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RIBS
26,1
The effect of corporate
governance mechanisms on
earnings management
2 Evidence from Saudi Arabia
Received 12 October 2013
Revised 12 January 2014
Ali Abedalqader Al-Thuneibat,
Accepted 2 February 2014 Hussam Abdulmohsen Al-Angari and
Saleh Abdulrahman Al-Saad
Department of Accounting, Faculty Economics and Administration,
King Abdulaziz University, Jeddah, Saudi Arabia

Abstract
Purpose – The purpose of this paper is to investigate the compliance of Saudi shareholding companies
with the requirements of corporate governance issued by the Board of Capital Market Authority in the
Kingdom and their impact on earnings management.
Design/methodology/approach – A questionnaire was used to collect data about the compliance of
the Saudi shareholding companies with corporate governance requirements and discretionary accruals
(DAs) were calculated from the financial statements of these companies using the modified Jones model,
then multiple regression was used to test the relationship between the variables.
Findings – The results of the study revealed that there was no statistically significant linear
dependence of the mean of DAs on corporate governance. Additionally, no statistically significant effect
for internal audit, audit committee and board of directors on earnings management was detected.
However, the results revealed that there was a slight negative effect for internal audit scope of work and
independence and audit committee independence on DAs.
Research limitations implications – This research paper is applied on Saudi Arabia, a Middle
East country with specific characteristics, that is, a specific context, and, therefore, the results must be
interpreted within this context
Practical implications – Regulators of Saudi corporations may need to reassess the effectiveness of
corporate governance requirements issued by the Capital Market Authority and the actual
implementation of these requirements. Researchers also may need further investigation of this
phenomenon within its context.
Social implications – The results of the study are very important to the Saudi society because they
put a big question mark on the relevance of corporate governance of the Saudi shareholding companies
Originality/value – The paper provides new evidence about the effect of corporate governance
mechanisms on earnings management in a Middle East environment, which may suggest that there is
a need to expand this study using other methodologies to delve into the depths and understand this
Review of International Business phenomenon within its context.
and Strategy
Vol. 26 No. 1, 2016 Keywords Audit committee, Corporate governance, Internal audit, Board of directors,
pp. 2-32
© Emerald Group Publishing Limited Earnings management
2059-6014
DOI 10.1108/RIBS-10-2013-0100 Paper type Research paper
Introduction Corporate
Corporate governance has been described as the system by which organizations are governance
directed and controlled (Büyüksalvarcı and Abdioglu, 2010; Messier et al., 2008), or as a
set of relationships between a company’s management, its board, its shareholders and
mechanisms
other stakeholders (OECD, 2004; Tricker, 2009). Over the past decade, governance of
companies has attracted much attention, and previous research, largely conducted
using international data, has suggested that better governed firms outperform poorer 3
governed firms in a number of key areas (Lin and Hwang, 2010; Brown and Gorgens,
2009; Messier et al., 2008; Liu and Lu 2007; Chen et al., 2006; Davidson et al., 2005;
Skousen et al., 2005; Chung et al., 2002). Brown and Gorgens (2009) argued that corporate
governance structure influences a number of aspects of its business model, including the
setting of company objectives and how those objectives are to be achieved, the
monitoring and assessment of risk and performance optimization. Minna (2011) found
that analysts tend to issue favorable recommendations for firms with better corporate
governance mechanisms.
It is also expected that corporate governance improves corporate oversight over
earnings and reduces management manipulations and improves financial statements
reliability (Leuz et al., 2003; La Porta et al., 2002). Corporate governance is about building
credibility, ensuring transparency and accountability as well as maintaining an
effective channel of information disclosure that would foster good corporate
performance (Jimoh and Iyoha, 2012). It is also about how to build trust and sustain
confidence among the various interest groups that make up an organization (Rogers,
2008). Of course, a strong corporate governance structure will provide strong
monitoring tools over managerial decision-making and limit earnings management
activities.
An investigation of previous literature related to earnings management reveals that
researchers mentioned various interrelated definitions. For example, Jackson and
Pitman (2001) defined earnings management as “an intentional structuring of reporting
or production decisions around the bottom line impact” (Alkhabash and Al-Thuneibat,
2009). It is also defined as a purposeful intervention in the external financial reporting
process with the intent of obtaining some private gain (Schipper, 1989), and the use of
judgment in financial reporting and in structuring transactions to alter financial reports
to either mislead some stakeholders about the underlying economic performance of the
company or to influence contractual outcomes that depend on reported accounting
judgments (Healy and Wahlen, 1999).
The concern about the quality of accounting numbers and its relationship with
corporate governance quality is increasing over time, following the periodical clusters of
business failures, frauds and the litigation (Chambers, 1999; Tie, 1999). In Saudi Arabia,
a great concern has been given to regulations related to economic and business
development, including the development of accounting and auditing standards and
governance requirements. The Board of Capital Market Authority in the Kingdom
issued corporate governance regulations in 2006 and amended them by Resolution of the
Board Number 1-10-2010 dated October 1, 2010. The Board of Capital Market Authority
declared that the regulations of corporate governance include rules and standards that
regulate the management of joint stock companies listed in the Exchange to ensure their
compliance with the best governance practices that would ensure the protection of
shareholders’ rights as well as the rights of all stakeholders.
RIBS The effectiveness of different corporate governance systems is influenced by
26,1 differences in countries’ legal and regulatory frameworks, and historical and
cultural factors, in addition to the structure of product and factor markets. Corporate
governance mechanisms and their effectiveness may also vary, depending on
industry sectors and type of productive activity (Maher and Andersson, 1999). Saudi
Arabia is a monarchy based on Islam. It is the largest country in the Arabian
4 Peninsula. Its political, economic and social systems are rooted in Islam’s traditions,
which creates an environment with specific characteristics that encourage
researching accounting and auditing issues including governance and earnings
management. Therefore, this paper goes on to investigate whether Saudi
governance requirements reduce management manipulations in earnings. The
findings of the study are expected to shed light on the usefulness of these regulations
in safeguarding the interests of all stakeholders by means of providing them with
reliable information that are free from management manipulations.

