1

CHAPTER 1

OVERVIEW OF RESEARCH

1.1 INTRODUCTION

The East Asian financial crisis in 1997/1998 exposed the weak governance and poor

governance standards that were blamed indirectly in part for the crisis (Nam and Nam,

2004). This weakened foreign investors’ confidence in the East Asian capital market,

including Malaysia (Leng, 2004; Abdul Rahman and Haniffa, 2005). Much later in 2001,

the tragic collapses and losses of giant companies such as Enron Corporation, WorldCom

and Tyco International in the United States (US), which is known to have the best regulated

and most efficient capital market in the world, further reinforced the critical need to

improve the corporate governance system in both developed and developing countries.

Additionally, other scandals such as Parmalat in Italy and many others (e.g. Bre-X and

YBM Magnex in Canada, Royal Ahold in the Netherlands, Credit Lyonnais and Vivendi in

France, Metalgesellschaft in Germany, HIH Insurance Ltd. in Australia), have drawn

attention to corporate governance reforms around the world. There is urgent need to

improve reported earnings quality as the capital market needs precise and unbiased

financial reporting to value securities and encourage investors’ confidence (Pergola, 2005).

Erosion in the quality of financial reporting is perceived to be associated with financial

reporting irregularities such as fraudulent financial reporting, earnings management and

financial restatements (Wan Hussin and Ibrahim, 2003). The unexpected financial collapse

of BCCI and Maxwell Corporation and the harsh economic climate in the United Kingdom

2

(UK) in early 1990 spurred initiatives on fostering good governance to improve financial

reporting and accountability of all listed companies registered in the UK (Cadbury Report,

1992). The Cadbury Report (1992) links corporate governance and financial reporting

quality and warns that financial reporting quality may be compromised by ineffective

governance mechanisms. In fact, in the US, the National Commission on Fraudulent

Financial Reporting known as the Treadway Commission (TC) emphasized the role of

various key players (management, board of directors, audit committees, internal auditors

and external auditors) in the corporate governance systems as agents to help prevent

financial reporting fraud about 15 years earlier. Failure of the executives, auditors and

audit committees to embrace the TC recommendations is believed to have resulted in the

meltdowns of Enron, WorldCom and other companies in the US (Barrier, 2002).

Malaysia has not been without its share of corporate mischief and misconduct. Several

high-profile cases involving big companies such as Technology Resources Industries, FA

Peninsular, Tat Sang, Time dotCom and Malaysian Airlines Systems have been witnessed.

Recently, market sentiments were shaken when two former independent non-executive

directors of Transmile Group Bhd were charged with ‘knowingly authorizing the furnishing

of a misleading statement’ to Bursa Malaysia1 in relation to the affairs of the express air

cargo operator2. Further, news regarding ‘accountants and auditors under spotlight’ cast

doubt on the role played by accountants, auditors as well as audit committees in protecting

the credibility of the financial statements of listed companies following the Securities

Commission’s (SC) revelation that not all public listed companies in Malaysia have been

truthful in their financial statements3.

1 Prior to April 2004, Bursa Malaysia was known as Kuala Lumpur Stock Exchange (KLSE). 2 The Star, November 15, 2007, ‘Ex-directors charged over misleading info’. 3 Business Times, August 19, 2005, ‘Accountants, auditors under spotlight’.

3

In response to the risks posed by corporate governance breakdown, many countries4 have

taken proactive action to reform their code on corporate governance to improve and

strengthen the corporate governance systems. In developing economies such as Malaysia,

the implementation of good corporate governance practice reduces exposure to financial

crises as well as contributing to sustainable economic development (The World Bank

Report, 2005). The economic crisis in 1997 resulted in a massive loss of foreign investors’

confidence in the Malaysian capital market (Abdul Rahman and Haniffa, 2005). In 1999,

the government established a high level Finance Committee on Corporate Governance

comprising government and industry representatives to establish a framework for corporate

governance best practices. The committee carried out detailed investigations through a

survey of Corporate Governance Best Practices of Public Listed Companies. This survey

was conducted by Bursa Malaysia and PriceWaterhouseCoopers (PWC) to develop

recommendations for corporate governance best practices for Malaysia (Ow-Yong and

Guan, 2000).

The report of the Committee focused on the board’s monitoring role and highlighted the

importance of the board of directors as one of the internal corporate governance

mechanisms to enhance shareholder value and protect shareholder wealth. After a year,

following the issuance of the Finance Committee’s Report on Corporate Governance, the

Finance Committee issued the Malaysian Code on Corporate Governance (MCCG) in

March 2000. This Code describes the principles for corporate governance best practices.

The Malaysian Code came into full effect in January 2001 with an amendment to the listing

requirements of the Bursa Malaysia. The revamped Listing Requirements are considered a

4 See e.g. Cadbury Report 1992, Greenbury Report 1995, Malaysian Code on Corporate Governance 2000, Singapore Code of Corporate Governance 2001, Thailand Code for Best Practice for Directors of Listed Companies 2002, Sarbanes-Oxley Act 2002, NYSE Corporate Governance Rules 2003, Bangladesh Code of Corporate Governance 2004, Hong Kong Corporate Governance Code 2004 at http://www.micg.net/code.htm

4

major milestone in corporate governance reform, bringing into effect the Finance

Committee Report on Corporate Governance, thereby creating an environment that

demands a higher standard of conduct and a higher quality of disclosure from corporate

governance participants in Malaysia. Furthermore, recent changes in the Revised

Malaysian Code on Corporate Governance 2007 (Revised MCCG, 2007) show greater

clarity of the role of the board in hiring suitable management, compensating, monitoring,

replacing and planning the succession of senior management to strengthen the control

exercised by boards over their companies. In order to meet the existing and anticipated

world-wide competition, the revised Malaysian Code aims to meet emerging global

competition with the shift to full disclosure in line with developments in the domestic and

international capital markets (Revised MCCG, 2007).

However, East Asian countries face problems when adapting and strengthening corporate

governance practices. These economies are generally characterised by several significant

features, namely, a high level of ownership concentration; excessive government

intervention; weak legal systems and enforcement; lack of quality information; as well as a

lack of developed legal structures and institutions, that present specific and daunting

obstacles for promoting good governance practices (Claessens and Fan, 2002; Leuz et al.,

2003; Bhattacharyay, 2004; Cheung and Chan, 2004; Nam and Nam, 2004). The

ownership structure of East Asian companies contrasts sharply with that of companies in

developed, Western countries such as the UK and the US where shareholding is commonly

dispersed with clear separation of ownership and management. Although the markets are

still classified as emerging markets, many Asian countries have implemented regulatory

reforms that mirror corporate governance practices adopted by new Western corporate

governance laws and codes. To some extent these reforms raise questions with regards to

5

their effectiveness in Asian corporate environments that are characterised by differences of

legal, regulatory, economic, social and cultural factors (Cheung and Chan, 2004).

Like other East Asian countries, concentrated shareholdings by individuals and families,

together with significant government equity holdings are two features that distinguish the

ownership patterns of Malaysian corporations from their western counterparts (Abdullah,

2006a). According to Thillainanthan (1999), concentration of shareholdings through cross-

holdings and a pyramid structure is very common in Malaysian corporations with

controlling shareholders being either individuals or families who have more than 50 percent

ownership, which may contribute to deficiencies in corporate governance. The ownership

structure in Malaysia is largely a result of the national economic agenda (Gomez and Jomo,

1999). Hence, the Malaysian market provides a different setting for the implementation of

corporate governance schemes compared to other countries within this region (Chu and

Cheah, 2006). The domination of Malays5 in politics and Chinese in commerce, business

and economics in Malaysia, provides a unique research setting that is not found elsewhere

(Abdullah, 2006a).

Historically, Malaysia was a former British colony. Hence, the development of company

law in Malaysia closely follows the pattern of the United Kingdom’s company legislation.

The Malaysian accounting and auditing standards replicate those found in the UK as well as

other commonwealth countries such as Australia and New Zealand (Gul, 2006). Although

there are broad similarities with regards to accounting and regulatory environments with the

US and the UK, the Malaysian corporate sector operates in a different institutional

environment, which is characterised by the existence of politically favoured corporations

5 Also known as Bumiputera, literally ‘son of the soil’.

6

(Gul, 2006). The government intervention, partly in response to ethnic rioting in 1969, in

the form of the New Economic Policy (NEP)6 in 1970, intended to eliminate the

identification of race with economic functions (Tam and Tan, 2007). The NEP is aimed at

achieving 30 percent Bumiputera ownership of the corporate sector by 1990. This resulted

in an affirmative action in favour of the Bumiputera7 (Malay) (Gomez and Jomo, 1999).

Since then, the Bumiputera have been given priority of various concessions including

business contracts, access to capital as well as other subsidies (Johnson and Mitton, 2002).

Various state agencies are also established to meet the NEP objectives (Chu and Cheah,

2006). Though Bumiputera ownership has grown tremendously from 2.4 percent in 1970

to 18.9 percent in 2004, the ownership still fell short of the initial target of 30 percent8.

Meanwhile, Chinese equity ownership has increased to more than double that of the

Bumiputera (see: Table 1.1).

Corporate governance practices in developing markets have not been studied as intensively

as in developed markets. Until recently, most governance studies focused on firms with a

diffused ownership structure, mainly in US and UK settings. However, in most Asian

countries, specifically developing countries, many firms are closely owned or privately held

with the principal shareholders typically playing an active role in management (La Porta et

al., 1999; Jaggi and Leung, 2007). In light of this, the agency problems among firms with

such concentrated ownership structures have yet to be sufficiently analysed (Cho and Kim,

2007). Thus, this study investigates the effect of board of directors’ characteristics,

ownership structure and ethnicity on the reported earnings quality of Malaysian firms,

subsequent to the implementation of corporate governance reforms introduced by the

6 The NEP was initiated by the government to correct the imbalance between Chinese and indigenous Malay (Bumiputera) in the economy, where economy is predominantly run by the Chinese to the exclusion of Malays (Gul, 2006). 7 Bumiputera refers to Malaysian for Malays and other indigenous ethnic groups (Haniffa and Cooke 2005, p.398). 8 The Ninth Malaysian Plan reported that the proportion of Bumiputera companies in all economic sectors remained very low.

7

Malaysian government in 2000. In a country like Malaysia, which exhibits concentrated

ownership structure and more ethnically diverse and economic growth, great concerns arise

regarding the relationship between majority and minority shareholders (Chu and Cheah,

2006) as well as between ethnic groups that maintain and practice their own cultural values

and religious beliefs (Salleh et al., 2006).

Table 1.1

Ownership of Share Capital1 (at par value) of Limited Companies,

1970, 1995, 2000 and 2004

Ownership Group 1970 1995 2000 2004

Bumiputera

Individuals & Institutions2 Trust Agencies3 Non-Bumiputera

Chinese Indians Others Nominee Companies

Foreigners

2.4

1.6 0.8

28.3

27.2 1.1

- 6.0

63.4

20.6

18.8 2.0

43.4

40.9 1.5 1.0 8.3

27.7

18.9

17.2 1.7

41.3

38.9 1.5 0.9 8.5

31.3

18.9

17.2 1.7

40.6

39.0 1.2 0.4 8.0

32.5

Sources: Second Malaysian Plan, 1971-1975; Seventh Malaysian Plan, 1996-2000; Eighth Malaysian Plan, 2001-2005; Ninth Malaysian Plan, 2006-2010. Notes: 1 Excludes shares held by Federal and State Governments.

2 Refers to shares held through institutions channelling Bumiputera funds such as the Permodalan Nasional Berhad (PNB) unit trust schemes, Amanah Saham MARA, Lembaga Tabung Haji, Lembaga Tabung Angkatan Tentera and Koperasi Polis.

3 Refers to shares held through trusts agencies such as PNB, Perbadanan Usahawan

Nasional Berhad, Perbadanan Nasional Berhad, Majlis Amanah Rakyat (MARA), Bank

Pembangunan Malaysia Berhad and State Economic Development Corporations.

8

1.2 RESEARCH OBJECTIVES

The primary objective of this study is to examine the relationship between board of

directors’ characteristics, ownership structure, ethnicity and earnings quality through the

analysis of accrual quality in Malaysia. The main research question is: Do board of

directors’ characteristics, ownership structure and ethnicity influence the earnings quality in

Malaysia?

In addition, the theoretical framework, specific research objectives and research questions

of the study include:

Theoretical

Framework Research Objectives Research Questions

1.

Agency, Resource Dependence

To identify the characteristics of the board of directors that determine its effectiveness in monitoring and enhancing the reported earnings quality.

Do board compositions (i.e. board independence and CEO duality) influence the quality of earnings? Do board expertise (i.e. financial expertise, governance expertise and firm-specific expertise) influence the quality of earnings?

2.

Agency

To investigate the impact of different types of ownership structure on earnings quality.

Do managerial ownership, family ownership and institutional ownership impact earnings quality?

3.

Political Costs, Legitimacy

To explore and examine the influence of ethnicity on earnings quality in Malaysia.

Is there any relationship between Malay and Chinese directors and earnings quality in Malaysia?

9

1.3 RESEARCH MOTIVATION AND CONTRIBUTION

Although there is significant literature on corporate governance issues in Malaysia,

discussions on the relationship between corporate governance and earnings quality have not

been extensively explored. While other studies in the Malaysian context investigate the

relationship between corporate governance and performance (see e.g. Abdullah, 2004;

Abdul Rahman and Haniffa, 2005; Che Haat, 2006), corporate governance and earnings

management (Abdullah and Mohd Nasir, 2004; Norman et al. 2005; Abdul Rahman and

Mohamed Ali, 2006; Hashim and Susela, 2006; 2008b) and corporate governance and audit

quality (Yatim et al., 2006; Salleh et al., 2006), this paper extends prior study by examining

the link between the board of directors characteristics and earnings quality, measured by

accrual quality, to provide evidence of the board’s ability to provide a higher quality of

financial reporting. While prior studies mainly focus on the board’s monitoring role, this

study also includes ownership structure and ethnicity as two other important institutional

characteristics that may possibly influence the way the managers and the board of directors

govern their firms in producing higher quality reported earnings. The study offers an

alternative explanation on the association between governance and financial reporting

quality by examining the role of ownership structure and ethnicity that explicate the unique

institutional context of an Asian country. This provides fresh evidence of the institutional

context in enhancing corporate governance practices in emerging markets around the world,

especially in the East Asian region.

This study contributes to the literature on the association between corporate governance

mechanisms, ownership structure, ethnicity and financial reporting quality in several ways:

10

1. It adds to recent literature showing the links between corporate governance and

financial reporting quality, in a different institutional setting. Despite the legislative

reforms on corporate governance structure, the relationship between corporate

governance and earnings quality remains a relatively unexplored research issue and

investigation of the association between corporate governance structures and the quality

of reported earnings in different institutional settings, specifically from a developing

country such as Malaysia, provides interesting evidence on this aspect of corporate

governance research. In Malaysia, the involvement of state-owned and government

linked companies, including political parties and family controlled firms, are common.

This influences the role of governance in the firms that offers an interesting perspective

of corporate governance systems to be compared (Chu and Cheah, 2006).

2. Most prior studies linking institutional features and earnings quality in the East Asian

market are cross country studies (see e.g. Fan and Wong, 2002; Leuz et al., 2003;

Boonlert-U-Thai et al., 2006). However, findings of cross country studies have been

questioned for limited sample size, endogeneity problems, noisy variables and severe

omissions of correlated variables (Gul, 2006). Since different countries have different

levels of investor protection, legal enforcement and ownership structure, it is important

for the researcher to acknowledge these factors when discussing earnings quality in

different countries that are based on different socio-economic factors (Boonlert-U-Thai

et al., 2006; Lo, 2007) to provide a more meaningful earnings quality study. Thus, this

study focuses on a specific country study, i.e. Malaysia to provide a better

understanding of the link between governance and financial reporting in emerging

countries. Concentration on a country helps to control for different factors that affect

11

studies across countries, thus providing a deeper understanding of the issues being

examined, especially in jurisdictions outside of the US and the UK (Jaggi et al., 2007).

3. This study addresses the issue of corporate governance effectiveness after the

Malaysian corporate governance reforms. Malaysia provides an interesting platform for

examining this issue as MCCG 2000 includes the requirement for a well-balanced and

effective board (i.e. having a balance of executive directors and non-executive directors

including independent non-executive directors) and the separation of power between the

chairman and the chief executive officers (CEO) to ensure higher quality financial

reports are conveyed to the users of the financial statement. Additionally, the Code also

requires non-executive directors to have the necessary skills and experience and be a

person of calibre and credibility in order to bring independent judgment to the board.

Further, recent changes in the Revised MCCG 20079 show greater clarity on the

nominating committee role, which consists exclusively of non-executive directors, to

recommend candidates for directorship. They are required to consider among other

factors, the skills, knowledge, expertise and experience of candidates so that the

appointed directors will be able to discharge their functions more effectively. While

most prior studies on board of director’s characteristics focus mainly on the role of

board independence and CEO duality, this study also examines their expertise to

effectively monitor the financial reporting process. Although the Revised MCCG 2007

does not state specifically the criteria for skills and expertise, this study attempts to

9 The aim of the Revised Malaysian Code on Corporate Governance (Revised MCCG, 2007) is to further strengthen corporate governance practices in line with developments in the domestic and international capital markets. The Prime Minister, Dato’ Seri Abdullah Ahmad Badawi announced in the 2008 Budget speech that ‘the Code is being reviewed to improve the quality of the board of

public listed companies by putting in place the criteria for qualification of directors and strengthening the audit committee, as well as the

internal audit function of the public listed companies’ (Revised MCCG 2007, p.i). The revised MCCG 2007 enriches the role of the nomination committee by requesting that when candidates are recommended for directorships they should have the necessary skills, knowledge, expertise, experience, professionalism, and integrity to strengthen and ensure the board discharges its roles and responsibilities effectively.

12

gather evidence through various proxies of expertise, such as financial expertise,

governance expertise and firm-specific expertise.

4. Despite the fact that there is extensive literature that discusses the role of the ownership

structure in corporate governance around the world (Shleifer and Vishny, 1997; La

Porta et al. 1999), there is a scarcity of prior research that empirically examines the

relationship between the ownership structure and financial reporting outcomes in the

context of a developing country. Except for prior studies that examine the relationship

between the ownership structure and performance (see e.g. Bathala and Rao, 1995;

Mitton, 2002; Ng, 2005; Vethanayagam et al., 2006; Chu and Cheah, 2006), little is

known about the relationship between ownership structure and financial reporting

quality, especially on the earnings quality issues in less developed economies.

Furthermore, prior studies have found inconclusive evidence in ownership studies due

to limitation of ownership concentration that ignores the issues of shareholders’

identities (Chu and Cheah, 2006). This study extends the existing literature by

including different types of ownership structure and its impact on the quality of

earnings, focusing on the Malaysian business environment where concentrated

ownership structure is prevalent.

