Can Corporate Governance Mechanism Reduce Earnings Management in Saudi Arabia?

Background of Saudi Arabia

Saudi Arabia is classified as one of the developing nations, located in Asia whose capital city is Riyadh. The state’s economy is majorly run through mining of petroleum products. A study conducted by (Alamri 2004) indicates that the country has a population of 25 million and covers an area estimated close to 2, 100, 00 Skm. It is further noted that 95% of the total land area is a desert (Al- Angari 2004). Due to the severe climatic condition, the only economic activity which favors this place is mining, specifically fossil fuels.

One of the primary reason which has contributed to the climatic change in the area is continuous falling of trees to create space for oil excavation. Forested areas have been invaded with the principal objective of extracting the valuable mineral (Albassam 2014). However, the trend has affected the agricultural activities negatively, making the country to be classified as mono-economy. The high population also has constrained the available resource to an extent of polluting the environment (Al-ghamdi and Al-angari 2005, p.49).

Additionally, the country has witnessed many reforms in the social and political environment. Around 1937, after the discovery of oil in Saudi Arabia, many people shifted from agricultural life and started mining the petroleum products (Alghamdi and Ali 2012). Other sectors of the economy were largely neglected, as people found the new mechanism to make money. However, the wells are gradually depleting, posing a danger to the populace. More reforms have been enacted by the government in conjunction with foreign state, to help in reviving the businesses. The trend is witnessed by movement of multination enterprises into the nation, to exploit the available opportunities. Similarly, the political influence has considerably changed. When the state started producing petroleum products, the government controlled the energy sector (Al-Harkan 2005). With the aim of developing an amicable relationship with other countries, Saudi joined OPEC, which controls the prices of the petroleum products. Moreover, Saudi Arabia has not been influenced by other nations regardingculture, and society. The official language is Arabic, which has continued to dominate (Al- Moataz and Basfar 2012, p.63). 

The system of leadership is Monarchy, where the king is central in controlling internal and external affairs (Beiner et al. 2004, p.329). The type of governance is based on the descendants of Abdul-Aziz, hence does not allow people to choose their leader of choice. All branches of power; executive, legislature and judicial are controlled by the king. According to Bhagat (2008, p.259), Saudi is a developing nation whose economy is sustained by oil production. The study affirms that it is the most significant source of petroleum products and contributes a quarter of total world’s oil consumption.  Other economic activities in the state have an insignificant impact on the GDP (CMA, 2012). However, irrespective of good income from the exports of the product, the government has not fully invested in education. Most of the technical experts are sourced from the foreign land, therefore, vulnerable to labor scarcity.

Although the economy of Saudi Arabia is relatively small in size compared to developed nations, it is one of the best performing in the third world countries(Coles et al. 2 .001,p.25). The trading environment has been improving gradually, and investors are getting interested in startup companies in these areas (Dehaene et al. 2001, p.384). The government has embraced the role of regulatory bodies which checks on the quality of services and products. Scholars consider that the changes which are enacted by the state departments are slow and might fail to survive in international business (Bhagat 2008).

Legal System

The development of a nation is dependent on the structures of the law governing different sectors of the economy (Denis and McConnel 2003, p.35). In business, there exist specific regulations which should be met by the entrepreneur. Similarly, the government has a responsibility to safeguard the rights of investors, to mitigate the chances of losing their monies. Saudi Arabian constitution is written based on Islamic tradition. The country has a withstanding relationship with United State and Britain, which influences their legal system and business regulations such as company law (Coles et al. 2001, p.46). Regarding social ethics, the law acknowledges equality and respect for humanity, as it is the belief of the Muslims. Additionally, all banks and financial institutions are measured based on international standards. Although the state has its mechanism to guarantee quality, the influence of foreign partners has shifted the attention of Saudi Arabia to focus on a broader scope of the market by comparing their productivity with other players in global trade.

Monitoring Bodies

The performance of the country is dependent on how well the respective quality assurance bodies execute their work. According to Capital Market Authority (2007), one aspect that distinguishes an impoverished nation and the developed one is the state of earnings management. Countries with high monitoring bodies perform better regarding GDP because the loss of revenue is mitigated (Alamri 2014). There are various agencies, both private and government-owned, trusted to assist in unearthing rogue mechanism of doing business. Saudi Arabia has developed its economy and managed to establish different organizations that monitor the trading activities. Some of them are discussed in the following paragraphs.

Ministry of Commerce & Industry (MCI)

It is considered the main body of monitoring the companies in Saudi Arabia. Over the years, significant changes have occurred within this organization, aiming to improve the state of service delivery (Alshehri 2012). Some of the roles performed by the members are regulating the entry and exit of the market. The country’s development is witnessed when the firms are doing legal and acceptable businesses.  The role of this body is to ensure the entrepreneurs perform the activities which meet the standards stipulated during the registration period. Additionally, MCI supervise industries and companies to mitigate the chances of exploiting the customers (Al-Mousa and Al-Adeem 2017, p.9).Setting regulations under which similar businesses should operate erodes the possibility of unhealthy competition, which is the source of compromising the quality of products.