Literature review and hypotheses development


The basic component of an accounting information system is the communication
process, that is, the basic objective of accounting is to provide the users with useful
information to facilitate decision-making process. The medium of communication is
represented by the various financial statements, which are the ultimate product of the
financial reporting process. To be useful, the financial statements should be relevant,
reliable, comparable and understandable. This process of communication is the
responsibility of management.
Management is responsible for providing stakeholders with useful information
about the results of their operations and financial position. However, the underlying
probability of conflict of interests between management and external users of financial
reports and the asymmetry of the information provided, both created an inevitable need
for the governance process (Leuz et al., 2003; La Porta et al., 2002).
Management may be endemic in a purposeful intervention in the external financial
reporting process, with the intent of obtaining some private benefits, that is,
management may take deliberate steps within the constraints of generally accepted
accounting principles to achieve some desired results. This intervention process by
management is known as earnings management (Abbott et al., 2007; Davidson et al.,
2005).
Earnings management nowadays is a worldwide phenomenon and attracted the
attention of many researchers all over the world (Watts and Zimmerman, 1990; Fields
et al., 2001; Healy and Wahlen, 1999; Gaver et al., 1995; Holthausen et al., 1995). This
phenomenon confronts trust and transparency in financial reporting. It includes
illegitimate earnings management using practices by violating the Generally Accepted
Accounting Principles (GAAP) or laws (Baralexis, 2004) and legitimate earnings
management using practices within the flexibility provided by the GAAP (Degeorge
et al., 1999). Earnings management practices are recognized as attempts by
management to influence or manipulate reported earnings (Akers et al., 2007). These
practices include activities to overstate income to the desired number and other
practices to understate income to the desired amount.
Managers have incentives to manage income to meet earnings targets or to make
earnings look less risky (Bergstresser and Philippon, 2006; Baker et al., 2003). However,
incentives for earnings management vary depending on the situations. These incentives Corporate
include meeting analysts’ expectations and company predictions (Kasznik, 1999), governance
avoiding violating debt covenants (Jiambalvo, 1996), smoothing income toward a
long-term sustainable trend (Beidleman, 1973), income-based compensation contracts
mechanisms
(Xie et al., 2001; Shuto, 2007), reducing income taxes (Kasanen et al., 1996), management
buyout (Foster, 1986), potential merger (Meisel, 2013), dividends contracts (Kasanen
et al., 1996) and strategically manipulate bonus income (Healy, 1985). 5
Similarly, Leuz et al. (2003) estimated that insiders use earnings management to
conceal corporate performance from outsiders in an attempt to protect their private
control benefits. Therefore, protection mechanisms are expected to limit insiders’ ability
to manipulate earnings and protect outsiders’ interests. Within the context of the
growing concern about corporate performance, transparency and trust, regulatory
agencies all over the world showed accelerated interest in building trust and enhancing
transparency. An important, clear and evident evidence about this growing concern is
the development of corporate governance mechanisms all over the world.
Corporate governance defined as a system including people, processes and activities
that would help ensuring stewardship over assets (Messier et al., 2008). It is considered
by many researchers as an important tool for monitoring management activities (Lin
and Hwang, 2010; Messier et al., 2008; Liu and Lu, 2007; Chen et al., 2006; Davidson et al.,
2005; Skousen et al., 2005; Chung et al., 2002). Lin and Hwang (2010) stated that a good
corporate governance structure helps ensuring that managements utilize assets in the
best interest of the principals and communicate them relevant and reliable financial
statements. Chen and Zhang (2012) found that the magnitude of discretionary accruals
(DAs) in Chinese listed firms decreases significantly after the promulgation of the
Chinese governance requirements.
Corporate governance describes how companies ought to be run, directed and
controlled. The corporate governance structure specifies the distribution of rights and
responsibilities among the different participants in the organization (such as the board,
managers, shareholders and other stakeholders) and lays down the rules and procedures
for decision-making (Büyüksalvarcı and Abdioglu, 2010). Blair (1995) argued that
corporate governance should be regarded as the set of institutional arrangements for
governing the relationships among all of the stakeholders that contribute firm-specific
assets.
Corporate governance structure consists of mechanisms established to oversee and
influence the actions of the firm’s management. The role of these mechanisms in relation
to financial reporting is to ensure compliance with mandated reporting requirements
and to maintain the credibility of a firm’s financial statements and safeguard against
earnings manipulation (Dechow et al., 2011; Davidson et al., 2005; Dechow et al., 1995).
The basic objectives of corporate governance are to build credibility, ensure
transparency and accountability as well as maintain an effective channel of information
disclosure that would foster good corporate performance (Jimoh and Iyoha, 2012; Leuz
et al., 2003; La Porta et al., 2002). These objectives represent the basic pillars of corporate
governance. They are comprehensive and represent the needs of all interest groups.
However, on the one hand, these interest groups have some conflict in their interests.
This conflict may lead those govern an economic entity to use their power to satisfy their
own interests on the account of other groups. One important mechanism used by those
who govern the entity is the use of earnings management. On the other hand, those who
RIBS are responsible for regulation should handle this conflict and safeguard the interests of
26,1 all groups by issuing and enforcing what is called corporate governance mechanisms.
Transparency represents an integral pillar of corporate governance because it
reduces the information asymmetry between a firm’s management and external users
(Sandeep et al., 2002). Transparency includes the quantity and quality of information
presented and disclosed to the public. Similarly, as another pillar of governance, trust
6 has many facets, including reliability, honesty and openness (Wayne and Megan, 2002;
Hoy and Tschannen-Moran, 1999; Tschannen-Moran and Hoy, 1998, 2000). A strong
corporate governance structure is expected to provide for sound monitoring of
managerial decision-making (Porta et al., 2002). An explicit monitoring of management
can be found in the requirements of corporate governance requirement issued by the
Board of Capital Market Authority in the Kingdom of Saudi Arabia in 2006. The
requirements of this code are expected to be means supposed to serve as a monitoring
device that will reduce managers’ incentives to manipulate reported earnings.
Therefore, it is hypothesized that the compliance with corporate governance
requirements has a statistically significant effect on earnings management activities by
managers.
This primary hypothesis will be divided into three secondary hypotheses about three
of the basic mechanisms of corporate governance including internal audit, audit
committee and board of directors.

Internal audit
The Institute of Internal Auditors (IIA) defines internal auditing as an independent,
objective assurance and consulting activity designed to add value and improve an
organization’s operations. It helps an organization accomplish its objectives by bringing
a systematic, disciplined approach to evaluate and improve the effectiveness of risk
management, control and governance processes. The IIA definition of internal audit
provides evidence about the scope of the work and activities of internal audit. It covers
the evaluation of efficiency and effectiveness of all operations of an entity, risk
management and governance process. This definition implies that internal audit
function is a comprehensive monitoring function concentrates on performance
transparency and trust.
Internal audit is one of four cornerstones of effective corporate governance, along
with the audit committee of the board of directors, executive management and the
external auditor (Douglas et al., 2009). Internal audit is a basic component of corporate
governance monitoring mechanisms (Skousen et al., 2005; Hermanson and Rittenberg,
2003). This function is an important tool of corporate governance that is expected to
protect against earnings management activities (Douglas et al., 2009; Skousen et al.,
2005; Hermanson and Rittenberg 2003). Douglas et al. (2009) found a significant negative
relation between the overall internal audit function quality and absolute abnormal
accruals.
The internal audit function should contribute to lower risk of management and
employee fraud (Douglas et al., 2009; Abbott et al., 2007; Asare et al., 2003; Hermanson
and Rittenberg, 2003; Becker et al., 1998). It is a comprehensive function interrelated
with all components of an internal control system. It is a basic monitoring tool over all
activities and all levels of management. That is, modern internal audit monitors
management activities and, therefore, it is expected to reduce management involvement Corporate
in earnings management activities. governance
Okezie (2004) argues that an internal audit function is expected to be a significant
influential on entities operations and their continuity. An effective internal audit should
mechanisms
promote the achievement of internal control objectives and, therefore, help in leading the
bath to performance, trust and transparency. Kiabel (2012) stated that internal audit is a
long-standing function and an effective tool for management in many organizations. 7
Fadzil et al. (2005) had also noted that internal auditors help run a company more
efficiently and effectively to increase shareholders’ value. Previous research
concentrated on the role of internal audit on management practices of earnings
management (Kiabel, 2012; Douglas et al., 2009; Fadzil et al., 2005; Okezie, 2004). For
example, Douglas et al., (2009) conducted a study about the effects of internal audit
function on earnings management and found that the internal audit function quality is
associated with a moderate level of earnings management. Bejide (2006) argued that an
effective internal audit service can, in particular, help reduce overhead, identify ways to
improve efficiency and maximize exposure to possible losses from inadequately
safeguarded company assets, all of which can have a significant effect on the bottom
line. However, although internal auditors monitor management activities, their primary
clients are management and, therefore, their independence is always threatened.
Davidson et al. (2005) found no evidence that the presence (versus absence) of an internal
audit function is associated with a lower level of earnings management. The above
arguments about the role of internal audit in reducing earnings managements lead us to
set the first sub-hypothesis stating that internal audit independence, competence and
activities have a statistically significant effect on earnings management activities[S1].