5. Given the conflicting theoretical viewpoints regarding the relationship between family

ownership and agency costs, this study further investigates whether the existence of

family board members on the board provides incentives to reduce or create agency costs

in the Malaysian context. Some argue that family controlled firms reduce agency costs

as they carry along their family name and reputation into the business while others

argue that family controlled firms create agency costs by extracting private benefits at

13

the expense of minority shareholders (Bartholomeusz and Tanewski, 2006). Though

family controlled firms are often cited to misappropriate firms’ resources, it is argued

that the benchmark is mainly based on a dispersed ownership structure, which is less

relevant in emerging economies (Chu and Cheah, 2006). Hence, this study attempts to

provide evidence on the effect of family ownership on the reported earnings quality.

This should shed light on the issues of conflicting interests between the controlling

owners and minority shareholders in the Malaysian environment.

6. Recent literature acknowledges the importance of the institutional investors in corporate

monitoring to protect minority shareholder’s interests. Institutional investors in

Malaysia have emerged as a powerful constitution with a significant role in corporate

governance. The establishment of the Minority Shareholder Watchdog Group (MSWG)

that represents the five largest institutional funds in Malaysia – the Employee Provident

Fund (EPF), Lembaga Tabung Angkatan Tentera10 (LTAT), Lembaga Tabung Haji

11

(LTH), Social Security Organization (SOCSO) and Permodalan Nasional Berhad12

(PNB) – to monitor and deter abuses by company insiders shows the Malaysian

government’s commitment to encourage shareholder activism in Malaysia. Prior

studies that examine the role of institutional investors from the perspective of financial

reporting quality is limited (Velury and Jenkins, 2006) and this study extends prior

study by examining the association between institutional ownership and accrual quality

in the Malaysian context.

10 Army Savings Board 11 Pilgrimage Savings Board 12 National Equity Board

14

7. Another interesting issue that has a significant impact on business ethics, corporate

practices and the behaviour of board members in Malaysian corporations is ethnic

characteristics (Ow-Yong and Guan, 2000). Malaysia is a multiethnic society with

Chinese and Malays dominating economics and politics in Malaysia. In summary of

Malay cultural aspects and leadership styles, Mansor and Kennedy (2000) note that the

Malays emphasize collective morale rather than the achievement in business (i.e. high

on collectivism) and a comparatively short time horizon (i.e. low professionalism). In

contrast, Chinese leaders display remarkably high entrepreneurship and practice the

legalistic approach in leading organisations (i.e. high professionalism). The Chinese

leader maintains good self-discipline and applies strategic thinking that serve as

important values to the success of Chinese family managed businesses (Wah, 2002).

As the directors of Malaysian corporations come from different ethnic backgrounds,

examination of their influence over the quality of financial reporting quality will

provide a new direction on the sociological aspects of corporate governance research.

8. Following recent work by Francis et al. (2005), Boonlert-U Thai et al. (2006), Doyle et

al. (2007) and Jaggi et al. (2007), this study applies the accrual quality model

developed by Dechow and Dichev (2002) that captures one aspect of the quality of

accruals and earnings. The use of the accrual quality model, as an improved measure of

earnings quality, in this study is to overcome the weaknesses of measurement errors in

the earnings management model (i.e. absolute discretionary accrual) in measuring

earnings quality13. Among seven earnings attributes to define earnings quality (i.e.

accrual quality, persistence, predictability, smoothness, value relevance, timeliness and

13 See McNichols (2000) on the research design issues in earnings management studies for detailed discussions and evidence on aggregate accruals models possible misspecification to characterize discretionary behaviour.

15

conservatism) evaluated by Francis et al. (2004) to investigate the relationship between

cost of equity and attributes of earnings, the accrual quality model outperforms the

other attributes that were characterized as accounting-based and market-based

attributes.

1.4 SIGNIFICANCE OF STUDY

This study is significant from several aspects:

1. Theoretical Contribution

This study offers theories pertaining to the influence of the board of directors,

ownership structure as well as ethnicity on the quality of reported earnings. Though

prior studies have tended to focus on the influence of corporate governance and firm

performance and corporate governance and earnings management, this study attempts

to close the knowledge gap by linking corporate governance and earnings quality

through the analysis of accrual quality in Malaysia. Not only focusing on internal

governance mechanisms, this study expands the role of governance to include substitute

mechanisms to determine their significance on the reported earnings quality in

Malaysian corporations. The empirical findings of the study could provide useful

insights for accounting standard setting bodies, investors, analysts and researchers to

better understand how accrual accounting could improve the quality of earnings and

how the board of directors, ownership structure and ethnicity affect the quality of

earnings.

16

2. Implications to Policy Makers

The Malaysian corporate landscape has made significant progress in corporate

governance practices since the release of the MCCG 2000, where mandatory reporting

of compliance with the Code has permitted shareholders and the public to assess and

determine the standards of corporate governance by Malaysian listed companies. By

examining the association between corporate governance mechanisms and earnings

quality, this study provides a basis to determine whether existing requirements imposed

upon all firms are heading in the right direction. The findings of this study will be

useful to the regulators in deliberating policies on issues related to corporate

governance, thus determining the direction of future governance policies for Malaysian

corporations.

3. Implications to Academic and Business Practices

Though many argue about what good governance entails (Barton et al., 2004), this

study attempts to reconfirm extant studies by examining various aspects of corporate

governance mechanisms, including the board of directors’ characteristics, the

ownership structure as well as the ethnicity variables and its link to the quality of

reported earnings. The findings of this study will be useful to investors in evaluating

the quality of financial information of the academic research to understand the role of

various corporate governance mechanisms to alleviate conflicts of interest between

management and shareholders as well as to the managers in enhancing the quality and

credibility of their financial reporting quality. This study contributes to the body of

knowledge on accounting and the growing empirical literature and encourages further

research on the association of corporate governance and earnings quality.

17

1.5 CHAPTER ORGANISATION

The remainder of the thesis is organised as follows. The next chapter, Chapter 2 discusses

the concept of earnings quality. Chapter 3 provides an overview of corporate governance

in general and focuses specifically on East Asian corporate governance issues. It

synthesises the extant literature on corporate governance and identifies gaps from an Asian

perspective focusing both on theory and research contribution. Chapter 4 explains the

theoretical framework, hypotheses, and research methodology used in the study. Chapter 5

presents and discusses the empirical results. Chapter 6 concludes the overall results,

acknowledges limitations inherent in the scope of study and research design and identifies

additional potential issues for future research.

Thus far, this chapter provides a general overview of the study by showing the need for

corporate governance mechanisms to regain investors’ confidence towards the integrity of

accounting numbers. The financial reporting scandals of very large corporations in the US,

which has been considered as the best regulated, most liquid, most efficient market, call

into question the reliability of reported earnings and appropriate governance mechanisms to

improve the quality of financial reporting. The scandals together with the Asian financial

crisis in 1997/1998 have drawn attention to the corporate governance reforms around the

world, including Malaysia, to improve and strengthen current corporate governance

systems.

The role of the board of directors as the apex of corporate governance systems is seen as

crucial to the effectiveness of corporate governance systems as well as to the success and

survival of the company. Though corporate governance reforms have been very progressive

18

and largely based on Anglo-American models, critics believe that the reform measures are

cosmetic because of the concentrated ownership structure and the embedded institutional

and socio-cultural norms in East Asian economies that limit the effectiveness of these

reforms. To address this issue, this study attempts to provide empirical evidence of the

joint effect of board of directors’ characteristics, ownership structure and ethnicity on the

quality of reported earnings in Malaysia, which has differences in the business and

institutional environments as well as the ownership structure of firms compared to those of

US and UK firms. The next two chapters will provide thorough discussions on the issues

of earnings quality and corporate governance mechanisms.

19

CHAPTER 2

EARNINGS QUALITY: A REVIEW AND SYNTHESIS OF LITERATURE

2.1 INTRODUCTION

Even though earnings quality has been an area of interest to researchers in financial

accounting for many years, the term earnings quality only became a significant issue after

the failure of highly publicised scandals such as Enron Corporation, Tyco International and

WorldCom (to name but a few) in the United States, which is known to have the best

regulated and the most efficient capital market in the world. As described in the preceding

chapter, high quality and transparent financial reporting is essential to value securities and

instil investor confidence. As investors, institutional owners, analysts and regulators all

rely on the quality of reported earnings when making decisions. False reported earnings

will cause huge losses on their investment and could harm the economy as a whole through

the adverse effect of low quality earnings (Pergola, 2005).

Dechow and Schrand (2004, p. viii) state in their preface of earnings quality monograph

that ‘understanding a company’s quality of earnings requires expertise in finance,

accounting and corporate strategy and a strong knowledge of the industry in which the

company operates and the governance mechanisms monitoring and rewarding employees

and managers’. Therefore, it is the purpose of this chapter to explain the concept of

earnings quality, its usefulness, its construct and measures as well as outside factors that

affect earnings quality to demonstrate why it is an important concept to be examined in the

study.

20

The remainder of the chapter is organised as follows. Section 2.2 describes the concept of

earnings quality. Section 2.3 discusses the usefulness of earnings and examines prior

literature on earnings quality studies. Section 2.4 highlights various earnings quality

constructs and measures derived from prior research based on the various definitions of

earnings quality. The incentives for earnings management and its relationship with

earnings quality is discussed in Section 2.5. Section 2.6 offers a brief discussion on the role

of governance to safeguard the quality of earnings. The chapter ends with Section 2.7

summary and conclusion.

2.2 EARNINGS QUALITY CONCEPTS

The concept of earnings quality evolved in the 1930s from the fundamental analysis notion

of searching for undervalued and overvalued securities through the analysis of a company’s

financial statement, in comparison to the firm’s true value (Ayres, 1994). The idea is that

under or overvalued securities impact the quality of earnings as it is priced at less or more

than its true value. Thus, in order to assess the firms’ true earning power, Bernstein and

Siegel (1979) argue that it is important for the users of the financial statement to make

some determination of the quality of its earnings.

Among the earliest published papers from academic researchers that described the earnings

quality concept were Bernstein and Siegel (1979) and Siegel (1982). At that time, there

was widespread confusion of what should be included in the concept of earnings quality, as

earnings numbers gained a considerable interest in security analysis for the securities

evaluation procedure and debt instruments ratings.

21

For the purpose of earnings evaluation, Bernstein and Siegel (1979) put forward three

important elements for the concept of earnings quality, which are integrity, reliability and

predictability14. They suggest that the existence of these three elements provides an

important basis for understanding the notion of ‘quality’ in earnings. Nonetheless,

Bernstein and Siegel (1979) argue that the quality of earnings is directly associated with

the management’s and accountant’s discretion in choosing and using accounting policies.

The use of a liberal accounting policy compared to a conservative accounting policy is

argued in their paper to prove that overstated earnings lead to a lower quality of earnings.

Following the work by Bernstein and Siegel (1979), Siegel (1982) carries out a survey to

determine how the preparers and users of financial statements view the attributes of good

or poor earnings quality. 350 questionnaires were mailed to the financial experts (i.e.

accountants, security analysts, financial managers) and M.B.A. students to answer

questions related to the concept of earnings quality. Overall, his study shows that the

financial experts are familiar with the concept of earnings quality and find the term

earnings quality is a meaningful and useful concept. The respondents agree that companies

try to boost earnings in various ways such as by changing the accounting method, reducing

discretionary costs, selling material assets, recognizing tax carry forward losses and

declining bad debt provisions, which cause a deterioration in earnings quality (for more

complete results of the survey, see: Siegel 1982, p.65-68). The results of the survey

generally show that the use of more liberal accounting policies lead to a lower quality of

earnings.

14 As earnings figures are affected by accounting and business choices, integrity is a very important element to ensure that earnings figures are not manipulated with the intention to increase the reported income of the firm. An overstatement or understatement of earnings, merely to enhance earnings figures that does not reflect economic reality, destroys the quality of reported earnings as well as the ability of earnings to predict future earnings. Reliability, on the other hand, is to ensure that the earnings figures contain a good signal of the firm’s earning power.

22

Ayres (1994) brings forward the issues of perceived earnings quality into the concept of

earnings quality. She argues that perceived earnings quality is as important as actual

earnings quality and that managers should consider the trade-off between earnings

improvement and possible negative perceptions of earnings quality. In making accounting

policy choices and in managing accruals, she warns managers to be aware of three

important factors that can influence investors’ perception of earnings including –

impression management, income smoothing and earnings management factor. If users had

the impression that the managers had manipulated the earnings numbers to report higher

earnings figures, the earnings would be regarded as less informative and would not be

reliable for firm valuation. This will result in a lower perception of the earnings quality,

which in turn leads to lower market values.

Ku Ismail and Abdullah (1999) extend prior research by Bernstein and Siegel (1979) and

Siegel (1982) by investigating the issues of earnings quality in Malaysia. Their survey

aims to obtain perceptions of financial analysts on issues relating to earnings quality and

accounting conservatism. As predicted, they find that the respondents feel that the use of

liberal accounting policies lead to a lower perceived degree of accounting conservatism and

lower earnings quality, which supports the contention made by earlier studies of Bernstein

and Siegel (1979) and Siegel (1982). As the majority of the respondents are familiar with

the concept of earnings quality and agree that earnings quality is an important and useful

concept to Malaysian financial analysts, they conclude that prior findings in US studies

with regards to the usefulness of earnings quality concept may well be extended to the

Malaysian environment.

23

Generally prior studies suggest that the more liberal the firm’s accounting policies, the

lower the quality of earnings (Bernstein and Siegel, 1979; Siegel 1982; Ku Izah and

Abdullah, 1999; Shaw, 2003). However, as earnings numbers are subject to individuals’

choices between generally accepted accounting principles and business options as well as

external economic conditions, Bernstein and Siegel (1979) posit that analysts examine the

policies used in comparison with the typical accounting policies employed in the industry

to distinguish between management discretion and normal business operation. This they

suggest will render the earnings numbers more meaningful and more reliable as indicators

of future income. The next section provides discussions on the usefulness of earnings and

its related literature.

2.3 USEFULNESS OF EARNINGS AND EARNINGS RESEARCH

Financial reports are one of the major mediums by which information is disseminated to the

external user (Wild, 1996). The joint International Accounting Standards Board (IASB)

and Financial Accounting Standard Board (FASB) exposure draft on the Conceptual

Framework for Financial Reporting (2008, p.13) states that:

“The objective of general purpose financial reporting is to provide financial

information about the reporting entity that is useful to present and potential equity

investors, lenders, and other creditors in making decisions in their capacity as

capital providers. Information that is decision useful to capital providers may also

be useful to other users of financial reporting who are not capital providers.”

24

Since information is crucial in this process, Wild (1996) argues that it is important to

ensure that the financial reports, and the numbers therein, convey high quality financial

information to the users. High quality information diminishes agency problems by closing

the information asymmetry15 gap that exists between the management and shareholders

(Karamanou and Vafeas, 2005) and is crucial to the proper functioning of capital markets

(Shaw, 2003).

The separation of ownership and control of a firm create information asymmetries that lead

to a high degree of reliance on financial information, especially on the reported earnings by

the users of financial statements. Earnings are widely believed to be a premier source of

financial information in the marketplace, especially for security valuation and contracting

purposes (Lev, 1989; 2003; Schipper and Vincent, 2003; Francis et al., 2005). The issue of

earnings quality is crucial as users need to assess the quality of the information provided in

the financial statement in making reliable valuations. Financial analysts use earnings as

performance measures for forecasting future outcomes of securities (Siegel, 1982).

Corporate board and institutional investors use earnings to gauge firm performance and

quality of management (Lev, 2003). Earnings are also used by shareholders as a direct

basis for awarding bonuses and indirectly as reference points for triggering the award of

executive stock options for senior managers (Peasnell et al., 2000). Further, standard

setters also view earnings quality or more generally financial reporting quality as indirect

measures to assess the quality of financial reporting standards (Schipper and Vincent,

2003).

15 Information asymmetry refers to the fact that the management has inside information about the true economic status of the firm that they may or may not share with stakeholders (Pergola 2005, p.178).

25

The Financial Accounting Standard Board (FASB) framework suggests that the objective

of earnings is to facilitate the prediction of future investor cash flow or stock returns (Lev,

1989). Under Section 43 of FASB conceptual framework (1976), it is stated that:

“The primary focus of financial reporting is information about an enterprise’s

performance provided by measures of earnings and its components. Investors,

creditors and others who are concerned with assessing the prospects for enterprise

net cash inflows are especially interested in that information. Their interest in an

enterprise’s future cash flows and its ability to generate favourable cash flows leads

primarily to an interest in information about its earnings…”

As earnings are considered as the primary profitability indicators, early studies have given

special focus to the information content of earnings and provide evidence that earnings

convey significant information about a firm’s value (Finger et al., 1994; Dechow et al.,

1998; Bartov et al., 2001; Cheng and Yang, 2003). Studies have examined whether

earnings provide a better indication of firm value compared to the other measures of

accounting measurement.

Finger (1994) and Dechow et al. (1998) show that current earnings, compared to the current

operating cash flows, are better in forecasting future cash flows over long forecasting

horizons. Similarly, Lev and Zarowin (1999) find that reported earnings are more highly

correlated with stock prices and returns than operating cash flows. Based on a linear model

of incremental information, Ali (1994) finds that earnings have incremental information

content beyond working capital from operations and cash flows. Bartov et al. (2001, p.105)

state that, ‘….since earnings are cash flows adjusted for accruals, it is arguable that cash

flows cannot be more value relevant than earnings nor can cash flows provide incremental

value relevance over earnings.’

26

Building on the model of Dechow et al. (1998), Barth et al. (2001) investigate the roles of

accruals in predicting future cash flows by disaggregating earnings into six major accrual

components, including change in account receivables, change in inventory, change in

account payable, depreciation, amortization and other accruals. They find that aggregate

earnings data is not more useful than current cash flows in predicting future cash flows but

that disaggregating accrual components of earnings provides information that is more

useful in predicting future cash flows. They argue that aggregate earnings masks

information relevant for predicting future cash flows and that by disaggregating accrual into

cash flows and its major components it further increases the ability of earnings

predictability in forecasting future cash flows.

In the global perspective, Bartov et al. (2001) provide evidence that earnings are more

important than cash flows for explaining the variation in stock return in three Anglo-Saxon

countries (i.e. US, UK and Canada) but not in non-Anglo-Saxon countries (i.e. Germany

and Japan consolidated sample). They argue that understanding the national differences is

vital to international investment decisions and the efficient allocation of global resources,

and demonstrates that the valuation relevance of earnings and cash flows is not universal,

and depends on the national reporting regime.

However, opposed to the FASB’s statement that earnings number provides a better forecast

than cash flow numbers in predicting future cash flows, studies by Bowen et al. (1986),

Burgstahler et al. (1998) and Charitou and Clubb (1999) find that cash flows provide a

better prediction of future cash flows compared to the current earnings. Charitou et al.