Capital Market Authority

It started in the 1950s as the unofficial organization, before gaining full independence in 2004, after the authority realized its success in helping the businesses to perform well (Al-Tonsi 2003). It comprises of five board members who report directly to the minister. Some of the roles played by CMA are protecting the dealers and investors from illegal activities which might lead to litigations. Also, it regulates the companies by providing policies that increase investments and transparency in the market. Since the organization has administrative autonomy, the leaders are not supposed to involve in any commercial practices (Beasley et al. 2000, p.42). The duties can be summarized as providing security to the investors from unsound practices, reducing risks through the enactment of standards and measures, monitoring all trading activities in Saudi Arabia and enhancing efficiency in the market. The organization has a pertinent role in improving the economic performance.

Saudi Stock Exchange.

Stock is the prerequisite for the economic growth to be realized in a nation. It is defined as the trading of currency with the aim of making profit. Banks and government agencies indulge in this business, to make more money to finance pertinent developmental agendas within the country. According to Capital Market Authority (2011), factors such as political instability and unfavorable investment environment lowers the confidence of entrepreneurs, hence affecting the stock exchange negatively. In Saudi Arabia, the stock market is self-regulated and is formed by nine members, who are answerable to the prime minister (Capital Market Authority 2010). Among the nine, five comes from government ministries while four are from a brokerage firm.

Listing of companies started in 1936 when the first automobile company in Arabia took part in stock exchange market (Bhagat and Bolton 2008). Through the year 1976, there was a rapid increase of firms, which coincided with the tremendous surge of oil prices. Additionally, buying of shares from foreign investors and banks increased the number of industries and banks. The control of stock was informal since there was no permanent body within the country’s law that provided policies and regulation regarding the market. The government formed a committee from the ministry of commerce that oversaw the various economic activities. Towards the year 2004, stock exchange was fully established with responsibilities of ensuring the institutions followed the set trading rules (Beiner et al. 2004, p.328).

The recent trends witnessed in the Saudi is privatization of companies and industries by the government (Faraj 2014). Family and private industries are converted to public management leading to a large number of businesses under this category. A study released by Capital Market Authority (2012) identified that the number of listed firms have projected from 81 to around 144, distributed all over the country. Through this move, more investors have been attracted to the nation because it is more stable. Some of the responsibilities of the stock exchange market are; support the education of investors and creation of awareness concerning the market, ensure integrity in the market and coordinate the trading activities to bring excellence. The table below indicates market share among different companies between 2001 to 2009 (Faraj 2014).

Table 1: Listed companies between 2001 and 2009(Faraj 2014)

The table above indicates the number of companies within Saudi Arabia between 2001 and 2009, and the market share which they claimed at that time. The data suggest that there has been an increase of registered companies due to privatization.

Certified Public Accountants Organization (SOCPA)

The organization is managed by members who are selected by the ministry of commerce (Bukhari 2014). The appropriate role they are tasked with is the auditing and accounting for the various activities performed by companies in the country. One of the primary reason the government has embraced and promoted quality assurance is to reinforce the culture of excellence and transparency in reporting the revenues collected. Some of the roles mandated for this body are; publishing of accounting and auditing policies standards on significant topics to expose the users to the new development in the area, monitoring the actions of professionals to ensure that they conforms to the laid down standards, researching on new growth in the field and holding conferences to educate the public and stakeholders on the best practices (Chan and Li 2008, p.17).

Challenges Facing the Governance Framework

The four bodies which have been discussed (CMA, MCI, the stock market, and Certified Accountants Body) plays a vital role in enhancing trading activities within the country. However, they are faced with some challenges which impede them from adhering to their full requirements (Coles et al. 2001, p.26). The first problem is little confidence from the investors and the locals. Until recently, Saudi has been operating on a mono system. The primary economic activity which has been sustaining the populace is oil products. Foreign companies had little hope of performing well in this nation due to lack of policies to guarantee their survival in the volatile market (Dehaene et al. 2001, p.385). Additionally, the government has not funded the organization adequately to do their work independently. For any state managed body to actualize its job well, enough resources are needed to facilitate their oversight role. Saudi Arabia has been embracing the functions of these institutions slowly, compared to the developed states. Furthermore, the cost associated with entering CMA is cumbersome. Businesses opt to look for other inexpensive methods to raise the income, like diversifying the investments.

Internal Governance Framework

The model through which various businesses operate in Saudi Arabia is regulated and managed by authorized bodies whose functions are found within the country’s law. According to Dennis and McConnel (2003, p.32), there are stipulated ethical standards and policies which directs on what the companies are supposed to do. Various bodies such as CMA are trusted with performance enactment. The following paragraphs will discuss pertinent internal governance within the state.

