Monitoring and Credibility of Financial Statement

This chapter reviews previous studies related to the credibility of financial statement, market reaction, corporate governance and other monitoring mechanisms. In other words, it looks at how investors perceive the credibility of financialA statement reportA and market reaction. Financial statement credibility has declined because accounting defects raise questions within the investment community about internal controls, management integrity, audit committee oversight, external auditor quality, etc. In existing academic literature, several determinants explain the investor reaction to financial statement report. This chapter discusses several literature related to financial credibility and stock price reaction, monitoring and credibility of financial statement.

2.2 Some study on financial reporting in Saudi Arabia

Based on a sample of non-financial Saudi companies listed on the Saudi Stock Exchange, Naser and Nuseibeh (2003) assess the quality of information disclosed. They compare the extent of corporate disclosure before and after the creation of the SOCPA. They classify information disclosed in the annual reports into three main categories: mandatory, voluntary related to mandatory, and voluntary unrelated to mandatory disclosure. The results indicate a relatively high compliance with the mandatory requirements in all industries covered by the study, with the exception of the electricity sector. As for the voluntary disclosure, whether related or unrelated to mandatory disclosure, the analysis reveals that Saudi companies disclose information more than the minimum required by law. The level of voluntary disclosure, however, is relatively low. The analysis also shows that the creation of SOCPA has had little impact on corporate reporting in Saudi Arabia. Alsaeed, K. (2006) investigates the impact of several firm characteristics on the extent of voluntary disclosure. The results show that the mean of the disclosure index was lower than average. Also, it was found that firm size was significantly positively associated with the level of disclosure. The remaining variables, however, were found to be insignificant in explaining the variation of voluntary disclosure. Based on data collected via questionnaires, five user groups were selected to examine their attitudes towards companies' annual financial statement in Saudi Arabia. Naser and Nuseibeh (2003) examine the usefulness of the annual report of Saudi joint stock companies. The subject groups were individual investors, institutional investors, financial analysts, bank credit officers, and government representatives. The analyses indicate that the user groups surveyed in the study rely mainly on information made directly available by the company and do not consult intermediary sources of corporate information in order to make informed decisions. The result is expected in a developing country like Saudi Arabia where there is a limited number of listed companies and where businesses and financial communities have many social and business links, resulting in relatively easy interaction between the user groups and related companies. In the same context, users may perceive some information sources to be important in an absolute term. In a Survey of five major user groups, namely individual investors, institutional investors, creditors, government officials and financial analysts (users of corporate annual reports in Saudi Arabia), Al-Razeen, and Karbhari (2004) examine the perceptions of the users of annual corporate reports. The focus is on the use and importance of the seven different sources of corporate information contained in Saudi annual reports. The result indicated that the balance sheet and the income statement are the most important sections of the annual report to most of the Saudi user groups. The board of directors' report was found to be the least popular. Al-Sehali and Spear (2004) examine the decision relevance and timeliness of accounting earnings in Saudi Arabia during the 1995-1999 sample periods. The result shows that the publication of accounting earnings leads individual investors to revise their security holdings. However, this evidence is limited to cases where firms reported profit. Using a combination of mail questionnaires and semi-structured interviews, Haniffa, R. and M. Hudaib (2007) investigate if the business and social environment affect the perceptions of audit performance of users and auditors. The results further indicate the 'performance gap' arises from four factors in the environment within which auditing is practiced: licensing policy, recruitment process, the political and legal structure and dominant societal values. Interview results reveal the influence of institutional and cultural settings on the audit expectations gap and indicate that the inclusion of Islamic principles in auditing standards and the code of ethics would help reduce the expectations gap that exists in Saudi Arabia.

