The Management of Reported Earnings to Avoid Political Costs: A Study of Saudi Arabian Firms

Abstract

Allegations of accounting fraud in have attracted much attention from both the financial press and accounting regulators. This study provides evidence of the practice of deliberate earnings management on the part of managers in Saudi Arabia. The empirical analysis is carried out using a sample of 46 companies listed on the Saudi Stock Market over the period 2005-2007, using multivariate statistical analysis. After controlling for ownership diffusions, the study's overall findings confirm our expectation: managers of Saudi-listed companies which are large and have high ratio of foreign employees to total employees tend to manage earnings to avoid potential political costs. It is argued that these findings justify a detailed study of the political effects of the Saudi Government's Development Plans on the overall integrity of financial reporting in Saudi Arabia. Introduction After the 2006 accounting-related scandals in Saudi Arabia (e.g. Anaam International Holding Group and Bishah Agriculture Development Company), both the financial press and accounting regulator (Saudi Organization for Certified Public Accountants, hereafter SOCPA) have expressed concern about the pervasiveness of earnings management and the overall integrity of financial reporting in Saudi Arabia. The accounting empirical literature in Saudi Arabia indicates that earnings management behaviour does exist among Saudi-listed companies. Almoghaiwli (2001) focused on a single accounting policy, namely the Zakat policy, and provided empirical evidence on the relationship between the accounting treatment of Zakat by 48 Saudi-listed companies in 1995 and incentives for earnings management. Alsehali (2006) tested the relationship between aggregate accruals and incentives for earnings management. He found that, during the period 2001-2004, managers of 40 Saudi companies manipulate accruals in order to reach specific benchmarks in the level of reported earnings and understate any real unfavourable earnings (e.g. earnings losses or earnings decreases). This study is somewhat similar to the studies of Almoghaiwli (2001) and Alsehali (2006) in that its aim is to empirically investigate the factors that may explain the presence of earnings management in Saudi Arabia. However, our study differs from the two Saudi studies in that it develops an explicit link between the political process in Saudi Arabia and its effect on conducting earnings management behaviour. More specifically, the current study predicts that managers of Saudi-listed companies manage reported earrings so as to avoid the potential political costs of the goals of the 2005-2009 Saudi development plan including privatisation of government owned enterprises, end to the subsidisation, and replacement of foreign labour with Saudi workers. Furthermore, we follow the work of Dechow, Sloan, and Sweeney (1995) and Leuz, Nanda, and Wysocki (2003) in measuring earnings management by income smoothing variable, which is equal to one minus the contemporaneous correlation between the change in accounting accruals and the change in operating cash flow. We expect that this method would produce a more refined test of the research hypotheses and enhance the reliability of our study. The current study might also unique as it offers SOCPA new evidence on whether managers' political incentives in Saudi Arabia influence reported earnings, given that such evidence enables an improved understanding of the significant effect of accounting standards on resource allocation. The empirical analysis is carried out using a sample of 46 companies listed on the Saudi Stock Market over the period 2005-2007. The study's multivariate test results confirm our expectation: managers of Saudi-listed companies which are large and have high ratio of foreign employees to total employees tend to manage earnings to avoid potential political costs. The remainder of the paper is organised as follows. In section 2, we briefly review prior literature on earnings management. …