weetman, 2003), low likelihood of
litigation risk (Fawzy, 2003), less regulated capital market (Moore, 1995), high degree of
ownership concentration (Djankov et al., 2008), high level of book-tax conformity (Farag,
2009) and high level of secrecy as identified based on the accounting values developed by
Gray (1988) [2]. These characteristics open the door for the preparers of financial reports
incentives to issue low-quality financial reports in the context of Egyptian business
environment. More specifically, top managers and controlling shareholders have a significant
power to exercise discretion over reported earnings and thus leaving existing and potential
shareholders less protected (Elsayed, 2010). Accordingly, these differences among counties
might yield different findings.
Interestingly, the findings of the current study reveal that the effectiveness of corporate
governance mechanisms not only has a direct effect on the quality of reported earnings but it
has an indirect effect through firms’ performance. Furthermore, the findings also indicate
that the direct path is substantially more important than the indirect path in case of using
accounting-based performance measures, while the indirect path is substantially more
important than the direct path in case of using market-based performance measures.
Overall, the findings of the current study have both theoretical and practical implications
and contributes significantly to fulfil gaps in the existing literature as follows: First, the
relationship between corporate governance quality and earnings quality became
questionable during the financial crisis of 2007/2008, in which corporate governance
mechanisms did shortfall to limit firms’ managers to manage earnings opportunistically
(Aebi et al., 2012; Ellul and Yerramilli, 2013). In an experimental study conducted by Ebaid
(2013), it is suggested that the voluntary application of corporate governance practices by
Egyptian firms enhances investors’ perceptions of the quality of financial reporting.
However, Ebaid (2013)’s study could be criticised for being subjective and based on the
judgments of postgraduate students of accounting and finance. Interestingly, Khalil and
Ozkan (2016) showed that solely increasing the ratio of non-executive directors on the firm’s
JAEE board of directors or audit committee may not be sufficient to deter earnings management
behaviour in the context of Egyptian environment over the period 2005–2012. Accordingly,
this issue has raised the researcher’s concern to empirically investigate whether the recently
issued corporate governance code in 2011 has improved the quality of reported earnings of
Egyptian firms.
Second, while most existing studies have paid more attention to the traditional corporate
governance mechanisms (e.g. board structure and its committees, internal and external
auditing, ownership structure and shareholders’ rights) (Al-Shammari, 2014; Abraham and
Cox, 2007; Al-Shammari, 2014; Bedard, Chtourou and Courteau, 2004; Davidson et al., 2005;
Dobler et al., 2011; Donnelly and Mulcahy, 2008; Goodwin, 2003; Khalil and Ozkan, 2016), few
prior studies have investigated risk-oriented governance mechanisms such as: risk
committee and designating a chief risk officer (CRO), particularly after the financial crisis
of 2007/2008 (Aebi et al., 2012; Ellul and Yerramilli, 2013; Grove et al., 2011; Lajili, 2009;
Mongiardino and Plath, 2010). However, the criticism has been that corporate governance
quality is not unidimensional in which using single or few multiple surrogates for measuring
corporate governance quality may be less reliable and less valid (Jiang et al., 2008). More
specifically, Khalil and Ozkan (2016) and Larcker et al. (2007) pointed out that using a single
indicator for measuring corporate governance might cause measurement errors and
inconsistent regression coefficients. Therefore, the current study contributes to fill the void in
the corporate governance literature by constructing a comprehensive index for measuring
corporate governance quality that includes both traditional and risk-oriented governance
mechanisms.
Third, prior studies found that the relationship between corporate governance quality and
the level of firm’s performance are mixed (Arouri et al., 2014; Chauhan et al., 2016; Epps and
Cereola, 2008; Florio and Leoni, 2017; Karuna, 2007; Kumari and Pattanayak, 2017; Larmou
and Vafeas, 2010; Leung et al., 2014; Mueller, 2006; Spira and Page, 2003; Victoria, 2006;
Wagenhofer, 2015). Such contradictory findings can be attributed to the existence of different
measures for performance such as: return on assets, return on equity, return on sales, price-to-
earnings ratio, market-to-book value ratio, Tobin’s q, etc. (Bhagat and Bolton, 2008; Dechow,
1994; Epps and Cereola, 2008; Larcker et al., 2007; Ma and Ma, 2017). Therefore, the current
study emphasises on both accounting and market-based performance measures, to determine
which performance measures exert significant mediating effect on the relationship between
corporate governance quality and earnings quality (i.e. to determine whether the weight of
accounting-based performance measures is relatively more important than the weight of
market-based performance measures or vice versa). Indeed, this may have an important
implication related to pay-performance issue, as suggested by Bugeja et al. (2017) and Cornett
et al. (2008).
The remainder of the current study is organised as follows: section two reviews the
literature related to the proposed analytical model that specify the relationships among
corporate governance quality, performance and earnings quality. Section three presents the
research method including the sample selection procedures as well as the variables
measurement. Section four presents data analysis and results. Finally, section five presents
discussions and draws conclusions.

2. Conceptual framework and development of hypotheses

2.1 The direct relationship between corporate governance quality and earnings quality
Based on agency theory, it is suggested that effective corporate governance mechanisms
played a monitoring role in deterring managers’ propensity to commit an opportunistic
behaviour through earnings management practices, which in turn improve the quality of
reported earnings and reduce agency costs (Jensen and Meckling, 1976). Studies on the direct
relationship between corporate governance quality and earnings quality are extensive. For Corporate
example, Xie et al. (2003) examined the relationship between corporate governance quality governance
(measured by board independence, audit committee expertise, a higher frequency of board
meetings and audit committee meetings) and earnings quality (measured using the Modified
and earnings
Jones Model); they documented a negative relationship between effective corporate governance quality
quality and managers’ propensity to manipulate earnings. This result is consistent with Zalata
et al. (2018), in which the presence of financial expertise on the audit committee, driven by more
female financial experts, significantly reduces earnings management. Also, Chen et al. (2007)
found evidence that the independence of supervisors, the financial expertise of independent
directors and the voluntary formation of independent directorships are associated with a lower
likelihood of earnings management. Moreover, Dey (2008) reported that earnings credibility
increases with board effectiveness. Furthermore, Osma (2008) also found that board
independence is important in constraining earnings management (measured by research and
development (R&D) expenses manipulation). This finding is also in corroboration with
Habbash et al. (2013) and Marzuki et al. (2016).
In a similar vein, Ching et al. (2006) found evidence that independent directors and outside
blockholders restrain earnings management in family-controlled firms. Consistently, Zhong
et al. (2007) showed a negative relationship between corporate governance mechanisms
(measured by ownership concentration) and managers’ practices of manipulating earnings.
Similarly, Xu et al. (2012) examined the influence of ownership structure on earnings quality
(measured by four contemporary earnings quality proxies, including volatility of earnings,
variability of earnings over cash flows, correlations between accruals and cash flows and
level of discretionary accruals) of firms listed on the Chinese Stock Exchanges. They found
that privately-owned firms, foreign-owned firms and society-owned firms outperform the
state-controlled firms in ensuring the quality of reported earnings; meanwhile, foreign-owned
firms have the highest earnings quality among all types of ownership groups. Moreover,
Kasipillai and Mahenthiran (2013) exhibited that ownership structure and board structure
affect the extent to which earnings management is associated with a deferred tax component.
Also, Saenz Gonzalez and Garcıa-Meca (2014) revealed that boards that meet more frequently
take a more active role in monitoring managers, so showing a lower use of manipulation
practices. In addition, Khalil and Ozkan (2016) found that the existence of non-executive
directors and audit committee are not enough in curbing earnings management practices.
However, the effect of board independence on earnings management practices is contingent
on the levels of ownership held by executive directors and larger shareholders, as well as the
composition of audit committee. Recently, Kumari and Pattanayak (2017) found evidence that
corporate government practices (e.g. board characteristics, audit practices and performance-
based remuneration) deter managers’ ability to manage earnings opportunistically [3].
Interestingly, using the government-score (G-score) developed by Gompers et al. (2003) as
a proxy for corporate governance quality, Jiang et al. (2008) found positive relationship
between government-score and earnings quality. Moreover, Chang and Sun (2009) examined
the impact of the Sarbanes-Oxley Act (SOX) act on earnings informativeness and earnings
management. They reported that audit committee independence and board independence are
significant in improving the informativeness of reported earnings and in constraining
earnings management post-SOX, but insignificant pre-SOX. Also, Leventis and
Dimitropoulos (2012) attempted to investigate the role of corporate governance in curbing
earnings management behaviour of US-listed banks during the period of the Sarbanes-Oxley
Act (2003–2008), and they reported that well-governed banks engage less in aggressive
earnings management behaviour through the use of discretionary loan loss provisions. In
addition, Lassoued et al. (2017) also revealed a significant negative relationship between
ownership concentration and earnings quality (measured by the absolute value of
discretionary loan loss provisions) for developing countries (i.e. Middle Eastern and North
JAEE African (MENA) countries) in the context of banking industry. Similarly, Bajra and Cadez
(2018) examines the impact of two central corporate governance mechanisms (which are:
internal audit function quality and board of directors’ quality) on the incidence of earnings
management for cross-listed European firms after major changes were implemented in
corporate governance policies (e.g., Sarbanes-Oxley Act in the US and the 8th Company Law
Directive in the European Union); they found that both mechanisms have a negative direct
effect on the incidence of earnings management.
In the context of risk-oriented governance mechanisms, few empirical studies have
examined the impact of risk-oriented mechanisms such as risk functions, risk committee and
the existence of chief risk officer (CRO) on earnings quality. To the best of the researcher’s
knowledge, only Bentley et al. (2012) pointed out that an effective risk-management functions
would reduce the likelihood of frauds or misstatements since low risks (i.e. well-managed
risks) might eliminate the needs to manage or manipulate earnings, especially in poor
performance years. Nonetheless, Chtourou et al. (2001) neither found a significant relationship
for audit committee independence nor the percentage of independent members on the board
with earnings quality. Also, Baxter and Cotter (2009), Osma and Noguer (2007) and Piot and
Janin (2007) found no significant relationship between audit committee independence and
earnings quality. Recently, Outa et al. (2017) also found that that discretionary accruals
component is not significantly related to corporate governance suggesting the voluntary
corporate governance code does not deter earnings management practices in Kenyan non-
financial firms. This result was also consistent with Ahmed (2013). However, the findings of
most empirical studies generally exhibited that effective corporate governance mechanisms
are associated with high level of earnings quality [4]. Hence, it is expected that corporate
governance quality has a direct and positive effect on earnings quality (path 1), as illustrated
in Figure 1. Thus, the first hypothesis is stated in its alternative form as follows:
H1. There is a direct and positive relationship between corporate governance quality and
earnings quality (path 1).