(2000), Cheng and Yang (2003) and Stunda and Typpo (2004) show that cash flows are a

natural alternative performance indicator to evaluate firm performance when earnings are

27

transitory and extreme. While earnings are shown to have a stronger statistical association

with accounting returns than cash flows, cash flows play a more important incremental role

when earnings are transitory (Charitou et al., 2000). Stunda and Typpo (2004) suggest that

rather than a substitute, cash flow information appears to be a good compliment to earnings

information when earnings contain transitory components.

Overall, prior studies provide greater support for the premise that earnings are more useful

in predicting future cash flows to assess firm performance. However, a cash flow based

measure of performance appears to become a natural alternative performance indicator

when earnings are transitory and extreme. Though the IASB framework does not elevate

the information about performance above that of other financial reporting information, the

joint IASB and FASB exposure draft on the Conceptual Framework for Financial

Reporting (2008) concludes that financial performance measured by accrual accounting is

important and is essential to assess the entity’s ability to generate net cash inflows. Given

the usefulness of earnings, the next section discusses the various constructs and measures of

earnings quality.

2.4 EARNINGS QUALITY CONSTRUCTS AND MEASURES

There is no agreed-upon definition for earnings quality and a variety of definitions exist in

the literature. One of the most common definitions utilised to define earnings quality is the

use of persistence and sustainability accounting earnings. Lipe (1986), Komerdi and Lipe

(1987) and Richardson (2003) view earnings to be of higher quality when the earnings

number is more persistent. A highly persistent earnings number is viewed as sustainable

and a high quality of earnings relates to the earnings that can be sustained for a long period

28

of time. Other researchers define earnings in terms of predictive ability of past earnings to

predict future earnings (Lipe, 1990). Earnings are viewed to be of higher quality when past

earnings are more predictive in forecasting future earnings.

Makar et al. (2000), Dechow and Schrand (2004) and Bellovary et al. (2005) define

earnings quality as the ability of reported earnings numbers to reflect the company’s true

earnings as well as its usefulness to predict future earnings. Dechow and Schrand (2004,

p.5) define earnings to be of high quality when the earnings numbers ‘is one that accurately

reflects the company’s current operating performance, is a good indicator of future

operating performance and is a useful summary measure for assessing firm value’. Others

define it by relating to earnings management. Brown (1999), Healy and Wahlen (1999) and

Leuz et al. (2003) view earnings to be of higher quality when earnings management is low.

Schipper and Vincent (2003, p.98) define earnings quality as ‘the extent to which reported

earnings faithfully represent Hicksian income’. Hence, the closer the earnings are to the

Hicksian income16, the higher the quality of earnings. Amernic and Robb (2003) believe

that the term quality of earnings should comprise more than the financial statement items.

They include information/communication environment into their definition of earnings

quality as they believe that all the important players in the financial reporting process could

have a significant influence over the financial reports produced to the users of financial

reporting17.

16 ‘Hicksian income corresponds to the amount that can be consumed (that is the paid out dividends) during a period, while leaving the

firm equally well off at the beginning and the end of the period’ (Hicks 1939, p.176 cited in Schipper and Vincent 2003, p.97). Using Hicksian income, Schipper and Vincent (2003) try to explain the variation in the earnings quality constructs and measures used in accounting research to provide evidence of the trade-offs inherent in choosing among the various empirical measures of earnings quality. The Hicksian income allows researchers to consider reported earnings even in the absence of accounting rules and implementation thus provides a neutral benchmark to observe earnings quality. 17 Amernic and Robb (2003) have put forward management as one entity that might affect the quality of earnings. Because management is one of the internal structures of the accounting entity, they might influence the quality of earnings from a variety of perspectives such as corporate culture and ethical climate.

29

Schipper and Vincent (2003, p.98) state that ‘although the phrase ‘earnings quality’ is

widely used, there is neither an agreed-upon meaning assigned to the phrase nor a

generally accepted approach to measuring earnings quality’. Quality of earnings is a

multidimensional concept that makes different people consider quality of earnings

differently18 (Teets, 2002). Furthermore, Barker (2004) notes that no definition of earnings

has been provided in the FASB conceptual framework, which makes earnings difficult to

interpret. Nevertheless, for the particular interest of this study, the definition utilised by

Dechow and Schrand (2004) is proposed to be the most appropriate definition to be adopted

as it considers all the elements for high quality of earnings (i.e. persistence, predictability

and lack of variability) in one definition. The definition suggests that earnings are of high

quality when the earnings number accurately reflects the firm’s true earnings, is helpful to

predict future performance and is a useful summary to evaluate the firm’s performance.

Based on a range of definitions of earnings quality, various constructs and measures of

earnings quality have been developed by academic researchers. In the next sub-section,

five main attributes of earnings (i.e. persistence, predictability, variability/smoothness,

discretionary accruals and accrual quality) that are commonly used by researchers to

construct and measure earnings quality are discussed.

2.4.1 Persistence

Investors always view highly persistent earnings numbers as sustainable and prior research

has interpreted the relation between a firm’s reported earnings and its stock return as a

measure of earnings persistence (Schipper and Vincent, 2003). Earnings that are more

18 Referring to Teets (2002, p.356),‘some consider quality of earnings to encompass the underlying economic performance of a firm, as

well as the accounting statements that report on that underlying phenomenon, others consider quality of earnings to refer only to how

well accounting earnings convey information about the underlying phenomenon’.

30

persistent are viewed as higher quality and more desirable. Researchers have focused on

the magnitude of the earnings-return relation and examine whether this association relates

to the time-series properties of earnings (see e.g. Lipe, 1986; Kormendi and Lipe, 1987;

Richardson, 2003). Lipe (1986) and Kormendi and Lipe (1987) provide strong evidence of

the relation between the accounting earnings and the reactions of stock return, and

demonstrate the importance of earnings persistence as a factor to explain the return-

earnings relation.

Although the approach to examine the relationship between stock return and earnings are

varied, current research has focused on the earnings response coefficient to measure

earnings persistence and earnings quality (Lipe, 1990; Basu, 1997; Abdullah, 1999; Balsam

et al. 2003). Earnings response coefficients measure the investors’ reaction to earnings

news where the stronger the earnings response coefficients the greater the persistence,

thereby indicating a higher quality of earnings. A study by Lipe (1990) reports that the

market reaction of stock returns to each component of earnings depends on the

component’s persistence, where the greater the persistence, the larger the reaction to a

typical earnings shock.

However, Schipper and Vincent (2003) argue that non-persistent earnings may be caused

by the outcome of the normal application of accounting standards in some economic

environments. They argue that intervention from the management in the financial reporting

process can also transform non-persistent earnings to persistent earnings number. Non-

accounting economic reasons, such as a company cutting prices or offering special

financing to increase sales might also have a non-persistent impact on earnings but is likely

31

to be hidden if analysts do not conduct a detailed analysis to study the revenues and costs,

and focus solely on earnings (Cornell and Landsman, 2003). For this reason, Schipper and

Vincent (2003) have disconnected persistence from the representational faithfulness19 of

reported earnings in their commentary paper to assess earnings quality based on the FASB

Conceptual Framework, and to the economic based definition of earnings developed by

Hicks.

2.4.2 Predictability

Lipe (1990) refers earning’s predictive ability as the ability of past earnings to predict

future earnings. He observes the relative ability of earnings to predict future earnings is

reflected in the variance of stock price changes during the announcement of earnings. As

the earnings predictability increases, the absolute magnitude of the earnings shock becomes

smaller leading to a lower variance of price changes. Decreases in variance make current

earnings information more useful in predicting future earnings, and, therefore, increasing

the predictability of earnings and its association with higher earnings quality.

A simple approach to measure earnings predictability is to use last year’s earnings measure

to predict next year’s measure (Cornell and Landsman, 2003). The measure is designed to

measure how well past values of earnings measure predict future values of that earnings

measure. However, the use of predictability to measure earnings quality has been criticised

for not accurately reflecting the quality of earnings. As earnings number is often subject to

manipulation, persistence and predictability alone is not sufficient to indicate that earnings

are of high quality (Dechow and Schrand, 2004). They argue that managers always try to

make earnings numbers to be highly predictable to improve their reputations with analysts

19 Representational faithfulness means “correspondence or agreement between a measure description and the phenomenon that it

purports to represent”(FASB Concept Statement No.2, para.63)’ (Schipper and Vincent 2003, p.98)

32

and investors20. Furthermore, the ability to forecast is often limited to the business model

and economic situations that make cyclical and growing firms are difficult to predict

(Schipper and Vincent, 2003).

The predictability method is also argued to be significantly biased against GAAP earnings

(Cornell and Landsman, 2003). When a company incurs one-time charges or write-offs in

the event of a merger or restructuring, current year earnings are no longer a good predictor

for future earnings as it produces idiosyncratic variations in the regression that will produce

unnecessary errors in the analysis21. Moreover, there is no priori reason to believe that the

relationship between stock prices and accounting earnings is likely to be stable over time,

making historical accounting data inappropriate for forecasting future earnings without

understanding the earnings power of a company on a component-by-component basis

(Cornell and Landsman, 2003).

2.4.3 Variability/Smoothness

Absence of variability is related to smoothness and sometimes associated with high quality

earnings. According to Schipper and Vincent (2003), other approaches taken by the

researcher to assess earnings quality include testing whether the management has engaged

in smoothing practices. Ayres (1994) refers income smoothing practices as an attempt to

report a steady or growth in earnings as managers believe that smooth earnings are more

highly valued; minimize the risk of possible debt and dividend covenant violation; and can

maximize management bonuses.

20 Dechow and Schrand (2004) discuss how Enron consistently had positive quarterly EPS and small positive EPS surprises to the end of 2000 but at the same time the managers were hiding losses throughout this period. 21 Cornell and Landsman (2003) give example of AOL Time Warner’s write off of approximately $50 billion in 2002. According to Cornell and Landsman, this bias would destroy the predictive power of GAAP earnings.

33

Leuz et al. (2003) in their study of earnings management across 31 countries use two

measures of smoothing interventions: the ratio of standard deviation of operating earnings

to the standard deviation of cash from operations; and the correlation between changes in

accruals and changes in cash flows. They noted, smaller ratios implied higher income

smoothing practices while the existence of negative correlations between changes of

accruals and operating cash flows are evidence of income smoothing practices. However,

there are weaknesses associated with variability or smoothness as a measure of earnings

quality. One of the weaknesses is the inability of the model to represent the faithfulness of

its reporting business model and economic environment (Schipper and Vincent, 2003).

Smoothness can be a result of management intervention in the financial reporting process

and earnings that are smoothed or managed are thought to be less informative and thus are

lower quality (Leuz et al., 2003). Furthermore, smoothness may create the impression that

earnings have been manipulated and may lead to lower market values and potential future

problems in the capital markets as investors perceive that managers are not reporting

earnings fairly (Ayres, 1994).

2.4.4 Discretionary Accruals

The most widely used construct to measure earnings quality is through the discretionary

accruals model that captures earnings management (discretionary accruals imply earnings

management and lower quality of earnings). According to Schipper and Vincent (2003,

p.102), ‘in direct estimation approaches, the residuals (or sometimes prediction errors)

from a regression of total accruals (or the specific accrual of interest) on accounting

fundamentals capture earnings management and are viewed as an inverse measure of

earning quality’.

34

Three commonly used research designs to test earnings management are the aggregate

accruals model, specific accruals model, and the distribution of earnings after management

model (McNichols, 2000). Among the three most commonly applied designs in the

earnings management literature, the aggregate accruals model proposed by Jones (1991) is

the most popular and is extensively used in the literature to measure earnings management

(McNichols, 2000). Researchers have focused on the total accruals (measured as difference

between net income before extraordinary items and cash flows from operations and

comprised of changes in non-cash working capital accounts and non-cash income statement

items) to measure management’s discretion over earnings (Wiedman, 2002).

To distinguish between managed and unmanaged portions, the total accruals are separated

into two components, (1) the non-discretionary component (i.e. component that arises

naturally from company’s economic activities) and, (2) discretionary component (i.e.

managed portions). Jones (1991) model introduced a regression to control for non-

discretionary components by modelling a linear regression between total accruals and

changes in sales and property, plant and equipment (Dechow et al. 1995)22. Ideally,

changes in the working capital should move proportionately with changes in sales and

changes in non-cash income statement items. For example, depreciation expenses should

move proportionately with the level of property, plant and equipment. However, when the

total accrual changes do not move proportionately with these items relative to other firms in

the same industry and year then the unexpected or discretionary portions of total accruals is

assumed to be managed portions (Wiedman, 2002). This managed portion measures

managerial manipulations and is viewed as an inverse measure of earnings quality.

22 Dechow et al. (1995) make a modification to the original Jones model by including change in receivables to adjust for the change in revenues. The modified Jones model exhibits the most powerful test in detecting earnings management compared to the original Jones (1991) model (Dechow et al., 1995).

35

While the aggregate accruals model has been very popular and is widely used in the

literature to examine the existence of earnings management, the model has been criticised

for potential measurement errors in the discretionary accrual proxies23. Klein (2002) notes

that any proxy for abnormal accruals yields biased metrics if the measurement error in the

proxy is correlated with omitted variables. Firms with large earnings or cash flows from

operations have also been shown to bias the estimation of discretionary accruals (Bedard et

al., 2004). In fact, most prior studies have acknowledged the aggregate accruals model as a

noisy proxy for earnings management (Bedard et al., 2004; Davidson et al., 2005; Lo;

2007: Aljifri, 2007). Due to the difficulty of measuring discretionary and non-discretionary

accruals, Aljifri (2007) raises the question of the accuracy and reliability of earnings

management results.

Recognizing the limitation of the aggregate accruals model, McNichols (2000) suggests

that researchers use a specific accruals model and distribution model to measure earnings

management. By focusing on the specific accruals model, the researcher can use their

knowledge of the institutional arrangement to clearly identify between the discretionary and

non-discretionary components of a specific industry. The researcher can exploit their

knowledge on the GAAP to develop intuition for the fundamentals that should be included

in the regression. The use of the specific accruals model can be applied to industries that

have greater volatility and helps to induce estimation error in parameter estimates that often

create problems in the aggregate accruals model.

23 See McNichols (2000) for detail reviews on the research design issues in earnings management studies.

36

However, the use of the specific accruals model requires researcher institutional knowledge

to identify the magnitude of earnings manipulation. As the model relies on managers’

discretion over earnings, unspecified accrual management might reduce the power of the

specific accruals test for earnings management. Burgstahler and Dichev (1998), DeGeorge

et al. (1999) and Holland and Ramsay (2003) focus on the density of the distribution of

earnings after management to test for earnings management. These studies focus on the

behaviour of earnings around specified benchmarks or targets to see whether managers use

earnings management to meet certain targets, such as avoiding reporting losses or earnings

decline (income-increasing approach) or delaying reporting profits to facilitate meeting

targets easily in the future (income-decreasing approach).

Burgstahler and Dichev (1997) show evidence that firms manage reported earnings to avoid

earnings decreases and losses to decrease the costs imposed on the firm in transactions with

stakeholders. Similarly, Holland and Ramsay (2003) report that Australian listed

companies manage earnings to ensure reporting of positive earnings and to sustain the

previous year’s profit performance. However, McNichols (2000) argues that the model is

silent on the incentives for management to achieve specific benchmarks. Questions as to

whether the incentives vary across the firms and the extent to which the targets might be

appropriate in different contexts are still left unanswered.

2.4.5 Accrual Quality

To overcome the weaknesses of the discretionary accruals model, Dechow and Dichev

(2002) devised an innovative approach to test for earnings quality by focusing on a new

measure based on a direct estimation of accruals to cash relations also known as the accrual

37

quality model. The model builds on the argument that the beneficial role of accruals is

reduced by estimation errors. Hence, earnings which map more closely into cash are more

desirable (Francis et al., 2004). In this model, Dechow and Dichev (2002) do not

distinguish between non-manipulative estimation error and intentional earnings

management because regardless of managerial intent, accrual quality will be systematically

related to firm and industry characteristics. This distinction is important because most

existing research presumes that accruals and earning quality is only affected by

management intention to manipulate accounting earnings when such intentions are often

unobservable or sporadic (Dechow and Dichev, 2002).

McNichols (2002) in her discussion of the quality of accruals and earnings by the Dechow

and Dichev (2002) model, proposes a modified model to include changes in revenue and

property plant and equipment. By combining the Dechow and Dichev (2002) model and

modified Jones (1991) model to include these two additional variables, she shows a

significant increase in the explanatory power of the accrual quality model and thus a

reduction in the measurement error. She argues that these two additional variables are

important in forming expectation about current accruals that provide more complete

characterization of the relation between accruals and cash flow.

While the Dechow and Dichev (2002) model does not distinguish between intentional and

unintentional estimation errors (Schipper and Vincent, 2003), Francis et al. (2005) propose

a model that distinguishes between the accrual quality driven by economic fundamentals

(innate accrual quality) and management choices (discretionary accrual quality) as prior

literature on the relation between accruals and cash flows (see e.g. Healy and Wahlen,

38

1999; Dechow et al., 2000; McNichols, 2002) address the uncertainty in a firm’s

environment and managerial intervention that surrounds the financial reporting process as

important factors that need to be considered when evaluating a firm’s financial reporting

quality. McNichols (2002) suggests that incorporating management’s incentives to

exercise discretion over accruals in the model will result in different implications than those

of the present model.

Thus far, it appears in this section that management intervention has an influential effect on

the validity of each of the constructs and measures discussed. To address the issue, the next

section provides discussions on earnings management and its impact on the quality of

earnings.

2.5 EARNINGS MANAGEMENT

It is always important to discuss earnings management when measuring earnings quality as

the earnings management measure is often interpreted as an inverse measure of earnings

quality. There is a large body of academic literature discussing the issue of earnings

management (Schipper, 1989; Healy and Wahlen, 1999; Dechow and Skinner, 2000; Lo,

2007). Schipper (1989, p.92) defines earnings management as ‘…purposeful intervention

in the external financial reporting process, with the intent of obtaining some private gains’.

Additionally, Healy and Wahlen (1999, p.368) state that earnings management may occur

‘…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.’

39

SEC Chairman, Arthur Levitt, in his September 1998 “Numbers Game” speech, expressed

his concern and fear about earnings management practices and the damaging effects these

practices can have on the quality of earnings. Teets (2002) identifies three distinct sets of

decisions that affect the quality of earnings: decisions made by standard setters, choices

made by management on accounting method used and judgment and estimates by

management in implementing chosen alternatives. ‘Choices, judgments and estimates are

an inevitable consequence of not being able to observe, measure and communicate

economic value-added accurately and reliably’ (Brown 1999, p.61). There are many ways

that managers can exercise judgment in financial reporting and this wider range of choices

brings more opportunities to management teams to manipulate earnings for their own

advantage. Judgment creates opportunities for managers to manage earnings by choosing

reporting methods and estimates that do not accurately reflect a firms’ underlying

economics (Healy and Wahlen, 1999).