Corporate Governance Code

It refers to the predefined policies and rules which guides the businesses within the nation. Saudi Arabia has well-established standards that are gaining momentum with time. The government and private sectors are working conjointly to facilitate the favorable trading environment for any investor (Falgi 2009). The major importance of having a laid down way of doing things mitigate malpractices in various sectors. The ministry of Commerce recognizes that the rights of the shareholders should be respected regarding offering the right dividends and in a timely manner (Falgi 2009). Consequently, any person with more than twenty shares is allowed to attend general meetings which discuss financial matters of organizations (Faraj 2014). Moreover, disclosure and transparency of revenues is a requirement for any listed firm. The adoption of corporate governance codes was influenced by the changing trends of doing business in the world, where individual measures of regulations weretaken to compete favorably with international enterprises.

Listing Rules and Corporate Governance Mechanisms

Companies listed in the stock exchange market are regulated by specific policies to eliminate illegal practices (Hariri 2013). The Saudi Arabia CMA published amended rules which were the development of the previous regime. Some of the changes enacted were; every company is expected to appoint a financial and legal advisor, as a means of adhering to the quality standards. Additionally, the investors are given the right to withdraw or amend their subscriptions (Saudi Arabian Monetary Agency 2009). Corporate governance is the process through which organization’s objectives are aligned with the market environment. The country has adopted external monitoring as the form of mechanism to track the actions of various businesses. The bodies oversee performance and offer corrective measures. Furthermore, independent audit of different companies is embraced, to foster accountability in the financial reporting (Faraj 2014).

Saudi Companies Act and Corporate Governance Mechanisms

The current Act has significant improvements compared to what was previously used in the country. With the new changes, it is clear on how the new companies will be entering the market (Stainbank and Ramatho 2008, p.156).  Additionally, corporate restructuring is provided for, with an introduction of companies with the single shareholder.  Before the proposal of the current regulations, Saudi Arabia only allowed groups whose formation comprised of more than two members. According to Faraj (2014), the new policies will also affect the governance of businesses, with external monitoring being embraced.

Challenges Facing the Internal Governance Framework

The critical element in governance is financial aspect. Compliance costs are enormous to an organization. It is estimated that companies in Saudi Arabia spend an estimate of 40% to cover the cost of required standards (Falgi 2009). Investors are discouraged from entering such a market hence look for alternatives in other countries. Second, an entrepreneur in this country perceive the new mechanisms of regulating their activities as a threat (Hariri 2013). They find it as constraints to their work as opposed to the anticipated effects. The local investors fail to accommodate the changes hence results to declining production.  Pressure from the public on regulators is undoubtedly another challenge. The political class and business owners might deliberately fail to honor the suggestions given by the registered regulatory organization, slowing down the expected growth (Wan and Ong 2005, p.278).

The Accounting and Auditing Profession in Saudi Arabia

The field has undergone several transitions over the years, until today when Saudi Arabia can enjoy some of the positive outcomes of incorporating the skills in the running of its economy (Xie et al. 2003, p.298). Before the emergence of company law in 1965, the country lacked certified auditors and this period witnessed high licensing of unsatisfactory companies (Yermack 1996, p.187). In 1991, there were more efforts by both the government and educational institutions to bring the profession into play. The auditing and accounting field establishment coincided with the formation of certified accountant’s body that maintained standards and also researched best accounting practices. Although tremendous achievements have been realized in accounting and auditing profession, there are challenges which threaten their performance. Some of them are’ monopoly of services, lowering of audit fees and lack of competence. The stated issues impair the quality of services offered in the country.

Ownership Structure in Saudi Arabia

A study conducted by Capital Market Authority (2012) revealed that 75% of the companies in Saudi Arabia are family owned. It was further noted that the government dominated public utilities. From the year 2005, the country has witnessed a myriad of reforms that have shaped the market (Farah 2014). In the year 2006, corporate governance was implemented with all companies adopting the new change. Along, most of the organizations were privatized, and market globalization was considered as an alternative to explore new opportunities. The improvement distributed the ownership of firms which was previously confined to the family and state.

Summary

Saudi Arabia’s history is short in comparison to the other countries. The economy of this nation stemmed out from agricultural, to stand as the top in the Middle East. The system of leadership is the monarchy, based on Islam law, which influences business environment. However, the state has adopted other regulations derived from the most developed countries such as United State. The recent trend of privatization has helped re-distribution of the ownership structure from family and state-owned.

This chapter discusses the monitoring bodies that supervise the activities of the companies within the nation. The literature reveals that such organizations shape the economic environment, by coming up with regulations and policies that control the trading activities. Accounting standards are widely discussed with reference to the developed nations. The work reveals that corporate governance is at nascent phases in Saudi Arabia. Inefficient legal framework has contributed to the slow development of the system. Additionally, there is lack of accountability from different institution mandated to conduct the oversight roles.

The chapter has also detailed the historical development of accounting profession. Researchers affirm that the profession has faced challenges such as monopoly of auditing by a few firms. The trend denies other people from practicing, hence forcing them out of the market. Second, illegal competition from the unlicensed companies obscures fair representation in the economy. Low audit fees also discourage the professional from engaging in any monitoring tasks. It has been cited as a major cause for improper reporting of the financial statement since the auditors resort to bribes to meet their interests. Overall, the chapter has given a complete overview of Saudi Arabia, focusing on the legal system, corporate governance, and ownership structure.

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