Audit committee
One of the characteristics of good corporate governance is the presence of an audit
committee. The audit committee must use its independence and competence in carrying
out its activities set out by regulators. The basic activities of an audit committee set out
by the Saudi regulations include the oversight of the financial reports, oversight the
external audit function and oversight the internal control system including the internal
audit function. These responsibilities are expected to strengthen oversight over
financial reporting and mitigate the use of illegitimate earnings management.
There are several prior studies that have examined the effectiveness of audit
committees in monitoring earnings management practices by managements (He et al.,
2007; Lin et al., 2006; Davidson et al., 2005; Yang and Krishnan, 2005; Abbott et al., 2007;
Klein, 2002; Xie et al., 2001). Many of these previous research suggested that the
existence of audit committee is expected to enhance financial reporting quality and
reliability (Uadiale, 2012; DeZoort, 1998; Carcello and Neal, 2000) and play an important
role in constraining earnings management (Jaggi and Leung, 2007).
The Saudi Corporate Governance Regulations (Article 14,a) stated that the board of
directors shall set up a committee to be named the “Audit Committee”. Its members shall
not be less than three, including a specialist in financial and accounting matters.
Executive board members are not eligible for Audit Committee membership. The core
principles of this committee are independence and competence. Chtourou et al., (2001)
stated that independence and competence are core principles and basic requirements for
any monitoring mechanism, that is, they are essentials for external audit, internal audit
RIBS and audit committee. These two requirements represent the basic characteristics for any
26,1 oversight body.
Previous studies concentrated on independence and competence of audit committees,
with little attention given to the activities of these committees other than the number of
their meetings. Regarding the effect of the number of the meetings, the results of some
previous research indicate that there is no evidence of a significant relation between the
8 number of audit committees’ meetings and earnings management (He et al., 2007;
Davidson et al., 2005).
On the first hand, independence is the backbone of any oversight board. It is the
cornerstone of the audit committee to be effective in carrying out its responsibilities
without any bias to any interested party. We need an active oversight to achieve all
company objectives and safeguard the interests of all individuals and groups in
shareholding companies. Safeguarding the interest of the financial statements’ users
means that an active oversight leads to lower fraud, lower earnings management and
reliable financial reporting. This means that independence is associated with better
oversight, and, in turn, audit committee will be associated with lower level of earnings
management.
Many research papers find that there is a negative relation between audit committee
independence measured by the number of non-executive directors and earnings
management (Chen and Zhang, 2012; Abbott et al., 2007; Klein, 2002; Abbott and Parker,
2000). Chen and Zhang, (2012) stated that the independence and technical competence of
audit committee members are also very important for their effective monitoring.
Non-executive members of audit committees have incentives to maintain and enhance
their reputation and, therefore, they are interested in achieving a high degree of financial
reporting quality, which leads to reduce management involvement in earnings
management (Vafeas, 2005; Yang and Krishnan, 2005). However, some previous
research found no evidence of a relation between the number of independent members of
an audit committee and earnings restatements (He et al., 2007; Lin et al., 2006; Yang and
Krishnan, 2005; Davidson et al., 2005; Xie et al., 2001) and others found a positive
relationship (Bryan et al., 2004; Beasley, 1996). They suggest that the time available to
those outside members is not enough to keep them monitoring management activities
related to the financial statements.
On the other hand, it is argued that competence is a prerequisite for any individual or
body seeking to carry out his responsibilities toward those who delegated him a
responsibility (Mangena and Pike, 2005; Abbott et al., 2007; Xie et al., 2003; Felo et al.,
2003). Because of their responsibility for overseeing internal control and financial
reporting, good governance dictates that audit committee members should possess a
certain level of competencies (Chtourou et al., 2001). DeFond et al. (2005) find that audit
committees competence plays a significant role in improving companies’ corporate
governance. Some studies found that the financial experience of audit committees’
members is associated with lower levels of earnings management (Mangena and Pike,
2005; Abbott et al., 2004; Xie et al., 2003; Felo et al., 2003). DeZoort and Salterio (2001) find
that the accounting experience of an audit committee members as well as their
knowledge of auditing are positively associated with the likelihood that they will
support the auditor in an auditor– corporate management dispute. Xie et al. (2003) stated
that firms whose audit committees have members with financial experience have lower
levels of earnings management.
However, other studies found no evidence of a statistically significant association Corporate
between the level of financial experience of audit committee’s members and earnings governance
quality (Lin et al., 2006; Yang and Krishnan, 2005). The results of other studies revealed
that the presence of an audit committee is not significantly related to the level of DAs
mechanisms
(Kang et al., 2008; He et al., 2007; Davidson et al., 2005). This theorizing about the role of
audit committee on earnings management leads to setting the second sub-hypothesis
stating that audit committee independence, competence and activities have a statistically 9
significant effect on earnings management activities..

Board of directors
Board of directors are responsible for the stewardship of managements to carry out their
duties in the best interests of those who delegated them a responsibility to run all
activities of their entities. Therefore, board of directors are subject to pressures to
demonstrate that shareholders rights are protected and enhanced. This pressure creates
internal pressures on management to meet the objectives of their entities. Therefore, the
board plays a major role in the corporate governance framework. It is mainly
responsible for monitoring managerial performance and achieving an adequate return
for shareholders while preventing conflicts of interests and balancing competing
demands on the corporation (Maher and Andersson, 1999). When necessary, the board
also has the authority to replace the management of the corporation. For example, if the
management is under-performing, then the board can replace the current management
with a new, presumably more efficient, management that will maximize the firm’s
profits (Maher and Andersson, 1999).
The Saudi Corporate Governance Regulations (Article 11) stated that the board of
directors must carry out its duties in a responsible manner, in good faith and with due
diligence. A member of the board of directors represents all shareholders. Many studies
investigated the impact of boards of directors independence on managers activities and
their findings are approximately the same (Firstenberg and Malkiel, 1980; Vance, 1983;
Brickley et al., 1994; Byrd and Hickman, 1992; Subrahmanyam et al., 1997). Dunn (1987)
stated that when the percentage of independent members of the board of directors
increases the monitoring and controlling function over managers’ activities will be
improved. Boards oversee the stewardship of management and prescribe the basis for
measuring performance and rewarding or penalizing management.
The Saudi Corporate Governance Regulations (Article 12) stated that the majority of
the members of the board of directors shall be non-executive members. It is prohibited to
conjoin the position of the chairman of the board of directors with any other executive
position in the company, such as the chief executive officer or the managing director or
the general manager. The independent members of the board of directors shall not be
less than two members or one-third of the members, whichever is greater. The
proportion of independent outside directors on the board leads to more effective
monitoring (Hermalin and Weisbach, 1991; Cotter et al., 1997; Mayers et al., 1997; and
Bhagat and Black, 2002). Independent non-executive directors are motivated to work in
the best interests of the minority shareholders as they bear substantial reputation costs
if they fail in their duties (Chen et al., 2010; Chen and Delmas, 2010; Fama and Jensen,
1983; Srinivasan, 2005).
Agrawal and Chadha (2005) show that two corporate governance attributes
including the incidence of independent directors with a background in accounting or
RIBS finance on the board and audit committee and the presence of the chief financial officer
26,1 (CFO) on the audit committee can reduce the probability of using DAs. Similarly,
Uadiale (2012) found that a board dominated by outside directors brings a greater
breadth of experience to the firm and are in a better position to monitor and control
managers, thereby reducing earnings management. Klein (2002) stated that there is a
negative relation between outside directors and earnings management. Chen and Zhang
10 (2012) found also that the Corporate Governance Code has a positive impact on curbing
earnings management through the introduction of independent non-executive directors
on the board and the audit committee and the accounting/financial experts sitting on the
audit committee. Cornett et al. (2008) stated also that board independence and earnings
management are negatively correlated. Similarly, Xie et al., (2001) found that earnings
management is less likely to occur in companies in which the board of directors include
independent outside directors with corporate experience.
However, there are some other researchers who believe that non-executive directors
on the board perform little role in monitoring the board because of a lack of real
independence, time as well as enough information (Gilson and Kraakman, 1991; Patton
and Baker, 1987). To be effective, independent non-executive directors should have both,
strong incentives to monitor the board and the capabilities to identify earnings
management (Peannell et al., 2000).
This theorizing about the role of board of directors on earnings management leads to
setting the third sub-hypothesis stating that board of directors’ independence,
competence and activities have a statistically significant effect on earnings management
activities.

Study design and methodology


The purpose of this study is to determine the effect of the compliance of Saudi
shareholding companies with corporate governance requirements on the usage of
earnings management. On one hand, three measures of a company’s corporate
governance will be used to reflect some of the basic principles of corporate governance
including:
(1) Audit committee independence, competence and activities.
(2) Internal audit independence, competence and activities.
(3) Board of directors independence, competence and activities.