However, to convincingly document earnings management is not an easy task. The

definition of earnings management centres on managerial intent, which is remarkably

difficult to observe (Dechow and Skinner, 2000; Wiedman, 2002; Lo, 2007). It is normal

to observe the pattern of reported numbers in providing evidence of earnings management

by looking for contexts where earnings management is most likely to occur and to try and

gather large samples of firms in a particular context in order to provide systematic evidence

of earnings management across the sample (Wiedman, 2002). Hence, discussions over the

earnings management measurement issues are on-going due to the difficulty in

differentiating between management’s true belief and management’s intent to manipulate

earnings. Figure 2.1 presents the distinction between fraud and earnings management as

viewed by Dechow and Skinner (2002, p.239).

40

Figure 2.1

The Distinction between Fraud and Earnings Management

Accounting Choices “Real” Cash Flow Choices

Within GAAP

“Conservative”

Accounting

“Neutral”

Accounting

“Aggressive”

Accounting

Overly aggressive recognition of provisions or reserves Overvaluation of acquired in-process R&D in purchase acquisitions Overstatement of restructuring charges and asset write-offs Earnings that result from a natural operation of the process Understatement of the provision for bad debts Drawing down provisions or reserves in an overly aggressive manner

Delaying sales Accelerating R&D or advertising expenditures Postponing R&D or advertising expenditures Accelerating sales

Violate GAAP

“Fraudulent”

Accounting

Recording sales before they are “realizable” Recording fictitious sales Backdating sales invoices Overstating inventory by recording fictitious inventory

Source: Adapted from Dechow and Skinner (2002)

41

Healy and Wahlen (1999) argue in their review of the earning management literature and its

implications for standard setting that previous literature on earnings management does not

provide much evidence on the question of interest to standard setters, except documenting

the existence of earnings management. Questions regarding the scope and the extent of

earnings management are left unanswered, in part, because of these measurement issues.

Furthermore, given that managers are more sophisticated, the ways they engage in earnings

management are not simple-minded earnings management and it is not surprising that

recent studies do not document evidence of earnings management in their studies (Lo,

2007).

In light of these measurement issues, evidence of earnings management is obtained by

looking at the managerial incentives to manage earnings (Dechow and Schrand, 2004). The

conditions that exist for manager’s incentive to manage earnings are identified and

followed by the estimation of unexpected accruals to see the effect of managers’ discretion

(Healy and Wahlen 1999). Christensen et al. (1999) suggest that when managers have both

the incentive and opportunity to manage earnings, they are more likely to engage in

earnings management. There are three main incentives that provide grounds for the

managers to smooth earnings discussed in prior literature, which are contractual incentives,

market incentives and regulatory incentives (see e.g. Healy and Wahlen, 1999; Jackson and

Pitman, 2001; Dechow and Skinner, 2002).

42

Debt covenants, management compensation agreements, job security and union

negotiations are examples of four major contractual situations where managers may engage

in earnings management activities. Peasnell et al. (2000) state that shareholders commonly

use earnings as a direct basis for awarding bonuses and indirectly as reference points for

triggering the award of executive stock options for senior managers. As a result, managers

may manipulate reported earnings to avoid unfavourable wealth consequence from an

adverse earnings outcome. Healy (1985) suggests that managers manipulate accruals to

maximize earnings based bonuses. Although managers have an incentive to increase

earnings in order to increase the bonus this action is only taken when unmanaged earnings

are between the upper and lower bounds. Otherwise, when the unmanaged earnings are

below the lower bound or above the upper bound, managers have an incentive to decrease

earnings and reserve them for future periods.

Managers may also engage in earnings management when they perceive a connection

between reported earnings and the company’s market value. Prior research has

documented the existence of earnings management in connection with seasoned equity

offering, initial public offering, mergers and management buyouts and insider equity

transactions. Burgstahler and Dichev (1997) show that firms manage reported earnings to

avoid earnings decreases and losses to decrease the costs imposed on the firm in

transactions with stakeholders. They estimate that about 8-12% of firms with small pre-

managed earnings decreases, manipulate earnings to achieve earnings increases and about

30-44% of firms with small pre-managed losses manage earnings to create positive

earnings.

43

Marquardt and Wiedman (2004) show that the greater the managers’ incentives for earnings

management, the less informative the earnings announcement to investors. They find

evidence of earnings management activity in the year of secondary equity offering when

incentives and opportunity are strongest for firms to manage earnings. As for secondary

equity offering, Roosenboom et al. (2003) also document earnings manipulation in the first

year of initial public offerings in the Dutch market, which explains the long-run stock price

underperformance.

Erickson and Wang (1999) and Louis (2004) find that acquiring firms manage earnings

upwards in the periods prior to the merger agreement, which supports the contention of

prior studies that acquirers have an incentive to manage earnings to increase stock prices

and reduce the cost of buying targets. Similarly, Abdul Rahman and Abu Bakar (2004)

report evidence consistent with income-increasing accruals by acquiring firms in the period

preceding the completion of acquisition in Malaysia, which supports the use of accounting

earnings manipulation to increase share prices during the pre-acquisition period.

Managers also tend to manage earnings when it comes to influence the action of regulators

or government officials. Jackson and Pitman (2001) observe that managers may influence

the actions of regulators or government officials by managing the results of operations,

thereby minimizing political scrutiny and the regulation effects on their companies.

Christensen et al. (1999) investigate the relation between ex-ante incentives of insurance

managers to engage in earning management to meet regulatory standards and the

informativeness of earnings. They find evidence that when managers’ incentives to

manage earnings are high, reported earnings are significantly less informative.

44

In the global earnings management study, Leuz et al. (2003) report that earnings

management scores are lower in countries with developed equity markets, dispersed

ownership structure, strong investor rights and strong legal enforcement. They examine the

systematic differences in corporate earnings management across 31 countries using four

measures of earnings management: (1) smoothing reported earnings using accruals; (2) the

correlation between accruals and cash flows; (3) the magnitude of accruals; and (4) the

extent of small loss avoidance. Based on the aggregate earnings management score,

calculated by averaging the country ranking for the four individual earnings management

measures, Leuz et al. (2003) show that earnings management scores are lower in countries

with strong investor protection such as in the US, Australia, Canada and the UK. In

addition they provide evidence that the level of outside investor protection (the extent of

minority shareholder rights and legal enforcement) endogenously determines the financial

reporting quality to the outsiders where lower earnings management is associated with

greater outsider protection and a high quality of financial reporting.

Thus far, this study reviews the academic evidence on earnings management and its impact

on the quality of earnings. Though difficult to convincingly document earnings

management due to the research design issues, researchers try to gather evidence of

earnings management by focusing on incentives for earnings management and provide

support of less informative earnings when the incentives to manage earnings are high.

While prior studies suggest that there is strong evidence that earnings management does

occur, the question that naturally arises is ‘how companies are able to get away with it’

(Dechow and Schrand 2004, p.62). The question leads to the next discussion of the critical

role that corporate governance can play in safeguarding and enhancing the quality of

earnings.

45

2.6 EARNINGS QUALITY AND CORPORATE MONITORING

One of the most important functions that corporate governance can play is to ensure the

quality of the financial reporting process (Cohen et al., 2004). Watts and Zimmerman

(1978, p.113) state that ‘one function of financial reporting is to constrain management to

act in the shareholders’ interest’. Given the increasing complexity of business today, more

comprehensive information is required by investors to make their investment decisions.

The financial reporting scandals of very large corporations in the United States, which has

hitherto been considered as the perfect model for financial reporting and capital market

regulation, has contributed to the loss of investors’ confidence towards the integrity of

accounting numbers. This resulted in a significant withdrawal of investment from the

securities market in 2001 and 2002 (Saudagaran, 2003). These scandals together with the

Asian financial crisis 1997/1998 have drawn attention to corporate governance reforms

around the world and the need to improve the quality of reported earnings as the capital

market needs precise and unbiased financial reporting to value securities and encourage

investors’ confidence.

Davis-Friday et al. (2006) show that the value relevance of earnings and book value in four

Asian countries, Indonesia, South Korea, Malaysia and Thailand were significantly reduced

during the Asian financial crisis and is related to the countries’ weak corporate governance

mechanisms. McKinsey & Company’s (2002) survey on corporate governance issues,

found that the majority of investors agree that corporate governance is of great concern and

that strengthening the quality of accounting disclosure should be top priority. The majority

of institutional investors are willing to pay a high premium for companies with good

corporate governance, averaging 12-14% in North America and Western Europe, 20-25%

46

in Asia and Latin America and over 30% in Eastern Europe and Africa. The survey further

evidences that the majority of the respondents (i.e.71 percent) state that accounting

disclosure is the most important factor impacting their investment decisions and 52 percent

of the respondents identify improving financial reporting quality as the governance priority

for policymakers.

Bushman and Smith (2001) note that publicly reported accounting information can be used

as important input information in various corporate governance mechanisms. The

importance of corporate governance mechanisms to improve financial reporting quality is

widely acknowledged (see Cohen et al., 2004 for a comprehensive discussion) and good

governance helps reduce the risk of financial reporting problems. Hermanson (2003, p.44)

notes, ‘Good governance goes in-hand with reduced risk of financial reporting problems

and other bad accounting outcomes’. Evidence of the association between poor

governance and poor financial reporting quality including earnings manipulation, financial

restatements and fraud is extensive (see for example Beasley, 1996; Dechow et al., 1996;

Beasley et al., 2000; Peasnell et al., 2000; Klein, 2002; Xie et al., 2003; Kao and Chen,

2004; Davidson et al., 2005; Peasnell et al., 2005). Due to the difficulty in identifying the

signal of financial reporting quality, factors such as earnings management, financial

restatements and fraud have been the focus of researchers to define financial reporting

quality, as the existence of these factors restrain the attainment of high quality information

and reflect the failure in the financial reporting process (Cohen et al., 2004).

However, Li (1995) argues that the differences in corporate governance across countries

emerge as a result of the variations in the ownership structure. An understanding of the

effects of various ownership structure variables is vital to explaining the corporate

47

governance and control process of firms under different national types of institutional

arrangements and national contexts. Although major institutional differences exist between

developed and developing countries, there is scarce evidence from prior literature that

examines the issues of corporate governance and financial reporting quality in the context

of developing countries, with a highly concentrated ownership structure, such as Malaysia.

Most studies have been performed in developed countries such as in the US and the UK.

Furthermore, recent findings by the Malaysian Institute of Accountants’ Financial

Statements Review Committee (FSRC) on compliance levels indicate that Malaysian

companies are not up to the mark in terms of financial reporting (FSRC Report, 2006). A

total of 15 areas on non-compliances with applicable accounting standards and approved

standards on auditing were compiled by the FSRC. The findings are rather worrying and

call attention on the role of corporate directors and auditors to improve the quality of

financial reporting as well as to give clear, comprehensive and credible information to the

users of the financial statement to facilitate informed decision-making. The question of

whether corporate governance is effective, given the extensive corporate governance

reforms to enhance the quality of reported earnings, is still an open question requiring

further empirical investigation. Literature pertaining to this issue is comprehensively

discussed in the following chapter.

2.7 SUMMARY AND CONCLUSION

In this chapter, a body of research relating to earnings quality is reviewed. Evidence from

prior research suggests that earnings quality is an important and useful concept. Earnings

are considered to be the main variable in the marketplace for share valuation, in credit and

48

investment decisions, in management and debt contracts as well as for standard setters to

assess the quality of financial reporting standards. It is clear that the dispute about earnings

quality arises because of the different measures used to estimate earnings quality based on

the valuation information they contain (Cornell and Landsman, 2003; Schipper and

Vincent, 2003; Bellovary et al., 2005). It is noted that the empirical measures used in

academic research to assess earnings quality and empirical measures of earnings quality are

likely to be sensitive to differences in firm level economic circumstances and business

models (Schipper and Vincent, 2003).

Issues relating to earnings management and its effects on the quality of earnings

information are discussed. Prior studies provide evidence on the existence of earnings

management when managers have both the incentive and opportunity to manage earnings.

Three main factors (i.e. contractual incentives, market incentives and regulatory incentives)

are identified to create motives for earnings management that lead to a lower quality of

earnings. While prior research suggests that earnings management does occur, recent

research demonstrates the critical role of corporate governance in monitoring earnings

management behaviour and improving earnings quality. It is documented that good

governance is associated with greater earnings quality. While these studies continue to

provide evidence of the association between sound governance and a high quality of

financial reporting, evidence from other economies, especially from developing countries is

very limited, hence, the motivation for the present study. The next chapter discusses issues

related to corporate governance globally, including specific reviews in the East Asian and

Malaysian context, as well as a comprehensive review of prior literature on the association

between corporate governance mechanisms and financial reporting quality.

49

CHAPTER 3

CORPORATE GOVERNANCE: A REVIEW AND SYNTHESIS OF LITERATURE

3.1 INTRODUCTION

The Asian financial crisis in 1997/1998 compounded the importance of good corporate

governance practices to help restore investors’ confidence in the East Asian market. The

financial crisis together with highly publicised scandals in the United States revealed the

critical need for firms in both developed and developing countries to improve corporate

governance practices and regain investors’ confidence in the integrity of accounting

numbers. Erosion in financial reporting quality has raised troubling questions about the

implementation of various aspects of corporate governance practices.

Consequently most Asian countries have been proactive in improving and strengthening

corporate governance systems. Malaysia introduced the Malaysian Code on Corporate

Governance (2000) outlining the principles and best practices for corporate governance.

The Malaysian Code was fully implemented in January 2001 with a revamp of the listing

requirements of the Bursa Malaysia. The Revamped Listing Requirements represent a

major milestone in corporate governance reform, creating an environment that demands

higher standards of conduct and a higher quality of disclosure from corporate governance

participants in Malaysia.

50

While lessons can be learnt from the models of corporate governance in developed

economies, there does seem to be a general agreement that new Western corporate

governance laws and codes are deficient, to some extent, in meeting the requirements of

users in Asian developing countries with particular ownership structures, business

practices, enforcement capabilities and cultural values (Barton et al., 2004). The question

that surfaces is whether the corporate governance reforms adopted by Asian developing

countries are appropriate or effective for those countries (Cheung and Chan, 2004).

Therefore, the purpose of this chapter is to synthesise present literature on corporate

governance and identify gaps from an Asian perspective focusing both on theory and

research contribution to extant corporate governance literature.

The remainder of the chapter is organised as follows. Section 3.2 discusses the corporate

governance overview in general followed by the specific reviews of East Asian corporate

governance issues in Section 3.3. Section 3.4 reviews the Malaysian corporate governance

development and framework. After identifying the theoretical issues, Section 3.5 provides

a review of prior studies on the relationship between corporate governance and financial

reporting quality, focusing on the role of boards of directors, ownership structure and

ethnicity. The chapter ends in Section 3.6 with a summary and conclusion.

51

3.2 CORPORATE GOVERNANCE OVERVIEW

Corporate governance, put simply, means the act of governing firms to protect the interests

of shareholders. The separation of ownership and control has led to the selection of

appropriate governance mechanisms to ensure an efficient alignment of interests for

principals and agents. Shleifer and Vishny (1997) view corporate governance from a

straightforward agency perspective that deals with the ways investors ensure that they get

their investment back from managers. The agency theory concerns the principal-agent

problem in the separation of ownership and control of a firm and addresses the potential for

agency problems (Jensen and Meckling, 1976; Fama and Jensen, 1983). Contracts signed

between the shareholders and the managers actually give managers substantial residual

control rights that create opportunities for them to expropriate the shareholders’ funds

(Shleifer and Vishny, 1997).

Agency theory suggests that where there is a separation of ownership and the control of a

firm, the potential for agency problems exist because of the conflict of interests between

principals and agents. Although shareholders can discourage managers from diverging

from the shareholders’ interests, by devising appropriate incentives for managers and then

monitoring their behaviour, unfortunately, this is complicated and costly. The cost of

resolving the conflicts of interest between managers and shareholders are called agency

costs and these costs are defined as the sum of the monitoring costs of the shareholders and

the costs of implementing control devices such as employing the board of directors, audit

committee and auditors. Therefore, it can be expected that contracts will be devised that

provide managers with appropriate incentives to maximize the shareholders’ wealth.

52

The Cadbury Report (1992, p.15) in Section 2.5 defines corporate governance as:

‘… the system by which companies are directed and controlled. Boards of directors

are responsible for the governance of their companies. The shareholders’ role in

governance is to appoint the directors and the auditors and to satisfy themselves

that an appropriate governance structures is in place. The responsibilities of the

board include setting the strategic aims, providing the leadership to put them into

effect, supervising the management of the business and reporting to shareholders on

their stewardship. The board’s actions are subject to laws, regulations and the

shareholders in general meeting’.

The definition in the Cadbury Report emphasizes the important role of boards of directors

as an agent to direct and control the firms and to communicate the true underlying financial

information to the shareholders (Ow-Yong and Guan, 2000). The board of directors is

presumed to perform the monitoring role on behalf of the shareholders (John and Senbet,

1998) and has the main duty of leading and directing the firm to achieve corporate goals by

closely monitoring management activity so that the interest of the shareholders is well

protected (Abdullah, 2004). Further, the board is regarded as the most powerful and cost

effective governance mechanism for monitoring management in pursuing activities that

increase a firm’s value (Abdullah and Mohd Nasir, 2004). The existence of an effective

board ensures the efficient alignment of managers’ and owners’ interests, to stimulate

shareholders wealth and earnings, so that the earnings are comparable between each

shareholder of the same firm (Vethanayagam et al., 2006).

In the post-Asian financial crisis and post-Enron era, corporate governance reforms have

become the most important agenda issue globally. Many countries have issued Codes of

Best Practices in Corporate Governance that address the basic governance issues of board

effectiveness and accountability to bring greater power balance within the firm. The main

focus is to enhance the effectiveness of the board of directors so that shareholders’ interests

can be better protected by focusing on the role of board independence, effective system of

53

controls and transparency, which are generally seen as crucial for effective governance

mechanisms (Ng, 1998). For example, the Cadbury Report (1992) focuses on the

monitoring functions of boards as well as the role of auditors to enhance the quality of

internal controls and financial reporting. Among the fundamental recommendations in the

Report are the separation of powers between the chairman and chief executive officer,

inclusion of a majority of independent non-executive directors on the board, a formal

selection process for directors and the establishment of an audit committee comprised

solely of non-executive directors. The Toronto Exchange Corporate Governance

Guidelines (1994) recommend that all public listed companies in Canada have a majority of

outside directors on the board (Park and Shin, 2004). The Sarbanes-Oxley Act (2002)

requires all audit committee members to be independent from management, at least one

audit committee member to have financial expertise, the audit committee to oversee the

accounting and financial reporting process as well as the audit of financial statements

(Bedard et al., 2004). All these guidelines suggest that with respect to board composition

the best practice is to have at least a majority of non-executive or independent directors.

