Corporate Social Responsibility Disclosure and Real Activities Earnings Management: The Interaction Impact of Corporate Governance and IFRS in Saudi Arabia

Abstract

Corporate social responsibility disclosures (CSRD) have gained increased attention in business debate and practice, from businesses and stakeholders globally. Despite the increasing importance of CSRD, there are concerns about the purpose of these disclosures. These principally hinge on two perspectives: ethical and managerial opportunism. Ethically, the argument holds that participation in CSRD reduces opportunistic behaviour. In addition, CSRD reduces agency problems by providing an environment that decreases motivation to engage in earnings management practices. Managing earnings is the intentional alteration of an organisation’s external financial reporting. Managers who engage in earnings management practices may resort to CSRD to deflect stakeholder attention from their opportunistic actions, thereby protecting their positions.

Previous studies that have examined the relationship between CSRD and real activities earnings management (RAEM) remain contested. Further, there is a lack of knowledge regarding CSRD practices in developing countries. In terms of earnings management, associated studies have primarily examined accrual-based earnings management with a limited focus on RAEM. Moreover, little research has been conducted on RAEM in Saudi Arabia. The interaction effect between International Financial Reporting Standards (IFRS) has yet to be explored. There has been limited investigation into the interaction between various components of internal corporate governance (e.g. board characteristics and audit committees) and the ownership structures on the relationship between CSRD and RAEM.

The purpose of this research is to address the limitations in the current literature. This research investigated the impact of CSRD on RAEM, in addition to investigating IFRS, internal corporate governance and ownership structures on the RAEM, and their interaction on the relationship between CSRD and RAEM.

Data for this research were derived from 704 observations from non-financial firms listed on the Saudi stock exchanges between 2013 and 2020. A balanced panel of data consisting of multiple observations over an eight-year period is utilised. To collect secondary data, two approaches were taken. First, study data were collected from the selected companies’ annual reports, which are available through DataStream. In the second approach, data were collected manually from annual reports available on the Saudi Arabian stock exchange (https://www.tadawul.com.sa). More specifically, the variables gathered manually from the annual reports are the CSRD, internal corporate governance and ownership structures. RAEM measures were calculated using a well-known evaluation model developed by Roychowdhury (2006) and the modified 2020 model by Cohen et al. (2020). This research develops the CSRD index by building 40 checklists. An ordinary least squares model with robust standard errors and an industry fixed effect were applied to all models in the study.

The findings of this research reveal that CSRD and RAEM are significantly negatively associated. The researcher applies three approaches to address potential endogeneity issues: (i) an instrumental variable analysis (2SLS) technique, (ii) propensity score matching (PSM) and (iii) reverse causality. This research finds that the results are robust to endogeneity concerns. The researcher applies various robustness tests to provide evidence that CSRD firms are less likely to engage in RAEM practices. The results of IFRS with RAEM indicate that they are significantly positively related. The results of internal corporate governance (board size, presence of the royal family on the board and frequency of audit committee meetings) are negatively and significantly related to RAEM. Managerial ownership, institutional ownership, government ownership and family ownership are negatively significantly related to RAEM. It appears that RAEM practices were more constrained for CSRD firms during the pre-IFRS adoption period. The high presence of the various components of internal corporate governance strengthens the negative relationship between CSRD and RAEM practices, compared with the low presence of the same internal corporate governance components. The findings of this research indicate that the presence of managerial ownership, institutional ownership, government ownership and family ownership strengthens the negative relationship between CSRD and RAEM practices in comparison with the absence of managerial ownership, institutional ownership, government ownership and family ownership.

This research is the first to: (i) investigate the relationship between CSRD and RAEM in the Saudi context; (ii) investigate whether the adoption of IFRS influences earnings management through RAEM by Saudi listed companies; (iii) explore various components of internal corporate governance, characteristics of the board, audit committees and ownership structures on RAEM within Saudi listed companies; and (iv) assess the interaction impact of IFRS, various components of internal corporate governance, characteristics of the board of directors, audit committees and ownership structures on the relationship between CSRD and RAEM. A theoretical explanation is presented using an integrative approach, in which the researcher applies numerous theories, including agency, institutional, legitimacy and stakeholder theories.

This research provides policymakers and companies with a variety of implications related to regulations, company monitoring measures and the importance of CSRD. This research will aid understanding of the value of integrating elements of internal corporate governance to a high degree combined with CSRD on constrained RAEM. This research can inform policymakers and companies of the importance of the presence of ownership structure. These findings will benefit Saudi Arabia and countries that maintain similar institutional environments to Saudi Arabia, such as Gulf Cooperation Council countries.