Corporate Governance and Earnings Management in Saudi Arabian Family-Controlled Companies - Research Proposal Example

Table of Contents Introduction …………………………………………………………………………………… 2 Problem statement …………………………………………………………………………….. 2 Aims and Objectives …………………………………………………………………………... 3 Rationale for the study ………………………………………………………………………… 4 Hypothesis of the study ………………………………………………………………….……... 5 Methodology ………………………………………………..………………………………… 6 Literature Review ……………………………………..…….……………………………..….. 7 Corporate Governance and earning management case study from Saudi Arabian family-controlled companies Introduction Corporate governance includes processes, laws, customs, policies, and institutions affecting the administering, directing and controlling of a corporation (or company). Corporate governance also entails relationships among the stakeholders involved in the company and the governing goals of the corporation (Bruno 2005). The principal stakeholders of the company are the shareholders, the board of directors and the management. Other stakeholders of a company include employees, suppliers, regulators, customers, creditors, and the community at large (Daniel 2007). Problem statement Earnings management has lately become a pressing issue in companies not only in current accounting practice within the companies but also in the debate on corporate governance (Thomas 2004). Managers sometimes tend to mislead stakeholders about the company’s underlying economic performance or influence some contractual (Thomas 2007) outcomes that depend solely on reported accounting figures by either using their own means of judgments in financial reporting (Williams 2004). They structure transactions to ensure they alter financial reports. Consequently, earnings management leads to a set of the company’s financial statements that do not really provide a fair and true representation of the company’s commercial activities and dealings with other corporations (Holton 2006, p.12-20). According to Healy (1999), the term earnings management is a situation that occurs when managers of a company use judgment in the company’s financial reporting and in transactions structuring to alter financial reports (Marie 2006). The routine is either to mislead some stakeholders of the company about the economic performance of a respective company or in pursuit of influencing contractual outcomes depending on reported accounting numbers (Daniel 2007). Earnings management mostly involves the artificial decrease or increase of profits, revenues, or earnings per share figures using aggressive accounting tactics (James 2008, p. 345). Aggressive earnings management can be said to be a form of fraud and it is completely different from a reporting error (Bruno 2005). The reasons for earnings management in a company are diverse and they range from the company’s intention to satisfy analysts’ of the company’s operations expectations to receive incentives to realize bonuses, or to help maintain a competitive position for the company within the financial market in the country (Thomas 2004). Legal earnings management happens only if the adjustment of the company’s financial reports is in line with the country’s financial reporting standards. Earnings management becomes is always fraudulent financial reporting incases where it falls outside these bounds or practices unacceptable accounting practice (James 2008, p. 345). Aims and Objectives The major aims of this research are to measure, evaluate, analyze, and provide guidance on initiatives employing to Corporate Governance and earning management in Saudi Arabia’s family controlled companies, and to foreshadow the impacts of the practice in these companies including production, trust and future developments of the company. It also aims at enhancing the contribution of the corporate sector in the realization of sustainability, with a focus on the country’s financial sector. To do so, the research advances and critically evaluates some of the practical and theoretical knowledge on the role played by the corporate sector. It provides significant insights and great recommendations to all companies and business leaders. It also aims at contributing to public discussions and shaping political agenda of the company on the role of the country’s corporate sector in realizing financial sustainability. Objective 1: Impacts of earning management in the companies operations Objective 2: Impacts of earning management to the future of Saudi Arabian companies The core objective of the research is exploring the consequences and limits of current country’s earnings management practices. In a first approach, “Earnings Management – impacts to the companies operations”, the research aims at shedding light on both retrogressive and current earnings management mechanisms and strategies. In a second approach, “Impacts on the future of Saudi Arabian companies” the study analyzes implications of earnings management to the future of contracting parties and investors in the company and outline recommendations for better management practices for these companies to safeguard the future of the corporate management sector. Leading academics in the research will share the results of their latest company researches including business schools. Corporate within the country’s system will also devolve good information on the topic to help come up with tangible information on earnings management. Rationale