However, Cohen et al. (2004) argue that restricting the view of corporate governance to the

monitoring role played by boards of directors and audit committees may potentially

undervalue the role that corporate governance can play. They argue that all major

stakeholders in the governance mosaic, including inside and outside the firms, are

important participants in the corporate governance process (see: Figure 3.1). The

interrelationship between the various actors and mechanisms within the corporate

governance mosaic is crucial for effective governance mechanisms to enhance the quality

of financial reporting.

54

Figure 3.1: Corporate Governance Mosaic and Financial Reporting Quality

Source: Adapted from Cohen et al. (2004)

Courts & Legal System Financial Analysts Legislators

Regulators Stock Exchanges Stockholders

Audit Committee Board of Directors

Internal Auditors External Auditors Management

Financial Reporting Quality

55

Though boards of directors often play a key role in corporate governance, other actors and

mechanisms in the governance process also impact the quality of financial reporting (Cohen

et al., 2004). For example, audit committees are expected to monitor the firm’s financial

reporting processes, including preventing fraudulent financial reporting, as they are likely

to influence the companies’ approach to financial reporting and compliance with legal and

ethical standards (Turley and Zaman, 2004). The effective audit committee should be able

to assist the management in achieving the company’s objectives and goals through the

implementation of good and transparent management. Apart from audit committee

function, the role of external auditors is also important to ensure that the financial report is

accurate and reflects the true client’s activities and net assets (Chung et al., 2005).

Recently, the role of the internal auditors has also been significantly expanded from its

traditional function of control checker towards the strategic role of corporate governance

partner within an organisation (Ravendran, 2005). There are four cornerstones of corporate

governance in upholding good governance (i.e. board of directors, audit committee,

external auditors and internal auditors) and failure of one cornerstone would make others

find it extremely difficult to manage (Ravendran, 2005).

Besides the role of internal governance mechanisms, Cohen et al. (2004) suggest that other

actors external to the corporations such as regulators, legislators, financial analysts, stock

exchanges, courts and legal systems as well as stockholders also influence the interactions

among the actors who are directly involved in the governance of corporations. As stated by

John and Senbet (1998, p.374), corporate governance is ‘… a means by which various

stakeholders24

exert control over a corporation by exercising certain rights as established

24

Stakeholders of a corporation include equity-holders, creditors, employees, consumers, suppliers and the government (John and Senbet

1998, p.372)

56

in the existing legal and regulatory frameworks as well as corporate bylaws’. The

inclusion of other stakeholders in the corporate governance system provides a balance

between economic, social and individual objectives that promotes productive economic

development (Muller, 2003). The Organisation for Economic Co-operation and

Development (OECD), Principles of Corporate Governance 2004 states that an appropriate

and effective legal, regulatory and institutional foundation is necessary to ensure an

effective corporate governance framework in any one country. To support effective

corporate governance, laws and regulations, which are both enforceable and are backed by

effective government agencies, are needed to avoid abuses of minority shareholders

(OECD, 2004). Furthermore, a stable legal system and supportive current legislation

(including accounting systems and regulations governing the official listing on stock

exchange) create attractiveness for foreign investors to make an investment (Muller, 2003).

Based on different institutional foundations, there are two well-known corporate

governance models – the Anglo-American (one-tier system) and the Franco-German (two-

tier) model. A one-tier or unitary system places the board of directors as the highest

governing body in the company. In the Anglo-American system (that applies to the United

Kingdom and the United States), more generally referred to as the ‘market model’ or

‘shareholder model’, the companies rely heavily on the private shareholders of the capital.

The ownership structure in Anglo-American countries is more dispersed among a large

number of unrelated individual and institutional investors (Li, 1995). The accounting rules

are determined by the disclosure needs of shareholders and the asymmetric problem is

addressed through financial reporting and other public disclosure. The shareholders do not

generally influence the direction of the firm but elect the board of directors to manage the

company (Bartov et al., 2001). The board of directors becomes the highest governing

57

control system and the role of an effective board of directors is crucial to the effectiveness

of corporate governance systems.

However, the two-tier system exists to serve the interests of a wide range of stakeholders

and is commonly practiced in Germany and Japan. In contrast to the Anglo-American

countries, the major source of capital in Franco-German countries comes from the banks.

The ownership structure in each individual firm in the two-tier system is often concentrated

within a small number of directly related firms, banks and families that results in cross-

shareholding between firms (Li, 1995). All public listed companies in a two-tier system

have dual boards – the supervisory board and the managerial board. The supervisory board

is responsible for strategic decision-making while the managerial board is responsible for

the execution of the day-to-day strategies. The role of the banking sector is very prominent

in this system and the interests of the public and the stakeholders are defined by the

company’s supervisory board such as Keiretsu in Japan, Chaebol in Korea and Aufsichrat

in Germany. For example, in Japan, a bank has access to the critical and timely

information of its member firms as they are highly involved in the strategic and financial

planning of the firms, thus, giving them opportunities to monitor managerial decisions

(Phan and Yoshikawa, 2000). In the two-tier system, the management is accountable to

both shareholders and the supervisory board.

However, developing countries in Asia face problems in strengthening corporate

governance. Bhattacharyay (2004) highlights seven key problems including (1) excessive

government intervention; (2) highly concentrated ownership structure; (3) weak external

discipline in the corporate sector; (4) weak legal systems and regulatory framework; (5)

lack of quality information; (6) lack of investors’ protection; and (7) lack of a developed

58

capital market, all of which undermines the effectiveness of the corporate governance

mechanism employed in Asia. The next section provides a review of the present state of

corporate governance and issues related to corporate governance in East Asian economies,

including Malaysia, to identify gaps in promoting good governance practices from an Asian

perspective.

3.3 ISSUES IN CORPORATE GOVERNANCE IN EAST ASIAN COUNTRIES

Although the interest in corporate governance practices in Asian countries has been

sporadic, efforts towards good governance practices have increased following the outbreak

of the Asian financial crisis 1997/1998. This crisis led to intense liquidity problems in

Asian countries due to a significant withdrawal of investment from foreign investors as a

result of the loss of confidence in the Asian capital market. Pomerleano (1998), examining

the corporate performance of seven East Asian economies, indicates that corporations in

East Asian economies suffered significant damage as a result of high debt equity ratios and

that a large number of Asian corporations became insolvent and had to recapitalise during

the Asian financial crisis.

The crisis, however, shed light on the fundamental issues that encompass good governance

practices in East Asian emerging markets. The promotion of good corporate governance

practices is seen as a necessary step to promote the development of local equity markets as

well as to provide a higher level of foreign investor confidence in the Asian capital market

(Cheung and Chan, 2004). The president of the Development Bank of Singapore, Ng Kee

Choe, in his speech during the seminar of ‘Global Lessons in Banking Crisis Resolution for

East Asia’, in May 1998, addresses the issue of governance and transparency to engender

59

greater investor confidence in the East Asian region that was still reeling from the impact of

the Asian financial crisis. He expressed his concern about the current state of corporate

governance in East Asia as it was clearly lagging behind that practiced in developed

Western economies (Ng, 1998).

Nevertheless, in some Asian countries, the judicial system, capital markets and institutional

investors remain underdeveloped and merely adopt new corporate governance laws and

codes designed for North America or Western Europe. As the Asian countries differ

significantly in ownership structure, business practices and enforcement capabilities it is

argued that simple adoption is a huge mistake that will affect the region as a whole (Barton

et al., 2004). As the evolution of corporate governance practices is a very complex process

that involves the interaction between internal and external players, the forces for both

change and continuity in corporate governance varies from one country to another and

needs to be examined in an institutional context and through organisational choices to

understand the specific institutional arrangement (Yoshikawa and McGuire, 2008).

Two issues of primary importance in Asian corporate governance are the ownership

structure of business and conflicts of interest and self-dealing (Jordan, 1999). Contrary to

the conflict of interest between outside shareholders and managers in a diffused ownership

structure, such as that commonly found in the UK and the US, the agency problem centres

around conflicts between the controlling owners and minority shareholders in Asia, where

ownership concentration is prevalent (Claessens and Fan, 2002). Unlike western

economies, many companies in East Asian countries are family owned and family managed

or directed with the major shareholders often also directors and managers (Ng, 1998; Ball

et al., 2003). Concentration of ownership in the hands of family members through

60

pyramidal and cross-holding structures affects the nature of contracting, creating agency

conflicts between controlling owners and outside shareholders (Fan and Wong, 2003).

As reported in Finance Asia 2001 (see: Table 3.1), approximately 58 percent of all Asian

companies can be classified as being family owned (based on 20 percent cut-off point)

where Hong Kong (66.7 percent) and Malaysia (67.2 percent) show the highest degree of

family ownership of total market capitalisation controlled by family groups (Cheung and

Chan, 2004). While prior studies indicate that the first generation of family owned

companies are likely to show a high degree of entrepreneurship and risk tolerance as well

as focusing on overall value-maximizing objective of the company, second and third

generations of family owned companies exhibit intricate issues of alignment of interests

between the majority and minority shareholders for future research (Cheung and Chan,

2004).

Table 3.1: Total Value of Listed Corporate Assets under Family Control

Total value of listed

corporate assets that

families control (percent) Country/

economy

No. of

corporations

surveyed

Share of total

market

capitalization

(percent)

Percent

family-

owned (20

percent +

control)

State-

owned

(percent) Top 5

families

Top 10

families

Hong Kong, China 330 78 66.7 1.4 26.2 32.1

Indonesia 178 89 71.5 8.2 40.7 57.7

Malaysia 238 74 67.2 13.4 17.3 24.8

Philippines 120 82 44.6 2.1 42.8 52.5

Singapore 221 96 55.4 23.5 19.5 26.6

Republic of Korea 345 76 48.4 1.6 29.7 26.8

Taiwan Province of China 141 66 48.2 2.8 14.5 18.4

Thailand 167 64 61.6 8.0 32.2 46.2

Source: Finance Asia (2001), Adapted from Cheung and Chan (2004)

Another issue of concern relating to Asian corporate governance is the significant state and

group ownership of corporations in East Asian economies. The Finance Asia 2001 reports

that Singapore has the highest level of state-controlled listed companies compared with

other East Asian countries with a market value of 23.5 percent, followed by Malaysia with

61

13.4 percent of value under state control (Cheung and Chan, 2004). Expectedly, when the

family ownership and state ownership are both included, the Asian stock exchanges

represent about 70 percent of market capitalisation, which suggests a domination of family-

controlled firms and state-controlled firms in East Asian markets.

Another significant issue is group ownership of corporations in Japan and Korea (Cheung

and Chan, 2004). The Japan-Keiretsu and Korea-Chaebol present a unique closed system

of monitored corporate settings and are characterised by interlocking cross-holdings of

equity. A study by Chung et al. (2004) finds that the unique interlocking corporate

ownership structure of Japan corporations has an impact on accrual valuation. They

provide evidence that cross-business shareholdings exacerbates tunnelling or managerial

opportunism by controlling shareholders through discretionary accruals that cause the

market to discount the discretionary accruals of firms with high cross-business

shareholdings in Japan.

Other remarkable issues related to East Asian economies are related to political influences

on financial reporting practices (Ball et al., 2003; Gul, 2006). Government intervention in

the financial reporting process varies across East Asian economies with the Hong Kong

government adopting a lasissez-faire approach, the Malaysian and Singapore governments

taking a more interventionist approach and a more direct approach from the Thailand

government in standard setting and financial reporting practices (Ball et al., 2003). In

business, there exists a close connection between governments and large corporations in

East Asia, often termed as ‘crony capitalism’ (Ball et al., 2003). These crony companies’

ties with government-linked companies have often been cited for poor stock performance

(Chu and Cheah, 2007).

62

In Malaysia, one-man or family run companies (Halim, 2001) and significant government

equity holdings (Abdullah, 2006a) distinguish the ownership pattern of Malaysian

companies and may complicate the effectiveness of corporate governance mechanisms.

Large ownership or ownership concentration, where controlling shareholders have more

than 50% ownership, is common in Malaysia and may contribute to deficiencies in the

corporate governance system employed (Thillainathan, 1999). The World Bank (1999)

reports that about 85 percent of companies in Malaysia have owner-managers; the post of

CEO, chairman of the board or vice-chairman belongs to a member of the controlling

family or a nominee; and large shareholders typically owning more than 60 percent of

shares. Companies with an extensive occurrence of individual and family owners and

managers tend to discourage professionalism, encourage non-compliance and facilitate

false accounting as well as resulting in a severe conflict of interest (Halim, 2001).

Due to the predominance of family and state controlled business in East Asian economies,

the challenge to improve corporate governance is to balance the relationship between

majority and minority shareholders (Jordon, 1999). Fan and Wong (2002) report that

accounting transparency in seven East Asian economies (i.e. Hong Kong, Indonesia,

Malaysia, Singapore, South Korea, Taiwan and Thailand) is generally low and is related to

agency problems and relationship-based transactions. Concentrated ownership, with its

complicated pyramidal and cross-holding ownership structure, is typical in East Asian

economies and creates agency conflicts between the controlling owners and outside

investors, causing earnings figures to lose credibility as investors perceive them to be

manipulated by the controlling owners. Additionally, high ownership concentration is also

associated with low earnings informativeness as it reflects the controlling owners desire to

protect proprietary information related to rent seeking activities.

63

Given the clear pattern of concentration of ownership and convergence of major

shareholding and management, Cheung and Chan (2004) argue that some corporate

governance practices in the Western corporate governance model may not be fully effective

in the Asian setting of concentrated ownership structure. The tightness of ownership allows

self-interested behaviour of managers to go unchallenged internally, by the board of

directors, and, externally, by takeover markets, as the controlling owners, who are often

also the managers, gain effective control of a corporation and have the power to determine

how the company is run and may expropriate the minority shareholders’ wealth (Fan and

Wong, 2002). Cheung and Chan (2004) raise the issue of board composition (such as a

number of independent non-executive directors) when inside directors dominate the board.

As the directors are elected by the controlling owners, it raises doubts as to whether the

independent directors are truly independent and provide an adequate degree of monitoring

of the majority shareholders. Given that the supply of qualified independent directors is

limited in many Asian countries, the issue of board independence is critical and the

requirements for a majority of independent directors who are truly independent, seems

unattainable in substance for Asian corporations (Barton et al., 2004).

The country factor becomes an important consideration in setting an effective corporate

governance framework, as two companies in two different countries may experience

different legal, regulatory and market standards (Cornelius, 2005). The legal systems might

also present barriers for enforcing corporate governance principles in Asian countries as the

legal systems and enforcement are still developing institutions and laws (Cheung and Chan,

2004). DeMiguel et al. (2005) show that the main institutional factors (i.e. investor

protection, development of capital markets, activity of the market for corporate control and

64

effectiveness of boards) embodied in a corporate governance system affects the relationship

between ownership structure and performance.

In countries with poor shareholder protection, the controlling owners, either state or

families, have control over firms in excess of their cash flow rights and have the power to

expropriate the minority shareholders. Consequently improving the legal environment is

difficult, which raises the question of minority shareholders protection (La Porta et al.

1999). Mitton (2002) found that firm-level differences in variables, related to corporate

governance of five East Asian countries, i.e. Indonesia, Korea, Malaysia the Philippines

and Thailand, had a strong impact on firm performance during the 1997/1998 financial

crisis. Specifically, firms with higher disclosure quality, higher outside ownership

concentration and less diversified operations revealed greater stock performance during the

crisis. This suggests that in countries with weak legal protection of minority shareholders,

at least some power to protect minority shareholder interests’ lies at the firm level, where

those with higher disclosure quality and transparency; a more favourable ownership

structure; and less diversified operations; appeared to provide protection to the minority

shareholders during the crisis (Mitton, 2002).

While lessons can be learnt from the models of corporate governance in developed

economies, Ng (1998) suggests that best corporate governance practices in the East Asian

region should be adapted and tailored to the circumstances peculiar to companies in the

region. Corporate governance systems are a product of a complex set of legal, regulatory,

economic and social factors that differ from country to country. Cheung and Chan (2004)

suggest that corporate governance guidelines and codes should be designed and adopted by

each constituent country before a unified Code of Practice can be applied. A single

65

standard or ‘one size fits all’ corporate governance standard is not appropriate to be applied

to all Asian countries, where a highly concentrated ownership structure and weak legal

systems and regulatory framework are a common phenomenon.

The next section provides a review, specifically, of the Malaysian corporate governance

development and framework to provide evidence of the Malaysian government’s efforts

and initiatives in strengthening corporate governance practices and enhancing investors’

confidence in the Malaysian capital market.

3.4 MALAYSIAN CORPORATE GOVERNANCE FRAMEWORK

3.4.1 Corporate Governance Initiatives Pre 1997 Financial Crisis

In Malaysia, efforts to foster corporate governance mechanisms began in earnest after the

financial crisis in 1997 (Che Ahmad et al., 2003, Abdullah, 2004). Although corporate

governance has progressed since the establishment of the Malaysian Companies Act 1965,

which describes the roles and responsibilities of directors and managers to keep proper

accounting records (Abdullah and Mohd Nasir, 2004), the financial crisis provided an

impetus for corporate governance reforms with the publication of the Report on Corporate

Governance in February 1999. The aim was to improve disclosure and good corporate

governance practices in Malaysia and re-establish the investors’ confidence in the

Malaysian capital market (Report on Corporate Governance, 1999).

Undeniably, the efforts to strengthen the regulatory frameworks of the corporate sector

commenced long before the Asian financial crisis, with the establishment of the Securities

Commission (SC) in March 1993 as a watchdog to improve the legal and regulatory

66

framework governing the capital market (Wan Hussin and Ibrahim, 2003). The Securities

Industries Act (SIA) 1983 and Securities Commission Act (SCA) 1993, under the authority

of the Ministry of Finance, represent the legislative and regulatory framework of

Malaysia’s capital market. The SIA 1983 provides supervision and control over the

securities industry by prohibiting artificial trading and market rigging, as well as regulating

the operations of securities dealers that make the legal and regulatory institution in

Malaysia appear to be well defined, even prior to the crisis (Liew, 2007). Additionally, in

1993, the Malaysian Stock Exchange’s Listing Requirement required listed companies

seeking to be listed on the Bursa Malaysia, to set up audit committees of at least three

people, comprising a majority of independent directors, in line with the stock exchanges in

the UK and US, to promote higher standards of corporate disclosure (Wan Hussin and

Ibrahim, 2003).

To enhance the accountability of directors in Malaysia, the Companies Commission of

Malaysia (CCM) (formerly known as the Registrar of Companies-ROC) introduced the

Code of Ethics for Directors in 1996 as an initiative to create effective boards. A survey by

the Asian Development Bank in 2000 found that Malaysia had the highest level of effective

boards of directors as a supervision body compared to other East Asian countries – Korea,

Indonesia, Philippines and Thailand (Liew, 2007). During the same year, the SC shifted

from a merit-based system (MBS) to a disclosure-based regulation (DBR) to inculcate

higher standards of disclosure, due diligence, corporate governance and accountability

among the directors of public companies and their advisers. Under the new systems the

role of the SC shifts from evaluating the relative merits of the issuer and its securities to

regulating the disclosure of quality information while the merit of any securities is restored

to the hands of investors (Che Haat, 2006).