On the other hand, DAs are used as measures of the usage of earnings management.
Earnings management is recognized as attempts by management to influence or
manipulate reported earnings by using specific accounting methods (or changing
methods), recognizing one-time non-recurring items, deferring or accelerating expense
or revenue transactions or using other methods designed to influence short-term
earnings (Akers et al., 2007). The use of accruals to temporarily boost or reduce reported
income is one mechanism for earnings management. Accruals are components of
earnings that are not reflected in current cash flows, and a great deal of managerial
discretion goes into their construction. (Bergstresser and Philippon, 2004). They argued
that the opportunity to manage earnings arises, in part, because reported income
includes both cash flows and changes in firm value that are not reflected in current cash
flows. While cash flows are relatively easy to measure, computing the change in firm’s
value that is not reflected in current cash flows often involves a great deal of discretion.
The accruals components of income capture the wedge between firms’ cash flows and Corporate
income. governance
mechanisms
Data and data sources
For the purpose of this study, we used two appropriate data sources, which are generally
acceptable to provide a basis for the measurement of our variables. The first type of data
is the responses of the financial managers and internal auditors of the Saudi 11
shareholding companies about the compliance of the firms with the requirements of the
basic principles of corporate governance. A questionnaire was designed to collect the
data of the compliance of the Saudi shareholding companies with the requirements of
the corporate governance.
Compliance is the independent variable. It means the compliance of the Saudi
shareholding companies with the requirements of corporate governance issued by the
Board of Capital Market Authority. Basically, we concentrated on three mechanisms of
governance including internal audit, audit committee and board of directors. For each
one of these three mechanisms, we defined and measured the scope of work,
independence and competence according to the requirements issued by the Board of
Capital Market Authority, as we mentioned in the questionnaire (see the Appendix AI).
Therefore, the questionnaire consisted of three sections, the first section included
questions about internal audit, the second section included questions about the audit
committee’s requirements and the third section included questions about the board’s
requirements (see the Appendix AI).
The first section included statements that measure internal audit’s scope of work,
independence and competence: scope of work was measured by Statements 1-11,
independence was measured by Statements 12-14 and competence was measured by
Statements 15-20. The second section included statements that measure audit
committee’s scope of work, independence and competence: scope of work was measured
by Statements 1-11, independence was measured by Statements 12-14 and competence
was measured by Statements 15 and 16. The third section included statements that
measure board of directors’ scope of work, independence and competence: scope of work
was measured by Statements 1-14, independence was measured by Statements 15 and
16 and competence was measured by Statements 17 and 18.
All questions were measured on a five-point Likert scale. The answers of the
respondents were used to compute the mean of the scope of work, independence and
competence for each mechanism, and the mean of all components of each mechanism
was computed, then the mean was converted into a percentage to be incorporated in the
regression model.
The second source of data is the financial statements of the firms who responded to
the questionnaire. We used the financial statements to calculate the DAs used by
managements of these companies. Earnings management will be measured by the
magnitude of DAs using the modified Jones model. The usual starting point for the
measurement of DAs is total accruals. A particular model is then assumed for
the process generating the non-discretionary component of total accruals, enabling total
accruals to be decomposed into a discretionary and a non-discretionary components.
Previous studies have found that the modified Jones model is the most powerful and
effective model for identifying DAs (Dechow et al., 1995).
RIBS TAit /Ait⫺1 ⫽ ø1jt( 1/Ait⫺1 ) ⫹ ø2jt关 ( ⌬REVit ⫺ ⌬ARit ) /Ait⫺1 兴 ⫹ ø3jt( PPEit /Ait⫺1 ) ⫹ ␧it
26,1
Where:
TAit ⫽ total accruals for Firm i in the Year t calculated as the difference between
net income before extraordinary items and cash flow from operations
(TAit ⫽ NIit ⫺ CFOit) (Becker et al., 1998);
12 Ait⫺1 ⫽ total assets of the previous period, i.e. at Time t ⫺ 1;
⌬REVit ⫽ revenue for Firm i, in Time t less revenues in Time t ⫺ 1;
⌬ARit ⫽ accounts receivable in Time t less accounts receivable in t ⫺ 1;
PPEit ⫽ gross property, plant and equipment for Firm i in Year t;
NIit ⫽ net income amount of Firm i at Year t; and
CFOit ⫽ amount of cash flow from operations of Firm i at Year t.
Then, the non-discretionary accruals (NAs) will be estimated using the cross-sectional
Jones model. The industry–year-specific parameter estimates from the above
cross-sectional Jones model are used to estimate the firm-specific NAs (NAit) for every
year of the study. NAs are calculated as a percent of lagged total assets using the
cross-sectional modified Jones model; that is:

NAit /Ait⫺1 ⫽ { ø1( 1/Ait⫺1 ) ⫹ ø2关 ( ⌬REVit ⫺ ⌬ARit ) /Ait⫺1 兴 ⫹ ø3( PPEit /Ait⫺1 )}

DAs are the resulting residual after deducting NAs from the total accruals. Thus, DAi,t
for Firm i in Year t is calculated as:

DAit ⫽ ( TAit /Ait⫺1 ) ⫺ ( NAi,t /Ait⫺1 )

After calculating DAs, the following model will be used to investigate the effect of
corporate governance mechanisms on earnings management:

DA it ⫽ ␤0 ⫹ ␤1ACOMM it ⫹ ␤2BOARDit ⫹ ␤3INTERNALit ⫹ ␤4(OCFit /Ait⫺1 )


⫹ ␤5LAit ⫹ ␧it

Where:
DAit ⫽ level of DAs for Company i at Time t;
ACOMMit ⫽ compliance with audit committee requirements by Company i at
Time t;
BOARDit ⫽ compliance with board of directors requirements by Company i at
Time t;
INTERNALit ⫽ compliance with internal audit requirements by Company i at Time
t;
OCFit ⫽ operating cash flows for Company i at Time t; and
LAit ⫽ natural logarithm of total assets for Company i at Time t.

Population and sample


The target population of this study consists of all the Saudi shareholding companies
listed on the Saudi Bourse for 2011. The number of listed companies is 160 companies.
To create a unifying theme between the firms in the study sample and eliminate any Corporate
factors that might create noise, and thus affect the findings of this study, firms in the governance
sample were selected based on the following criteria:
mechanisms
• The firm’s shares should be listed for trading on the bourse during2011, which is
the period of study.
• The firm’s financial statements must be available for 2011 to provide for the
financial data needed to calculate the study’s variables.
13
• The firm should not have undergone an extraordinary event, such as a merger or
acquisition, or other similar transactions that might result in reorganization of the
firm’s business segments and, as a consequence, affect the entity and its financial
statements.

Based on the above criteria, the number of firms included in the sample amounted to 120
firms. A questionnaire was sent to all these companies. We used many methods of
communication with the respondents, that is, by mail, email and by hand. However, the
number of responses was 90 responses with a response rate of 75 per cent, which is
reasonably acceptable. We used these firms’ financial statements to calculate DAs and
then test the hypotheses. In other words, two sources of data were used, the first one is
the responses of the firms to the questionnaire and the other is the financial reports of
those firms that responded to the questionnaire.

Limitations
Even though a questionnaire represents a structured technique for collecting primary data,
there are some limitations of such research method, that is, respondents to questionnaires
may record their own answers. Additionally, care has to be taken when creating a
questionnaire. However, it is a technique in which various persons are asked to answer the
same set of questions and we think that our questionnaire is well designed to motivate the
respondents to give accurate and complete information to get reliable and relevant data.
Furthermore, we discussed the questionnaire with our colleagues to assure its relevance for
measuring the variables of the study. To assess whether the different items of the
questionnaire form a reliable measure of corporate governance principles, Cronbach’s alpha
was computed. The alpha coefficients for the items measuring the requirements of boards of
directors, audit committees and internal audit ranged between 0.82 and 0.90, which indicates
strong internal consistency and reliability.