for the study The reason for the study is to outline companies in Saudi Arabia especially the family controlled companies in detailing and rating their performances putting across earnings management as a weigh measure. The study is important in improving the operations of the corporate in the Saudi Arabia system in relations to earnings management. Its main rationale is providing an overview of the status of the Saudi Arabian family controlled companies to give a clear perspective of how the companies are operation and the influence earnings management has in them. It also purposes to reveal the strengths and weakness of earning management in the family controlled companies to have a perfect detailing of what a good company’s profile looks like. It is meant to provide guidance into how a company in Saudi Arabia should operate in strengthening the corporate sector and stabilizing the country’s financial sector. The rationale of the study also revolves in the mission to identify valid operations and condone better practices in the family controlled companies. The research is a solution to providing a basis of rating Saudi Arabian family controlled companies to come up with a standard measure of verifying a legitimate company and its acceptable operations. The research will provide recommendations for the family controlled companies, which they can implement in facilitating a better running of the companies operations and enhancing a successful future for these companies therefore, stabilizing the country’s financial sector. Hypothesis of the study Earnings management has a major impact on family controlled companies in Saudi Arabia. The family controlled companies in Saudi Arabia under perform because of the poor decisions made in earnings management for the corporate in these companies. The future of the family controlled companies in Saudi Arabia is at stake. The companies risk a collapse in the near future. This is because of the poor approaches in the earnings management issue leading to loss of trust, confidence and future prospects of the respective companies. There is a strong relationship between the family controlled company operations and success in Saudi Arabia and the Corporate Governance and earning management. Corporate governance literature mostly advances the concept that certain aspects of a company’s board of directors', improve monitoring of the company’s managerial decisions (Holton 2006, p.12-20). Among these is the decision by the managers to manage earnings. Prior studies in this topic have shown that earnings management, in a common feature in public companies but less prevalent in case where a high level of board independence exists in a company. However, there is equally less evidence on the board independence effectiveness on earnings management in Saudi Arabia’s family-controlled companies (Simeon 2000). This issue is very interesting in particular; therefore, companies are susceptible to several types of agency concerns. It is the purpose of this research to shed light on the issue of Saudi Arabia’s company earnings management in family-controlled companies, with a characteristic of low board independence environment (Daniel 2007). In this research, board independence uses two parameters for its estimation including proportion of independent directors of the company and lack of Board Chairman or CEO duality function, with special focus paid to the situations where the CEO happens to be a controlling-family member. The research will provide empirical results with cleat evidence that the impact of a company’s board independence on earnings management is generally weaker in family-controlled companies in Saudi Arabia. The same effects in companies are also for the cases where the CEO of the company is a member or associated to the controlling-family (James 2008, p. 345). Methodology In this research on Corporate Governance and earning management from Saudi Arabia family-controlled companies, the methodology used is a case study analysis. It plays a role of analyzing a sample of the companies to involve in the research to derive data on earnings management. The case study will also purpose to identify the strengths and weakness of earnings management by comparing the several cases of family controlled companies in terms of their success in operations. In detail, the case study will also develop a standard measure of a company in Saudi Arabia in relation to earnings management to use in the verification of the other company’s operations. An analysis of the findings on data obtained from the company’s directors, managers, stakeholders and other parties will be done after the completion of data collection. The analysis, details coming up with situation analysis for the Corporate Governance and earning management in Saudi Arabian family-controlled companies. From the case analysis, recommendations will be drawn for the family controlled companies within Saudi Arabia on matters relating to Corporate Governance and earning management in order to improve their operations locally and globally. Literature Review Most of the Literature on the issue of earnings management focuses on public ownership companies (Simeon 2000). However, there is also evidence on the relationship between earnings management and board independence in family-controlled companies (Enrique 2007, p.117-140). Family-controlled companies are very prominent and prevalent