Table 1: Summary of previous studies examining

Financial reporting in Saudi Arabia

Year of study

Author

Variables used

Result

2003 Naser, K. and R. Nuseibeh Type of information (mandatory vs.voluntary) and the effect of SOCPA creation on the level of accounting disclosure By using a sample of non-financial Saudi Companies listed on the Saudi Stock Exchange. The results of the analysis indicated a relatively high compliance with the mandatory requirements in all industries covered by the study, with the exception of the electricity sector. As for the voluntary disclosure, whether related or unrelated to mandatory disclosure, the analysis revealed that Saudi companies disclose information more than the minimum required by law. 2006 Alsaeed, K Firm size, debt, ownership dispersion, firm age, profit margin, return on equity, liquidity, industry type and audit firm sizeas well asthe extent of voluntary disclosure. The results show that the mean of the disclosure index was lower than average. Also, it was found that firm size was significantly positively associated with the level of disclosure. The remaining variables, however, were found to be insignificant in explaining the variation of voluntary disclosure. 2003 Naser, K. and R. Nuseibeh The perception of seven groups(individual investors, institutional investors, financial analysts, bank credit officers, and government representatives) of the usefulness of the annual report The analyses indicate that the user groups surveyed in the study rely mainly on information made directly available by the company and do not consult intermediary sources of corporate information in order to make informed decisions. 2004 Al-Razeen The perception of five major user groups, namely individual investors, institutional investors, creditors, government officials, and financial analysts. The seven different sourcesof corporate information includethe board of director's report, the auditor's report, the balance sheet, the income statement, the statement of retained earnings, cash flow statements and the notes to the financial statements The study found that the balance sheet and the income statement are the most important sections of the annual report to most of the Saudi usergroups. The board of directors' report was found to be the least popular. 2004 Al-Sehali and Spear the decision relevance and timeliness of accounting earnings It appears that the publication of accounting earnings leads individual investors to revise their security holdings. However, this evidence is limited to cases where firms reported profit. The empirical results further suggest that earnings are timely in terms of their association with security returns and that increasing the measurement interval significantly improves this association. The tests also show that positive and negative earnings have differential implications for the timeliness of accounting earnings. 2007 Haniffa, R. and M. Hudaib business and social environment factors and audit expectation gap The results further indicate the 'performance gap' arises from four factors in the environment within which auditing is practiced: licensing policy, recruitment process, the political and legal structure, and dominant societal values.

2.3 Agency theory and market reaction

An agency relationship exists when a person or an agent is hired by a principal or owner to make decisions on behalf of the principal. Agency problem arises when the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify what the agent is actually doing. The problem here is that the principal cannot verify that the agent has behaved appropriately. The main focus of the theory in the agency relationship is the selection of appropriate governance mechanisms between principal and agents that will ensure an efficient alignment of principal and agent interests. Its goal is to ensure that agents serve the interests of the principals thereby minimizing agency costs. Agency relationship is used by Jensen (1986) to propose a theory which is widely known as 'Jensen free cash flow theory'. According to Jensen, the free cash flow exists in a company when there are excess funds left over after taking into account all positive net present value projects. He argues that conflict of interest between shareholders and managers over the payout policies of these free cash flows could explain the stock price reaction. The theory predicts that stock prices will increase if there is an unexpected dividend payment or stock repurchase announcement and will decrease if an unexpected increase in demand for funds through equity offering is announced for companies experiencing positive free cash flows. The negative impact in stock price may be due to likelihood that management may misuse the funds which are under their control; as a result, the market gives a lower valuation of the company's shares.

2.4 Agency theory, financial credibility, and stock price reaction

.