Results and discussion


As mentioned in the methodology section, we used a questionnaire to collect data about
the compliance of the Saudi shareholding companies with the requirements of corporate
governance. We used also the financial statements of the shareholding companies to
calculate the DAs as a measure of earnings management. We start our analysis by
investigating the reliability of the data collected by the questionnaire. To assess whether
the different items of the questionnaire form a reliable measure of corporate governance
requirements, Cronbach’s alpha was computed. The alpha coefficients for the items
measuring internal auditors’ scope of work, independence and competence are close to
0.90, the coefficients related to audit committees’ scope of work, independence and
competence are close to 0.82 and the coefficients related to board of directors’ scope of
RIBS work, independence and competence are close to 0.85, which indicates strong internal
26,1 consistency for the data related to all variables.

Descriptive statistics
To test the research hypotheses, we started by investigating the degree of management
involvement in earnings management. As mentioned in the methodology section, we
14 used DAs as a proxy for earning management.
The absolute values of DAs ranged from 0.04 to 0.38. Table I shows that the average of all
values of DAs of the shareholding companies is 0.162 with a significance value of 0.000,
which indicates that the shareholding companies use earning management, but there are
some differences between them because there is a wide range between the minimum and the
maximum values of DAs. It also appears from the table that the standard deviation is 0.11,
which supports the view that there is some dispersion in DAs values.
Table I shows also the descriptive statistics related to the degree of the commitment
of the Saudi shareholding companies with the basic requirements of corporate
governance mentioned by the Saudi code of corporate governance. The table shows that
there is a high degree of compliance with each mechanism of corporate governance.
That is, the mean of all attributes of governance ranged between 4.275 and 4.928 on a
five-point Likert scale.
The respondents of the companies stated that internal audit within their
organizations represents an independent appraisal function established by the
management of an organization for the review of the internal control system as a service
to the organization as a whole. We see from the table that the internal audit function
achieves a high degree of compliance with the scope of work that includes all
requirements of modern comprehensive internal audit function. The table shows that
the mean of the scope of internal audit is 4.27 on a five-point Likert scale, which
represents approximately a percentage of 85.5 per cent. The scope of internal audit
function included the evaluation of the effectiveness of risk management, control and
governance processes. It includes the assurance about the compliance of management
and employees with policies, regulations and roles, the review of all activities to assure
the achievement of efficiency and effectiveness of all activities and the evaluation of all

Variable Mean (%) SD t value Significance

DA 0.1621 – 0.11088 8.651 0.000


Internal audit scope of work 4.2750 85.5 0.59393 42.583 0.000
Internal audit independence 4.6190 92.4 0.51222 53.349 0.000
Internal audit competence 4.4214 88.4 0.57128 45.787 0.000
Audit committee scope of work 4.4418 88.8 0.54372 48.330 0.000
Audit committee independence 4.3857 87.7 0.72847 35.617 0.000
Audit committee competence 4.6000 92 0.65079 41.817 0.000
Board of directors scope of work 4.4543 89 0.52037 50.640 0.000
Board of directors independence 4.2857 85.7 1.14587 22.127 0.000
Board of directors competence 4.9286 98.5 0.42258 69.000 0.000
Minimum and maximum values of DA 0.04-0.38
Table I. Number of cases 90 companies
One-sample t-test The percentage calculated by dividing the mean on 5 that represents 100 per cent
expected risks that are associated with the companies’ activities. It appears also that Corporate
internal audit function comply with the basic requirement of independence. The table governance
shows that the degree of compliance is 4.6, which approximately represents 92.4 per
cent. The basic attribute of this independence is represented by its location in the
mechanisms
organizational structure, that is, it is a separate unit in the company and associated with
the audit committee and reports to it. Similarly, the internal auditors of the Saudi
shareholding companies seem to be highly qualified and have competency in accounting 15
and auditing standards. The table shows that the mean of achievement of competence
requirements is 4.42, which approximately represents 88.4 per cent.
The second mechanism of corporate governance investigated in this study is the
audit committee of Saudi shareholding companies. Table I shows that the mean of
responses related to audit committees’ scope of work is 4.44, which approximately
represents 88.8 per cent. It appears from the responses that the activities of the audit
committees of the Saudi shareholding companies are comprehensive and include all
activities mentioned by the Saudi corporate governance code with a high degree of
compliance with all of the requirements. The requirements included the committees’
recommendation to the board of directors for hiring and firing internal auditors,
discussing external auditors’ nominations and their fees, discussing the audit
plan, discussing and following up the notes and recommendations of external auditors,
discussing and following up the notes and recommendations of internal auditors and
coordinate between internal auditors and external auditors. The activities of the audit
committees also included the review of internal control systems and providing
managements with their recommendations about the development of the system and the
amendments needed to any deficiencies.
The table shows also that the mean of the responses related to audit committees’
independence is 4.38, which approximately represents 87.7 per cent. The basic attribute
of independence of the Saudi audit committees is represented by a high percentage of
non-executive members in comparison with the total number of the committees’
members. This attribute of independence represents one of the important attributes of
independence according to regulations all over the world. The second important
attribute of audit committees’ independence is represented by their independence from
the board of directors and administration of their companies. The members of the audit
committees are qualified, that is, most of them have accounting and finance
qualifications and have reasonable experience in business issues. The table shows that
the mean of the responses regarding the qualifications of the committees’ members is
4.6, which approximately represents 92 per cent.
The third mechanism of corporate governance investigated in this study is the board
of directors of Saudi shareholding companies. It appears from the table that the mean of
responses related to the scope of activities of boards of directors is 4.45, which
approximately represents 89 per cent. Their activities include the participation in the
formation of the companies’ strategies, the approval of the plans and objectives and the
supervision of their implementation. Their activities also include the determination of
the appropriate capital structure for the company, the supervision of the design and
development of internal control systems and their implementation and setting
disclosure policies and procedures. Their activities also include the development of
policies and procedures to ensure the companies’ commitment to the laws, regulations
and standards that lead to the disclosure of the information, which are necessary for the
RIBS users of financial statements. These activities are comprehensive and similar to
26,1 governance requirements all over the world. These activities are expected to work in the
best interest of the users of the financial statements and are expected to advocate trust,
transparency and reduce the involvement with earnings management.
The table shows the mean of responses related to the board independence is 4.28,
which approximately represents 85.7 per cent and this is a high degree of independence.
16 The basic attribute of this independence represented by the number of non-executive
directors included in the boards, that is, at least half of the boards’ members are
non-executives. The other attribute is that the annual renewal for the members of
the boards of directors is approved by the general assembly. These attributes of
independence are very important and expected to promote neutrality and therefore
provide a good basis for objectivity and reliability. This means that this characteristic
will help in reducing the activities of illegal earnings management. It is also noted that
the members of the boards are qualified, that is, the mean of the responses regarding the
qualifications of the boards members is 4.9, which approximately represents 98.5 per
cent. This is a very high degree of competence and it provides the board with a high
degree of prudence and care in carrying out all activities.

Hypotheses testing
Before interpreting the results of the regression, a test of multicollinearity must be done
to check whether the values of regression coefficients are not inflated because of the
correlation between the independent variables. The general rule of thumb is that
variance inflation factors (VIFs) exceeding 4 warrants further investigation, while VIFs
exceeding 10 are signs of serious multicollinearity requiring correction (Kaplan, 1994
and Leahy, 2000). We investigated the multicollinearity when we analyzed the effect of
the basic independent variables (the basic components of corporate governance
including internal audit, audit committee and board of directors) on DAs, and when we
analyzed the effect of all components of internal audit, audit committee and board of
directors on DAs. Looking at Tables II-V), we see that the VIF values for all independent
variables, and when using all models, are range between 1.03 and 3.876, which means
that the factors are very small, and, therefore, the expected effect on the regression
results is minimal.

