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This chapter gives an overview regarding to this research. It consists of research background, problem statement, research objectives, and the contribution of study. Basically, this chapter outlines the basic ideas regarding to this research.
Background of study
1.2.1 Evolution of corporate governance in Malaysia
The Asian Financial Crisis 1997 which emerged in Thailand had quickly spread to Indonesia, Philippines, Taiwan, Singapore, Hong Kong, South Korea, as well as Malaysia and the tiger economies of East Asia had experienced a serious downturn (Mishra & Bhattacharya, 2011). The crisis caused rapid withdrawal of private capital by those foreign investors and expansion of credit to companies operating in Malaysia (Mahbob & Govindan, 2000). The economic crisis revealed Malaysia itself to numerous severe flaws in corporate governance practices namely, over-leveraging by companies, weak financial structure, lack of transparency, disclosure and accountability (Rashidah & Fairuzana, 2006). The business community especially the investors had lost their confidence towards the effectiveness of corporate governance mechanisms within the corporation in Malaysia (Saleh et al., 2005). As a result, the regulators should set new rules and regulations to cover the loopholes and the corporation must put right their imperfect corporate governance structure (Mishra & Bhattacharya, 2011).
Corporate governance is the process and structure used to direct and manage the business and affairs of the company towards enhancing business prosperity and corporate accountability with the ultimate objective of realizing long-term shareholder value, whilst taking into account the interests of other stakeholders (Malaysian Code on Corporate Governance 2012). The first version of MCCG was drafted in 1999 and approved in March 2000 by the Ministry of Finance in order to improve the monitoring function of corporate governance mechanism in Malaysia. The Code organized the principles and best practices of good governance and described optimal corporate governance structures as well as internal processes (MCCG 2007). It aimed to enhance legal and regulatory frameworks in the companies. Since then, the Securities Commission (SC) had developed MCCG 2000 and the former Code was substituted by MCCG 2007. MCCG 2007 represented the continued collaborative efforts between Government and the industries to further strengthen the board of directors and audit committees, and ensuring that the board of directors and audit committees discharge their roles and responsibilities effectively (MCCG 2007).
In the future, SC would focus on enhancing the corporate governance ecosystem. Thus, SC issued the Corporate Governance Blueprint 2011(Blueprint) which figures out the strategic plan aimed to reinforcing self and market discipline, which MCCG 2012 is the key deliverable of the Blueprint. The development was due to the rapid changes in market dynamics, international developments and also the needs to continuously recalibrate and enhance the effectiveness of the corporate governance framework.
The Enron, WorldCom and some other scandals of U.S. giant firms, as well as Transmile Bhd in Malaysia had increased the awareness of stakeholders on the effectiveness of corporate governance locally (Johari et al., 2008). Thus, Bursa Malaysia put a lot of efforts to strengthen the corporate governance framework under the Listing Requirements. The CEO of Bursa Malaysia, Datuk Tajuddin Atan commented in the MCCG 2012 seminar, saying that he wants the listed companies to recognize the value that comes in underscoring corporate governance practices into the core of business operations as that will create good business sustainability (The Star, 2012).
Corporate governance is the process to run a business for increasing the wealth of an organization and maximizing the shareholder value in the long run (Liew, 2007). Whilst, the ultimate goal is to supervise and manage the firm's activities in order to secure the interests of investors (Mishra & Bhattacharya, 2011). According to Asian Corporate Governance Association-CLSA Watch Report 2012, Malaysia was ranked jointly with Japan in the fourth position, after Singapore, Hong Kong and Thailand. It shows that the companies in Malaysia have put more attention to develop good corporate governance practices in recent years. (The Star Online, 28 September 2012).
1.2.2 Introduction of earnings management
Corporate governance issues has triggered the attention of the regulators, academicians, and practitioners because there is a belief that corporate governance enhances investors' confidence and boosts the economic health of listed companies (Coleman and Biekpe, 2006; Garg, 2007). In this case, the management is possibly motivated to manipulate earnings due to maximizing firm's value (Beneish, 2001), avoiding negative earnings surprises (Matsumoto, 2002), as well as mitigating reporting losses and earnings declines (Park & Shin, 2004), so called earnings management.
HoIn Malaysia, every listed company is required to submit audited financial statement and annual report within the time frame set by Bursa Malaysia (formerly known as Kuala Lumpur stock Exchange). The financial statements provide valuable information to the external parties such as investors, the significant 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 expectation (Healy and Wahlen,1999).
