rahman and ali - 2006 - board, audit committee, culture and earnings management- malaysian evidence

Board, audit committee, cultureand earnings management: Purpose – Aims to investigate the extent of the effectiveness of monitoring functions of board of directors, audit committee and c

Board, audit committee, culture

and earnings management:

Purpose – Aims to investigate the extent of the effectiveness of monitoring functions of board of

directors, audit committee and concentrated ownership in reducing earnings management among

97 firms listed on the Main Board of Bursa Malaysia over the period 2002-2003.

Design/methodology/approach – The current study employs the cross-sectional modified version

of Jones, where abnormal working capital accruals are used as proxy for earnings management.

Findings – The study reveals that earnings management is positively related to the size of the board

of directors This supports the view that larger boards appear to be ineffective in their oversight duties

relative to smaller boards A possible explanation for the insignificant relationship between other

corporate governance mechanisms (independence of board and audit committee) and earnings

management is that the board of directors is seen as ineffective in discharging their monitoring duties

due to management dominance over board matters The apparent reason for this phenomenon is

attributed to the board of directors’ relative lack of knowledge in company’s affairs The study also

found that ethnicity (race) has no effect in mitigating earnings management, possibly due to the more

individualistic behaviour of the Bumiputra directors The modernisation of Malaysia and also the

increase in Bumiputra ownership of national wealth may have caused the Malays to be more

individualistic, similar to their Chinese counterpart.

Originality/value – Since, there are relatively few studies conducted in this area specifically among

Malaysian firms, this study will broaden the scope by providing empirical evidence of the relationship

between various corporate governance characteristics, cultural factors and earnings management.

Keywords Earnings, Boards of directors, Audit committees, Culture, Malaysia

Paper type Research paper

Introduction

Based on agency theory, issues associated with the separation between ownership and

control will lead managers (agents) to act in an opportunistic manner by increasing

their personal wealth at the expense of the owners (principal) of an organisation (Jensen

and Meckling, 1976) As financial statements provide value-relevant information to the

external parties of the organisation, the heavy reliance placed on accounting numbers

create powerful incentives for managers to manipulate earnings to their own

advantage The incentives for managers to manipulate reported earnings may be

influenced by job security, contractual agreements between managers and the external

stakeholders, self-interest in the presence of compensation schemes or the need to

achieve target earnings and to meet market expectations (Healy and Wahlen, 1999)

As such, earnings management, even if it is being done not in violation of the

accounting standards, may lead to inaccurate information about the company Hence, it

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Managerial Auditing Journal Vol 21 No 7, 2006

pp 783-804

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is crucial for an organisation to have an effective corporate governance mechanism tosafeguard the rights of the investors in getting the true and fair information of thecompany.

The 1997 economic crisis in Malaysia has exposed serious weaknesses in corporategovernance practices namely, weak financial structure, over-leveraging by companies,lack of transparency, disclosure and accountability The introduction of the MalaysianCode of Corporate Governance (2000) and the Bursa Malaysia Revamped ListingRequirement (2001) highlight the importance of corporate governance and disclosurerequirements This is particularly so with regard to the appointment of the majority ofindependent directors to the board and the forming of an audit committee comprising

of at least three independent directors to strengthen capital market, boost investors’confidence and improve the credibility and accountability of financial informationproduced by listed companies As such, the focus of the study is to acquire anunderstanding of whether the existence of corporate governance mechanisms, namelythe composition of the board of directors and audit committees, are effective inextenuating earnings management behaviour amongst Malaysian public listedcompanies In essence, by examining the relationship between earnings managementand corporate governance characteristics, the effectiveness of board monitoring can befurther evaluated and improvised by the regulators This study also aims to provideadditional evidence that supports or rejects prior research findings in developedcountries and to determine whether the findings can be generalised in Malaysia.Malaysia is of interest because it is a developing country with an emerging capitalmarket and unlike the dispersed shareholding of the Anglo-Saxon world, Malaysia ischaracterised by concentrated shareholding Many of the listed companies in Malaysiaare family owned or controlled, with many companies having evolved from traditionalfamily owned enterprises, reflecting different cultural traditions and aspirations(Claessens et al., 2000) Unlike companies with dispersed shareholding, there is areduced agency problem in a company with concentrated ownership due to a bettermatching of the control rights of the dominant shareholder with its cashflow rights.Thus, the incentive of the controlling shareholder is more likely to be aligned to theinterest of other shareholders In fact, past studies have shown that concentrated orblock ownership can assist the board in increasing its monitoring effectiveness(Shleifer and Vishny, 1997) As such, the study also aims to provide evidence on theimpact of the presence of block shareholdings by outside investors on the effectiveness