Dependent variable (DA)


R R2 Adjusted R2 Standard error of the estimate F Significance

0.313 0.098 0.011 0.11029 1.121 0.356

Unstandardized Standardized Collinearity


coefficients coefficients statistics
Independent Standard
Table II. variables B error Beta t Significance Tolerance VIF
Regression
coefficients Internal audit ⫺0.062 0.044 ⫺0.243 ⫺1.404 0.170 0.971 1.030
(corporate Audit committees 0.033 0.038 0.150 0.853 0.400 0.941 1.063
governance and DAs Board of directors 0.034 0.040 0.145 0.838 0.408 0.968 1.033
in general) Number of cases 90 companies
Dependent variable (DA)
Corporate
R R2
Adjusted R 2
Standard error of the estimate F Significance governance
mechanisms
0.238 0.057 ⫺0.035 0.11278 0.621 0.607

Unstandardized Standardized Collinearity


coefficients coefficients statistics 17
Standard
Independent variables B error Beta t Significance Tolerance VIF

Internal audit scope


of work ⫺0.040 0.043 ⫺0.213 ⫺0.917 0.366 0.565 1.769
Internal audit
independence ⫺0.010 0.044 ⫺0.047 ⫺0.231 0.819 0.746 1.340 Table III.
Internal audit Regression
competence 0.001 0.040 0.003 0.014 0.989 0.722 1.385 coefficients (internal
Number of cases 90 companies audit and DAs)

Dependent variable (DA)


R R2 Adjusted R2 Standard error of the estimate F Significance

0.328 0.108 0.022 0.10967 1.250 0.309

Unstandardized Standardized Collinearity


coefficients coefficients statistics
Standard
Independent variables B error Beta t Significance Tolerance VIF

Audit committee scope


of work 0.009 0.039 0.043 0.229 0.821 0.801 1.249
Audit committee
independence ⫺0.036 0.031 ⫺0.239 ⫺1.186 0.244 0.707 1.415 Table IV.
Audit committee Regression
competence 0.062 0.035 0.366 1.761 0.088 0.665 1.503 coefficients (audit
Number of cases 90 companies committees and DAs)

The impact of corporate governance on earnings management


Table II shows some statistics related to the relationship between corporate governance
and DAs in general. The table shows that the correlation between corporate governance
and DAs is 0.313, which indicates that there is a positive relationship between them, but
it is statistically insignificant because the significance value is 0.356, which is more than
0.05.
The adjusted R2 is used to assess the explanatory power of models employed for testing
our hypotheses. It determines, in percentage, how much of the variation in DAs is attributed
to the compliance with corporate governance requirements. The table shows that the
adjusted R2 is equal to 0.011, which means that nearly 1 per cent of the variation in earnings
management (measured by DAs) is interpreted by corporate governance. Table II also
RIBS Dependent variable (DA)
26,1 R R2 Adjusted R2 Standard error of the estimate F Significance

0.273 0.075 ⫺0.015 0.11170 0.833 0.486

Unstandardized Standardized Collinearity


18 coefficients coefficients statistics
Standard
Independent variables B error Beta t Significance Tolerance VIF

Board’s scope of work 0.041 0.037 0.193 1.105 0.278 0.976 1.024
Board of directors’
Table V. independence 0.000 0.017 ⫺0.007 ⫺0.037 0.971 0.917 1.091
Regression Board of directors’
coefficients (board of competence 0.057 0.048 0.219 1.208 0.236 0.909 1.101
director and DAs) Number of cases 90 companies

provides information about the overall regression because the value of the significance is
0.356, which is higher than 0.05; then, the conclusion is that the relationship between
corporate governance in general and DAs is very small and statistically insignificant at a
level below 0.05. In other words, no statistically significant linear dependence of the mean of
DAs on corporate governance was detected.
Table II also shows the regression coefficients for each mechanism of corporate
governance used in this study. The first mechanism of corporate governance
investigated in this study is the internal audit function. The table shows that the
correlation coefficient for the variable internal audit is ⫺0.062, and the significance
value is 0.170, which is higher than the significance level used in this research (0.05);
therefore, the effect of internal audit on DAs is negative but statistically insignificant.
This conclusion means that the internal audit function has a slight role in reducing the
involvement of management in earnings management.
The second mechanism of corporate governance investigated is the audit committee. The
table shows that the correlation coefficient for the variable audit committee is 0.033, and the
significance value is 0.4; therefore, the effect of audit committee on DAs is minimal and
statistically insignificant. This conclusion means that the audit committee has no significant
role in reducing the involvement of management in earnings management.
The third mechanism of corporate governance investigated in this study is the board
of directors. The correlation coefficient for the variable board of directors is 0.034, and
the significance value is 0.408; therefore, the effect of board of directors on DAs is very
slight and statistically insignificant. This conclusion means that the board of directors
has no significant role in reducing the involvement of management in earnings
management.

The impact of internal audit attributes on earnings management


This section investigates the relationship between internal audit attributes and DAs
separately (without the inclusion of the audit committee and board of directors in the
regression). Table III shows some statistics related to the relationship between internal
audit and DAs in general. The table shows that the adjusted R2 is ⫺0.035, which means
that approximately 4 per cent of the variation in earnings measurement (measured by Corporate
DAs) is interpreted by internal audit. However, the table provides also information governance
about the overall regression, because the value of the significance is 0.607, which is
higher than 0.05; then, the conclusion is that the relationship between internal audit in
mechanisms
general and DAs is negative, very slight and statistically insignificant at a level below
0.05. In other words, no statistically significant linear dependence of the mean of DAs on
internal audit was detected. This conclusion is similar the previous mentioned 19
conclusion.
Table III shows also the regression coefficients for each attribute of internal audit
used in this study. The first attribute of internal audit investigated in this study is the
scope of work of internal audit. The table shows that the correlation coefficient for the
scope of work of internal audit is ⫺0.04, and the significance value is 0.366; therefore,
the effect of the scope of work of internal audit on DAs is very slight, negative and
statistically insignificant. This conclusion means that the scope of the work of internal
audit function may have a slight role in reducing the involvement of management in
earnings management.
The second attribute of internal audit investigated in this study is the independence
of internal audit. The correlation coefficient for independence of internal audit is ⫺0.01,
and the significance value is 0.4; therefore, the effect of internal audit independence on
DAs is very slight, negative and statistically insignificant.
The third attribute of internal audit investigated in this study is the competence of
internal audit. The correlation coefficient for internal audit competence is 0.001, and the
significance value is 0.989, which is more than the significance level used in this research
(0.05); therefore, the effect of internal audit competence on DAs is statistically
insignificant. These results provide evidence contradicts the results of many previous
studies that ascertained the importance of internal audit as a governance mechanism
that helps in curbing earnings management activities (Douglas et al., 2009; Abbott et al.,
2007; Asare et al., 2003; Hermanson and Rittenberg, 2003; Becker et al., 1998). We agree
that our results seem to be abnormal in comparison with previous research. However,
we think that our results provide new good evidence from a different environment, that
is, a different context. Our results also shed light on the real role of internal audit. That
is, we expect that internal audit, regardless of the appearance of independence, and the
expanded level of fieldwork scope, works as a medium for management service. This
argument would suggest that internal audit as a monitoring tool may concentrate only
on the activities of employees and lower levels of management, and therefore do not
stand against the desires of top management. However, we expect that the context
within which the internal auditors work is an important factor influencing the
effectiveness of an internal audit.

The impact of audit committee attributes on earnings management


This section investigates the relationship between audit committee attributes and DAs
separately (without the inclusion of the internal audit and board of directors in the
regression). Table IV shows some statistics related to the relationship between an audit
committee and DAs in general. The table shows that the adjusted R2 is (0.022 per cent),
which means that (0.022 per cent) of the variation in earnings management (measured by
DAs) is interpreted by the audit committee. However, the table also provides information
about the overall regression. Because the value of the significance is 0.309, the conclusion is
RIBS that the relationship between audit committee in general and DAs is very slight and
26,1 statistically insignificant at a level below 0.05. In other words, no statistically significant
linear dependence of the mean of DAs on audit committee was detected.
Table IV also shows the regression coefficients for each attribute of audit committee
used in this study. The first attribute of audit committee investigated in this study is the
scope of work of the audit committee. It appears from the table that the correlation
20 coefficient for the scope of work of audit committee is 0.009, and the significance value
is 0.821, which is higher than the significance level used in this research (0.05); therefore,
the effect of the scope of work of the audit committee on DAs is nearly zero and
statistically insignificant.
The second attribute of audit committee investigated in this study is the
independence of audit committee. The correlation coefficient for independence of audit
committee is ⫺0.036, and the significance value is 0.244, which means that the effect of
audit committee independence on DAs is negative, slight and statistically insignificant.
The third attribute of audit committee investigated in this study is the competence of
audit committee. The correlation coefficient for audit committee competence is 0.062,
and the significance value is 0.088, which means that the effect audit committee
competence has on DAs is slight and statistically insignificant.
It appears from the results mentioned in this section that we have a new evidence
about the effectiveness of audit committees in protecting the interests of stakeholders
even when that contradicts the management desires. This conclusion is not in
congruence with previous research findings, which stated that the independence and
competence of audit committees’ members help in reducing earnings activities
(Pucheta-Martinez and Fuentes, 2007; Karamanou and Vafeas, 2005; Al-Mudhaki and
Joshi, 2004; Bédard et al., 2004; Xie et al., 2003; Klein, 2002).