As such, earnings management, even it is being done not in violation of the accounting standards, may lead to inaccurate information about the company. Hence, it is crucial for an organization to have an effective corporate governance mechanism to safeguard the rights of the investors in getting the true and fair information of the company (Rashidah & Fairuzana, 2006). Incentive to engage in earnings management could be mitigated as well through effective corporate governance mechanism (Fatimah et al., 2009).
Generally, there are 2 types of earnings management, efficient earnings management and opportunistic earnings management (Scott,2000) . For instance, improving earnings in informative on communicating private information reflecting the former type and management reports earnings opportunistically to maximize the utility is the example of latter type of earnings management. Goel & Thakor (2003) commented that earnings management is able to alter the reporter earnings so that they do not reflect the economic earnings, whether it can be higher or lower than the actual performance.
Many researches had been done to investigate the association of corporate governance mechanism and earnings management in Malaysian context by using variety of proxies, such as proportion of independent board(Saleh et al., 2005), size of the board (Mohamad et al, 2012), ownership structure (Rashidah & Fairuzana, 2006), and audit committee(Hussain & Mustafa, 2012).
1.2.3. Introduction of audit committee characteristics
In this study, audit committee characteristics have been chosen as the variables and examine how the characteristics associate with the level of earnings management in the companies. According to Healy and Wahlen (1999), earnings management occurs when managers use judgment 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.
Various researches have been done on audit committee's characteristics in Malaysia. Saleh et al. (2007) has investigated the effectiveness of audit committee characteristics such as independence of members, size, and frequency of meeting and knowledge of members to monitor management behavior with respect to their incentives to manage earnings, based on selected sample of 561 public listed companies. They found that presence of fully independent audit committee reduces earnings management. It was also found that the knowledgeable audit committee and held more meetings can curb earnings management better in the companies. Besides that, Hussain & Mustafa (2012) also conducted research to find out the effect of audit committee characteristics towards earnings management by using 270 Malaysian Shariah-compliant companies. They concluded that audit committee size and accounting expert's role have non-significant relationship with the discretionary accruals. Additionally, there is negative significant relationship with independent non-executive directors in audit committee. The trend shows that audit committees play a significant role in oversee reporting and internal control, as well as improving the relevance and reliability of an entity's financial reporting nowadays.
Malaysia public listed companies have been required by Bursa Malaysia to establish an audit committee since 1 August 1994 (Rashidah and Fairuzana, 2006). A board of a listed company should establish an audit committee comprising at least three members, the majority of whom are independent, while all members should be non-executive directors. The effectiveness of board can be increased by appointing committees with specialized skills (Audit committee and corporate governance, Deloitte 2009).
Audit committee is one of the important aspects in corporate governance stated in the MCCG (Saleh et al, 2007). Hence, it is crucial to investigate the audit committee characteristics and how it affects or mitigates the level of earnings management. This question is to be examined in the context of Malaysia public listed companies with respect to the impact the Malaysian Code on Corporate governance on the companies as well as the extent of earnings management.
The research questions in this study are:
What are the impacts of audit committee characteristics on the earnings management in Malaysian companies?
What is the relationship between size of audit and earnings management in a company?
What is the relationship between the independence of audit committee with earnings management in a company?
What is the relationship between frequency of audit committee meetings and earnings management in a company?
What is the relationship between the competence of audit committee and earnings management in a company?
The research objectives in this study are:
To examine the relationship between size of audit committee, independence of audit committee, frequency of audit committee meetings, competence of audit committee with earnings management.
To test whether enhancing corporate governance mechanisms is associated with the earnings management in the public listed companies.
To examine whether the implementation Malaysian Code of Corporate Governance impacts firm's level of earnings management.
To assess the effectiveness of audit committee to monitor management behavior in mitigating earnings management practice within Malaysia's regulatory and business environments.
Contribution of the study
The study contributes to the understanding and knowledge on the effect of effective audit characteristics in mitigating earnings management practice in a developing country such as Malaysia. Besides the study also provide the understanding of Malaysia Code of Corporate Governance regarding earnings management towards Malaysian regulators, since MCCG 2012 was newly issued.
In Malaysia, there are quite a number of researches done on the relationships between board characteristics, ownerships, independent directors and earnings management but limited researches have been conducted on audit committee characteristics solely. There is always conflicts happened between internal management and external auditors. Hence, one of the important roles of audit committee is to resolve the divergences between both parties. Besides, the audit committee is responsible to regulate the internal control system and ensure the reliability of financial reporting. This research can contribute in a way that providing more empirical evidence between the relationship of audit committee characteristics and earnings management to the community. Consequently, the government as well as the company itself can use it as a benchmark for them to evaluate the extent of earnings management time to time.