around the globe characterized by different types of problems in their respective agencies (Holton 2006, p.12-20). A substantial portion of these problems in the respective companies is attributed to the prevalent conflict between company’s minority shareholders and the controlling-family. Suggestions from this case are that an independent company board is able to provide mitigations on agency problems that exist repetitively between the minority shareholders and the controlling-family (James 2008, p. 345). However, in respective family-controlled companies, the family typically has a major role to play in the governing of the company. For instance, it is liable to choose the members of the company’s board. Consequently, the role of board monitoring, and its effect may decrease when the structure of the board is determined by the controlling-family (Enrique 2007, p.117-140). There are many options available to board of directors of the company to improve top managers monitoring and enhance the reduction of agency problems. Empirical studies results indicate that a board with a higher level of independence results to a reduction of earnings management. Earnings management occurs in cases when managers' discretion particularly is used to alter respective financial statements to mislead stakeholders about the performance of the respective company or influence performance contractual outcomes of the same company. Many of the family controlled companies are non-financial, controlled by an individual owner in the company or by family-members related to the company who are block holders owning more than 50% of the capital in the company. Such a sample dichotomy in the company enables a through testing of the hypotheses in this study. The empirical findings of the research support the hypothesis of the impact of earning management on the company following board independence compromise in the occasion of the company’s governance (Bruno 2005). It is clear those family-controlled companies particularly, are prone to carry out the process of earnings management in avoiding covenant violation. The company follows these practices because the controlling families have a tendency to defend their respective controlling position within the company and among other competitors of the company (Enrique 2007, p.117-140). However, the respective family-controlled companies are not sensitive to the useful income-smoothing strategies, which are important in the operations of the company. This is the case with the companies tending to focus mainly on long-term benefits of the company rather than indulging in short-term investment strategies. A typical board structure of a company is composed of several outside directors, appointed by the shareholders of the company and assumed to act in the promotion of shareholders' interests (Crawford 2007, p.342). The board also includes top company's officers, possessing critical information that regards current and future operations and activities of the company, which is equally necessary for the board’s decision-making process, monitoring and performance evaluation (Marie 2008). However, the top management inclusion in the board among board members at times gives a rise to enormous conflict of interests because the management at times attempt transferring wealth from company’s stockholders using the advantage of information asymmetry. When the ownership concentration of the company is low, directors and top management may collude (Marie 2008). To mitigate such a possible agency problems in the company, shareholders must structure a board considering its ability to guarantee acceptable independence degree for all members (Crawford 2007, p.342). For example, the company’s board of directors must include several independent members including professionals who do not have a management role or any other business or company ownership ties. Such directors should have expertise, an institutional affiliation, and a professional reputation, which they have to preserve (Crawford 2007, p.342). Because of establishing such a board structure, there are less possibilities of collusion among the board members at the top management. Empirical evidence supports this theory widely adding that the presence of independent directors among the board members reduces an agency’s costs in all companies’ settings (Marie 2008). They show that in companies where independent directors are present they play an important role in management buyouts and in case where serious problems in the agency exist between shareholders and top managers (Crawford 2007, p.342). Another mechanism greatly used in increasing the board’s independence is separating the chairperson of the company’s board from the chief executive officer (CEO) of the company. This helps to avoid “CEO duality” in the company’s operations (Denis 2003, p. 1-36). From the agency theory perspective, the duality of the CEO forces a weakening of the board considerably reducing its ability to monitor management objectively. Crawford (2007) raises strong objection to this kind of a board's structure and makes suggestions of a separation between the two functions completely to do away with CEO duality. Because the chairperson functions to run board meetings as well as supervising the process of evaluating, hiring, firing, and compensating, the CEO together with top managers of the company, it is necessary and most crucial