67

In 1997, Malaysia became the first country in Asia to set up an independent standard setting

body, the Malaysian Accounting Standards Board (MASB), under the Financial Reporting

Act (FRA) 1997 (Wan Hussin and Ibrahim, 2003). The MASB is an independent authority

to develop and issue accounting and financial reporting standards in Malaysia, and, under

the FRA, all companies listed on the Bursa Malaysia are required to comply with the

accounting standards approved by the MASB. The mission of the MASB is to develop and

promote high quality accounting and reporting standards that are consistent with

international best practices for the benefit of users, preparers, auditors and the public in

Malaysia with direct contribution towards the international development of financial

reporting.

Although a lot of efforts and initiatives have been ongoing to improve the corporate

governance practices, Malaysia has seen several high-profile cases of corporate

misconduct, such as, Bumiputera Malaysia Finance, Renong, Perwaja Steel, Technology

Resources Industries, Malaysian Airlines System, to name but a few. As a consequence,

the government recognised the importance of good governance practices to strengthen the

Malaysian financial and capital market (Abdul Rahman, 2006). Furthermore, it is apparent

that the efforts and initiatives by the government, prior to the crisis, clearly did not prevent

the 1997/1998 crisis from adversely affecting the Malaysian capital market. This suggests

that either, (1) the initiatives were largely rhetorical, superficial reforms; or (2) were

implemented too late to prevent runs on the nation’s currency or major capital outflows

(Liew 2007, p.729).

68

3.4.2 Corporate Governance Initiatives Post 1997 Financial Crisis

Corporate misconduct, together with the 1997/1998 financial crisis, provided impetus for

rigorous efforts for corporate governance reforms, by both government and industry, to

identify and deal with weaknesses highlighted by the crisis to regain investors’ confidence

in the Malaysian capital market. The key areas underlying the Malaysian corporate

governance reform includes strengthening the protection of the minority shareholder’s

right, enhancing the transparency and accountability of directors, strengthening the

regulatory enforcement and promoting training and education at all levels in corporations

(Report on Corporate Governance, 1999).

The government has taken proactive action to review and strengthen corporate governance

in Malaysia with the establishment of the high level Finance Committee on Corporate

Governance and the Malaysian Institute of Corporate Governance (MICG). The formation

of the high level Finance Committee on Corporate Governance in March 1998, which

included government and industry representatives, is to identify and address weaknesses

highlighted by the 1997 financial downturn and to establish a framework for corporate

governance best practices. The inception of MICG on the other hand is to raise the

awareness and good corporate governance practices by businesses and corporate

development in Malaysia. MICG provides an independent platform for various

stakeholders to interact and debate corporate governance issues to promote continuous

improvement in corporate governance best practices. The MICG mission is to improve and

promote corporate governance best practices as well as to strengthen corporate governance

principles and compliance efforts.

69

After the formation of the high level Finance Committee on Corporate Governance, the

committee carried out detailed investigations through a survey of Corporate Governance

Best Practices of Public Listed Companies. This was jointly conducted by Bursa Malaysia

and PriceWaterhouseCoopers (PWC) to develop recommendations for corporate

governance best practices for Malaysia (Ow-Yong and Guan, 2000). The report of the

Committee focused on the boards’ monitoring role and highlighted the importance of

boards of directors as corporate governance mechanisms to enhance shareholder value and

protect shareholder wealth. A year after the issuance of the Finance Committee’s Report

on Corporate Governance, the Finance Committee then issued the Malaysian Code on

Corporate Governance (MCCG) in March 2000.

Malaysian corporate governance’s model has very much followed the Anglo-American

system where the framework is driven mainly by concern for shareholders’ interest

(Abdullah, 2004). In the Anglo-American system or generally referred to ‘market model’ or

‘shareholder model’, the board of directors play an important role as the highest internal

control system in the company to monitor the performance of management (Abdullah,

2004). Given the historical connection between Malaysia and the UK, the Malaysian Code

was basically modelled after the UK Combined Code on Corporate Governance (Ow-Yong

and Guan, 2000).

Corporate governance as defined by the Finance Committee on Corporate Governance in

Malaysia 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 account the

interests of other stakeholders’ (Report on Corporate Governance 1999, p.52). The

70

definition emphasizes the contribution of corporate governance to both business prosperity

and accountability, to enhance shareholder value so that they will receive an appropriate

return on their investment. Additionally, the board has the primary responsibility to the

shareholders and other stakeholders to create shareholder wealth in the market economy.

Corporate governance will serve as a set of rules to persons who have the power to direct

and manage the firm, to enable them to make accountable decision-making.

Bursa Malaysia has adopted most of the recommendations of the Code on Corporate

Governance in order to enhance the transparency of public listed companies’ disclosure.

The Code was brought into full effect in January 2001 with the amendment to the Bursa

Malaysia listing requirement. In order to enhance the transparency of public listed

companies in Malaysia, listed firms with a financial year ending after 30 June 2001

onwards are required to include in their annual report – the statement of corporate

governance, a statement of internal control, composition of the board of directors,

composition of audit committee, quorum of audit committee and any additional statements

by the board of directors (Kuala Lumpur Stock Exchange, 2001).

The board of directors is discussed as the first principle in the MCCG 2000 and under Part

2 (AA) of MCCG 2000, the role, composition and structure of the board of directors are

viewed as the most crucial elements for effective corporate governance mechanisms for

Malaysian companies. The Code recommends that firms have a well balanced and

effective board to take the lead role in establishing best practice in corporate governance.

A well-balanced board is defined as having a balance of executive directors and non-

executive directors, including independent non-executive directors, to ensure effective

decision making by the board with no domination from individual or small groups of

71

individuals. Additionally, the Code also requires that non-executive directors have the

necessary skills and experience and be persons of calibre and credibility in order to bring

independent judgment to the board.

The Code recommends for the board to establish an audit committee of at least three

directors, a majority of whom are independent, to implement and support the oversight

function of the board (Part 2 (BB) MCCG 2000, p.13). In Part 3 of the MCCG 2000, the

role of institutional shareholders is addressed as one of the important mechanisms to protect

shareholders’ wealth. The Code recommends that institutional shareholder’s make use of

their votes and make direct contact with managers and board members to address issues

pertaining to performance, corporate governance and other matters affecting shareholder’s

interest.

Bursa Malaysia also calls for all directors to undergo continuous training (i.e. Mandatory

Accreditation Programme and Continuing Education Programme) to enhance their

capabilities in performing their responsibilities as directors as well as to influence corporate

thinking on issues relating to corporate governance (Zulkafli et al., 2005). This training

programme is aimed at enhancing the competency and professionalism of company

directors and is a prerequisite to continued listing (Wan Hussin and Ibrahim, 2003).

Companies with a financial year-end of 31 December 2005 onwards were required to

disclose the training attended by the directors in the annual report (The World Bank Report,

2005).

72

The launch of the Capital Market Masterplan (CMP) by SC in February 2001 shows the

government proactive response to ensure the recommendations contained in the Report on

Corporate Governance will be affected in a timely and comprehensive manner. In the

CMP, 10 out of 152 recommendations deal with the development of the institutional and

regulatory framework for the capital market from 2001 to 2010. These focus specifically

on the corporate governance issues. In addition, the establishment of the Corporate Law

Reform Committee, in August 2003, to spearhead the corporate law reform programme, is

seen as another milestone for the success of corporate governance reforms in Malaysia

where corporate governance issues are high on the priority of the committee.

Another initiative taken to ensure the success of corporate governance reforms in Malaysia

is the establishment of the Minority Shareholder Watchdog Group (MSWG) in 2001, to

encourage independent and proactive shareholder participation in listed companies.

MSWG functions as the think-tank and resource centre and as an effective check and

balance mechanism on behalf of the minority shareholders to deter abuse from the majority

shareholders. This non-profit organization represents the five largest institutional funds in

the country, including the Employee Provident Fund (EPF), Lembaga Tabung Angkatan

Tentera (LTAT), Lembaga Tabung Haji (LTH), Social Security Organization (SOCSO) and

Permodalan Nasional Berhad (PNB) (Abdul Wahab et al., 2007).

Further amendments were also made to SIA 1983 in 2004 to introduce provisions

governing whistle blowing and enhance enforcement/investor redress mechanisms to

breaches of securities laws. The amendments enhance investor avenues for judicial redress

in the case of contraventions of the SIA 1983 or the Listing Requirements. Additionally, in

August 2004 Bursa Malaysia issued the Best Practice in Corporate Disclosure as a guide

73

for listed companies to comply with disclosure obligations under the Listing Requirements

and securities law. To complement the MCCG 2000, the Putrajaya Committee on

Government Link Companies (GLC) High Performance (PCG) introduced a framework to

guide GLC transformation and upgrade the effectiveness of GLC Boards with the

introduction of the ‘Green Book’ in April 2006.

In line with the 2008 Budget, the MCCG 2000 has been revised to strengthen the roles and

responsibilities of boards of directors and audit committees with the issuance of the

Malaysian Code on Corporate Governance (Revised MCCG 2007). The revised MCCG

2007 enriches the role of the nomination committee by requesting that when candidates are

recommended for directorships they should have the necessary skills, knowledge, expertise,

experience, professionalism, and integrity to strengthen and ensure the board discharges its

roles and responsibilities effectively. Additionally, the Revised Code also requires for the

audit committee to comprise at least three members (all must be non-executive directors), a

majority of whom are independent. The Revised Code also recommends for all audit

committee members to be financially literate with at least one member being a member of

an accounting association or body. The Revised Code is aimed at strengthening the role of

audit committees in the financial reporting process to assist them in effectively discharging

their duties.

Evidence from the Global Competitiveness Report provides evidence that Malaysia tends to

perform well across the different governance dimensions and that the average quality of

governance practices is actually higher compared to some more advanced OECD markets

74

(Cornelius, 2005)25. Indeed, the ten year period after the financial crisis witnessed a

tremendous change in the Malaysian regulatory framework to strengthen the financial and

capital market in the country. However, whether the efforts and initiatives are truly

effective in enhancing the quality of financial reporting in Malaysia remains relatively

empirically unexplored.

3.5 REVIEW OF PRIOR RESEARCH ON BOARD OF DIRECTORS, OWNERSHIP

STRUCTURE AND ETHNICITY AND THE FIRM’S FINANCIAL

REPORTING PROCESS

In this section, three areas of the literature that are relevant to the study are reviewed.

Section 3.5.1 focuses on board of director’ monitoring responsibilities, board composition

and expertise. Section 3.5.2 focuses on ownership structure, specifically, managerial,

family and institutional ownership and Section 3.5.3 discusses the literature on culture,

specifically, focusing on the element of ethnicity. Table 3.4, 3.5 and 3.6 (please refer page

120-137) guide the following discussions.

3.5.1 Board of Directors

The board of directors’ role as a monitoring tool is viewed as the most crucial element for

effective corporate governance mechanisms to enhance the quality and integrity of

accounting information (Cadbury Report, 1992; Malaysian Code on Corporate Governance,

2000). Fama and Jensen (1983) theorize that the board of directors is the most important

internal control mechanism that is responsible to monitor the actions of top management.

25

Malaysia scores 5.3 on a scale ranging from 1 to 7 for average perceived quality of public institutions and 5 for average perceived

quality of firm-level governance. Other countries scores for average perceived quality of public institutions and average perceived quality of firm-level governance; China (3.86, 4.33), Hong Kong, (5.64, 5.07), Indonesia (4.12, 4.27), Korea (4.52, 4.3), Singapore (5.64, 5.67), Taiwan (4.88, 5.03), Thailand (4.76, 4.40), respectively.

75

The separation of ownership and control in today’s modern corporation makes the board of

directors an important mechanism to protect the shareholders’ interests. Large corporations

normally have many residual claimants that make it too costly for all of them to be involved

in effective decision making. It is more efficient for the shareholders to delegate decision

control to the expert internal decision managers to initiate and implement organization

decisions. As shareholders normally diversify their securities in numerous firms, no single

individual in the firm has large enough incentives to devote resources to control the

management and delegation of the duties by shareholders to the boards of directors is

important to establish an appropriate control system within the firms and top management

(Beasley, 1996). Although the shareholders are the owners of the firms, the extensive

power to control is vested in the hands of the board of directors to manage the firms (Che

Ahmad et al., 2003).

However, creating a board that is effective in monitoring management actions is dependent

on the composition of individuals who serve on the board of directors (Fama and Jensen,

1983). Lately, many countries have reformed their code on corporate governance of boards

monitoring responsibilities and have focused mainly on independence, expertise and

diligence of corporate directors for the purpose of protecting shareholders’ interests

(Hermanson, 2003). The following discussion focuses on studies that examine this

phenomenon.

3.5.1.1 Board Independence

There are two conflicting views concerning the effectiveness of a board of directors,

namely, the agency theory perspective and the managerial hegemony theory perspective

(Abdullah, 2004). From an agency perspective, the board of directors is used for

76

monitoring executive opportunistic behaviour as they have the power to hire, fire, and

compensate top management including the chief executive officer. They represent the

interests of the firm’s shareholders by setting strategies, policies and goals that maximize

shareholders’ wealth (Fama and Jensen, 1983). Normally, the corporate board comprises

senior managers from within the company to take advantage of their management expertise.

However, the inclusion of inside board members brings a potential conflict of interest to

run the company and may be an ineffective monitoring device if it does not limit the

decision discretion of the top management and hence the agency theory suggests that the

presence of outside directors is required as the guardians of stockholders’ wealth (Peasnell

et al., 2003).

In order to be effective the corporate board must include outside members who can act as

arbitrators during disagreements among internal managers (Fama and Jensen, 1983). The

utilization of internal governance mechanisms such as the monitoring role of outside

directors (Fama and Jensen, 1983) may help reduce the potential for agency problems

created from the separation of ownership and control. Fama and Jensen (1983) argue that

the inclusion of outside directors26 increases a board’s ability to be more efficient in

monitoring its top management and to ensure there is no collusion with top managers to

expropriate stockholder wealth as they have incentives to develop their reputations as

experts in decision control. With their expertise, independence, objectivity and legal

power, outside directors become potentially powerful governance mechanisms to mitigate

agency costs and protect shareholders wealth (Li, 1994).

26

Fama and Jensen (1983, p.20) contend that outside directors signal to internal and external markets for decision agents that (1) they are

decision experts, (2) they understand the importance of diffuse and separate decision control and (3) they can work with such decision control systems.

77

While the proponents of the agency theory believe that having outside directors provides an

effective monitoring tool for the board (Fama and Jensen, 1983), proponents of the

managerial hegemony theory argue that the capability of outside directors to fulfil their

monitoring and overseeing role, when the management dominates and controls the board of

directors, is questionable (Abdullah, 2004). They argue that the boards are weak and

ineffectual in providing monitoring roles and ‘…act merely as ceremonial rubber stamps’

(Mallette and Fowler 1992, p. 1014). Due to the dominant role played by CEOs in the

director selection process, it is argued that outside directors are incapable of providing

independent judgment and raises concerns about the quality of independent directors

(Abdullah, 2004). The inclusion of outside directors who lack involvement in the corporate

activities as well as exposure to the day-to-day activities of the firm may hinder the

effectiveness of outside directors to monitor the operation of the firm (Petra, 2005).

Furthermore, as outside directors rely mainly on the CEO/management in obtaining

information about the company’s operation, it is possible that the management mediate the

outside directors’ monitoring effectiveness (Nowak and McCabe, 2003).

In understanding the roles that outside directors play, it is important to distinguish between

different categories of outside directors. Two categories of outside directors are noted –

‘independent directors’ and ‘grey directors’.

‘An independent director is an outside director who has no affiliation with the firm

other than the affiliation from being on the board of directors. In contrast, grey

directors are outside directors who have some non-board affiliation with the firm.

Grey directors are a potential source of violation of board independence because of

their other affiliations with management’ (Beasley 1996, p.448).

78

The independent directors must be solely outside directors who have no other relationship

with the company except that of being on the board of directors. Beasley (1996) argues

that the inclusion of grey directors who have affiliations with management may impair

board independence. Additionally, McCabe and Nowak (2008) suggest that it is important

for the recent studies to correctly classify between three different groups of directors –

independent non-executive directors (INDNEDs), non-independent non-executive directors

(NONINDNEDs) and executive directors (ED) – in order to understand the effect of each

group on board monitoring effectiveness27. While INDNEDs are considered as truly

independent directors, NONINDNEDs on the other hand are not independent and were

described by prior research as ‘grey areas’ (McCabe and Novak, 2008).

To test the monitoring incentives of outside directors and financial reporting quality,

studies have focused on issues such as fraudulent financial reporting (Beasley, 1996;

Dechow et al., 1996; Beasley et al., 2000; Uzun et al., 2004), earnings management

(Peasnell et al., 2000; Klein, 2002; Park and Shin, 2004; Norman et al., 2005; Abdul

Rahman and Mohamed Ali, 2006) as well as earnings quality (Abdullah, 1999; Vafeas,

2005; Jaggi et al., 2007).

Early studies explore the relationship between the composition of boards of directors’ and

financial fraud. Beasley (1996) tests the prediction of the agency theory, which suggests

that having a higher percentage of outside directors increases the board’s effectiveness and

shows evidence that the inclusion of a larger proportion of outside members on the board of

27 INDNEDs are ‘not a substantial holder, not being employed in any executive capacity by the company within the last three years, not a

professional adviser by the company, not a significant supplier to the company and having no significant relationship with the company

other than as a director’ while NONINDNEDs are not truly independent as they might be ‘the former employees, major shareholders or

directors holding some other contractual relationship with the organizations such as providing goods or services’ (McCabe and Novak 2008, p.8).

79

directors provides better oversight of management and, thus, significantly reduces the

likelihood of fraud incidence. He suggests that outside members on the board increases its

effectiveness to prevent financial statement fraud by effectively monitoring management

activity. Dechow et al. (1996) report similar findings for firms subject to the Securities and

Exchange Commission (SEC) accounting enforcement actions and their study provides

support for investigating the importance of corporate governance structures in enhancing

the financial reporting quality.

Beasley et al. (2000) extend the Beasley (1996) and Dechow et al. (1996) study and focus

on three volatile industries (technology, health care and financial services) and corporate

governance mechanisms of 66 companies involved in alleged cases of fraudulent financial

reporting in the US. They observe similar findings in relation to the proportion of outside

directors that sit on the board. Fraud companies in all three industries are found to have

less independent boards and generally fraud companies have very weak governance

mechanisms relative to no-fraud companies. Similarly, Uzun et al. (2004) also find that

fraud companies have less independent directors than companies that have not committed

fraud. Their study supports recent corporate governance requirements for a majority of

independent directors to increase the quality of boards as well as to reduce the incidence of

corporate fraud.