of the board in mitigating opportunistic earnings management activity in Malaysia.Previous studies in the area (Peasnell et al., 2001; Klein, 2002; Xie et al., 2003) haveexamined the effectiveness of corporate governance attributes in mitigating earningsmanagement behaviour but they have not examined cultural factors that may affectthe level of earnings management in a country Cultural factors are important becausethe traditions of a nation are instilled in its people and might help explain why thingsare as they are (Haniffa and Cooke, 2002) Malaysia has its own unique historicalbackground resulting from the cultural influence of different countries that eitheroccupied Malaysia (Britain) or have had business practices in Malaysia (India andChina) Hence, it is made up of various races, religions, creeds, customs and languages.These multiracial groups fall into two main categories: those with cultural affinitiesindigenous to the region, classified as the Malays or Bumiputras (literally meaning

“sons of the soil”), and those whose cultural affinities lie outside, classified as

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non-Bumiputra (consisting primarily of Chinese, Indians and others) Relative to their

Chinese counterparts, the Malay directors have been found to have a higher level of

voluntary disclosure (Haniffa and Cooke, 2002) and thus may have fewer tendencies to

manage earnings The examination of the level of earnings management in a

multiracial society like Malaysia will, therefore, contribute to the existing knowledge

on earnings management

The remainder of the paper is organised as follows The next section discusses the

relevant literature on issues pertaining to earnings management and the role of board

monitoring together with cultural factors, which lead to the development of

hypotheses The third section explains the research method followed by a discussion

of the results in section four The paper ends with a summary and the conclusion of the

research

Literature review and hypotheses development

Earnings management occurs:

when managers use judgement in financial reporting and in structuring transactions to

alter financial reports to either mislead some stakeholders about the underlying economic

performance of the company, or to influence contractual outcomes that depend on reported

accounting numbers (Healy and Wahlen, 1999, p 6)

However, earnings management, unlike fraud, involves the selection of accounting

procedures and estimates that conform to generally accepted accounting principles

(GAAP) That is, any firms that have earnings management would be manifested

within the bounds of accepted accounting procedure manipulation

The management’s use of judgment in financial reporting has both costs and

benefits Benefits include potential improvements in the management’s credible

communication of private information to stakeholders that improve resource allocation

decisions (Healy and Palepu, 1995) However, shareholders will face potential agency

costs if managers manage earnings to obtain abnormal private gains that may take the

form of increased compensation (Guidry et al., 1999) or reduced likelihood of dismissal

when performance is low (Weisbach, 1988) The act of managing earnings does not

necessarily reflect the true performance of the company, a situation that may

contribute to shareholders and investors making inaccurate judgments about the

company Thus, effective board monitoring is important in reducing the incidence of

earnings management when incentives for such manipulations are high

Board of directors’ characteristics

Agency theory supports the idea that to increase the board’s independence from

management, boards should be dominated by outside directors Among the arguments

is that non-executive directors are needed to monitor and control the actions of the

directors whose behaviour has been referred to by Jensen and Meckling (1976) as

“opportunistic” The presence of those non-executive directors may influence the quality

of directors’ deliberations and decisions, provide strategic direction and improve

performance (Zahra and Pearce, 1989), thus ensuring that management is acting in a

responsible way and in the best interests of the shareholders as well as the stakeholders

The resource dependence theory also argued for more non-executive directors on the

board, due to their expertise, prestige and contacts (Kesner and Johnson, 1990)

Board, audit committee, culture 785

However, some researchers do acknowledge the drawbacks of having a highproportion of non-executive directors on the board Such shortcomings include stiflingstrategic actions (Goodstein et al., 1994), excessive monitoring (Baysinger and Butler,1985), lack of business knowledge to be effective (Patton and Baker, 1987) and lack ofreal independence (Demb and Neubauer, 1992) This is especially so if thesenon-executives are former employees of the firm or have personal relationships withone of the executives.