2.2 The indirect relationship between corporate governance quality and earnings quality: the
mediating effect of performance
2.2.1 The direct relationship between corporate governance quality and performance.
According to resource-based theory, it is suggested that the resources possessed by a firm
are considered the primary determinants of its level of performance, and this may contribute
materially to the sustainable competitive advantage and success of the firm (Wernerfelt,
1984). Therefore, the resource-based theory is used as a justification for creating a sustainable

Figure 1.
Conceptual model and
hypotheses
competitive advantage of the firm. However, these resources are heterogeneous in nature (i.e. Corporate
tangible and/or intangible resources) and not value added without proper management governance
(Barney, 1991). Proper management is related to the application of good corporate
governance, as it has become critical in enhancing firm’s performance and in maintaining
and earnings
sustainability. quality
Empirically, the relationship between corporate governance quality and the level of
performance has been the focus of extant studies. For instance, it has been argued that
independent and more experienced boards in terms of financial and operational expertise
could increase their capabilities in executing their functions (Mueller, 2006). In a similar vein,
prior study conducted by Victoria (2006) found that independent boards had a positive
correlation with performance. Also, Larmou and Vafeas (2010) provided evidence that board
size has a positive relationship with the level of performance. In addition, compensation
committee is also used as a mechanism to motivate managers to exert more efforts for
improving performance (Karuna, 2007; Wagenhofer, 2015). Nonetheless, Epps and Cereola
(2008) did not find significant evidence on the relationship between firms’ corporate
governance rating (measured by institutional shareholder services (ISS)) and firms’ operating
performance.
In addition, Arouri et al. (2014) revealed that the extent of family, foreign and institutional
ownership have significant positive relationship with bank performance. However,
government ownership in addition to chief executive officer (CEO) duality and board size
has no significant impact on performance. Also, Leung et al. (2014) found no significant
relationship between the independence of corporate boards or board committees and firm
performance in family firms, whereas board independence is positively associated with firm
performance in non-family firms. Furthermore, Chauhan et al. (2016) and Kumari and
Pattanayak (2017) showed a positive relationship between the quality of corporate
governance (measured by ownership concentration) and the level of performance.
Moreover, internal control and risks management are also perceived to be important
mechanisms for improving firms’ performance by altering risks into competitive advantages,
increasing the confidence of shareholders with respect to cash flows stability, as well as
reducing shareholders’ reluctance to invest in risky and long-term investments such as
research and development (R&D) (Spira and Page, 2003). Recently, Florio and Leoni (2017)
provided evidence on the positive relationship between risk management functions and the
level of performance. Overall, it can be argued that there is a positive relationship between
corporate governance quality and firm performance. Hence, it is expected that corporate
governance quality has a direct and positive effect on performance (path 2), as illustrated in
Figure 1. Thus, the second hypothesis is stated in its alternative form as follows:
H2. There is a direct and positive relationship between corporate governance quality and
performance (path 2).
2.2.2 The direct relationship between performance and earnings quality. Following the
signalling theory, it is expected that managers of firms that are performing well have more
propensity to disclose more information about their real earnings in order to send signs to the
market about the quality of the firms they manage and to differentiate themselves from poor
quality firms (Verrecchia, 2001). Consistently, Gul et al. (2009) found that firms with a high
level of performance are less likely to engage in income-increasing earnings management
behaviour because they are already performing well. Also, Dechow and Schrand (2004)
indicated that reported earnings accurately reflect a firm’s current operating performance.
Similarly, Dechow et al. (2010) set a framework in which reported earnings quality is a
function of firm’s fundamental performance. Thus, it has been argued that managers can use
earnings management to reduce the likelihood of dismissal when performance is poor
(Peasnell et al., 2005).
JAEE Empirically, Dechow et al. (2000) reported that US firms manage earnings
opportunistically to delay reporting poor performance. In a similar vein, Dechow and
Dichev (2002) pointed out that mangers attempted to opportunistically postpone reporting
poor performance by avoiding losses or declines in earnings. Another reason for managers to
engage in management earnings practices is to avoid large decline in stock prices due to
negative earnings surprises or crashes (Skinner and Sloan, 2002) [5]. Consistently, managers
choosing different accounting methods that increase income and conceal the loss to mask a
deteriorating performance and to prevent debt covenants violation (DeFond and Jiambalvo,
1994; Habib et al., 2013). Rosner (2003) and Lee et al. (2006) pointed out that poor performance
firms that suffer bankruptcy would severely engage in income-increasing earnings
management practices. In contrast, firms with extremely poor performance might also
severely decrease their reported earnings to improve their performance in the following
period, which is commonly known as the “big bath” practice, this implicitly means that
management is engaged in earnings management practices (Scott, 2011) [6]. Arguably, Watts
and Zimmerman (1990) showed that managers in firms with a higher level of financial
performance tend to manage earnings downward when they are in excess of their bonus
bounds contracts. Moreover, Ma and Ma (2017) exhibited that low earnings quality is
associated with high corporate performance; they argued that the negative association of
earnings quality with corporate performance is an inherent phenomenon of a new emerging
market within an economy booming period, particularly in China.
Recently, Mostafa (2017) examined the presence of earnings management practices based
on the operating performance of Egyptian firms by testing whether poor operating firms are
more likely to engage in opportunistic income-increasing practices than firms with high
operating performance. The result showed that firms with low operating performance tend to
manage earnings upward to offset their low performance (i.e. the level of discretionary accruals
are positively and significantly higher for firms with poor operating performance than firms
with high operating performance). Lambert (2001) contended that one possible reason for
managers’ behaviour to manipulate earnings is that most management compensation
contracts are mainly designed based on reported earnings. Also, Kumari and Pattanayak
(2017) found a similar result in the context of Indian banking industry. Hence, it is expected
that performance has a direct and positive effect on earnings quality (path 3), as illustrated in
Figure 1. Thus, the third hypothesis is stated in its alternative form as follows:
H3. There is a direct and positive relationship between performance and earnings quality
(path 3).
2.2.3 The mediating effect of performance. Mediation occurs when two paths are sequential in
which the independent variable affect the mediator variable and the mediator variable affect
the dependent variable. Empirically, Peasnell et al. (2005) argued that board effectiveness
(proxied by outside board members) could deter income-increasing earnings management
when performance, as a contingent variable, satisfying the following thresholds: (1) avoid
reporting a loss; (2) report a growth in profits and (3) meet the analysts’ consensus forecast. In
addition, Cornett et al. (2008) examined the impact of governance structure (proxied by
institutional ownership of shares, institutional investor representation on the board of
directors and the presence of independent outside directors on the board) on earnings
management practices when firm performance is used as a basis for management
compensation (i.e. stock options). They found evidence that strong governance
mechanisms largely offset the harmful impact of stock options, in terms of reduced
earnings management practices committed by managers. This evidence is also consistent
with institutional investors being able monitor and constrain the self-interest behaviour of
corporate managers to increase or decrease the reported profits towards the desired level or
range of profits (Chung et al., 2002).
 In a similar vein, Zhu and Tian (2009) found that board structure effectiveness improves Corporate
the quality of reported earnings when firm performance is adjusted to exclude discretionary governance
accruals. Interestingly, the findings of Khalil and Ozkan (2016) revealed that non-executive
directors in Egypt are seemed to be added to the board of directors merely to comply with
and earnings
regulations in appearance, rather than excreting their monitoring functions in deterring quality
earnings management practices committed by top management. Therefore, it is more about
the board of directors’ behaviour towards managers’ financial reporting decisions. In other
words, if the firm reported a good level of performance, board of directors might become
more sceptical and challenge managers’ financial reporting decisions, particularly those
decisions subject to managers’ discretion with respect to earnings. This implies that
applying effective corporate governance does not necessarily yield the favourable direct
effect on earnings quality if firm’s performance is poor, and this might open the door for
managers’ discretion for using accruals opportunistically to conceal firms’ true
performance.
Also, according to prior arguments in Section 2.2.1 and Section 2.2.2, corporate
governance quality is related to firms’ performance and that the firms’ performance is, in
turn, related to the quality of reported earnings. Accordingly, performance exerts a mediating
effect of on the relationship between corporate governance quality and earnings quality [7].
Hence, it is expected that the level of performance has a mediating effect on the relationship
between corporate governance quality and earnings quality, as illustrated in Figure 1. Thus,
the fourth hypothesis is stated in its alternative form as follows:
H4. There is an indirect relationship between corporate governance quality and earnings
quality, through firms’ performance.
The conceptual model illustrating the direct and indirect (mediated by performance) paths
between corporate governance quality and earnings quality is illustrated in Figure 1. The
research method is discussed next.