Peasnell et al. (2000) extend prior studies by investigating the role of governance in

curbing earnings management. Using abnormal working capital accruals to proxy for

earnings management, Peasnell et al. (2000) find a significant negative relationship

between earnings management and the proportion of non-executive board members in the

post-Cadbury period, suggesting that a high proportion of non-executive directors does

80

constrain earnings management activity. Appropriately structured boards following the

issuance of the Cadbury Report have effectively increased the quality of financial reports in

the UK. Klein (2002) reports similar findings for 692 large-publicly traded US firms for

which she finds a negative association between board independence and abnormal accruals.

Her findings also suggest that firms changing their boards from having a majority to a

minority of outside directors are found to have higher adjusted abnormal accruals in the

year of the change compared to their counterparts. Correspondingly, using a sample of 434

listed Australian firms, Davidson et al. (2005) also find a significant negative relationship

between earnings management and the presence of a majority of non-executive directors.

Their findings support the agency theory claims that independence of the board members is

an effective monitoring mechanism to protect shareholders’ interest.

The role of outside directors in the protection of shareholders has long been a subject of

much debate and research, especially in developing countries where the ownership structure

is highly concentrated. Results from prior studies in developed countries, with a dispersed

ownership structure, confirm the agency theory claims of effective monitoring mechanisms

by independent directors. However, whether prior research findings in developed countries

apply in developing countries, where concentrated ownership is common, is still an open

question. Li (1995) provides evidence of the differences of board composition employed

by 390 large manufacturing firms based in Japan, Western Europe and the United States.

She suggests that different types of ownership structure affect the percentage of outside

directors on the board. In countries with a diffused ownership structure such as the United

States and Western Europe, she finds that more outside directors are needed to control

management behaviour and to resolve the free-rider problems created from separation of

ownership and control. However, when the ownership becomes more concentrated or the

81

banks have significant control over the management such as in Japan, fewer outside

directors are needed as the concentrated owners have more incentive to control

management behaviour and closely monitor the management to reduce conflicts between

the shareholders and managers.

Using a sample from Taiwan, Kao and Chen (2004) test whether outside directors play a

monitoring role in the Taiwanese market where the ownership structure is highly

concentrated and find significant negative evidence between earnings management and the

presence of more outside members on the board. Park and Shin (2004), however, do not

find empirical support of the association between earnings management and board

independence in Canada, where the ownership structure is highly concentrated and a large

block holder controls the public traded firms. Their study suggests that ‘… adding outside

directors to the board may not achieve improvement in governance practices by itself,

especially in jurisdiction where ownership is highly concentrated and the outside directors’

labour market may not be well developed’ (Park and Shin 2004, p.455). Due to a lack of

ownership interests, outside directors have only a token ownership in Canada. Similarly,

Cho and Kim (2007) show that outside directors had only a weak positive impact on firm

profitability in Korea, which is mitigated by the controlling power of large shareholder and

blockholder ownership in a negative fashion that demonstrates a substitution effect among

governance mechanisms.

Evidence of board independence effectiveness in Malaysia is however inconclusive.

Abdullah’s (1999) study finds evidence of a positive and significant role of board

independence on earnings quality proxy by earnings response coefficient and provides

support that independent directors are effective control mechanisms in a firms’ financial

82

reporting process. In addition, a study by Salleh et al. (2006) also reports a significant

finding between a higher proportion of independent directors and a higher audit quality

proxy by audit fees. Their study highlights the importance of a board’s independence in

relation to its monitoring role and strengthening of audit quality.

Whilst Abdullah (1999) and Salleh et al. (2006) show evidence that the inclusion of a larger

proportion of independent directors on the board of directors provides better oversight of

management, a study by Abdullah (2004), Che Haat (2006) and Vethanayagam et al.

(2006), did not find any empirical support of an association between board independence

and performance for the Malaysian sample. Abdullah (2004) and Vethanayagam et al.

(2006) raise issue regarding the quality and accountability of independent directors when

some directors who are classified as independent are not truly independent from

management. Additionally, a study by Abdullah and Mohd Nasir (2004), Norman et al.

(2005) and Abdul Rahman and Mohamed Ali (2006) also does not find any significant

evidence between independence of boards and earnings management. Although they did

not find any significant relationship, studies by Haniffa and Cooke (2002), Norman et al.

(2005) and Abdul Rahman and Mohamed Ali (2006) show a contradictory sign on the

relationship between board independence and the accounting issues they examined. In

additional analyses, Norman et al. (2005) report a positive and significant association

between board independence and discretionary accruals proxy only in firms with negative

unmanaged earnings, which is contrast to their earlier expectation. Similarly, a more recent

work by Hashim and Susela (2008b), using a more recent sample, provides evidence of a

significant contrary sign between board independence and earnings management and brings

issues of whether Malaysian companies’ boards are effective and truly independent when

performing their duties.

83

Another interesting study by Klein et al. (2005) reports a surprisingly negative significant

relationship between board independence and the performance of the family firm’ sample

in Canada, which is contradictory with the prediction of agency theory. Many large firms

in Canada are controlled by individuals, family or private holdings companies. The results

of their study suggest that family firms may be better viewed from the vantage point of the

stewardship theory. While the agency theory suggests the role of the board as providing

monitoring services, the stewardship theory sees the role of the board as providing services,

thus, suggesting more participation from insiders and affiliated outsiders in the board

structures of family firms.

A study by Coffee (2005) raises issues regarding the differences in the structure of

ownership between countries with a dispersed and concentrated ownership structure, which

accounts for differences in corporate scandals. This implies that governance reforms

adopted in the United State may not be appropriate to countries with a concentrated

ownership system. This is supported by Barton et al. (2004) who observe that the

requirement for a majority of independent directors seems to be unrealistic for Asian

corporations (although it is essential to have some) for various reasons: (1) a scarcity of

qualified independent directors; (2) reluctance of the management to share inside

information as the information will be used by the outside director against them; and (3)

given that companies in Asia normally have a single majority owner, the requirements seem

unattainable in substance. As such, little is known about the degree to which board

independence contributes to a board’s governing effectiveness in an Asian environment and

it requires further empirical investigation.

84

3.5.1.2 CEO Duality

Apart from the directors’ independence, there is a requirement for a balance of power and

authority between the chairman and the Chief Executive Officer (CEO) so that no one

individual has unfettered power over decisions. In addition to the requirement of a well-

balanced board, the MCCG 2000 also recommends a separation of roles between the

chairman and the CEO to avoid the considerable concentration of power where the same

person performs both roles. With the separation between the position of the CEO and the

chairman it is hoped to provide an essential check and balance over the management’s

performance. Furthermore, the Cadbury Report recommends that all listed companies

should have no role duality to ensure a balance of power and authority leading to more

independent boards (Ow-Yong and Guan, 2000). Standards Australia International 2003

guidelines believe that the monitoring role by the board will be jeopardised when the CEO

is also the chairperson of the board (Davidson et al., 2005).

There are two points of view on the issue of the separation of powers between the chairman

and the CEO, based on the agency theory and the stewardship theory (Abdullah, 2004;

Abdul Rahman and Haniffa, 2005; Lin, 2005). Proponents of the agency theory believe

that the separation of the two roles is crucial for the monitoring of the effectiveness of the

board over management, by providing cross checking evidence against the possibility of

over-ambitious plans by the CEO (Gul and Leung, 2004). Because, when the same person

is holding two important positions, they are likely to pursue strategies that advance their

own personal interests over those of the company. It is argued that vesting the power of the

CEO and the chairman in a single person could severely impair the board’s effectiveness

(Abdullah 2004; Gul and Leung, 2004). In the absence of a clear separation between the

chairman and the CEO, the board is regarded as ineffective due to the lack of independence

85

when the CEO is in the position of monitoring his own decisions and activities (Bliss et al.,

2007). Petra (2005) argues that it is unreasonable to believe that the CEO/chairman will

evaluate themselves objectively. The agency theory puts full support for the separation of

power, with two separate individuals holding the position of chairman and CEO, thereby

allowing efficient monitoring by the board (Zulkafli et al., 2005).

In contrast, proponents of the stewardship theory believe that the combination of the two

roles enhances the decision making process and allows a CEO with strategic vision to guide

the board to implement a company’s objectives with the minimum of interference from the

board. Under the stewardship theory, it is believed that the CEO view themselves as

stewards of the organisation; allowing a cooperative relationship to exist between the CEO

and the chairman, and the board of directors (Lin, 2005). As a steward of the firm, his or

her actions are likely to achieve organisational rather than self-serving objectives.

Although the corporate governance models in the UK and the US share many similarities,

the models exhibit a stark difference when it comes to separating the roles of the chairman

and the CEO. While most companies in the UK (95 percent) adhere to the splitting role

between the chairman and the CEO, the majority of S&P 500 companies (80 percent) in the

US combine the roles of chairman and CEO (Coombes and Wong, 2004). The idea of

separating the role between the chairman and the CEO in UK corporations is because both

roles are considered to be different and potentially conflicting. If the CEO runs the

company and the chairman runs the boards, it is hoped that the chairman as well as the

board will be able to monitor and criticise the CEO or to express independent opinions.

Furthermore a separate role is argued to probe and encourage debate at board meetings

thereby building a more effective board. The independent chairman can help the board

86

focus on longer-term perspectives while the CEO focuses more on the running the business

(Coombes and Wong, 2004).

However, separating the role may also create confusion about who is doing what (Coombes

and Wong, 2004). There are issues of accountability and the chairman might even attempt

to usurp the CEO’s functions. In the US, there is no specific recommendation to split the

roles of chairman and the CEO. Recently, US companies are increasingly separating the

roles of the chairman and the CEO (Felton and Wong, 2004). But, the switch is not an easy

process as it requires careful planning and takes some time to execute smoothly.

Nevertheless, evidence related to role duality is inconclusive. Xie et al. (2003), Kao and

Chen (2004), Davidson et al. (2005) and Abdul Rahman and Mohamed Ali (2006) do not

find empirical support of the association between CEO duality and earnings management

activity in their study. As the board is already independent from the management,

Davidson et al. (2005) argue that it might be limited evidence on the additional oversight

provided by a non-executive chairperson. Furthermore, Petra (2005) raises the issue of the

capability of outside directors as a chairperson to influence the management decisions when

the ultimate control is still in the hands of the CEO.

A study by Davidson III et al. (2004) reports evidence consistent with the agency theory

prediction of increased agency problems with a dual governance structure. Focusing on a

sample of duality-creating successions and non-duality-creating successions28, they found

greater earnings management associated with companies whose succession announcement

28 Davidson III et al. (2004) argue that a new CEO-chair has pressure to show good performance, especially in their first year of a new appointment that creates strong incentives for them to manage earnings.

87

created a dual leadership structure compared to those with successions creating a non-dual

structure. Their study provides theoretical contribution as they focus on a specific situation

where duality may exacerbate agency problems by linking impression management and the

agency theory. Focusing on voluntary disclosure, a study by Gul and Leung (2004) also

shows evidence that CEO duality is associated with a lower level of voluntary disclosures

for the Hong Kong sample, thus supporting the view of the separation role between the

position of chairman and CEO to ensure the independence of the board and a greater

disclosure of corporate information.

A study by Abdullah (2004) focuses on the relationship of board independence, CEO

duality and a firm’s performance prior to the 1997/1998 crisis, to see the impact of these

internal governance mechanisms when it is voluntarily in nature. He found that Malaysian

companies appeared to comply with one-third of the requirements and non-dual leadership,

even before the issuance of the corporate governance report in 1999. In terms of the

effectiveness of the board structure prior to 1997, Abdullah (2004) does not find any

significant evidence between board independence, leadership structure and the joint effect

of these two with firm performance. However, a negative association is found between

board independence and a firm’s dual leadership structure that suggests a connection

between one individual controlling both the operations and internal monitoring, and board

structure.

Although Abdullah (2004) does not find any significant evidence between CEO duality and

performance for the period prior to the financial crisis, results from a study done by Abdul

Rahman and Haniffa (2005) reveal significant evidence of the relationship between role

duality and performance for pooled data for the years 1996 to 2000 for the Malaysian

88

sample. Although the MCCG 2000 recommends a separation role to ensure balance and

authority, surprisingly, the descriptive analysis reports a gradual decrease in the percentage

of separation for the roles of chairman and CEO from 1996 to 2000. Although the

incidence of role duality is still relatively low compared to other countries, the study

provides evidence that firms with role duality are not performing as well as firms with the

separation between the position of the CEO and the chairman (Abdul Rahman and Haniffa,

2005). Additionally, Norman et al. (2005) report that firms with role duality are managing

earnings more than firms with the two roles separated. Their finding suggests the need to

strengthen the Code recommendations of a separation of roles between the chairman and

the CEO to provide an essential check and balance over the management’s activity.

Consistent with the findings of Abdul Rahman and Haniffa (2005) and Norman et al.

(2005), Bliss et al. (2007) report a positive significant association between CEO duality and

audit fees in Malaysia. The result suggests that auditors view firms with CEO duality as

having a higher inherent control risk that leads to higher audit fees. Nevertheless, the

positive association is significantly weakened when they include independent audit

committees as a moderating variable. This suggests that having more independent directors

on audit committees, in the presence of CEO duality, is likely to reduce the audit fees

charged as auditors view firms with effective audit committee as less risky.

While both the role of board independence and CEO duality have been centrally important

in corporate governance research, prior studies have failed to provide systematic significant

evidence on the role of monitoring (i.e. board independence and CEO duality) and financial

reporting quality. Daily et al. (2003) suggest that over emphasis on the directors’ oversight

role to the exclusion of alternative roles such as resources, service and strategy roles and

89

ignoring of possibilities of intervening processes between governance and financial

performance are two potential explanations for limited evidence from board oversight

functions.

To broaden the focus beyond the board’s monitoring role, Daily et al. (2003) suggest that

researchers should consider other theoretical foundations such as the resource dependency

theory to provide more productive results of a board’s monitoring role. Although the

agency theory overwhelmingly dominates corporate governance research, other theories are

intended as complements to recognize many mechanisms and structures that might

reasonably enhance organizational functioning.

3.5.1.3 Board Financial Expertise

In the resource dependency theory, the directors’ resource role as a source of advice and

counsel for the CEO is important in bringing valued resources to the firms (Daily et al.,

2003). To play an effective role in enhancing the quality of financial reporting, it is

important for the inside and outside directors to provide access to resources needed by the

firms such as financial, governance and firm-specific expertise (Bedard et al., 2004).

Barton et al. (2004, p.61) suggest that for boards to perform their tasks effectively, they

must have the ability for ‘asking management tough questions, actively helping to set

corporate strategy, monitoring risk management, contributing to CEO successions plan

and ensuring that companies set and meet their financial and operating targets’. However,

this can only be achieved if the board has the necessary expertise to fully embrace such

duties.

90

To perform specified duties and responsibilities, the board members must consist of a

diverse collection of skills and competencies (Reilly, 2003). Having board members who

lack knowledge and experience actually threatens the firm’s overall performance due to the

inability to deal with issues affecting the firm’s business (CFA Institute, 2005). According

to Renton (2003), governance, strategic business direction and finance are three areas that

are important for the directors to have, as stated in the Institute of Directors-Good Practice

for Directors: Standards for the Board in the UK to be effective in performing their duties.

To be effective in addressing issues relating to the financial information of the company,

the directors should have a sound financial background and must at least be able to read and

understand the balance sheet (Renton, 2003). Boards of directors that include audit

committee members should have the necessary skills such as financial literacy to better

understand and correctly interpret financial information. Vafeas (2005) argues that for

audit committee members to be effective, they should have the necessary skills to

understand and interpret financial information correctly, to ensure that a higher quality of

financial report is conveyed to shareholders. The financial literacy is important for audit

committee members to perform their functions more effectively. Independent directors

with a corporate or financial background may be an important determinant of their

monitoring effectiveness as they have a better understanding of how earnings are managed

(Xie et al., 2003). Thus having board members with technical expertise is important for

them to perform their functions more effectively and efficiently, especially on issues that

relate to financial reporting.

91

The Blue Ribbon Panel29 addresses the issue of the financial sophistication of audit

committee members in preventing earnings management behaviour. It recommends that

audit committee members should be financially literate in order to ensure they can perform

their functions more effectively in overseeing the financial reporting process (Xie et al.,

2003). The SEC requires that every audit committee in the US should include at least one

member with financial expertise (Lin et al., 2006). In Malaysia, the revised MCCG Code

2007 requires all members of audit committees to be financially literate. This is so they are

able to understand and interpret financial statements to effectively fulfil their role in

monitoring the company’s system of internal control and financial reporting. Additionally,

the Code also requires that at least one audit committee member be a member of an

accounting association or body.

In an experimental setting, DeZoort and Salterio (2001) find that greater audit knowledge is

associated with audit committee member support for an auditor in ‘a substance over form’

dispute. Based on 23 questions comprising 12 financial reporting questions, 6 audit

reporting questions and 5 problem solving ability questions answered by 68 Canadian audit

committee members, they find that audit reporting knowledge is positively associated with

support from the auditor in an auditor-management dispute.

The study by Xie et al. (2003) finds that boards of directors with corporate or investment-

banking backgrounds are negatively related to the level of earnings management and

suggests that independent directors with corporate and financial backgrounds are an

29 The main theme underlying the Blue Ribbon Committee reports is that ‘firms can improve the quality of financial statements by

structuring and operating their audit committees more appropriately’ (Vafeas 2005, 1096).

92

important determinant of board monitoring effectiveness as they have a better

understanding of how earnings are being managed. Bedard et al. (2004) observe that the

presence of a financial expert on the audit committee is negatively related with the

likelihood of aggressive earnings management. Karamanou and Vafeas (2005) report that

audit committee expertise is positively related to the market reaction of earnings forecast.

Although Park and Shin (2004) do not find a significant association between board

independence and accrual management, they do find evidence that the presence of officers

from financial intermediaries on the board is helpful in limiting abnormal accruals when the

unmanaged earnings are below the target. They suggest that experienced outside board

members actually helps them understand the firms and its people better and thus enhances

their governance competencies. A study by Park and Shin (2004) sheds light on the

importance of board members and audit committees having financial expertise to be

effective in constraining the earnings management behaviour.

3.5.1.4 Board Governance Expertise

‘Economic theory suggests that one of the main factors motivating directors to act in

shareholders’ interests is their desire to establish a reputation in the labour market for

directorships, thereby increasing the value of their human capital’ (Peasnell et al. 1999,

p.106). Additional directorships signal the competence of directors in the managerial

labour market and provides a platform for directors to gain governance expertise (Bedard et

al., 2004). Governance expertise refers to the ability of the director to appreciate the

differences between management and direction and to have a good understanding of the

board’s operations, including the legal framework within which they operate (Renton,

93

2003). The greater the number of board seats directors hold, the more sensitive they are

likely to be to protect their reputations, thereby creating a strong incentive for them to

perform their duties well (Vafeas, 2005). Cross-directorship helps directors be more

transparent in making decisions as they can make comparisons based on knowledge of the

best board practices gained from other firms (Haniffa and Cooke, 2002).