Nevertheless, there has been considerable pressure on firms to increase the number

of non-executive directors on the board in the UK and USA (Davies, 2000) Similarly, allpublic listed companies in Malaysia must ensure that at least one-third of their board ofdirectors consists of independent non-executive directors, thus enhancing the board’sindependence of the management (Bursa Malaysia Revamped Listing Requirement,2001)

Several studies present evidence suggesting that effective governance with boardindependence improve firm performance (Agrawal and Knoeber, 1996; Baysinger andButler, 1985), while the dominance of non-executive directors (in terms of numbers)could provide them with more power to force management to improve the quality offirm disclosure (Haniffa and Cooke, 2002) Unlike a Canadian study by Park and Shin(2003) who found no significant difference between discretionary accruals (DAC) andboard composition, studies by Beasley (1996) and Klein (2002) found otherwise Theirstudies suggested that having outside independent directors on the board provideadded value to the board monitoring process Beasley (1996) found a significantnegative relationship between outside directors and the occurrence of fraudulentfinancial statements, whilst Klein (2002), Xie et al (2003) and Peasnell et al (2001)found that outside directors are negatively associated with DAC Peasnell et al (2001)suggested that the board balance between executive and non-executive directorscontributes towards the integrity of financial statements

Hence, previous empirical findings seem to suggest that boards which arestructured to be more independent of the management are effective in monitoring thecorporate financial accounting process, thus leading us to the following hypothesis:

(DAC) and the proportion of independent directors on the board

In addition, independent directors who had served the board for a certain period maydevelop better governance competencies as well as provide additional knowledge andexpertise to the firm, thus are capable of monitoring management performance Forexample, Peasnell et al (2001) found the average tenure of non-executive directors onthe board is negatively associated with the level of earnings management Experience

as board members of the firm allows outside directors to gain a better understanding ofthe firm and its people, thus enabling them to develop better governance competencies.This leads to the following hypothesis:

(DAC) and the competence of independent directors on the board

Further, the Malaysian code recommends that the role of the chairman be separatedfrom that of the CEO This is to ensure that the CEO would not be in a position with toomuch power to handle daily business operations Proponents of the agency theory also

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argue for the separation of these two roles The chairman, they argue should be

independent of company’s affairs while being on the board and in so doing will be a

useful check on the over-ambitious plans of the CEO (Blackburn, 1994) Proponents of

the stewardship theory, on the other hand, argue that this role duality (where a CEO is

also the chairman of the firm) will improve firm performance because the

management’s compensation is tied to the firm performance, and that the CEO’s

strategic vision can shape the destiny of the firm with minimum board interference

(Rechner and Dalton, 1991)

Past studies have reported that companies with duality function did not perform as

well as their counterparts (Abdul Rahman and Haniffa, 2005) and are more likely to be

subjected to accounting enforcement actions by the SEC for infringement of GAAP

(Dechow et al., 1995) In addition, Klein (2002) found that absolute value of DAC is

positively related to the CEO who holds a position on the board’s nominating and

compensation committee The results indicate that a CEO with excessive power over

board matters could easily manipulate earnings Hence, it is hypothesised that:

(DAC) and the separation of the roles of CEO and chairman

Board size is viewed as another important element in board characteristics that may

have an effect on earnings management The optimum number of board members

should be appropriately determined by the whole board to ensure that there are enough

members to discharge responsibilities and perform various functions (Malaysian Code

of Corporate Governance, 2000) Goodstein et al (1994) argued that smaller boards,

between four to six members might be more effective since they are able to make

timely strategic decisions, while larger boards are capable of monitoring the actions of

top management (Zahra and Pearce, 1989) In fact, large board members with varied

expertise could increase the synergetic monitoring of the board in reducing the

incidence of earnings management Xie et al (2003) and Peasnell et al (2001) found that

having a larger board is associated with less earnings management As such, the next

hypothesis, which is related to board size and earnings management, is set as follows:

(DAC) and the size of boards

Audit committee

Malaysian public listed companies have been required by Bursa Malaysia (previously

known as Kuala Lumpur Stock Exchange) to establish an audit committee since

1 August 1994 In addition, the code specifies that an audit committee should comprise

at least three directors, the majority of whom are independent, while its chairman

should be an independent non-executive director The establishment of the audit

committee is to ensure continuous communication between external auditors and the

board, where the committee meets regularly with the auditors to review financial

statements and audit processes and also internal accounting systems and control

A study by Muhamad Sori et al (2001) found that the Malaysian audit committee

chairman perceives that the committee plays an effective role in monitoring audit and

financial functions

Vicknair et al (1993) stated that in order to function effectively, audit committees

must be independent of the management as it allows both the internal and external

Board, audit committee, culture 787

auditors to remain free of undue influences and interferences from corporateexecutives Peasnell et al (2001) did not find sufficient evidence on the effectiveness ofthe audit committee in reducing the level of earnings management However, otherempirical studies generally show that the independence of the audit committee hasbeen found to be not only negatively associated with the occurrence of financial fraud(Beasley, 1996; Dechow et al., 1995), DAC (Xie et al., 2003), and being sanctioned forfraudulent or misleading reporting (Abbot and Parker, 2000), but are also positivelyrelated to financial reporting (Felo et al., 2003) Similarly, Choi et al (2004) found thatwhen members of the audit committee hold shares in a company, they have lessincentive to deter earnings management Thus, independence of the audit committee isarguably a key factor in enhancing their role in preventing misstatements in thefinancial statements Hence, the next hypothesis is as follows:

(DAC) and the proportion of independent directors on the audit committee

In addition, the need to have competent and experienced directors, particularly infinancial aspects, is equally important to audit committee members since the primaryfunction of an audit committee is to monitor the financial reporting process of anorganisation Xie et al (2003) and Choi et al (2004) reported that outside directors whoare financially competent, are effective as monitors in reducing earnings managementbehaviour Further, Felo et al (2003) found the percentage of audit committee membershaving expertise in accounting or financial management is positively related to thequality of financial reporting The Bursa Malaysia listing requirements stipulatesamong others, that at least a member of the audit committee must possess relevantskills, experience and qualified knowledge, such as being a member of the MalaysianInstitute of Accountants Hence, an audit committee that has knowledge and skills infinancial reporting is more likely to uncover opportunistic earnings managementactivity by the management:

(DAC) and the competence of members of the audit committee

Further, an audit committee that is independent and competent will play a more active,effective and efficient monitoring role Xie et al (2003) reported that the number ofboard meetings is negatively associated with the level of earnings management,indicating that the board that meets regularly could be better monitors This may stemfrom the notion that an active board that devotes time to rectifying any immediateissues may deter earnings management As such, the following hypothesis isdeveloped:

(DAC) and the frequency of meetings of audit committee

Concentrated ownershipUnlike in the UK and the USA which have a dispersed shareholder base, ownershipand control in Malaysian public listed corporations tend to be much more concentrated,with shares often being owned by identifiable and cohesive groups of “insiders” whohave longer term stable relationships with the company They may be members of thecompany’s founding families or a small group of shareholders, such as lending banks,

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other companies (through cross shareholdings and pyramidal ownership structures) or

the government (Claessens et al., 2000) Past studies have shown that concentrated or

block ownership can assist the board in increasing its monitoring effectiveness

(Shleifer and Vishny, 1997) and in terminating top executives in poor performing firms

(Denis et al., 1997) With regard to earnings management, Chtourou et al (2001) found

that firms with low-level DAC have a larger percentage of shares owned by

blockholders Thus, the presence of shareholders owning a large block of shares in a

company provides an additional monitoring mechanism that may deter opportunistic

earnings management:

(DAC) and concentrated ownership

Cultural characteristics

Accounting research has for many years focussed on the influence of cultural values on

the development of accounting practices Past studies have provided evidence on the

following: that accounting practices and disclosure are a function of the nation’s

cultural values (Perera, 1989; Mohd Iskandar and Pourjalali, 2000); that cultural

heritage affects attitudes towards business related fraud (Watson, 2003); and that an

organisation’s culture can predispose a company into considering fraudulent financial

reporting (Geriesh, 2003) Hofstede (1991) defines culture as the “collective

programming of the mind which distinguishes the members of one group or

category of people from another” Among the components of national culture are the

prevalent value systems that are transferred from generation to generation Values

refer to the broad preferences for one state of affairs over others They are the acquired

knowledge that people use to interpret experiences; direct feelings of good and evil, and

affect perceptions of how things are, that eventually affect behaviour (Hofstede, 1991)