3. Research method
The following subsections present the sample selection procedures as well as the variables
measurement.

3.1 Sample selection

A purposive sampling method is used. To be included in the sample, a firm should fulfil all the
following criteria:
(1) It should be listed in the Egyptian Financial Supervisory Authority (EFSA) for the
years 2011–2017 [8].
(2) It should have complete data for the years 2011–2017 as required, either from
published annual reports published by firms or available on their websites [9].
(3) Financial institutions are excluded, as they have special regulations pertaining to
bank corporate governance and are regulated by the Central Bank of Egypt (CBE).
(4) The financial statements of sample firms are prepared and presented in Egyptian
pound, which is the functional currency. Thus, gas and petroleum firms are excluded
from the sample.
(5) Firms within industries with market share more than or equal 25% are excluded, as
they might be indicators of oligopoly. Thus, firms belong to media, technology,
telecommunications and utilities are excluded from the sample.
JAEE Accordingly, the final sample consists of 125 Egyptian listed cross-sectional firms as
illustrated in Table 1 [10]. The sample firms accounted for 55% of the total population. Hence,
the sample is considered to be representative and sufficient consistent with Babbie (2016).
The data regarding corporate governance mechanisms, performance and earnings quality
will be collected through the annual reports of Egyptian firms from 2011 to 2017, which will
yield 875 firm-year observations [11]. More details on the measurement of variables are
presented in Section 3.2 below.

3.2 Measurement of variables

3.2.1 Corporate governance quality measurement. Instead of considering a single measure of
corporate governance quality, the current study constructs a comprehensive corporate
governance quality index (CGQI) based on “corporate governance principles” of the
Organization of Economic Co-operation and Development (OECD) issued in 2004 and the
corporate governance codes issued by the Egyptian ministry of investment and international
cooperation in 2005 and its updated version issued in 2011, as well as relevant prior studies
[12]. The choice to base the index on these sources of guidelines is made because they
effectively encapsulate all of the governance items requirements envisaged and were widely
used by prior studies for constructing CGQI.
Corporate governance quality index (CGQI) is a composite index that consists of 60 sub-
indices (items or attributes) of corporate governance divided unevenly across seven
dimensions as outlined in Appendix [13]. Among these, 10 sub-indices (items or attributes) are
related to board structure and functions (CG1), 10 sub-indices are related to audit committee
(CG2), seven sub-indices are related to internal audit and control (CG3), seven sub-indices are
related to external audit (CG4), four sub-indices are related to ownership structure (CG5), four
sub-indices are related to shareholders’ rights (CG6), 15 sub-indices are related to risk
committee (CG7).
To calculate the score of CGQI for each firm, the researcher designs a detailed
questionnaire that includes all governance attributes. Following content analysis approach,
each attribute in the sub-index is a binary (dichotomous) variable that takes a value of 1 or 0;
where, 1 indicates the presence/adherence of the attribute or item and 0 represents the
absence/non-adherence of it (See Babbie (2016) for more details about how to construct a
questionnaire). Missing facts for a certain attribute are assigned 0. All the scores of the
questions will then be added up to make the final unweighted corporate governance quality
index (CGQI). Therefore, the index indicating good corporate governance quality will get
higher score than the one indicating poor corporate governance practices. A maximum value
of 60 is assigned to those firms complying with all the attributes.
The score will be calculated for each firm as follows:
Pn
Xij
CGQIj ¼ i¼1 (1)
nj

Total firms listed according to EFSA from 2011 to 2017 224

Less
Firms with no published annual reports and not available on their websites (42)
Banks and financial services firms (45)
Firms with financial statements prepared and presented in foreign currency (3)
Table 1. Firms within industries with market share exceeds 25% (9)
Sample selection Total sample 125
Where, CGQIj represents corporate governance quality index for the firm j, Xij equals 1, if the Corporate
firm j meets the ith attribute or equals 0 if ith attribute is not met, nj is the number of attributes governance
expected to be complied by the firm. The score for CGQIj is calculated for each year in two
steps. In the first step, a total index is calculated for each firm and then the values of the total
and earnings
indices are aggregated to arrive at CGQIj for all firms for each year. The higher the index, the quality
higher the quality of corporate governance practices.
3.2.2 Earnings quality measurement. According to Healy (1985), accruals are relatively
large items that are subject to management’s discretion. Specifically, accruals represent the
inflated earnings that cannot be explained through firms’ fundamental and normal activities
(Jones, 1991). Therefore, discretionary accruals are often used as a proxy for earnings quality.
Total accruals can be divided into non-discretionary (normal) accruals and discretionary
(abnormal) accruals. The use of discretionary accruals as a measure of earnings quality is
based on the view that discretionary accruals are the components that cannot be explained by
accounting fundamentals (fixed assets and revenues) and are inversely related to earnings
quality (Francis et al., 2006) [14]. Therefore, managers usually exercise their discretion over
these items to manipulate earnings opportunistically.
The most frequently used approach for measuring earnings management is the modified
Jones model because it is more powerful for detecting sales-based manipulations practices
than other models (Dechow et al., 1995) [15]. Following the modified Jones model, first, total
accruals (TACC) are estimated, using cash flows approach, as follows [16]:
TACCi;t ¼ NIi;t  OCFi;t (2)
Where, TACCi,t is the total accruals for each firm i in year t, measured as income before
extraordinary items and discontinued operations (NIi,t) minus operating cash flows (OCFi,t).
Then, the non-discretionary accruals (NDACC) component is measured as follows:
  
NDACCi;t−1 ¼ B0 þ B1 ð1 TAi;t−1 Þ þ B2 ðΔREVi;t  ΔRECi;t Þ TAi;t−1 þ B3 ðPPEi;t TAi;t−1 Þ
(3)

Where, NDACCi,t is the non-discretionary accruals component for each firm i in year t; TAi,t-1
is total assets for each firm i in year t; ΔREVt is revenues for each firm i in year t less revenues
in year t-1; ΔRECi,t is net receivables for each firm i in year t less net receivables in year t-1;
PPEi, t is gross property, plant and equipment for each firm i in year t and B0, B1, B2 and B3 are
firm-specific parameters. In addition, since estimating discretionary accruals using raw data
might be biased towards large or small firms, then all variables are scaled by lagged total
assets (TAi,t-1) in order to reduce heteroscedasticity in residuals, consistent with Jones (1991).
Finally, the discretionary accruals (DACC) component is the difference between total
accruals (TACC) and the non-discretionary accruals (NDACC) component which is calculated
as follows:
DACCi;t ¼ TACCi;t  NDACCi;t−1 (4)

Because earnings quality is essentially an attempt to smooth earnings by inflating (deflating)

discretionary accruals to boost (limit) profit in a bad (good) year, the magnitude is more
relevant than the sign of discretionary accruals (Barton, 2001; Bergstresser and Philippon,
2006; Yu, 2008). Thus, the current study uses the absolute values of discretionary accruals
(‫׀‬DACC‫ )׀‬to measure the propensity of earnings management practices; therefore, lower
‫׀‬DACC‫ ׀‬suggests higher level of earnings quality, and vice versa.
3.2.3 Performance measurement. Based on prior studies (e.g. Abdel-Maksoud et al., 2015;
Kumari and Pattanayak, 2017; Ma and Ma, 2017), the current study employs two types of
measures for evaluating firm’s performance which are: accounting-based performance
measures and market-based performance measures.
JAEE 3.2.3.1 Accounting-based performance measures. Following Cornett et al. (2008), Gore et al.
(2007), Ma and Ma (2017) and Peasnell et al. (2005), the current study depends on pre-managed
earnings (PME) when calculating accounting-based performance measures to overcome the
mechanical relationship problem (i.e. earnings management practices are contingent of the
current firm’s performance before managing earnings). Peasnell et al. (2005) argued that
managers tend to manipulate earnings upward (downward) when either PMEt < 0 or
PMEt < Earningst-1 (PMEt > 0 or PMEt > Earningst-1 by a large margin). While Cornett et al.
(2008) and Gore et al. (2007) measured pre-managed earnings by subtracting abnormal
accrual from firm’s reported earnings during the current year (PMEt 5 Earningst–DACCt),
Ma and Ma (2017) and Peasnell et al. (2005) measured pre-managed earnings (PMEt) using
cash flows from operations (CFO). However, Peasnell et al. (2005) have criticised Gore et al.
(2007)’s proxy to measure PME, as it could lead to a backing-out problem, in which error in
estimating DACC will lead automatically to an equal error in estimating PME, which in turn
could result in spurious correlation between DACC and PME. Therefore, the current study
follows Ma and Ma (2017) and Peasnell et al. (2005) approach for measuring PME.

PMEi;t ¼ ½CFOi;t þ NDACCi;t  TAi;t (5)

Where, PMEi,t is the pre-managed earnings for each firm i in year t; CFOi,t is cash flows from
operations for each firm i in year t; NDACCi,t is the nondiscretionary accruals for each firm i in
year t, as calculated in equation (3) and TAi,t is the total assets for each firm i in year t.
The current study uses two proxies for measuring accounting-based performance which
are: return on assets (ROA) and return on equity (ROE).