The impact of board of directors attributes on earnings management


This section investigates the relationship between board of directors’ attributes and DAs
separately (without the inclusion of internal audit and audit committee in the regression).
Table V shows some statistics related to the relationship between board of directors and
DAs in general. It appears from the table that the adjusted R2 is ⫺0.015, which means that
approximately 2 per cent of the variation in earnings management (measured by DAs) is
interpreted by board of directors. However, the table provides also information about the
overall regression. Because the value of the significance is 0.486, we conclude that the
relationship between board of directors in general and DAs is negative, slight and
statistically insignificant at a level below 0.05. In other words, no statistically significant
linear dependence of the mean of DAs on board of directors was detected.
Table V shows also the regression coefficients for each attribute of board of directors
used in this study. The first attribute of board of directors investigated in this study is
the board’s scope of work. The table shows that the correlation coefficient for the scope
of work is 0.041, and the significance value is 0.278; therefore, the effect of the scope of
work of board of directors on DAs is very small and statistically insignificant.
The second attribute of board of directors investigated in this study is the
independence of the board of directors. The correlation coefficient for independence of
board of directors is 0.000, and the significance value is 0.971, which means that the
effect of board of directors’ independence on DAs is zero and statistically insignificant.
The third attribute of the board of directors is its competence. The correlation Corporate
coefficient for the board of directors’ competence is 0.057, and the significance value is governance
0.236; therefore, the effect the board of directors’ competence on DAs is very small and
statistically insignificant.
mechanisms

Discussion, conclusions and recommendations


The previous analysis of the compliance of the Saudi shareholding companies with 21
corporate governance requirements, and its effect on earnings management practices,
shows that there is a high degree of compliance with all requirements of corporate
governance related to internal audit, audit committee and board of directors. This high
degree of compliance is reflected in all attributes of these mechanisms of corporate
governance including their activities, independence and competence. The hypothesis
testing shows that the overall effect of corporate governance on earnings management
is statistically insignificant. This result contradicts the results of many previous studies
(Lin and Hwang, 2010; Messier et al., 2008; Liu and Lu 2007; Chen and Yuan, 2006;
Davidson et al., 2005; Skousen et al., 2005; Chung et al., 2002) that provided some
evidence that corporate governance reduces earnings management. However, our
results are consistent with other research findings in some international environments
(see, for example, Chi-Yih et al., 2012 and Mohamad et al., 2012). Chi-Yih et al. (2012)
examined empirically the effect of corporate governance mechanisms on
income-smoothing behavior in the People’s Republic of China. Their findings showed
that firms with more independent directors are more likely to engage in income
smoothing and governance mechanisms such as board of directors, supervisory board,
audit committee, external auditors and shareholders’ participation are not effective in
curtailing income smoothing in China. Similarly, Mohamad et al. (2012) found that none
of the corporate governance mechanisms has much impact on curbing earnings
management activities in Malaysian companies. Our conclusion seems to put a big
question mark on the effectiveness of corporate governance in Saudi Arabia. That is, our
results revealed that there is a high degree of compliance with corporate governance
requirements, but there is no significant effect on earnings management.
The results of the study show that the Saudi shareholding companies have
independent boards of directors, independent internal auditors and independent audit
committees. It may be argued that this independence is in need for further investigation.
The real independence is mind independence; in other words, independence of thought.
It is this type of independence that gives us assurance that these oversight mechanisms
and monitoring bodies put their knowledge and experience in the right track and deploy
them to achieve effectiveness.
Our analysis revealed that internal auditors of the Saudi shareholding companies
have the qualifications that needed for internal auditors to be competent, independent
and their activities are comprehensive and in accordance with the recent requirements of
internal audit standards. However, hypotheses testing revealed that there was no
statistically significant linear dependence of the mean of DAs on internal audit. The
effect of all attributes of internal audit including the scope of work, independence and
competence on DAs is statistically insignificant. Our results do not agree with many
previous research studies, which stated that there is a negative relationship between
internal audit and earnings management (Prawitt et al., 2009; Douglas et al., 2009;
Abbott et al., 2007; Asare et al., 2003; Hermanson and Rittenberg, 2003; Becker et al.,
RIBS 1998). However, our findings show that there is a slight and negative effect of the scope
26,1 of work and independence on earnings management but statistically insignificant.
Our analysis also revealed that audit committees of the Saudi shareholding companies
have the qualifications that is needed for competence, most of them are non-executives,
which represent independence in appearance, and their activities are in congruence with the
corporate governance requirements as set by the Saudi authorities. However, the hypotheses
22 testing revealed that no statistically significant linear dependence of the mean of DAs on
audit committee was detected. The effect of all attributes of audit committees including the
scope of work, independence and competence on DAs is statistically insignificant. However,
there is s slight and negative effect of their independence on earnings management. These
results, on the one hand, do not agree with the results of some previous research (Uadiale,
2012; Jaggi and Leung, 2007; Carcello and Neal, 2000; DeZoort, 1998) that suggested a
statistically significant effect. On the other hand, our results are similar to some previous
studies that find no evidence of a relation between the audit committee independence and the
level of earnings management (see, for example, He et al., 2007; Davidson et al., 2005; Yang
and Krishnan, 2005; Xie et al., 2001). Similarly, the results of this paper show that the audit
committee’s members competence and activities do not have significant effect on earnings
management, which is in contradiction with the results of other studies (Zhang et al., 2007;
Krishnan, 2005; Raghunandan et al., 2001). However, our results are similar to others
(Mangena and Pike, 2005; Yang and Krishnan, 2005; Abbott et al., 2007; Felo et al., 2003).
Our analysis revealed also that boards of directors of the Saudi shareholding
companies have the qualifications that needed for competence, most of them are
non-executives, which represent the independence in appearance, and their activities are
in congruent with the corporate governance requirements as set by the Saudi
authorities. However, the hypotheses testing revealed that there was no statistically
significant linear dependence of the mean of DAs on board of directors. The effect of all
attributes of board of directors including the scope of work, independence and
competence on DAs is statistically insignificant. These results seem to be not in
congruence with previous research (Ajinkya et al., 2005; Karamanou and Vafeas, 2005;
Xie et al., 2003; Klein, 2002), which argued that the role of boards of directors in limiting
earnings management cannot be ignored. However, we think that our results provide
new evidence in a different environment, and put a big question mark on the actual role
of boards of directors in reducing or preventing earnings management.
The previous literature suggests that the oversight or control function of the board is
the most critical of the directors’ role and this may lead to the conclusion that the
effectiveness of the board in limiting earnings management is contingent on the relative
independence of its members (Fama and Jensen, 1983; Shleifer and Vishny, 1997). We
agree that the monitoring process plays a pivotal role in developing and sustaining
strategy for efficient overall management of the resources owned by a business. It is a
continuing function that aims primarily to provide the management and main
stakeholders with an ongoing accountability and objective basis for performance
evaluation and reporting. It is expected that if outside directors on the board carry on
their responsibilities and monitor management activities, earnings management
activities will be minimized. However, even though the board of directors are dominated
by outsiders, they may not work effectively and, therefore, their role in monitoring
management may be very slight and do nothing regarding earnings management
practices. In other words, ineffective oversight of financial reporting by the board of Corporate
directors allows management to exercise discretion over financial reporting. governance
The results of this paper provide new evidence regarding the effect of corporate
governance mechanisms on earnings management, and this provides a good basis for a
mechanisms
specific type of recommendations. Firstly, because our results are not in congruent with
many previous research results, we should think deeply about the cause of these results.
Because our findings provide new evidence regarding the effect of corporate governance 23
on earnings management, regulators may consider our findings in their deliberations
regarding the potential role of corporate governance mechanisms including internal
audit, audit committee and board of directors in safeguarding the interests of investors
and all stakeholders.
We need to think deeply how we can improve these oversight boards and monitoring
mechanisms to achieve the targeted objectives rather than only setting requirements. We
need to improve the effectiveness of these mechanisms, taking into our consideration that the
cornerstone and the backbone of these monitoring mechanisms is the real independence,
which is the independence of mind rather than an independence of appearance.
We need to think about the type of earnings management used, that is, earnings
management is divided into legal and illegal and legitimate and illegitimate. This means
that the type of earnings management we find in our results may be as a result of legal
and legitimate earnings management; therefore, the monitoring mechanisms
investigated in this study will not prevent management from using this type because it
is a sort of legitimate creative accounting.
Finally, we would suggest that there is a need to investigate this phenomenon with its
context because we think that the effect of corporate governance mechanisms differs from
situation to another, that is, from one environment to another. We know that monitoring
mechanisms are socially constructed and their effectiveness depend on the context within
which these mechanisms operate. Therefore, researching this phenomenon within its
context requires using research techniques other than questionnaires. We may need to use
interviews, analyze archival data including internal reports and minutes of meetings of
oversight boards and consider environmental factors.