A  Agency problems in organizations result from the separation of ownership and control. As a result of this agency problem, managers have incentives to take actions that maximize shareholder wealth. The existence of such incentives reduces the credibility of the reported earnings numbers. External and internal controls are mechanisms to minimize these agency problems and to enhance the quality of reported earnings number. The absence of external and internal controls may result in reducing the credibility of financial reports. The impact of these monitoring mechanisms on the credibility of financial disclosures is likely to be proportional to the extent to which managers have incentives to distort these numbers. The existence of control system, that prevents or limits the degree of manipulation of accounting numbers that managers can engage in, will increase investor reliance on financial numbers, and hence, the greater the likelihood of establishing credibility in accounting numbers. Financial accounting information is the product of corporate accounting and reporting systems that measures and publicly discloses audited data concerning the financial position and performance of publicly held firms. Financial accounting systems provide direct and indirect input to corporate control mechanisms by contributing to the information contained in stock prices. The credibility of financial reporting reduces the information asymmetry between corporate manager and stockholder, improves investors confidence and raises the stock prices .A share price reaction to the release of financial information is taken to indicate that the announcement has information content while a high association between financial information and share price or returns over an extended period of time indicates that information provided by the accounting system reflects information that is being used by the capital market and this information will come from a multitude of sources. Capital market research often involves examining relations between financial information and share prices or returns. Reactions of investors are evidenced by their capital market transactions. Favorable reactions to information are presumed to be evidenced by price increase in the particular security, whereas unfavorable reactions to information are evidenced by a price decrease. No price change around the time of the release of information implies the information release does not provide anything that is new. Researchers in this area have begun to examine whether the stock price reaction to earnings surprises is related to the quality of the reported earnings numbers. Imhoff and Lobo (1992) find that firms with low consensus in the analysts' forecasts of earnings tend to have a low ERC??. Although it is possible that high prior uncertainty about the underlying value of the firm would also increase the dispersion in forecasts, Imhoff and Lobo conclude that it is more likely to proxy for the noise ???in accounting measures than for any prior uncertainty about underlying cash flows. Dey (2005) mentions that despite the lack of rigorous empirical evidence, there appears to be a long standing assumption that good governance is conducive to greater financial reporting credibility, particularly among regulators and legislators. For example, SOA of 2002, states one of its primary objectives as that of restoring investor confidence in corporate disclosures by mandating several governance reforms. Even prior to SOX, the recommendations of the COSO of the Treadway Commission (1992) , the Public Oversight Board (POB) of the SEC proactive division of the AICPA (1988; 1995), the Cadbury Committee Report on Financial Aspects of Corporate Governance (1992), among others, implicitly assert that various features of governance increase the credibility of financial statements.

2.5 Monitoring and credibility of financial statement

Jensen and Meckling (1976) define agency costs as the sum of monitoring costs, bonding costs and residual loss. Monitoring costs are expenditures paid by the principal to measure, observe and control agent's behavior. Despite the existence of the agency problems and agency cost discussed, the modern corporation, with the diffused share ownership which leads to such conflicts, has continued to be popular amongst both corporate managers and outside investors alike. This could be attributed largely to the evolution of internal and external monitoring mechanisms which are aimed at controlling such problems. It should be noted that there does tend to be a degree of interaction between each type of mechanism within firms. A contradictory view of monitoring has been provided by Burkart, et al. (1997). They argue that too much will constrain managerial initiative. Optimal levels of monitoring managerial policies are specific to an individual firm's contracting environment, (Himmelberg, et al., 1999). In the same context, critics of Cadbury (1992) have felt that this increased level of monitoring may act as a deterrent to managerial entrepreneurship. In relation to this, an argument has been provided by Himmelberg et al. (1999), that firms will tend to substitute various mechanisms depending on unobservable (to the econometrician) characteristics of the firm's contracting environment. Since this contracting group varies dramatically from one firm to the next, what is optimal for one need not be optimal for others. Within this context, Agrawal and Knoeber (1996) argue that if one specific mechanism is utilized to a lesser degree, others may be used more, resulting in equally good decision making and performance. Denis and Sarin (1997) argue that effective monitoring will be restricted to certain groups or individuals. Such monitors must have the necessary expertise and incentives to fully monitor management, in addition, such monitors must provide a credible threat to management's control of the company. Shleifer and Vishny (1997) point out that concentration of ownership is an effective form of monitoring as coordinating voting by small shareholders is a costly proposition. Additionally, they point to providers of debt capital as effective monitors since their preference for a specific course of action given mismanagement or default is generally written into debt covenants. Datta, et al. (1999) argue that banks, as insiders, have access to inside information whereas public must rely mostly on publicly available information. Because they have superior information, banks can provide more efficient monitoring which lowers the monitoring and bonding costs of other debt claimants. Certain aspects of monitoring may also be imposed by legislative practices. In the UK, companies are required to provide statements of compliance with the Cadbury (1992) and Greenbury (1995) reports on corporate governance. Non-compliance must be disclosed and explained, and the attention brought by statements of non-compliance will represent an additional source of monitoring.