ROAi;t ¼ PMEi;t Total assetsi;t (6)

ROEi;t ¼ PMEi;t Total equityi;t (7)

3.2.3.2 Market-based performance measures. The current study uses two proxies for
measuring market-based performance which are: price-to-earnings ratio (P/E) and market-to-
book value ratio (MTBV).
 
P E ratioi;t ¼ Price per sharei;t Earnings per sharei;t (8)

MTBV ratioi;t ¼ Price per sharei;t Book value per sharei;t (9)

3.2.4 Controls. Three control variables are incorporated in this study as firms-specific
characteristics which include: firm size, leverage and type of industry. These control
variables are argued to affect corporate governance quality (Baxter et al., 2013; Beasley et al.,
2005; Palaniappan, 2017), level of performance (Abbadi et al., 2016; Ebaid, 2009; Florio and
Leoni, 2017; Messner, 2015) and earnings quality (Francis and Wang, 2008). Firm size is
measured by the natural logarithm of total assets at the end of each year (Abdel-Maksoud
et al., 2015; Henri et al., 2016). Leverage is measured by the total debt divided by the total
assets at the end of each year (Branco and Rodrigues, 2008; Khemir and Baccouche, 2010).
Type of industry is a categorical variable which represents the industry in which the firm
operates and it equals 1 for basic resources, 2 for chemicals, 3 for construction and materials, 4
for food and beverage, 5 for healthcare and pharmaceuticals, 6 for industrial goods and
services and automobiles, 7 for personal and household products, 8 for real estate and 9 for
travel and leisure. Data analysis and results are presented next.

4. Data analysis and results

Structural equation modelling (SEM), using IBM® SPSS® AMOS™ Statistics Program
(Version 24), is employed to test the proposed analytical model. According to Hair et al. (2010),
SEM is more suitable compared to other traditional statistical method for testing Corporate
simultaneously existing relationships among the variables included in the research, in governance
which the dependent variable in one equation becomes an independent variable in the
subsequent ones. Also, the path analysis allows to conduct the confirmatory factor analysis
and earnings
(CFA) and facilitates the ability to represent unobserved constructs (latent variables) [17]. quality
Moreover, SEM is expected to reduce the measurement errors when using multiple indicators
by ensuring that all single indicators are measuring the same underlying construct by
confirmatory factor analysis (e.g. corporate governance quality variable). Furthermore,
following Hoyle (2000), SEM allows for the calculation of direct, indirect and total effects
when studying causal relationships between variables, including mediating variables.
The following subsections present the descriptive statistics for the model variables, the
evaluation of measurement models, the evaluation of structural model, control variables
analysis, additional analysis, longitudinal validity of the proposed model and tests for
controlling the potential endogeneity problem.

4.1 Descriptive statistics

The descriptive analysis presents the data distribution of measures of variables employed in
this study. Panel A of Table 2 reports the descriptive statistics of the overall CGQI along with
its dimensions. The overall mean score of CGQI is 44.07, which indicates that Egyptian firms
comply with the majority (73%) of CGQI attributes addressed in the CGQI. The lowest score is
32 and the highest score is 52. More importantly, the mean score of CG7 is 11.56, which
provides evidence regarding the awareness of Egyptian firms to the importance of risk
committee and risk management functions. Then, panel B of Table 2 shows the descriptive
statistics of performance variable. The means for accounting-based performance measures
represented by ROA and ROE are 0.241 and 0.247, respectively. In addition, the means for
market-based performance measures represented by P/E and MTBV are 18.416 and 3.182,
respectively. Finally, panel C of Table 2 reveals that the mean for ‫׀‬DACC‫׀‬, as a measure for
earnings quality, is 0.097.
For control variables, panel D of Table 2 shows that the mean for firms’ size is 18.350,
while the mean for leverage is 0.367. However, the distribution of sampled firms based on
industry categories reveals that the largest number of firms included in the sample are in the
category of food and beverage (17.60%), followed by real estate (16.80%), then construction
and materials category (16.00%). Meanwhile, the lowest number of firms included in the
sample are in the category of chemicals (5.60%).

4.2 Measurement models evaluation

The aim of this step is to ensure the validation of model variables measurements. This can be
done by conducting confirmatory factor analysis (CFA), composite reliability, internal
consistency, convergent validity and discriminant validity. The constructs must exceed the
recommended values to reflect an acceptable level (Hair et al., 2010; Mackenzie et al., 2005;
Nunnally, 1967) [18]. The measurement models for corporate governance quality and
performance are illustrated in Figure 2 [19].
The results reported in panels A, B and C of Table 3 indicate that all constructs exceed the
recommended cut-off values for confirmatory factor analysis, composite reliability (CR),
convergent validity and discriminant validity. The values of CR for corporate governance
quality, performance and earnings quality are: 0.923, 0.883 and 1, respectively, which are
considered adequate (Hair et al., 2010). Also, internal consistency for corporate governance
quality, performance and earnings quality are: 0.783, 0.692 and 1, respectively. The convergent
validity of the measurement models is verified by assessing each construct’s average
extracted variance (AVE); these are all found to be greater than 0.5 (Hair et al., 2010).
JAEE Variables N Mean Standard deviation Minimum Maximum

Panel A: Descriptive statistics of corporate governance quality index

CG1 875 7.71 2.156 7 10
CG2 875 7.25 1.820 6 9
CG3 875 5.42 1.537 4 6
CG4 875 5.60 1.335 4 6
CG5 875 3.73 1.144 3 4
CG6 875 6.38 1.458 5 7
CG7 875 11.56 3.016 7 13
Overall CGQI 875 44.07 7.875 32 52
Panel B: Descriptive statistics of performance
ROA 875 0.241 0.053 0.087 0.691
ROE 875 0.247 0.061 0.095 0.732
P/E 875 18.416 7.303 1.92 42.07
MTBV 875 3.182 1.21 1.36 7.25
Panel C: Descriptive statistics of earnings quality
‫׀‬DACC‫׀‬ 875 0.097 0.056 0.028 0.513
Panel D: Descriptive statistics for control variables
Firm size 875 18.350 2.624 9.863 22.718
Leverage 875 0.367 0.225 0.085 0.714

Industry code Industry category Number of firms [Mode] Percentage

1 Basic resources 9 7.20
2 Chemicals 7 5.60
3 Construction and 20 16.00
materials
4 Food and beverage 22 17.60
5 Healthcare and 12 9.60
pharmaceuticals
6 Industrial goods 16 12.80
and services and
automobiles
7 Personal and 8 6.40
household
products
Table 2. 8 Real estate 21 16.80
Descriptive statistics of 9 Travel and leisure 10 8.00
model variables Total 125 100.00

Figure 2.
The measurement
models
 Corporate governance Earnings
Corporate
Variables quality Performance quality R 2 governance
and earnings
Panel A: Confirmatory factor analysis – standardised factor loadings
CG1 0.739 0.546 quality
CG2 0.815 0.664
CG3 0.664 0.441
CG4 0.750 0.563
CG5 0.830 0.689
CG6 0.783 0.613
CG7 0.802 0.643
ROA 0.767 0.588
ROE 0.785 0.616
P/E 0.827 0.684
MTBV 0.855 0.731
‫׀‬DACC‫׀‬ 1.000 1.000
Panel B: Reliability criterion
Composite reliability (CR) 0.923 0.883 1.000
Internal consistency-Cronbach alpha 0.783 0.692 1.000
Panel C: Validity criterion
Convergent validity-average 0.634 0.655 1.000
variance extracted (AVE)

Discriminant validity
Table 3.
Corporate governance quality 0.796 – – Results of
Performance 0.383 0.809 – confirmatory factor
Earnings quality 0.476 0.341 1.000 analysis, composite
Panel D: Goodness of fit of the measurement models reliability, internal
consistency,
χ 2(df), p-value 32.926(14), p < 0.001 3.734(2), p < 0.001 0.000(0), p < 0.001 convergent validity,
CFI 0.982 0.955 1.000 discriminant validity
RMSEA 0.051 0.063 0.000 and goodness of fit of
Note(s): χ2 5 chi-square; CFI 5 comparative fit index and RMSEA 5 root mean-square error of the measurement
approximation models

Discriminant validity is also assessed by verifying that the average variance extracted (AVE)
for each construct is greater than the squares of its correlation with other constructs (Hair
et al., 2010). In addition, the overall acceptability of the measurement models is assessed using
chi-square statistic (χ 2), comparative-fit index (CFI) and root mean square error of
approximation (RMSEA) [20]. Panel D of Table 3 exhibits acceptable model fit. Hence, the
quality of overall measurement models is quite adequate and meet the recommended cut-off
values. The next step in SEM is to evaluate the structural model.
4.3 Structural model evaluation and hypotheses testing
In the second step of SEM is to evaluate the structural model in terms of path analysis
coefficients, t-statistics, goodness of fit indices and the proportion of variance (R2) (Hair et al.,
2010). The SEM model is depicted in Figure 3:
Panel A of Table 4 presents the results of the structural equation model path analysis of
the overall model. The results suggest that corporate governance quality has a direct positive
and significant effect on earnings quality (p[CGQ, EQ] 5 0.191; p < 0.01), and thus accepts H1.
This result supports prior studies regarding the importance of effective corporate
governance mechanisms on deterring managers’ ability to manage earnings
opportunistically (Baxter and Cotter, 2009; Bedard et al., 2004; Bentley et al., 2012;
JAEE e1
0.55
CGI
0.66 0.74
e2 CG2
0.82 e13
0.44 0.86
e3 CG3
0.66
0.56 0.75 Corporate 0.191
Governance Earnings
e4 CG4
0.83 Quality Quality
0.69
e5 CG5
078 e12
0.61 0.645 0.371
e6 CG6 0.80 0.79

