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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.
2.1 Earnings Management - Dependent Variables (DV)
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.
2.2 Audit Committees Characteristics - Independent Variables (IV)
Historically, 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 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 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).
2.3 Determinants of earnings management
2.3.1 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). There is a mixed result of studies, hence the study hypothesize the following:
H1: The size of audit committee is negatively related to the level of earnings management.
2.3.2 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. Therefore, the hypothesis stated as below :
H2: Audit committee with all independent members is negatively related to the level of earnings management.
2.3.3 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). Thus, from the discussion above , the following hypothesis is proposed :
H3: The competency of audit committee members is negatively related to the level of earnings management.
2.3.4 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. So, the hypothesis proposed is :
H4: The audit committee's meeting frequency is negatively related to level of earnings management.
2.4 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, the hypotheses that predict the determinants in monitoring the managerial behavior of earnings management are developed. The method for testing the stated hypotheses will be further discussed in the following chapter.