Investigation into Earnings Management Practices and the Role of Corporate Governance and External Audit in Emerging Markets: Empirical Evidence from Saudi Listed Companies

Abstract

Agency theory predicts that corporate governance mechanisms and external audit play an important role in enhancing financial reporting, while institutional theory views these mechanisms as practices or regulations which result from coercion by legislators who impose certain practices in order to improve organizational effectiveness, or as a result of imitation. In terms of earnings management practices, both theories provide an appropriate theoretical framework. Taking agency theory and institutional theory as points of departure, the primary purpose of this study is to: (1) investigate the motivations and techniques of earnings management and; (2) to what extent corporate governance and external audit can affect earnings management practices in Saudi Arabia.

To achieve this aim, the questionnaire survey is mainly used to explore the motivations and techniques of earnings management in Saudi Arabia by obtaining the different perceptions of respondents. In terms of the role of corporate governance and external audit in reducing earnings management practices, two models are constructed and a set of hypotheses are formulated. These models are examined, by a logistic regression, using a sample consisting of all companies listed on the Saudi Stock Exchange with the exception of financial and insurance companies which have different practices. In addition, semi-structured interviews are employed in order to provide a better understanding of the research questions, confirming and elaborating on the questionnaire survey and models’ findings and supporting the development of the hypotheses. They were subsequently undertaken, after the questionnaire survey, with 15 individuals including board members, audit committee members, external auditors and academic staff.
Although there were significant differences among respondents, the findings reveal that the four main incentives for Saudi managers to manage earnings are ‘to increase the amount of remuneration’, ‘to report a reasonable profit and avoid loss’, ‘to obtain a bank loan’ and ‘to increase share prices’. The findings also indicate that only seven statements relating to earnings management that received support from respondents were techniques of earnings management in Saudi companies. Agency and institutional theory may provide a sensible explanation for previous earnings management practices in Saudi Arabia.
Moreover, the expectation of beneficial corporate governance practices and external audit constraining opportunistic earnings management activities was, to a large extent, found to be inaccurate in Saudi Arabia. That is, no internal corporate governance variables, apart from outside director, board size and board meetings, examined in this research are shown to have any significant effect on earnings management. With the exception of auditor opinion, none of the external audit factors and ownership structure affects earnings management. Moreover, the interview survey shows many issues and interesting findings related to previous investigation such as nepotism, illegal competition, and lack of independence. Generally, the findings are not consistent with agency theory that ownership concentration, audit committee, and external audit might mitigate agency problems leading to reduced agency cost by aligning the interests of controlling owners with those of the company. However, previous finding can be interpreted by Institutional theory which views these mechanisms as practices or regulations resulting from coercion by legislators who impose certain practices in order to improve organizational effectiveness, or as a result of imitation.
It should be noted that the findings established in this study could be useful to external auditors and regulators and legislators in their attempts to constrain the incidence of earnings management and enhance the quality of monitoring mechanisms.