0.64
e7 CG7 Performance

0.77 0.79 0.83 0.86

ROA ROE P/E MTBV

Figure 3. 0.59 0.62 0.68 0.73

The structural model
e8 e9 e10 e11

Coefficient t-test

Panel A: Standardised direct, indirect, and total effects

Direct effect 7.40
p[CGQ, EQ] (H1) 0.191*
Percentage (44.40%)

Mediated paths
p[CGQ, Perf] (H2) 0.645* 14.75
p[Perf, EQ] (H3) 0.371* 11.72
Total indirect effect (H4) 0.239* 9.76
Percentage (55.60%)
Total effect r[CGQ, EQ] 0.430* 12.55
Testing for mediation 2.29
Sobel test
Panel B: Standardised path coefficients for control variables
p[Size, CGQ] 0.334* 11.41
p[Size, Perf] 0.245* 9.82
p[Size, EQ] 0.298* 11.06
p[Leverage, CGQ] 0.184* 7.34
p[Leverage, Perf] 0.157* 6.97
p[Leverage, EQ] 0.186* 7.39
p[Industry, CGQ] 0.092 6.01
p[Industry, Perf] 0.084 5.89
p[Industry, EQ] 0.139 6.76
Panel C: Overall model fit indices
χ 2(df), p-value 107.812(51), p < 0.001
CFI 0.952
RMSEA 0.045
R2 of performance 0.79
R2 of earnings quality 0.86
Note(s): *Denotes the level of statistical significance at 0.01 or less (two-tailed tests), p indicates path
Table 4. coefficients and r indicates (Pearson) correlation coefficients. The correlations among variables are adjusted for
SEM paths analysis random effects; χ2 5 chi-square; CFI 5 comparative fit index and RMSEA 5 root mean-square error of
results of overall model approximation. Statistical inference is based on standard errors clustered by firm and year
Davidson et al., 2005; Dey, 2008; Habbash et al., 2013; Kent et al., 2010; Osma, 2008; Xie et al., Corporate
2003; Zhong et al., 2007). This finding could be interpreted by the controlling role of corporate governance
governance in deterring earnings management practices committed by managers which is
consistent with agency theory (Jensen and Meckling, 1976). Furthermore, the results showed
and earnings
that corporate governance quality has a direct positive and significant effect on performance quality
(p[CGQ, Perf] 5 0.645; p < 0.01) and thus accepts H2. This result suggests that firms with
effective corporate governance mechanisms ensure the resources required to improve the
level of performance (Florio and Leoni, 2017; Karuna, 2007; Larmou and Vafeas, 2010;
Victoria, 2006). This finding is consistent with resource-based theory (Barney, 1991;
Wernerfelt, 1984). Moreover, the findings revealed that performance has a direct positive and
significant effect on earnings quality (p[Perf, EQ] 5 0.371; p < 0.01) and thus accepts H3. This
result is consistent with the signalling effect of good performing firms through exhibiting
high-quality reported earnings (Dechow et al., 2010; Dechow and Schrand, 2004; Lee et al.,
2006). This finding is consistent with signalling theory (Verrecchia, 2001). Finally, corporate
governance quality has an indirect positive and significant effect on earnings quality,
through performance (The standardised coefficient (p) for the mediated path between CGQ
and EQ 5 0.239, p < 0.01), which is consistent with prior studies such as Peasnell et al. (2005),
Cornett et al. (2008), Chung et al. (2002) and Zhu and Tian (2009) and thus accepts H4. To
confirm the mediation effect, a Sobel-test is carried out, and the results show that the Sobel-
test is significant (Sobel, 1982).
In sum, the results suggest a significant total effect of corporate governance quality on
earnings quality (r[CGQ, EQ] 5 0.430; p < 0.01). Of this total effect, 44.4% refer to the direct
effect of corporate governance quality on earnings quality (p 5 0.191; p < 0.01), while
55.6% refer to an indirect effect of corporate governance quality on earnings quality,
through performance (p 5 0.239; p < 0.01). Interestingly, it seems to the researcher that the
direct relationship between corporate governance quality and earnings quality is
relatively less important than the relationship mediated by performance. This implies
that capital market participants can process performance-related information
disseminated by firms faster than their perception regarding corporate governance
efficiency.
In addition, panel C of Table 4 reveals that the model meets the cut-off values for the three
fit indices mentioned previously (χ 2 5 107.812; CFI 5 0.952; RMSEA 5 0.045). Hence, this
indicates a good fit of the data of the Egyptian firms to the proposed model (Hair et al., 2010).
As the proposed model has fitted the data very well, it is not necessary to conduct further
examinations to re-specify the proposed model. Moreover, the R2 for performance is 0.79,
showing that performance is a meaningful mediator. Also, the overall R2 for earnings quality
is 0.86, which is considered quite strong.

4.4 Control variables analysis

Panel B of Table 4 shows that firm size has a positive and significant effect on corporate
governance quality, level of performance and earnings quality (p < 0.01 for all path
coefficients). This result is consistent with prior studies suggested that larger firms have
more ability to comply with corporate governance mechanisms, enhance their level of
performance and improve the quality of their reported earnings (Abbadi et al., 2016; Baxter
et al., 2013; Palaniappan, 2017). In contrast, leverage has a negative and significant effect on
corporate governance quality, level of performance and earnings quality (p < 0.01 for all path
coefficients). This result is also consistent with prior studies, suggesting that high leveraged
firms tend to be less adherence to corporate governance quality, less ability to monitor their
level of performance and more willingness to engage in earnings management practices
(Abbadi et al., 2016; Ebaid, 2009). Nonetheless, the type of industry has no significant effect on
all main constructs, consistent with Florio and Leoni (2017).
JAEE 4.5 Additional analysis
While the overall indirect effect of corporate governance quality on earnings quality is more
dominant than the direct effect, the decomposition of performance (as a mediating variable)
into accounting-based performance measures and market-based performance measures
reveals interesting findings. Table 5 presents the results of the model when performance as a
mediating variable is disaggregated by each of the four different measures of performance
which are: ROA, ROE, P/E and MTBV, separately. This means that there are four sub-models;
each sub-model is mediated by only one indicator for firms’ performance [21].
On one hand, the left-hand side of Table 5 decomposes accounting-based performance
measures into return on assets (ROA) and return on equity (ROE). Using ROA only as a
measure for accounting-based performance, the results show that the ratio of the direct path
coefficient p[CGQ, EQ] to the total correlation is (55.13%), which is the portion of the
correlation between corporate governance quality and earnings quality that is attributable to
the direct path. However, the ratio of the mediated path to the total correlation is (44.87%),

Performance proxied by accounting-based Performance proxied by market-based

measures–[Left-hand side] measures–[Right-hand side]
Model mediated by Model mediated by Model mediated by Model mediated by
ROA ROE P/E MTBV
Coefficient t-test Coefficient t-test Coefficient t-test Coefficient t-test