The remainder of the proposal is organized in three sections as follows. Next chapter will discuss and review the relevant literature on issues regarding the audit committee characteristics and earnings management, followed by the development of hypothesis for the research topic. The third chapter will explain the research methodology used to perform the analysis of independent variables and dependent variable, as well as the sample size chosen.
The previous chapter covers the background, research questions, research objectives, and the contribution of study. This chapter is organized to review the relevant literature in the area of the study. The chapter is discussing of the studies done on audit committees and earnings management. It covers issues pertaining to the effects of the size, independence, competency of audit committee and frequency of meetings on earnings management.
2.2 Empirical studies on earnings management
Healy & Wahlen (1999) propose that "Earnings management occurs when managers use judgment 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." On the other hand, a researcher defines earnings management as the purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain" (Schipper, 1989).
Earnings management is an important accounting issue for academics and practitioners alike (Dechow et al., 2011).Earnings are the most important item in financial statement as it is considered as a signal to indicate the overall performance of a business. Increased earnings basically represent an increase in company value, and vice versa. Norman et al. (2004) found that the management level has a strong incentive to manage earnings upward when the level of earnings is slightly negative. Dechow et al., (1995) have argued that managers was involved in earnings manipulation in order to attract capital and in order to avoid violation of contracts. As such, there is a widely held belief that firms are motivated to engage in manipulation of their earnings and to become involved in opportunistic behavior (Sani et al., 2012). Daniel et al. (2008) illustrates that manipulating earnings through GAAP can be exercised by accelerating the recognition of revenue, deferring the recognition of expenses, altering inventory accounting methods, changing estimates of bad debt and revising assumptions related to pension assets.
According to Jiraporn et al. (2008), earnings management is viewed as a detrimental to a firm value due to its impact on financial reporting quality. The management's use of judgment in financial reporting has both costs and benefits (Rashidah & Fairuzana, 2006). Healy & Palepu (1995) opined that there is potential improvements in the management's credible communication of private information to stakeholders that improve resource allocation decisions; whereas Guidry et al. (1999) argued that shareholders will face potential agency costs if managers manage earnings to obtain abnormal private gains that may take the form of increased compensation. Hence, the board of directors should also perform its function effectively since compliance with accounting standards is not enough to ensure the absence of manipulation in financial statements (Saleh et al., 2005). Earnings management may contribute to a situation that shareholders and investors making the inaccurate judgments about the company (Rashidah & Fairuzana, 2006). Thus, audit committee which is the subcommittee in the board of directors plays an important role in curbing the practices of earning management.
2.3 Empirical studies on audit committee characteristics
The primary role of the audit committee is to oversee and review the company's financial reporting processes, internal accounting controls, the audit process and more recently, its risk management practices (Klein, 2002; Mohamed & Hussain, 2005). The role of the audit committee has focused on the integrity of financial reporting and accounting matters. However, since recent corporate collapses and the Global Financial Crisis, audit committees have taken on an increasingly significant role with a mandate from the board of directors that covers a wide range of activities (Steven et al., 2012). The audit committee has long been seen as a vital institution in assisting the board of directors in overseeing the transparency and integrity of the financial reporting process (Klein, 2002).
It is now commonly accepted as a fundamental component of a corporate governance structure with its expanded activities resulting in some companies referring to their audit committees as "risk and audit committees" (Steven et al., 2012). Malaysian public listed companies have been required by Bursa Malaysia to establish an audit committee since 1 August 1994 (Rashidah & Fairuzana, 2006). Whilst, 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 (Rashidah & Fairuzana, 2006).
However, Rashidah & Fairuzana (2006) found that audit committees have an insignificant role in preventing the incidence of earnings management indicates that the establishment of an audit committee in listed companies has yet to achieve its intended goals. As such, some researchers expected that audit committee characteristics should be able to curb the practice of earnings management (Saleh et al., 2007). Audit committee characteristics have been examined by numerous researchers to assess the effect on financial decision making and risk management on corporate performance (Steven et al., 2012). The role of audit committees in ensuring the quality of corporate financial reporting has come under considerable scrutiny due to recent high-profile "earnings management" cases and the collapse of Enron (Jerry et al., 2006).