2.5.1 Corporate governance and reporting quality

Different theories (such as contract theory and agency theory) have been used to explain the role of corporate governance in increasing financial reporting quality by playing a crucial role in monitoring senior management. The notion of a separation of ownership and control implies a pathological condition carrying with it a presumption of the failure of market to supply a complete solution to managerial inefficiency and need for some form of regulatory intervention. There is the idea that there is a disciplinary gap in the modern public company because the shareholders fail to supervise management. From the perspective of contact theory, the members are not owners but simply one of several contracting parties supplying a factor of production, in their case, capital to joint enterprise since shareholders as preponderantly sophisticated financial institutions, would not be willing to provide capital other than on terms that adequately safeguard their interests. It can be assumed that the contractual process will result in the adoption of appropriate governance provisions from which outside intervention can only detract. Mangers who offer inadequate governance terms will suffer market penalties and hence they have an incentive to adopt controls that will be attractive to investors (Sheikh, and Rees 1995). The design of mechanisms for effective corporate control to make managers act in the best interest of shareholders has been a major concern in the area of corporate governance and finance. From the perspective of agency theory in a corporation, the shareholders are the principals and the managers are the agents working on behalf of, and for the interests of, the principals. A well-developed market for corporate controls is needed to solve problems of market failures, moral hazards, asymmetric information, and incomplete contracts. Various governance mechanisms have been advocated which include monitoring by financial institutions, prudent market competition, executive compensation, debt, developing an effective board of directors, markets for corporate control and concentrated holdings ( Bonazzi, and Islam (2007)). John and Senbet (1998) define corporate governance as the mechanism by which the stakeholders of a corporation exercise control over corporate insiders and management such that their interests are protected. Corporate governance therefore deals with the interests of stakeholders (which include parties like labor unions, consumer interests, etc). Corporate governance in this context is the control mechanism for efficient operation of a corporation on behalf of the stakeholder. According to Watts and Zimmerman (1986), corporate governance as a monitoring tool, has the ability to enhance the reliability of accounting earnings; and consequently, increase the informativeness of accounting earnings. Moreover, corporate governance helps investors by reducing the conflict of interest between managers and shareholders, enhancing the reliability of financial information and the integrity of the financial reporting process. Fama and Jensen (1983) argue that effective corporate boards would be composed largely of outside independent directors holding managerial positions in other companies. They argue that effective boards had to separate the problems of decision management and decision control. However, if the CEO was able to dominate the board, separation of these functions would be more difficult, and shareholders would suffer as a result. Corporate boards should act as monitors in disagreements amongst internal managers and carry out tasks involving serious agency problems A central problem in conducting an event study of the valuation effects of implementing corporate governance is that most implementation affects all firms in a country. However, Share price changes may reflect the implementation, but could also reflect other information. According to McColgan (2001), effective corporate governance by company boards requires both good information provided by insiders and the will to act on negative information provided by outsiders. Vafeas (2000) examines whether the informativeness of earnings is proxied by the earnings returns relationship, varies with the fraction of outside directors serving on the board and board size. The results suggest that earnings of firms with the smallest boards are perceived as being more informative by market participants. Black and Khanna (2007) suggest that properly designed mandatory corporate governance reforms can increase share prices in an emerging market such as India. Dey (2005) finds that most aspects of corporate governance are significantly associated with the credibility of reported earnings for firms in highest agency cost group. Lee, et al. (2005) examines how listed Chinese companies' governance practices affect domestic investors' reaction to their earnings reports. Choi, Frye, and Yang (2008) find that firms with weak shareholder rights experienced positive abnormal returns when SOX was passed. Using data for a sample of Canadian firms in the years 2001-2004, Niu, (2006), examines the association between corporate governance mechanisms and the quality of accounting earnings. He used two measurements for quality of earnings: accounting-based measurement (earnings management) and the market-based measurement (earnings informativeness). The result demonstrates that overall governance quality is negatively related to the level of abnormal accruals and positively influences the return-earnings association. Klapper and Love (2004) stated that greater investor protection increases investors' willingness to provide financing and should be reflected in lower costs and greater availability of external financing. This suggests that firms with the greatest needs for financing in the future benefit the most from adopting better governance mechanisms.