Panel A: Standardised direct, indirect and total effects

Total effect r[CGQ, EQ] 0.430* 12.55 0.430* 12.55 0.430* 12.55 0.430* 12.55
Direct path
p[CGQ, EQ] 0.237* 9.69 0.256* 10.01 0.149* 6.87 0.121* 6.52
Percentage (55.13%) (59.58%) (34.72%) (28.16%)
Mediated path
p[CGQ, Perf] 0.487* 12.73 0.449* 12.70 0.669* 14.87 0.632* 14.58
p[Perf, EQ] 0.396* 12.17 0.388* 11.76 0.420* 12.34 0.489* 13.06
Total mediated 0.193* 7.53 0.174* 7.21 0.281* 10.43 0.309* 11.25
Percentage (44.87%) (40.42%) (65.28%) (71.84%)
Testing for mediation 2.25 2.16 2.37 2.45
Sobel test
Panel B: Standardised path coefficients for control variables
p[Size, CGQ] 0.316* 11.35 0.311* 11.29 0.337* 11.44 0.365* 11.54
p[Size, Perf] 0.240* 9.80 0.235* 8.66 0.257* 10.07 0.250* 9.93
p[Size, EQ] 0.275* 10.37 0.262* 10.24 0.294* 10.94 0.342* 11.46
p[Leverage, CGQ] 0.204* 7.93 0.178* 7.26 0.183* 7.29 0.192* 7.44
p[Leverage, Perf] 0.127* 6.63 0.141* 6.79 0.217* 8.32 0.169* 7.15
p[Leverage, EQ] 0.185* 7.36 0.163* 7.04 0.210* 8.27 0.199* 7.78
p[Industry, CGQ] 0.073 5.72 0.082 5.87 0.095 6.09 0.112 6.48
p[Industry, Perf] 0.067 5.63 0.076 5.78 0.104 6.37 0.088 5.93
p[Industry, EQ] 0.131 6.68 0.115 6.50 0.144 6.81 0.156 6.90
Panel C: Overall model fit indices
χ 2(df), p-value 61.632(24), p < 0.001 63.161(24), p < 0.001 59.304(24), p < 0.001 56.208(24), p < 0.001
CFI 0.948 0.944 0.956 0.959
RMSEA 0.047 0.049 0.043 0.040
2
R of performance 0.78 0.76 0.79 0.81
Table 5. 2
R of earnings quality 0.85 0.83 0.86 0.88
SEM paths analysis
results of overall model Note(s): *Denotes the level of statistical significance at 0.01 or less (two-tailed tests), p indicates path
disaggregated by coefficients and r indicates (Pearson) correlation coefficients. The correlations among variables are adjusted for
different measures of random effects; χ2 5 chi-square; CFI 5 comparative fit index and RMSEA 5 root mean-square error of
performance approximation. Statistical inference is based on standard errors clustered by firm and year
which captures the portion of the correlation between corporate governance quality and Corporate
earnings quality that is attributable to the mediated effect (i.e. mediated by ROA only). Both governance
direct and mediated paths are highly significant with the direct path is substantially more
important than the indirect path.
and earnings
In a similar vein, using ROE only as a measure for accounting-based performance, the quality
results show that the ratio of the direct path coefficient p[CGQ, EQ] to the total correlation is
(59.58%), which is the portion of the correlation between corporate governance quality and
earnings quality that is attributable to the direct path. However, the ratio of the mediated path
to the total correlation is (40.42%), which captures the portion of the correlation between
corporate governance quality and earnings quality that is attributable to the mediated effect
(i.e. mediated by ROE only). Both direct and mediated paths are also highly significant with
the direct path is substantially more important than the indirect path.
On the other hand, the right-hand side of Table 5 decomposes market-based performance
measures into price-to-earnings ratio (P/E) and market-to-book value ratio (MTBV). Using P/E
only as a measure for market-based performance, the results show that the ratio of the direct path
coefficient p[CGQ, EQ] to the total correlation is (34.72%), which is the portion of the correlation
between corporate governance quality and earnings quality that is attributable to the direct path.
However, the ratio of the mediated path to the total correlation is (65.28%), which captures the
portion of the correlation between corporate governance quality and earnings quality that is
attributable to the mediated effect (i.e. mediated by P/E only). Both direct and mediated paths are
highly significant with the indirect path is substantially more important than the direct path.
Similarly, using MTBV only as a measure for market-based performance, the results show
that the ratio of the direct path coefficient p[CGQ, EQ] to the total correlation is (28.16%),
which is the portion of the correlation between corporate governance quality and earnings
quality that is attributable to the direct path. However, the ratio of the mediated path to the
total correlation is (71.84%), which captures the portion of the correlation between corporate
governance quality and earnings quality that is attributable to the mediated effect (i.e.
mediated by MTBV only). Both direct and mediated paths are also highly significant with the
indirect path is substantially more important than the direct path.
To examine the influence of control variables on the main constructs, each model has been
run with all control variables (i.e. size, leverage and type of industry). Nonetheless, the results
remain qualitatively unchanged compared to the results of the overall model, in which all the
results that were previously significant (i.e. firm size and leverage) are still significant and the
results that were not significant (i.e. type of industry) remain unchanged.
In sum, the findings of additional analysis suggest that the direct relationship between
corporate governance quality and earnings quality dominates the relationship mediated by
performance when performance is proxied by accounting-based performance measures
which suggests that, when there is a trade-off between the two, increasing the quality of
corporate governance quality has a bigger payoff, in the sense of increased earnings quality
effects, than does ensuring improved accounting-based performance. However, the findings
also revealed that the indirect relationship as the more important in case of using market-
based performance measures. In the context of management’s reporting and disclosure
decisions, the results suggest that efforts to improve earnings reporting should be evaluated
in light of corporate governance quality if accounting-based performance measures are used,
while considering the importance of corporate governance quality in improving earnings
quality indirectly if market-based performance measures are used.

4.6 Longitudinal validity of the proposed model

After testing the proposed model (including all the hypothesized direct, indirect and total
paths among variables of interest), it is necessary to show how this model has been made
JAEE amenable to longitudinal data. Accordingly, sequential chi-square difference tests (SCDTs)
are used (Bentler and Bonnet, 1980). More specifically, cross-validation tests are conducted, in
which the fit of the theoretical (proposed) model is compared to the fits of both saturated and
constrained models. The theoretical model suggests recursive relationships among all
variables of interest. While saturated model suggests that all variables are allowed to be free
in recursive relationships among the variables (i.e. a saturated model has the best fit possible),
constrained model posits that there are no relationships among variables.
Table 6 shows that the SCDTs between the theoretical model and saturated model are not
statistically significant. However, the SCDTs between the theoretical model and constrained
model are statistically significant (p < 0.01). Also, the SCDTs between the saturated model
and constrained model are statistically significant (p < 0.01). Therefore, the theoretical
(proposed) model provides an adequate fit to the data collected in the context of Egyptian
business environment during the period 2011–2017. More importantly, the results reveal that
the expected cross-validation index (ECVI) for the theoretical (proposed) model is 0.217, which
is lower than the ECVI for the saturation model is 0.258. These results indicate that the
proposed model has a powerful predictive validity, suggesting that the proposed model
exhibits the greatest potential for replication in the future and predicting future sample
covariances in the context of Egyptian business environment (Cudek and Browne, 1983).

4.7 Controlling for endogeneity

It has been argued that the problem endogeneity may arise due to many reasons, including
omitted variables, reverse causality/simultaneity, measurement error, common-method
variance, model misspecification and/or equilibrium conditions (Antonakis et al., 2010;
Larcker and Rusticus, 2010). For instance, it has been appropriately pointed out to the
researcher by an anonymous reviewer, the endogeneity questions that can be faced in this
study which are: (1) can earnings quality cause corporate governance quality on a
longitudinal basis? This is because it is likely that firms with lower earnings management
practices might attract good board members ensuring high level of compliance with
corporate governance principles in the long run. (2) Can earnings quality cause performance
especially on a longitudinal basis? This is true if the real effects (i.e. feedback effects to
management) of earnings quality are considered overtime. This is because it is likely that
firms with lower earnings management practices might lead to better level of performance.
This potential reverse causality/simultaneity explanation can raise serious doubts on the
validity of the findings (Antonakis et al., 2010).
One way to address the possibility of endogeneity problems, as suggested by Larcker and
Rusticus (2010), is to construct various alternative models. Consequently, in order to address
the possibility of endogeneity problems, the researcher develops other two models.

Model χ2 Δχ 2 df Δdf Significance Level*

Theoretical model 107.812 107.812 51 51 Not significant

Saturated model 0 0
Theoretical model 107.812 1319.552 51 274 p < 0.01
Constrained model 1427.364 325
Saturated model 0 1427.364 0 325 p < 0.01
Table 6. Constrained model 1427.364 325
Results of the Note(s): *Denotes the level of statistical significance at 0.01 or less (two-tailed tests). The expected cross-
sequential chi-square validation index (ECVI) is computed to compare the goodness of fit of the alternative models (lower values
difference indicate better fit to the model). The ECVI values for the theoretical and saturated models are 0.296 and 0.241,
tests (SCDTs) respectively
Model χ2 χ 2/df RMSEA CFI GFI NFI TLI
Corporate
governance
Theoretical model (I) 107.812 2.114 0.045 0.963 0.975 0.943 0.957 and earnings
CGQ → EQ
Perf → EQ quality
Theoretical model (II) 186.201 3.651 0.131 0.822 0.851 0.788 0.804
EQ → CGQ
Perf → EQ
Theoretical model (III) 195.024 3.824 0.145 0.780 0.794 0.736 0.758
CGQ → EQ
EQ → Perf
Acceptable fit standard NA 1.0 < χ 2/ <0.05 >0.95 >0.95 0 5 NFI ≤ 1.0 >0.95 Table 7.
df < 3.0 Summary of overall fit
Note(s): The correlations among variables are adjusted for random effects. χ 5 chi-square; χ /df 5 normed
2 2
statistics between
chi-square; RMSEA 5 root mean-square error of approximation; CFI 5 comparative fit index; GFI 5 goodness theoretical models (I),
of fit index; NFI 5 normed fit index and TLI 5 Tucker-Lewis index (II) and (III)

As specified and tested earlier, the first model [model (I)] consists of one exogenous variable
(corporate governance quality) and two endogenous variables (earnings quality and
performance), in which the researcher posited corporate governance quality is an antecedent
to earnings quality and performance is also an antecedent to earnings quality. The second
model [model (II)] consists of the same variables as the model (I), except that the researcher
posited a causal ordering where earnings quality is an antecedent to corporate governance
quality. Finally, the third model [model (III)] consists of the same variables as the model (I),
except that the researcher posited a causal ordering where earnings quality is an antecedent
to performance. Then, the researcher determines the relative good fit of the data of the
theoretical model (II) and the theoretical model (III) compared to the theoretical model (I).
Table 7 presents the results of the overall fit indices of theoretical models (I), (II) and (III).
A comparison of the fit indices between models (I) and (II) reveals that fit indices of model (I)
are significantly more powerful than model (II) (i.e. model (I) is considered the best-fit model
compared to model (II)) [22]. Similarly, a comparison of the fit indices between models (I) and
(III) shows that fit indices of model (I) are significantly more powerful than model (III) (i.e.
model (I) is considered the best-fit model compared to model (III)). From the results, the
researcher inferred a causal ordering going from corporate governance quality to earnings
quality, and not the vice versa. Also, the researcher inferred a causal ordering running from
performance to earnings quality, and not the vice versa.