2.4 Determinants of earnings management
2.4.1 Size of audit committee
The size of audit committee is referred to as the number of directors appointed to be members in the audit committee, in this regard there could be small, medium and large audit committees (Hussain & Mustafa, 2012). Audit committee size can have a significant effect on the monitoring of earnings management (Sani et al., 2012). Malaysian Code on Corporate Governance 2007(thereafter MCCG 2007) specifies that the board should establish an audit committee comprising at least three members, the majority of whom are independent, while all members of the audit committee should be non-executive directors. However, there is a question whether larger audit committee size would lead to more effective monitoring (Sani et al., 2012). Lin et al. (2008) argued that a larger audit committee may not necessarily cause in more effective functioning as larger audit committee may lead to unnecessary debates and delay the decisions. Hussain & Mustafa (2012) also proposed that there is a positive relationship between size of audit committee and earnings management. By contrast, Yang & Krishnan(2005) found that the size of audit committee has negative significant relationship with earnings management practice, which means there should be a positive effect of having large audit committees on financial reporting quality. Abdellatif (2009) suggested that the larger size of the audit committee can mitigate effectively asymmetric information during the seasoned equity offerings. Dalton et al. (1999) found a positive relation between size and the monitoring function of the board that result in higher performance documented, which indicates the larger size of board committee, the more diverse skills and knowledge are employed to enhance monitoring work (Pierce & Zahra, 1992). There is also researcher, who found no significant relationship between audit committee size and earning management (Xie et al., 2003; Abbott et al., 2004).
2.4.2 Independence of audit committee
The notion of being an independent director according to the Listing Requirement of Bursa Malaysia is referred to as the directors who are free from any relationship and independent from the company's management or having no shares in the company and having no relationship with any major shareholders, officers and executive directors (Hussain & Mustafa, 2012). A number of studies have concluded the relationship between audit committee independence and financial reporting quality. Vicknair et al. (1993) stated that audit committees must be independent of the management as it allows both the internal and external auditors to remain free of undue influences and interferences from corporate executives. Choi et al. (2004) found that when members of the audit committee hold shares in a company, they have less incentive to deter earnings management. Xie et al. (2003) concluded that the more independent audit committee is believed to provide better governance compared to less independent audit committee. Klein (2002) and Abbott et al. (2004) found a significant negative relationship between the number of independent director in audit committee and earnings management practice. On the other hand, some researcher get inconsistent result which concluded positively relationship (Felo et al.,2003) and no significant relationship (Jerry et al., 2006) with earnings management.
2.4.3 Competency of audit committee
According to MCCG 2007, all members the audit committee should be financially literate and at least one should be a member of an accounting association or body. In addition, all members should be able to read , analyze and interpret financial statements so that they will be able to effectively discharge their functions. Since, one of the duties of the audit committee is to review financial statements with respect to accounting policies, compliance with accounting standards and going concern assumption, they need a strong background in accounting (Saleh et al., 2007). Expertise whether it is in terms of qualifications or experience is expected to play a complementary role in enhancing the effectiveness of the audit committee with respect to audit and reporting quality (Steven et al., 2012). Majority studies suggested that audit committee with experience in accounting background can curb earnings management. DeZoort & Salterio (2001) argued that the audit committee's financial expertise increases the likelihood that detected material misstatements and corrected in a timely fashion. Abbott et al. (2004) reported a negative association between the audit committee's financial expertise and occurrence of earnings restatement. Xie et al. (2003) and Choi et al. (2004) reported that independent directors, who are financially competent, are effective as monitors in reducing earnings management practices. Hussain & Mustafa (2012) found that there is an insignificant negative relationship between the proportion of accounting expertise among the audit committee members and earnings management. Therefore, the presence of more members with accounting knowledge would trigger more audit committee meetings to be held due to more financial reporting issues to be discussed (Saleh et al, 2007). However, there is still some conflict studies proposed that audit committee's competency has no impact on quality of reporting earnings (Jerrt et al., 2006; Zgarni Inaam et al., 2012).
2.4.4 Frequency of meetings
According to Saleh et al. (2007), a more active audit committee is expected to provide an effective monitoring mechanism. MCCG 2007 stated that the audit committee should meet with the external auditors without executive board members present at least twice a year. This encourages a greater exchange of free and honest views and opinions between both parties. Few studies indicated the advantages of having meetings more frequently. Xie et al. (2003) found the number of audit committee meeting is negatively related to earnings management, which suggested that as the frequency of meeting increases, earnings management decreases. Similar results also emerge from Abbott et al. (2003) study proposed that regular meetings would make audit committee members more informed and knowledgeable about relevant accounting and auditing issue. They found that audit committees of firms restating their financial statements are not likely to meet at least four times a year. Another study from Beasley et al. (2000) also indicates that audit committees of firms charged by the SEC for fraudulent financial reporting meet less frequently than those of non-fraudulent firms.
2.5 Research Framework
This study examines the relationship between size, independence, competency of audit committee and frequency of meetings (IV) on earnings management (DV). The following model illustrates the various relationships examined in this study:
In this chapter, previous studies that relevant to the topic have been reviewed. The independent variables and dependent variable have been identified. The research framework is prepared to outline the overview of the variables. The research methodology and research hypotheses will be further discussed in the following chapter.