2.5.2 Internal control system

According to The Public Company Accounting Oversight Board (PCAOB), auditing standard differentiates three levels of internal control deficiencies based on the severity of the deficiencies. Control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. A significant deficiency is defined as a control deficiency, or combination of control deficiencies, that adversely affects the company's ability to initiate, authorize, record and process external financial data reliably in accordance with generally accepted accounting principles, such that there is more than a remote likelihood that a misstatement of the company's annual or interim financial statements that is more than inconsequential will not be prevented or detected. ????A material weakness is defined as a significant deficiency, or combination of the annual or interim financial statements that will not be prevented or detected. Saudi corporate governance code section (9 G) requires public companies to include in each annual report the auditors and managements' assessment on the effectiveness of the internal control system as a part of board of directors' report. In relation to this, samples used consists of the companies that report internal control weaknesses under SOX 302 and SOX 404, companies that report an effective internal control system under SOX 404, for fiscal years 2001-2004. Bedard, et al., 2006, investigate the relation between the SOX, internal control requirements and earnings quality. The result indicates that internal control deficiencies have an effect on financial statement quality as measured by unexpected accruals. In univariate analysis, Ashbaugh et. al. (2005) find that firms that report internal control deficiencies have greater performance adjusted total abnormal accruals and abnormal working capital accruals. Gupta and Nayar (2007) examine whether such internal control weakness disclosures convey valuation-relevant information to the US equity markets. This issue is important because increasing disclosure requirements without any attendant effect on valuation would impose unnecessary deadweight costs on the shareholders of a company. Thus, to understand whether such disclosures about the effectiveness of a company's internal controls over financial reporting have any new information content, they studied a number of voluntary disclosures made by the SEC registrants in the very early days of the SOX implementation. They find that internal control weakness disclosures are associated with a negative stock price reaction, on average, indicating that such disclosures do indeed convey valuation-relevant information. However, Browna et al. (2008) mention that prior studies of internal control disclosures under the 2002 SOX provide limited evidence on the impact of internal control regulation on reporting quality. Moreover, there is no empirical evidence on the reporting quality effects of mandatory internal control reforms in non-U.S. environments.

2.5.3 Audit Quality

The demand for auditing services arises from a desire to reduce the divergence of interests and information asymmetry between the owners (the principal) and mangers (the agent) in a principal agent relationship (Jensen, and Meckling, 1976). Managers can voluntarily increase the transparency of their actions by hiring independent auditors to monitor their behavior. As a result of the increase in the complexity of business structures, globalization activities and separation of fund providers from management, further assurance about the financial information provided by companies is expected from auditors. Controlling owners may employ different monitoring and bonding mechanisms to assure minority shareholders that their interests are protected. One of these monitorinig devices is extranal auditor. Recent research provides empirical evidence that high quality independent audits are used as monitoring and bonding mechanisms to alleviate agency costs (Fan and Wong, 2005). Teoh and Wong (1993) provide evidence that better quality auditors are associated with more credible financial reports, implying that high quality auditors give greater credibility and better quality to financial statements. By using a comprehensive sample of Joint stock companies audited by Arthur Andersen & Co (AAC), in Saudi Arabia, Al-Abbas, 2007 examines whether the criminal indictment has resulted in losses suffered by stock prices of Andersen's clients. The study reported no effect of this event on the returns.

2.5.4 Institutional ownership

Institutional investors provide another monitoring instrument on managers; Chung et al. (2002) indicate that large institutional shareholdings deter mangers from practicing their discretion over accruals. Fisher (2007) indicates that Jensen and Meckling's 1976 classification of residual loss of wealth in summary, predicts that the management may not always restrict their investment activity to positive present value projects. When negative present value projects are selected (and conversely, when positive present value projects are rejected), shareholders suffer a loss of wealth. The theory predicts that this wealth loss is negatively associated with the effectiveness of the monitoring regime (by capital providers) at the time of the investment decision. Monks and Minow (1995) state that Institutional investors have the opportunity, resources, and ability to monitor, discipline, and influence managers of firms. Hotchkiss and Strickland (2003) find that abnormal trading volume and increased variance at earnings announcements are related to the composition of institutional ownership.