5. Conclusion
The aim of this study was to examine the relationship between corporate governance quality,
performance and earnings quality. More specifically, two main research questions have been
investigated: (1) to what extent does corporate governance quality directly affect earnings
quality? (2) To what extent does performance mediate the relationship between corporate
governance quality and earnings quality? SEM was used in analysing the data collected from
a sample of 875 Egyptian-listed cross-sectional firms.
The measurement models evaluation revealed that the confirmatory factor analysis
(CFA), composite reliability (CR), internal consistency, convergent validity and discriminant
validity satisfied the threshold for all the measurements models. Also, the findings of the
structural model evaluation suggested six main conclusions:
(1) Corporate governance quality has a direct positive and significant relationship with
earnings quality. This result was consistent with agency theory which suggests that
JAEE effective corporate governance mechanisms play a monitoring role in deterring
managers’ propensity to commit an opportunistic behaviour through earnings
management practices, which in turn improve the quality of reported earnings
(H1 was supported).
(2) Corporate governance quality has a direct positive and significant relationship with
performance. This result was consistent with resource-based theory which suggests
that firms with effective corporate governance mechanisms provide the necessary
resources to maintain sustainable competitive advantage, which in turn enhance their
level of performance (H2 was supported).
(3) Performance has a direct positive and significant relationship with earnings quality.
This result was consistent with signalling theory which suggests that firms with
good performance have incentives to inform stakeholders about their high-quality
earnings to distinguish themselves from other risky firms with poor performance
(H3 was supported).
(4) Performance exerted a significant mediating effect on the relationship between
corporate governance quality and earnings quality. This result suggested that
corporate governance quality indirectly affect earnings quality, through firms’
performance (H4 was supported).
(5) Although both direct and indirect relationships were significant, the results of the
overall model showed that the indirect effect was relatively more powerful than the
direct effect.
(6) The disaggregation of performance measures into accounting-based performance
measures and market-based performance measures showed that if accounting-based
performance measures were employed, the direct effect has more weight than the
indirect effect; and if market-based performance measures were employed, the
indirect effect has more weight than the direct effect.
(7) The predictive validity of the proposed model, on a longitudinal basis, showed a high
potential for replication over different time-horizon.
(8) Testing for endogeneity confirmed that the direction of causality ran from corporate
governance quality to earnings quality and from performance to earnings quality.
The study’s findings have important theoretical and practical implications. From a
theoretical perspective, the findings indicated that the development of theoretical model that
includes the hypothesised relations between corporate governance quality, performance and
earnings quality can help to improve understanding of the way that corporate governance
quality affects earnings quality and highlight the mediating role of performance. In addition,
the findings of the current study provided an extended understanding of corporate
governance implications through identifying the dual-role of effective corporate governance
mechanisms in monitoring firms’ performance and in deterring managers’ ability to
manipulate earnings. Hence, effective corporate governance mechanisms reduce agency
costs, otherwise managers are at risk of dismissal or firms are exposed to merger and
acquisition threats or liquidation. Also, variations in earnings quality among firms could be
justified based on the ground of multiple theories such as: agency theory, resource-based
theory and signalling theory.
From a practical perspective, the current study contributed specifically to three streams of
research, namely (1) corporate governance, (2) performance and (3) earnings quality. First, the
findings of the current study shed light on the substantial changes that have taken place in
regulations related to corporate governance principles guidance issued by the Egyptian Corporate
ministry of investment and international cooperation since March 2011; all these changes governance
aimed at achieving the objective of financial reporting which is guided by the usefulness of
accounting information in general and earnings-related information in particular for
and earnings
stakeholders’ decision making. Thus, regulators can make the necessary changes needed for quality
corporate governance principles guidance. Also, while the corporate governance literature
has focused mainly on traditional governance mechanisms, few studies have examined risk-
oriented governance mechanisms such as risk management functions. However, the current
study has contributed by constructing a comprehensive corporate governance quality index
that combined both traditional and risk-oriented governance mechanisms. Second, prior
studies have provided little empirical evidence examining both accounting-based
performance measures and market-based performance measures. Nonetheless, the current
study investigated whether different measures of performance yield different findings. The
study revealed that market-based performance measures exert more dominance effect in their
mediation than accounting-based performance. This result has a managerial implication in
which using market-based performance measures, rather than accounting-based
performance measures, to design management incentive contracts could align the interests
between the agent and the principal. Hence, choosing the suitable basis to set incentives and
rewards of managers would increase contracting efficiency and minimise agency costs.
Lastly, most of the earnings quality literature provided evidence on a direct link between
corporate governance quality and earnings quality. Notwithstanding, the current study
showed that a great portion of the effect was indirectly occurred through performance. This
mediated link was overlooked in prior studies.
The following limitations should be considered. First, the study focuses specifically on one
proxy for measuring earnings quality which is the absolute value of discretionary accruals.
However, alternative proxies of earnings quality could be examined in future research, such
as income smoothing, earnings persistence and timely loss recognition. Another limitation is
that only financial performance measures were examined, namely, return on assets, return on
equity, price-to-earnings ratio and market-to-book value. Nonetheless, non-financial
performance measures could be investigated in future studies, such as balanced scorecard
(BSC). Moreover, considering cultural, political and legislative differences among countries,
the results may not be generalised outside the scope of the current sample (i.e. Egyptian listed
firms). Furthermore, the study provides avenues for future studies to extend the model by
incorporating other variables such as: capital structure, the level of conservatism, risk
management practices, gender diversity, etc. Also, future studies might examine the
applicability of the model in other corporate reporting contexts (e.g. social responsibility
reporting, intellectual capital reporting, sustainability reporting, etc.). Finally, future studies
could also extend to financial industry as well as to cross-country comparisons.

Notes
1. The name of the Egyptian ministry of investment has been changed into the Egyptian ministry of
investment and international cooperation in February 2017. Therefore, the current study uses the
later name.
2. According to Gray (1988), the Egyptian business sector is characterised by secretive culture in
which there is a preference for confidentiality and the restriction of disclosure of information about
the firm except to those who are closely related with its management and financing (Dahawy and
Conover, 2007). This low level of secrecy could be interpreted by the cultural (societal) values
identified by Hofstede (1980). For more details regarding the relationships between the accounting
values and Hofstede’s cultural values, please see Gray (1988).
3. Firms’ performance was used by Saenz Gonzalez and Garcıa-Meca (2014) as a control variable
when examining the relationship between corporate governance quality and earnings quality.
JAEE This implies, neglecting the potential relationship between corporate governance quality and firms’
performance. Meanwhile, Kumari and Pattanayak (2017) attempted to examine the relationships
among (1) corporate governance system and earnings management; (2) corporate governance
system and banks’ performance and (3) earnings management and banks’ performance, separately,
through employing ordinary least squares (OLS) regression analysis. However, the current study
uses structural equation modelling (SEM) to test a comprehensive model for the variables of
interest, through which firms’ performance is a mediating variable (i.e., firms’ performance is
influenced by corporate governance quality and that, in turn, influences earnings quality).
4. It is worthy to note that several prior studies provided evidence that using different governance
mechanisms and different earnings quality measures might yield different findings. For instance,
Bedard et al. (2004) revealed that board independence, audit committee independence and audit
committee expertise reduce upward earnings management; while board size, ownership
concentration and board experience reduce downward earnings management. In addition,
Davidson et al. (2005) also reported that both board independence and audit committee
independence has a stronger effect on earnings quality than audit quality and internal controls
when earnings quality is measured by Dechow et al. (1996) model. Moreover, Baxter and Cotter
(2009) documented that audit committee characteristics (such as: audit committee independence,
audit committee size and audit committee meeting frequency) are insignificant in reducing the
propensity of managers to manipulate earnings when Dechow and Dichev (2002) model is used for
measuring earnings quality. Furthermore, Kent et al. (2010) showed that audit committee
effectiveness (measured by audit committee independence, frequency of audit committee meetings
and the number of audit committee members) outperformed board independence in constraining
discretionary accruals when using Jones (1991) model for measuring earnings quality.
5. According to pecking order theory, high-performance firms operate in emerging countries might
still be engaged in earnings management practices to increase their debt capacities using internal
fund and debts rather than issuing shares (Myers, 1984). Furthermore, high-performance firms
operate in emerging economies are vulnerable to high level of fluctuations. Therefore, managers
tend to smooth their earnings through exercising their discretion over accruals (Myers and Majluf,
1984). In the Egyptian context, Khalil and Simon (2014) showed that most firms follow income
smoothing practices.
6. Degeorge et al. (1999) argued that one possibility for managers to exceptionally manipulate earnings
downward is when the current earnings exceed target earnings by a large amount which implies
managers’ willingness to shift abnormal positive earnings into coming periods to make future
targets of earnings are easier to be met. Another possibility is that managers might be reluctant to
report large earnings due to their prudency that it will result in increasing political cost (Jones, 1991).
7. Like a standard regression where one specifies a dependent variable as a function of explanatory
variables, path analysis requires the researcher to postulate source or causal variables, mediating
variables (influenced by source variables and influencing outcome variables), and outcome or
consequent variables. This ex ante specification can be derived from theory, or from knowledge-
based reasoning about the linkages among variables, or from both.
8. In March 2011, the Egyptian Institute of Directors (EIoD) issued the code of corporate governance
for the private sector in Egypt which reviewed, in cooperation with other entities, the code of
corporate governance that was published in October 2005 in order to update it, based on the latest
Egyptian and international experiences in light of the global financial crisis. Therefore, a fiscal year
of 2011 has been chosen as a base for the current longitudinal study to reflect the updated code of
corporate governance.
9. The study data will be obtained through the Egyptian stock exchange (EGX), Egypt for information
dissemination (EGID), Egypt Mubasher Trade and firms’ official websites.
10. The sampled firms belong to 9 different industries, as follows: basic resources; chemicals;
construction and materials; food and beverage; healthcare and pharmaceuticals; industrial goods
and services and automobiles; personal and household products; real estate and travel and leisure.
11. The sample size exceeds the minimum required for the application of SEM (Hair et al., 2010).
12. The current study also depends on other indices developed by other prior studies such as: e-index Corporate
developed by Bebchuk et al. (2009) and government-score developed by Institutional Shareholder
Services (ISS). governance
13. The current study incorporates not only traditional corporate governance mechanisms (which include
and earnings
6 dimensions represented by: board structure and functions, audit committee, internal audit and quality
control, external audit, ownership structure and shareholders’ rights) but also risk-oriented corporate
governance mechanisms (which include only one dimension represented by: risk committee).
14. See Dechow et al. (2010) for a more in-depth review of different earnings quality approaches.
15. Although Jones (1991) model is the generally used approach in earnings management literature, the
modified Jones model proposed by Dechow et al. (1995) is designed to eliminate the conjectured
tendency of the Jones (1991) model to measure discretionary accruals with error. Thereby, the
modified Jones model considers that the change in revenues is adjusted for the change in receivables
in the year.
16. Total accruals (TACC) could also be measured using balance sheet approach. According to balance
sheet approach, total accruals is estimated as follow: TACCt 5 ΔCAt – ΔCasht – ΔCLt þ ΔDCLt –
DEPt; where, TACCt is the total accruals at the end of year t; ΔCAt is the change in current assets in
year t; ΔCasht is the change in cash and cash equivalents in year t; ΔCLt is the change in current
liabilities in year t; ΔDCLt is the change in debt included in current liabilities in year t and DEPt is
depreciation and amortization expense for the year t. However, Bartov et al. (2000) and Collins and
Hribar (2000) argued that using balance sheet approach to compute total accruals is inferior
compared to cash-flows approach due to biasedness and lack of precision (i.e. noise).
17. Path analysis decomposes the correlation between two variables (in current study, corporate
governance quality and earnings quality) into a simple or direct path and a compound or indirect
path that includes a mediating variable (in current study, performance). This decomposition
provides evidence on the existence and relative importance of the direct and indirect paths between
corporate governance quality and earnings quality. Furthermore, latent variables are underlying
variables that cannot be observed directly, they are also known as “constructs” or “factors”. While
observed variables (indicators) can be measured directly, they act as indicators for an underlying
latent variable. Observed variables (indicators) sometimes called “reference variables” or “manifest
variables” (Hair et al., 2010). In current study, latent variables are corporate governance quality and
performance while the observed variable is earnings quality.
18. The cut-off values for constructs must exceed the recommended benchmarks as follow:
confirmatory factor analysis must be higher than 0.60; composite reliability must be higher than
0.70 and convergent validity must be higher than 0.50 (Field, 2005; Hair et al., 2010). Also, the
analysis of the reliability of each indicator (R2) is allowed by the multiple correlation coefficients
(Hatcher, 1994). This measure of reliability reflects he percentage of the variance of the indicator
that is explained by the latent variable. Although it is generally agreed that the higher the R2 the
greater the reliability of the indicator, there is no threshold.
19. There is no measurement model for earnings quality because it is an observed variable that could be
measured directly.
20. The cut-off values recommended for goodness-of-fit criterion are as follow: CFI is greater than 0.90
and RMSEA is less than 0.07 (Hair et al., 2010).
21. Firms’ performance is not considered as a latent construct in the analysis where each measure of
firms’ performance is considered separately.
22. The researcher also compared the strength of the individual standardised path coefficients. The results
showed that the standardised coefficient for the path between corporate governance quality and earnings
quality (p 5 0.191 [See Panel A of Table 4], p < 0.01) in model (I) is more powerful and more significant
than the standardised coefficient for the path between earnings quality and corporate governance
quality (p 5 0.045 [Untabulated], p 5 0.027) in model (II). Similarly, the results showed that the
standardised coefficient for the path between performance and earnings quality (p 5 0.371 [See Panel A of
JAEE Table 4], p < 0.01) in model (I) is more powerful and more significant than the standardised coefficient for
the path between earnings quality and performance (p 5 0.038 [Untabulated], p 5 0.032) in model (II).