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Prawitt, D., Smith, J. and Wood, D. (2009), “Internal audit quality and earnings management”, The
Accounting Review, Vol. 84 No. 4, pp. 1255-1280.
Schultz, E.L. Tan, D.T. and Walsh, K.D. (2010), “Endogeneity and the corporate
governance-performance relation”, Australian Journal of Management, Vol. 35 No. 2,
pp. 145-163.

Corresponding author
Ali Abedalqader Al-Thuneibat can be contacted at: aaaldu@Ju.edu.jo

Appendix

Dear Sir/Madam
Greetings
The researchers are conducting a study entitled: “The effect of corporate governance
mechanisms on earnings management: evidence from Saudi Arabia”. Kindly answer the following
questions that will help in achieving the objectives of the study. The contribution in answering
this questionnaire is of great importance to the achievement of the results of the study, the most
important of which is raising the level of corporate governance to serve all parties interested in the
company. Please note that this information will be treated confidentially, and will only be used for
the purposes of this research, and in its overall form.

Best regards
The researchers
RIBS Section one: Internal Audit:
This section aims to determine the extent of the internal audit commitment to the governance
26,1 requirements. Please tick (√) in front of the answer which reflects the reality in your company.
To which extent the Internal Audit performs and adheres to the following tasks:

Internal Audit’s Scope of Work Very Very


High Moderate Low
30 High low
1-Providing reasonable assurance that governance systems are
functioning as intended and will enable the organisation's
objectives and goals to be met.

2-Reporting risk management issues and internal controls


deficiencies identified directly to the audit committee.

3-providing recommendations for improving the


organisation's operations.

4-Providing support to the company's anti-fraud programs

5-Evaluating information security and associated risk


exposures

6-Aassuring that the employees are committed to the


policies and regulations.
7-Reviewing the operations and programs to ensure that the
results are in agreement with the objectives set in advance.
8-Internal auditors evaluate the efficiency of all activities.
9-Evaluating all functions and activities.
10-Evaluating the current and expected risks related to the
financial statements.
11-Providing reasonable assurance regarding the various
controlling aspects.
Internal Audit’s Independence
12-The internal audit department is independent unit in the
organizational structure.
13-The internal auditors report directly to the audit
committee.
14-Internal auditors don’t perform executive responsibilities
to help the management.
Internal Audit’s Competence
15-Internal auditors have accounting and auditing
qualifications
16-Internal auditorshave adequate knowledge of the
accounting standards.
17-Internal auditors have adequate knowledge of the
accounting and financial principles and the necessary
mechanisms to perform their work.
18-The number of the internal auditors is enough to conduct
the whole audit process.
19-Internal auditors have adequate experience in accounting
and auditing.
20-Internal auditors engage in continuous education and
staff development.
Section two: The Audit Committee Corporate
This section aims to determine the extent of the committee’s commitment to the governance
requirements. Please tick (√) in front of the answer which reflects the reality in your company. governance
mechanisms
To which extent the Audit Committee performs and adheres to the following tasks:

Very Very
Audit Committee’s Scope of Work High Moderate Low
1-Hiring internal auditors, determining their salaries and
High low
31
receiving their reports.
2-Supervising the company’s internal audit department to
ensure its effectiveness in executing the activities and duties
specified by the Board of Directors.
3-Reviewing the internal audit procedure and preparing a
written report on such audit and its recommendations with
respect to it.
4-Reviewing the internal audit reports and pursuing the
implementation of the corrective measures in respect of the
comments included in them.
5-Recommending to the board of directors the appointment,
dismissal and the remuneration of external auditors.
6-Supervising the activities of the external auditors and
approving any activity beyond the scope of the audit work
assigned to them during the performance of their duties.
7-Reviewing together with the external auditor the audit
plan and making any comments thereon.
8-Reviewing the external auditor’s comments on the
financial statements and follow up the actions taken about
them.
9-Reviewing the interim and annual financial statements
prior to presentation to the board of directors; and giving
opinion and recommendations with respect thereto.
10-Coordinating with the external auditor and the board to
resolve any disputes.
11-Reviewing the accounting policies in force and advising
the board of directors of any recommendation regarding
them.
Audit Committee’s Independence
12-The audit committee consists of non-executive members.
13-The audit committee has its own independence of the board
and the company’s management.
14-The audit committee don’t perform executive responsibilities
to help the management.
Audit Committee’s Competence
15-The Audit Committee includes members with accounting and
financial expertise which leads to perform its tasks.
16The members of the audit committeehave adequate knowledge
of the accounting standards.
RIBS Section three: Board of Directors
This section aims to determine the extent of the board’s commitment to the governance
26,1 requirements. Please tick (√) in front of the answer which reflects the reality in your company.

To which extent the board performs and adheres to the following tasks:

Board of Directors’ Scope of Work Very Very


High Moderate Low
32 High low
1- Participating in the formation of the company’s strategy
2-Approving the strategic plans and main objectives of the
company and supervising their implementation.
3-Laying down a comprehensive strategy for the company,
the main work plans and the policy related to risk
management, reviewing and updating of such policy.
4-Determining the most appropriate capital structure of the
company, its strategies and financial objectives and
approving its annual budgets.
5-Supervising the main capital expenses of the company
and acquisition/disposal of assets.
6-Deciding the performance objectives to be achieved and
supervising the implementation thereof and the overall
performance of the company.
7-Reviewing and approving the organizational and
functional structures of the company on a periodical basis.
8-Laying down rules for internal control systems and
supervising them.
9-Developing a written policy that would regulates
conflict of interest and remedy any possible cases of
conflict
10-Ensuring the integrity of the financial and accounting
procedures including procedures related to the preparation
of the financial reports.
11-Ensuring the implementation of control procedures
appropriate for risk management and disclosing them with
transparency.
12-laying a code of conduct for the company’s executives
and employees compatible with the proper professional
and ethical standards.
13- laying down procedures for supervising the code of
conduct.
14-Setting disclosure policies and procedures.
Board of Directors’ Independence
15-The majority of the members of the board of directors
are nonexecutives.
16-The chairman of the board of directors is prohibited to
conjoin this position with any other executive position in
the company.
Board of Directors’ Competence
17-The majority of the members of the board of directors
has accounting and finance qualifications.
18-The majority of the members of the board of directors
has adequate experience in accounting and finance.
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reproduction prohibited without permission.

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