to separate the positions. This will help the board to monitor the operations of the company effectively and continually. In a recent paper reports, Crawford (2007, p.342) argued that CEO duality is the major cause of the reduction in the company risk-taking propensity, serving as the top most risk of minimization preferences (Marie 2008). The report also indicates that some traditional behavior control mechanisms for the managers are ineffective in the companies where CEO duality exists (Hovey 2007 p.138-156). In a prior study of companies, Denis (2003, p. 1-36) show that companies practicing CEO duality, forces a reaction in the stock market showing clearly and with evidence supports that CEO duality is a weakening element of the company’s future operations. CEO duality links with other ineffective governance signs, for instance in the cases of company’s hostile takeovers (Jean 2009) or in the use of “poison pills” within companies (Garrett 2008, p.123-145). Board independence is also a challenge in providing reliable financial reporting. Denis (2003, p. 1-36) suggests that in cases of a company’s weak internal control environment, there is a creation of more opportunities for the company’s management to carry out all its accounting manipulation and fraud (Foucault 2000, p.123). Since the board itself is the internal control environment, also handles the responsible to establish other control systems, a board, which is independent, reduces the company’s accounting manipulation and facilitates the improvement of the company’s financial reports reliability (Colley 2004, p.232). A recent paper (Clarke 2004) identifies characteristics of respective family-controlled companies that help in the reduction of such agency problems (Hovey 2007 p.138-156). In particular, families involved in the company are likely to have strong incentive more than atomistic shareholders in the practice of monitoring managers (Garrett 2008, p.123-145). This is because bond typically undiversified portfolios including primarily company investment (Gillespie 2010). Second, families have a tendency of involving themselves in and have the best knowledge of their respective businesses (Michael 2009), which makes them able to monitor the managers better (Denis 2003, p. 1-36). Third, since families have a tendency to have investment horizons in long term rather than other shareholders, apparently, they do away with any possible myopic decisions from the managers’ perspectives (Foucault 2000, p.123). In such a context within the company, the manager’s incentive to carry out situations of earnings management to hide their opportunistic behavior from the shareholders has a possibility of decreasing drastically (Crawford 2007, p.342). In this application, family-controlled companies take the definition as those companies with more than one family linked by kinship in the operations of the respective company (Garrett 2008, p.123-145). The company’s have close affinity and hold solid alliances indirectly or directly hold a large share of the capital that enables them to control major decisions in the board of the company (Colley 2004, p.232). A survey of Italian companies done in 2003 listed reports from non-financial companies indicating that 67% of the respective firms have a classification as, family-controlled companies. This particular feature of reports makes Italy a perfect setting to research (Marco 2004) on the topic of family-controlled companies (Clarke 2004). However, another very important feature details the Italian corporate setting making it a better ground for research and findings on understanding the corporate governance role issues (James 2010). The governance of the functions and responsibilities of boards of directors in Italy is through the Italian Civil Code (Cadbury 2007). According to the laws, board members appointment is done in the s annual meeting of the shareholders meaning that it is open for everyone (Colley 2004, p.232). This indicates that they have fair representation in the board for all shareholders and decisions are sound and favorable for everyone. However, the law is not clear on the number of company directors as well as its composition (James 2010). Nonetheless, with the Italian Stock Exchange adopting a 1999 “Corporate Governance Code” (CGC), the decision-making on any earning management issue is better and fair for respective shareholders (Colley 2004, p.232). The CGC has non-binding guidelines for the country’s corporate governance structures designed with an aim of protecting shareholders’ interests (Clarke 2004). Though these guidelines are not comprehensively legally binding, they are better when it comes to representing a “code of best practice” (Hovey 2007 p.138-156). The CGC also recognizes problems of the agency related to the CEO duality as well as its implications on the company’s effectiveness in the functioning of the board (Cadbury 2007). References Bruno, V 2005, "Corporate Governance in the U.K.: is the comply-or-explain working?" (December 2005). FMG CG Working Paper 001 Cadbury, A 2007, "The Code of Best Practice", Report of the Committee on the Financial Aspects of Corporate Governance, Gee and Co Ltd. Clarke, T 2004, "Theories of Corporate Governance: The Philosophical Foundations of Corporate Governance," London and New York: Rout ledge Colley, J 2004, what is Corporate Governance? 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