Chuah (1995) argues that the mind of Malaysian managers is influenced by race,

education and the type of organisation they work for Using Hofstede’s (1983) four

dimensions (individualism, power distance, uncertainty avoidance, and masculinity) in

underlying the differences in the nation’s cultural values, Abdullah (1992) provides

evidence that the Malays are rated lower on individualism, which is partly attributed to

the fact that Islam emphasises groups and societies rather than individuals (Baydoun

and Willet, 1995) In addition, the concept of zakat (tax) in Islam promotes the

development of collectivism in the community by providing a mechanism for the rich

to help the poor Using race and education as surrogate for culture, Haniffa and Cooke

(2002) found the Chinese to be more individualistic and more secretive in their

disclosure partly due to their entrepreneurial skills that have a greater influence on the

Malaysian economy They, however, found Malaysian firms dominated by Malay

directors have a higher level of voluntary disclosure, which is consistent with the

Islamic business ethics that encourages transparency in business, thus may have fewer

tendencies to manage earnings As such, the presence of Malay directors on the

board of a company and on audit committees may deter opportunistic earnings

management:

(DAC) and the proportion of Malay directors on the board

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H10 There is a significant negative relationship between discretionary accruals(DAC) and the proportion of Malay directors on the audit committee.

Research designThe study examines 100 top companies listed on Bursa Malaysia Main Board,ranked by Market Capitalisation at 31 December 2001 (Investors Digest, 2002)January, for the period January 2002 to December 2003 A final sample comprising

of 97 top companies for both years is selected from the list after excluding severalcompanies that did not meet certain criteria in the study For example, companies

in the finance sector are excluded in the study since these companies comeseparately under the Banking and Financial Institutions Act of 1989 Moreover,they posses a unique and different working capital structure (Klein, 2002) Inaddition, utilities companies are also excluded because they are very muchregulated by the government and acquire different incentives and opportunities tomanage earnings (Peasnell et al., 2001) Companies that do not have completefinancial data, complete information on directors or whose annual reports areunavailable are also excluded

Data relating to the board of directors and the audit committee attributes aregathered using the company’s annual report as disclosed on the Bursa Malaysiaweb site Financial data are obtained from the Datastream Any missing financialfigures from Datastream are acquired from the annual report

Measuring earnings managementConsistent with Xie et al (2003) and Peasnell et al (2001), working capital accruals areused in this study as a measure for earnings management, as managers have a greatdeal of discretion in determining the actual earnings a firm reports in any given period(Teoh et al., 1998) In addition, managing earnings through accruals manipulation ismore subtle and difficult to detect by a lay user of financial statements

Consistent with empirical evidence from recent contemporary researches inearnings management, namely Klein (2002), Xie et al (2003), Dechow et al (1995) andPeasnell et al (2001), the current study uses the cross-sectional modified version ofJones (1991) While the ability of the modified Jones (1991) model in measuringearnings management has been challenged by some researchers, Dechow et al (1995)and Guay et al (1996) found that the model is the most powerful in detecting earningsmanipulation in the event of managers exercising their discretion over revenuerecognition For example, managers could determine the appropriate timing torecognise credit sales, which would either increase or decrease the reported earningsover a period In addition, a cross-sectional analysis is used in this study, instead oftime series as sample size can be maximised and survivorship bias problem can beeliminated (Peasnell et al., 2001)

In employing the modified Jones’ (1991) model, working capital accruals aredecomposed into non-discretionary and DAC The non-DAC or normal accruals areestimates by managers that represent changes in the underlying economicperformance of the company For example, as the level of sales and purchasesduring the growth period increases, the magnitude of accounts payable and accountsreceivable would increase accordingly On the other hand, DAC are open to managers’

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discretion and hence are operationalised as a proxy for earnings management in

the study

Non-DAC are estimated during the observation year (the year in which earnings

management is estimated) as:

The change in receivables is subtracted from the change in revenues to reflect the

fact that the change in receivables is treated as discretionary Estimates of the

regression model as illustrated in equation (2), in the estimation period Equation (2)

use data from all companies matched on the year of observation and are categorised in

the same industry groupings All variables in the regression model are deflated by

lagged total assets to reduce heteroscedasticity problems (Teoh et al., 1998; Abdul

Rahman and Abu Bakar, 2004; Abdul Rahman and Wan Abdullah, 2005)

In essence, the working capital accruals are regressed on the change in revenue

since the underlying assumption under this model is that revenue is a component of

non-DAC Equation (2) is estimated separately each year for all firms listed on

Datastream that are in the same industry category Consistent with Klein (2002),

industries with less than eight observations are excluded in the analysis The

in estimating changes in non-DAC

The discretionary working capital accruals (DAC) is then defined as the remaining

portion of the working capital accruals:

non-DAC for firm i in year t

Measurement procedure

The variables and their measurements used in this study are summarised in Table I

Consistent with Klein (2002), Becker et al (1998) and Warfield et al (1995), the study

incorporates absolute value of DAC as the dependent variable The direction of

earnings management is disregarded to include the combined effect of income

increasing and income decreasing earnings management

The variables for board of directors and audit committee are measured at the

beginning of the year in which earnings management occurs Four variables that

represent board of directors’ attributes are the proportion of independent directors,

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competence, CEO duality and board size The proportion of independent directors on

the board is measured by dividing the total number of independent non-executive

directors by the total number of board members (Klein, 2002; Xie et al., 2003; Peasnell

et al., 2001) As defined by Bursa Malaysia, an independent director is a director who is

independent of the management and free from any business or other relationship

which could interfere with the exercise of the independent judgment or the ability to act

in the best interest of the stakeholders

Similar to Chtourou et al (2001) and Peasnell et al (2001), competence of the board is

measured using the average tenure of the independent non-executive directors (the

total number of years of service divided by the number of independent non-executive

directors in a company) CEO duality is the separation of the role of chairman and CEO,

where firms that combined the title are labelled “1” and firms that separated the title

are labelled “0” Board size refers to the total number of board members, similar to that

employed by Xie et al (2003) and Peasnell et al (2001)

Similar to the studies conducted by Chtourou et al (2001) and Abdul Rahman and

Haniffa (2003), concentrated ownership is based on the percentage shareholding of the

combined number of significant shareholders in a company Three variables that

exemplify the audit committee characteristics are the proportion of independent

directors, competence and the activity of the audit committee As summarised in

Table I, the proportion of independent non-executive directors in the audit committee is

calculated by dividing the total number of independent non-executive directors in the

audit committee by the total number of audit committee members The competence of

an audit committee is measured based on the accounting qualification of the members

of the committee (Choi et al., 2004) taking the value of 1, if at least one member of the

committee is a qualified accountant and 0 otherwise Similar to Choi et al (2004), the

study also incorporates the frequency of meetings to gauge the audit committee’s

activity

The measurement of race as surrogate for culture in this study is acknowledged to

be biased but the effect of race may be significant in a multiethnic society like Malaysia

where each group maintains and practices its own cultural values and religious beliefs

The ethnic composition of directors on board is measured as the ratio of Bumiputra

directors to the total number of directors on board, whilst the ethnic composition of the

audit committee is the ratio of Bumiputra directors to the total number of directors on

the audit committee

Factors other than corporate governance practices and cultural factors may also

contribute to the reduction of earnings management The study uses six control

variables: ROA, leverage, cash flow, size, book to market value ratio and Big5 auditors,

as summarised in Table I Bartov et al (2000) reported that firms experiencing financial

difficulties (proxy by book to market ratios and financial leverage) as well as low firm

performance (ROA and cash flow) have more incentive to engage in earnings

management activity This is because, higher leverage and lower firm performance

means higher bankruptcy risk, which in turn will lead to litigation risks Past studies

have also shown that companies employing Big5 auditors reported lower levels of DAC

than companies employing non-Big5 auditors (Becker et al 1998) In comparison to low

quality auditors, high quality auditors such as Big5 auditors are more likely to detect

questionable accounting practices and to a certain extent may compel management to

follow accounting practices as prescribed by the accounting standards

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