2.5.2 Banks borrowing

The relation between managers and shareholders is not the only contract that induces firms to manage accounting reports, for example, debt contracts also provide managers with such incentives, thus possibly reducing the reliability of reported accounting numbers. Banks are an important corporate governance mechanism. Banks screen loan applicants before establishing firm and bank relationships to minimize unfavorable selection problems. They also monitor borrowers after bank loans are made to minimize moral hazard problems. Bank loans are different from publicly placed debt because banks know more about a company's prospects than other investors do. Shleifer and Vishny (1997) state that despite a number of theoretical discussions about governance by banks, there is little empirical evidence of their role. Boscaljon and Ho (2005) suggest that commercial banks from quality lenders play an increased role in reducing information asymmetries in environments where there is greater economic uncertainty. Easterbrook (1984) argues that external capital market monitoring brought to companies by debt financing forces managers in value maximizing strategies, rather than personal utility maximization. Carey, et al. (1998) conclude that financial institutions in general are intensive monitors but, due to regulatory and reputational factors, compared to finance companies, banks lend to less risky firms. Martel and Padron (2006) show that the Spanish Stock Market reacts positively and significantly to debt issue announcements. Given that the announcement of a bank credit agreement conveys positive news to the stock market about the borrowing firms, James (1987) documents a positive stock price response for bank loan agreements. Managerial risk aversion will also affect the financial policy of the firm. Higher debt is expected to reduce agency conflicts; Jensen (1986) also argues that the existence of debt in the firm's capital structure acts as a bonding mechanism for company managers. By issuing debt, rather than paying dividends, managers contractually bind themselves to pay out future cash flows in a way unachievable through dividends.

Table 1: Summary of previous studies examining

Corporate governance and other monitoring mechanisms with market reaction

and financial quality

Authors/ year Country IV DV result Jain and Rezaee (2006) USA Corporate governance, financial reporting quality, and audit quality. Accumulated abnormal return A positiveA A abnormalA returnA at theA time A ofA severalA legislativeA eventsA thatA increasedA theA likelihoodA ofA theA passage of the Act.

Lee,et.al. (2005) China Corporate governance Investors' reaction to their earnings reports. Investors in the domestically listed Chinese companies do seem to base their valuation decisions, at least in part, on these companies' earnings reports. This was indicated by the significant relationship between 'unexpected earnings and cumulative abnormal returns. However, the hypothesized effects of governance practice/choice is, on the whole, not supported. Niu (2006) Canada Corporate governance Earning quality Empirical tests demonstrate that overall governance quality is negatively related to the level of abnormal accruals and positively influences the return-earnings association Black, and Khanna ,(2007) India Corporate governance reforms Firms' Market Values They conclude that investors expected the Clause 49 reforms to benefit large firms, and likely also medium-sized firms. This suggests that properly designed mandatory corporate governance reforms can increase share prices in an emerging market such as India. Bhattacharyya and Rao (2005) India Corporate governance reforms volatility and returns The authors find insignificant results for volatility (volatility is lower post-adoption for both large and small firms, by similar amounts), and mixed results for returns (post-adoption returns are lower for the largest firms, but positive for a second set of large.????? Dey, A. (2005) USA Corporate governance Financial credibility Found that most aspects of corporate governance are significantly associated with the credibility of reported earnings for firms in highest agency cost group. Teoh and Wong (1993) USA Audit quality Credibility of reported earnings The result implies that high quality auditors give greater credibility and better quality to financial statements. Hotchkiss, E. S. and D. Strickland (2003) USA institutional investors trading behavior The findings show that it is not only ownership by individuals versus institutional investors but more importantly the composition of institutional shareholders that effects stock price behavior around the release of corporate information. Bedard, J., S. Bryan, et al. (2006) USA internal control requirements earning quality The result shows that the absolute level of unexpected accruals increases in the year internal control deficiencies are disclosed. This is consistent with an increase in earnings quality. Boscaljon, B. and C. C. Ho (2005). Hong Kong, Korea, Taiwan, and Thailand bank loan announcements Uncertainty and information content Findings suggest that commercial banks from quality lenders play an increased role in reducing information asymmetries in environments where there is greater economic uncertainty.

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