This chapter will discuss issues related to the research methodology, which consists of sample and data collection, data analysis, as well as the statistical technique that adapted to analysis the collected data.
3.2 Research Hypotheses
H1: The size of audit committee is negatively related to the level of earnings management.
H2: Audit committee with all independent members is negatively related to the level of earnings management.
H3: The competency of audit committee members is negatively related to the level of earnings management.
H4: The audit committee's meeting frequency is negatively related to level of earnings management.
3.3 Sample and Data Collection
The sample will be selected from the companies listed in Bursa Malaysia. The study will cover year 2007 until year 2009. The period is chosen because financial crisis happened in 2008 and many firms had suffered from economies downturn. Earnings and performance was the concerning issues, thus earnings management was more likely to be happened.
Data stream will be employed to collect the data on financial data needed to carry out discretionary accruals testing; while the data on audit committee characteristics will be gathered from the published annual reports. Any missing financial figures from Data stream will be extracted from the annual report manually. A total of 100 public listed companies (300 observations) will be selected randomly from all sectors. The financial companies will be excluded as they are subjected to a different regulatory framework. Additionally, companies that do not provide complete data will be excluded too.
3.4 Data Analysis
3.4.1 Cross- sectional Discretionary Accruals
According to Aminul et al. (2011), it is impossible to observe earnings management directly, but researchers normally investigate 2 venues of earnings management which are the choice of accounting methods and the management of accruals. Past studies had suggested that discretionary accruals method is an effective way to detect earnings management. Healy(1985) and DeAngelo(1986) used total accruals to measure management's discretion over earnings. Jones(1991) introduced a regression approach to control for non-discretionary factors influencing accruals, separating accruals into discretionary and non-discretionary accruals. Consequently, Dechow et al. (1995) had proposed modified Jones model when changes in sales are adjusted for the change in receivables. The modified model is designed to reduce the measurement error of discretionary accruals when discretion is applied over sale (Aminul et al., 2011). In addition, Dechow et al. (1995), Guay et al. (1996), and Peasnell et al. (2000) found that the modified Jones model provides the most powerful test for earnings management. Hence, the study will apply Modified-Jones Model (1995) to examine the extent of earnings management.
The discretionary accruals (DA) are treated as a proxy for the earnings management and it can be obtained after subtracting the non-discretionary accruals (NDA) from the total accruals (TA); while TA equals to the difference between net income and cash flow from operations.
TAit = NIit - OCFit
TAit = total accruals for firm i in year t,
NIit = net income for firm i in year t,
OCFit = operating cash flow for firm i in year t, At-1
TA is not reflecting the earnings management. It is raised when the management has the discretion to manipulate the earnings. Theoretically, accruals can be decomposed into discretionary accruals (DA) and non-discretionary accruals (NDA). As mentioned earlier, DA can be calculated by finding the difference between TA and NDA (DA = TA - NDA).
In employing the modified model, NDA are estimated during the observation or event year (the year in which earnings management is estimated), as follow:
NDAit = Î±1 (1/ TAit-1) + Î±2 [(Î”REVit - Î”RECit ) / TAit-1] + Î±3 (PPEit / Ait-1)
Î”REVit = change in net revenue for firm i in year t
PPEit = gross property plant and equipment at the end
of year t
Î”RECit = change in net receivables for firm i in year t
TAit-1 = total assets for firm i at the end of year t-1
Î±1 , Î±2, Î±3 = firm specific coefficient parameters
Finally, TDAit are calculated as the difference between TAit and NDAit
TDAit = TAit - NDAit
TDAit = Total discretionary accruals
TAit = Total accruals
NDAit = Non-discretionary accruals
3.4.2 Regression Model
In order to complete the calculation, a regression model can be used to measure the strength of association between the TDA and the explanatory variables Aminul et al. (2011).
TDAit = Î± + Î±1ACsizeit + Î±2ACindit + Î±3ACcompit + Î±4Fmeetingit + Îµit
TDAit = total discretionary accruals for firm i in year t,
ACsizeit = The size of audit committee
ACindit = Independence of audit committee
ACcompit = Competency of members in audit committee
Fmeetit = Frequency of audit committee meeting
Îµit = residual which represent the firm specific
discretionary portion of total accruals / error
term for firm i in year t
In this chapter, the population and the sample size have been identified. The research methods have also been suggested to test on the hypotheses developed in chapter 2. Finally, the method used for analyzing the data is described. The following chapter will demonstrate the findings and results.