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Appendix Corporate
governance
and earnings
Dimension(s) Sub-items
quality
(1) Board structure (1) Size of the board of directors is at least five, but not more than 11 members
and functions (10 (2) The roles and responsibilities of the board are clearly stated in the annual report
sub-items of the firm
numbered from (3) The chief executive officer (CEO) and chairman are different persons
1 through 10) (4) The number of board meetings held are at least twice in a year
(5) The ratio of non-executive directors is greater than ½ of the total board size
(6) The ratio of independent directors is greater than ½ of the total board size
(7) Information on qualification, training and experience of board of director’s
members is published
(8) The firm has procedures and policies in selection, nomination and termination of
board of director’s members and executive officers
(9) Profile of board of director’s candidates are notified to shareholders prior to
general shareholders’ meeting
(10) At least one member of the board members has a financial experience
(2) Audit committee (11) The firm has an audit committee
(10 sub-items (12) All member of audit committee are non-executive directors
numbered from (13) The ratio of independent directors is greater than ½ of the total audit
11 through 20) committee size
(14) The chairman of audit committee is an independent director
(15) Audit committee has at least one member that has financial expertise (i.e. is a
qualified accountant or other financial professional with experience of financial
and accounting matters)
(16) The size of audit committee is at least three members
(17) Audit committee holds regular meeting three times at least per year
(18) The firm has a formal policy (i.e. audit committee charter) on rules and
responsibilities of audit committee
(19) Audit committee closely worked together with the external and internal auditor
to perform review of the firm’s risk exposures and accounting procedures
(20) Audit committee monitor the efforts of management to correct shortcomings
identified by internal and external auditors
(3) Internal audit (21) The firm has an internal audit department
and control (7 sub- (22) A review of effectiveness of the key internal control policies and procedures
items numbered established for managing daily activities
from 21 through 27) (23) Duties and responsibilities of internal audit division are determined and disclosed
(24) The procedures of reporting any of the deficient on internal controls are identified
(25) Internal control report accompanying annual report
(26) Internal audit framework has been identified
(27) The chief executive officer (CEO) or chief financial officer (CFO) stated that the
firm’s internal controls are operating effectively and efficiently
(4) External audit (28) The firm employs one of the big-audit firms
(7 sub-items (29) Adequate written rules governing the external audit function
numbered from (30) Policies on the appointment of external auditor are stated
28 through 34) (31) The board members receive a copy of the auditor’s report
(32) Information about audit fees is provided in the annual reports of the firm
(33) Information about non-audit services undertaken by the audit firm and their fees
is provided in the annual reports of the firm
(34) The audit firm of the current year is different from the previous year (i.e. there is
audit rotation) Table A1.
Corporate governance
(continued ) quality index (CGQI)
JAEE Dimension(s) Sub-items

(5) Ownership (35) Information about shareholdings of board members is available at the date of the
structure (4 sub- annual report
items numbered (36) Less than 50% of firms’ shares are owned by block holders, institutional
from 35 through 38) investors or foreigners
(37) Independent directors own less than or equal 5% of equity interest directly or
indirectly in the firm or in its related firms
(38) Percentage of voting shares with controlling shareholders is stated
(6) Shareholders’ (39) The firm discloses details on the corporate social and environmental
rights (7 sub-items responsibility
numbered from (40) The firm reports on the forthcoming and completed shareholders’ meetings
39 through 45) (41) The ratio of nationals versus foreign shareholdings available on its annual
reports or website
(42) the firm has a section dealing with investor relations on its website
(43) There is an option for lodging complaints
(44) Dividends declarations policies are stated
(45) The firm uses the one-share-one-vote rule
(7) Risk committee (46) The chairman of risk committee – Chief Risk Officer (CRO) – responsible for firm-
(15 sub-items wide risk management is present within the firm
numbered from (47) A firm has a dedicated risk committee or a risk management division solely
46 through 60) charged with monitoring and managing risks within the firm
(48) The risk committee comprises only of non-executive directors
(49) The risk committee consists of a minimum of three members
(50) Duties and responsibilities of risk committee are identified and disclosed
(51) The firm discloses experience and certification held by each member of risk
committee
(52) The firm discloses the number of risk committee meetings held during the year
(53) Risk committee reports to board of directors instead of to the CEO.
(54) Risk committee report accompanying the annual reports
(55) The firm has in place effective and comprehensive risk management framework,
policies, processes and infrastructure to identify, measure and control the various
types of risks
(56) The nature of risk faced by the firm are identified and disclosed
(57) The activities within the firm which give rise to the risk are identified and
disclosed
(58) The methods to identify, monitor, manage and control the risks are stated
(59) The presence of any other risk that could materially impair the firm’s ability to
meet its corporate objectives and business strategies are disclosed
(60) The frequency of review/assessment of the firm’s risk management system is
Table A1. disclosed

About the author

Mohammed Adel Elzahaby is a lecturer in accounting at Faculty of Commerce (English section),
Damanhour University. He holds a Ph.D. in Accounting from Faculty of Commerce, Alexandria
University where he previously obtained M.Sc. and B.Sc. degrees in Accounting. His research interests
lie primarily in the areas of corporate disclosure, risk reporting, earnings quality, corporate governance,
and corporate social responsibility. He has been a member at the British Accounting and Finance
Association (BAFA), an observer at the International Accounting Standards Board (IASB), and an ad
hoc reviewer for Accounting Research Journal (ARJ). Mohammed Adel Elzahaby can be contacted at:
[email protected]

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