Haniffa and Hudaib (2006) suggest that the benefits from cross-directorship come from two

different motives – information exchange motive and control motive. Under the

information exchange motive, the multiple directorships serve as an influential source of

information relating to new policies, trade secrets and practices among firms. Multiple

directorships allow the directors to be exposed to recent economic trends; international

business; different management styles; monitoring behaviour; and different management

policy and practices. Under control motive, multiple directorship serve as a mechanism for

control and offers additional insights into the outcomes of other companies, facilitating

comparisons as well as enhancing control (Haniffa and Hudaib, 2006).

However, this is dependent upon the time and effort they spend, as a large number of

outside directors may limit the time they can devote to a particular firm, which in turn may

decrease their governing effectiveness (Bedard et al., 2004). Furthermore, as the directors

serve on several boards, it has been suggested that they may not be able to understand each

business well enough to be effective in performing their jobs (Bathala and Rao, 1995).

Nonetheless, for Malaysian cases, the Bursa Malaysia adopts restriction in the number of

directorship per director in its listing requirement in 2002. The maximum number of

directorship is ten in public listed companies and fifteen in private listed companies to

94

ensure the directors perform their duties effectively with less commitment, resources and

time available (Zulkafli et al., 2005).

In US study, Bedard et al., (2004) find that the average number of cross-directorships of

independent audit committee members is significantly related to both income-increasing

and income-decreasing earnings management. They find that the greater the additional

number of other directorships held by board members, the lower the likelihood of earnings

management activity of the firm. Similarly, a study by Norman et al. (2005) reports a

significant and negative association between multiple directorships and earnings

management in firms with negative unmanaged earnings. They suggest that multiple

directorships serve as important governance mechanisms in mitigating earnings

management activity and any attempt of earnings management would jeopardize directors’

future in the managerial labour market.

3.5.1.5 Board Firm-Specific Expertise

Other important characteristics to determine the expertise of the board come from studying

the impact of board tenure on financial reporting quality. Firm-specific expertise is

acquired through experience as a member of the board by developing more knowledge of a

company’s operations and its executive directors (Bedard et al., 2004). Beasley (1996)

finds negative and significant association between the number of years of board service for

outside directors and the likelihood of financial statement fraud. He believes that the

ability of boards to monitor management effectively is consistent with the increased

number of years they serve.

95

Nevertheless there are two conflicting views on the impact of director tenure length on

board effectiveness (Vafeas, 2005). On the one hand, it is argued that more seasoned

directors have greater experience and knowledge about the firm’s operation that enable

them to exercise better decision control compared to less experienced directors. On the

other hand, given that the directors have served the firm for quite a long time, their

independence is compromised as they become more likely to befriend management and

hence be less critical about the quality of financial reports (Vafeas, 2005).

A survey by Peasnell et al. (1999) finds that on average the length of tenure for non-

executive directors in the UK is five years with twenty five percent of the sample having

served the company more than six and a half years. In addition, their findings cast doubts

about the independence of the board who serve on boards too long. Xie et al. (2003) find

that the longer the tenure of directors, the less effective they became as they may co-opt

with management. They find a positive instead of negative relationship between board

tenure and the level of discretionary accruals.

For Malaysian companies, there is limited evidence on the study that relates to the role of

board expertise and financial reporting quality. Abdul Rahman and Mohamed Ali (2006)

do include one aspect of financial expertise in their study but do not find any support of the

relationship between expertise of audit committee members and earnings management

activity. They argue that the establishment of audit committees has yet to achieve its

intended goal. Also the study by Haniffa and Cooke (2002) that examines the effect of

governance and voluntary disclosures in the annual report also does not find any significant

evidence between cross-directorship and voluntary disclosures of Malaysian companies.

However, Haniffa and Cooke (2005) do find significant evidence between companies with

96

chairmen having multiple directorships and the extent of corporate social reporting. This

suggests that chairmen with experience have greater influence to reveal more concerning

corporate social disclosure.

3.5.2 Ownership Structure

The agency theory proposes ownership structure as one of the main corporate governance

mechanisms to solve agency problems and suggests that concentrated ownership will result

in more effective monitoring (Jensen and Meckling, 1976). While researchers in developed

countries focus on the conflict of interest between outside shareholders and managers in a

diffused ownership, in Asia where ownership concentration structures are more prevalent

the agency problem shifts to conflicts between the controlling owners and the minority

shareholders (Claessens and Fan, 2002). The concentrated ownership creates agency

conflicts between controlling owners and minority shareholders, which are difficult to

mitigate through the traditional functions of a board of directors (Fan and Wong, 2003).

The tightness of ownership allows self-interested behaviour of managers to go

unchallenged, internally by the board of directors and externally by takeover markets, as

the controlling owners, who are often also the managers, gain effective control of a

corporation and have the power to determine how the company is run and may expropriate

the minority shareholders’ wealth.

The following discussion reviews prior literature covering three different types of

ownership structure including managerial ownership, family ownership and institutional

ownership and its relation to the financial reporting quality.

97

3.5.2.1 Managerial Ownership

While having independent directors appears to be critical for the effectiveness of the

board’s monitoring function, the extent of shareholding held by management may affect

control over the board and the agency theory suggests that concentrated ownership will

result in more effective monitoring supporting convergence of interest hypothesis (Jensen

and Meckling, 1976). However, a study by Morck et al. (1988) offers two opposing points

with regards to the effect of managerial ownership – the alignment hypothesis and the

entrenchment hypothesis. While the alignment hypothesis suggests a uniformly positive

relationship, the entrenchment hypothesis suggests that too much equity interests may

entrench the managers to expropriate shareholder’s wealth.

Focusing on the earnings informativeness, Jung and Kwon (2002) find that earnings are

more informative as holdings of the owner increase in Korea, supporting the convergence

of interest hypothesis by Jensen and Meckling (1976). They show that as the managers’

holding increases, the agency cost reduces thus resulting in higher earnings quality and

informativeness. However, when they partition the sample into Chaebol30 vs. non-Chaebol

companies, they find the relationship between managerial ownership and earnings

informativeness becomes insignificant for the Chaebol sample, suggesting that management

and expropriation of minority shareholders offset the positive effects of convergence of

interest for Chaebol firms, reducing earnings quality and informativeness.

30

‘A Chaebol is a financial clique consisting of many enterprises engaged in a diverse business, and typically owned and controlled by

one or two interrelated family groups’ (Jung and Kwon 2002, p.304).

98

Using long-term returns as a measure for performance, Han and Suk (1998) report a

positive relationship between insider ownership and performance of 301 US listed firms for

the 1988-1992 period. They show that as inside ownership increases, stock returns also

increase. However, too high level of insider ownership is likely to entrench the managers

resulting in a negative relationship between ownership and performance. Karamanao and

Vafeas (2005) also report a negative significant association between insider ownership and

financial disclosure quality and argue that firms with lower managerial ownership demand

a greater need for an effective board and audit committee. Consistent with findings by

Karamanao and Vafeas (2005), Mohd Ghazali (2007) shows a significant and negative

association between insider ownership and corporate social disclosure in Malaysia

supporting the argument that in closely-held firms, public accountability is less of an issue

to the owner.

A survey by Peasnell et al. (1999) shows that on average, non-executive directors in the

UK only hold less than two percent of the total outstanding equity in the companies they sit

on the board of, compared with approximately seven percent of share ownership by the

executive director group. Their survey casts doubt on whether the non-executive directors

can be expected to perform their independent role effectively as there are low incentives

from the external labour market to monitor the management in the UK. While studies by

Han and Suk (1998), Karamanao and Vafeas (2005) and Mohd Ghazali (2007) focus on

inside member’s ownership, Beasley (1996) studies the effect of outside director’s

ownership and financial statement fraud. He provides evidence of a significant negative

relationship between outside directors’ ownership and the likelihood of financial statement

fraud. His findings suggest that a higher level of ownership held by outside directors does

help reduce the likelihood of financial statement fraud.

99

Given the “closely-knit” ownership of Malaysian companies, Abdullah (2006a) investigates

the influence of management and non-executives interest in financially distressed firms of

an 86-matched sample of distressed and non-distressed companies for the period of 1999-

2001. He does not find an association between board independence and CEO duality on

firm value, however, he finds a significant association between management interests and

firm value at the lower level and higher level of ownership. The study provides evidence of

a curvilinear effect of management interests on firm value and brings a new direction of

research to recognize the importance of the ownership pattern in examining the corporate

governance structure of Malaysian companies. Further, a study by Tam and Tan (2007)

finds that ownership concentration is prominent and entrenched in Malaysia regardless of

ownership type. Focusing on earnings management, Norman et al. (2005) find a negative

significant association between management ownership and earnings management activity

for Malaysian sample. Their study provides evidence of less earnings management

practices when the managerial equity ownership increases, supporting the convergence of

interest hypothesis by Jensen and Meckling (1976).

Bathala and Rao (1995) argue that limited evidence from prior studies on the direct

relationship between board composition and performance is due to the omission of other

correlated variables that affect firm performance including managerial ownership. It is

important for the researchers to incorporate insider ownership when discussing the

composition of boards of directors as a higher proportion of insider ownership held by

inside board members helps to closely align the managerial and shareholder interests, thus,

reducing the need for intense monitoring from external board members. The role of outside

board members is less critical for firms with a higher proportion of inside ownership and in

100

Bathala and Rao’s (1995) study they find an inverse relationship between the proportion of

outside board members and inside ownership of equity of 261 US listed firms.

To understand the linkage between managerial ownership and outside directors, Peasnell et

al. (2003) examine the ways in which these two mechanisms interact. They posit that the

interaction between managerial equity ownership and the demand for outside directors

follows a U-shape and non-linear relationship. Accordingly, they found evidence of a

strong non-linear relationship between managerial ownership and the demand for outside

directors and suggest that prior studies using linear models to estimate the relationship

between board composition and managerial ownership ‘may have significantly understated

the marginal rate of substitution between outside directors and insider ownership over low

and moderate ownership levels’ (Peasnell et al. 2003, p.233).

Further, a study by Peasnell et al. (2005) includes managerial share ownership as the

intervening variable and posits that the constraining association between earnings

management and the proportion of outside directors will be more prominent when the level

of managerial share ownership is low. Prior research by Peasnell et al. (1998 and 2003)

finds that managerial share ownership is significantly associated with the proportion of

outside members. The demand for non-executive directors is lower in companies where the

level of managerial ownership is high, as shareholders let the management run the

companies (Peasnell et al., 1998). Although Peasnell et al. (2005) find only a slight

significant association on the three-way interaction of managerial ownership, outside

directors and income-increasing abnormal accruals, this finding provides insights for future

research on the interaction of managerial share ownership and the proportion of outside

directors in constraining earnings management behaviour.

101

3.5.2.2 Family Ownership

A study of the role of the family ownership structure is critical to the effectiveness of

corporate governance employed by firms in Asia (Claessens and Fan, 2002). Unlike

developed countries such as the UK and the US, which have a dispersed ownership

structure, Asian firms have a more concentrated ownership structure where family control

is common in both small and established firms (Mak and Kusnadi 2005). La Porta et al.

(1999) reviews the corporate ownership structure of 27 countries around the world and

reveals that except in economies with very good shareholder protection, such as the United

States, families or the state typically control firms in countries with poor shareholder

protection. The controlling shareholders often control the firms through pyramidal

structures and have control rights in excess of their cash flow rights. These controlling

shareholders even participate significantly in the management process and have the power

to expropriate minority shareholders and raises questions of minority shareholders

protection.

Jaggi et al. (2007) report that family ownership of Hong Kong firms represents 60 percent

of the total market capitalisation with the ten largest family firms having control of 32.1

percent of total corporate assets in Hong Kong. According to Wiwattanakantang (1999;

2001), 80 percent of non-financial companies traded on the Stock Exchange of Thailand are

family owned and 34.81 percent of the firms are totally controlled by a single family. Mak

and Li (2001) argue that the role of government and family shareholders in Singapore is

very prominent, making it difficult to mount takeover attempts without the support of these

two controlling shareholders. Claessens et al. (2000) document that the ten largest families

in Indonesia, the Philippines and Thailand control half of the corporate assets, while in

Hong Kong and Korea, the ten largest families control about a third of the corporate sector.

102

They argue that wealth concentration might be a formidable obstacle to future policy

reform including corporate governance in East Asian corporations.

However, questions of whether family ownership provides an incentive to reduce agency

costs or create it, still remains an open empirical issue. There are two contradictory views

regarding the relationship between family ownership and agency costs. On the one hand,

several researchers agree that concentrated shareholdings in the hands of family have an

incentive to reduce agency costs through a better alignment of shareholder and managerial

interests. Bartholomeusz and Tanewski (2006) highlight several reasons as noted by prior

researchers that favour family firms as agents to reduce agency costs. First, as the benefits

and costs of the company are borne by the same person, family firms have more incentive

to protect their wealth as it is tied directly to the welfare of the company. Second, family

firms have greater expertise concerning the firm’s operation that places them in a better

position to effectively monitor the firm’s activities. Third, in order to protect the family’s

name and reputation, family firms strive to maximize the long-term wealth of their firms.

Fourth, given that the family member’s are tied together creates a special and unique

relationship that develops loyalty, efficient and effective communication and decision

making, which in turn reduces the agency costs.

However, according to Bartholomeusz and Tanewski (2006), other literature also draws

attention to the possibility that concentrated ownership by family firms creates agency

costs. First, family firms might use their concentrated blockholding to expropriate the

wealth of outside shareholders through excessive compensation, related-party transactions

and special dividends. Second, given that their wealth is undiversified, family firms tend to

be risk avoidant where they might use their control to invest in less risky projects that are

103

not aligned with other shareholders’ interests. Third, under the pyramidal control structure

(which is common in a family business group) family firms may create agency costs if the

family members pursue the interests of other members at the expense of outsiders.

The study by Bartholomeusz and Tanewski (2006) identifies the relationship between

family control and a corporate governance structure of 100 listed companies (i.e. 50 family

firms and 50 matched non-family controlled firms) trading on the Australian Stock

Exchange and found that family firms have lower outside directors’ shareholdings; fewer

large blockholders; a lower proportion of independent directors; a higher proportion of

‘grey’ directors and a greater combination of roles between CEO and Chairman compared

to the non-family controlled firms. This suggests that corporate governance structures

adopted by family firms create agency costs as the structures are inconsistent with

maximizing the value of the company. A study by Choi et al. (2007) reports a significant

difference on the effect of governance mechanisms between Chaebol vs. non-Chaebol firms

in Korea. In general, they find that the results of the Chaebol sample are much weaker

overall compared to the non-Chaebol sample, which suggests that Chaebols are so powerful

in Korea as to possibly dominate and nullify the oversight and market discipline function of

internal and external governance mechanisms.

There is always a risk associated with minority shareholders’ expropriation in companies

with a high ownership concentration in the hand of controlling family owners (Ng, 2005).

Focusing on financial disclosure, Fan and Wong (2002) find that earnings figures are less

informative when controlling owners possess high voting rights and when voting rights

substantially exceed cash flow rights. The earnings figure loses its credibility because

investors perceive that the figure is being manipulated by controlling owners.

104

A study by Ng (2005) finds a non-linear cubic relationship between ownership and

performance in a family-based environment of listed companies in Hong Kong. She finds

that at a relatively low level of family ownership (16.86 percent and below), managers, who

are normally the professional managers, entrench their interests with the companies as their

shareholdings are not substantial and tend to seek their self interest. However, at a wider

spectrum of medium level of ownership (16.86 percent to 63.17 percent), the results show

that family managers align their interests with the companies and the performance is

improved with a greater ownership concentration. Again when family managers gain a

relatively high level of ownership beyond (63.17 percent), they become so powerful and

entrench their interests with the companies to the detriment of the minority shareholders’

interests. Similarly, Jaggi et al. (2007) note that outside directors monitoring effectiveness

is reduced in family controlled firms, which results in a lower quality of reported earnings

in Hong Kong.

Nevertheless, a study by Wang (2006) documents a positive and significant relationship

between founding family firms and earnings quality, consistent with the alignment effect of

family ownership on the supply of earnings quality. Using three different proxies of

earnings quality, he reports evidence that higher founding family ownership is associated

with lower abnormal accruals, greater earnings informativeness and less persistence of

transitory loss components in earnings. Wang (2006) suggests three reasons why founding

family firms are less likely to manage earnings: 1) long-term business horizon; 2) a higher

stake in the firm; and 3) to preserve the family’s reputation.

105

An analysis of a sample of companies comprising over 50 percent of Bursa Malaysia’s

market capitalisation in December 1998 by World Bank (1999), shows that the five largest

shareholders in these companies owned 60.4 percent of the outstanding shares and more

than half of the voting shares. Additionally, the report provides evidence that 67.2 percent

of shares were in family hands, 37.4 percent had only one dominant shareholder and 13.4

percent were state-controlled. Given the significant amount of shares held by family

members in Malaysia, it is surprising to find that the relationship between the effect of

family ownership and the financial reporting quality has not been extensively explored.

In the Malaysian context, Haniffa and Cooke (2002) find a negative significant association

between the proportion of family members on the board and the extent of voluntary

disclosure by Malaysian companies. The presence of many family members as board

members may result in less demand for voluntary disclosure as they have better access to

inside information. Additionally, Mohd Ghazali and Weetman (2006) report similar

findings between family domination and the extent of voluntary disclosure after the 1997

financial crisis. They argue that family-owned companies remain secretive even after the

corporate governance reform, which suggests they preserve a tradition inherited from the

past and resist attempts to change their attitudes towards greater voluntary disclosure at the

point of regulatory change. However, in terms of firm performance, Chu and Cheah (2006)

find that the effect of family ownership on performance is positive and significant and

suggest that family controlled firms still maintain the passion for entrepreneurship in

Malaysia. They suggest that family businesses in Malaysia focus on firms output

efficiency, expansion, as well as maximization of shareholders’ value.

106

3.5.2.3 Institutional ownership

Considering the influence of shareholder activism in governance reforms, it is important to

obtain insight into governance practices (Daily et al., 2003). To date, institutional

investors’ participation has emerged as an important force in corporate monitoring, serving

as a mechanism to protect minority shareholders’ interests. The significant increase in the

institutional investors’ shareholdings has led to the formation of a large and powerful

constituency, which plays a significant role in corporate governance. For example, in the

US, the California Public Employees’ Retirement System (CalPERS) has been active in

seeking greater director independence. Further, in firms in which they invest their funds,

CalPERS requests that the firms have a majority of independent directors sitting on the

board and even identifies the lead directors for the post of chairman as well as imposing age

limits on directors (Daily et al., 2003).

In the UK, institutional investors own between 65 to 75 percent of the United Kingdom

stock market, which suggests the prominent role that institutional shareholders can play as

an agent for governance systems (Mallin, 2003). In fact, Hermes Investment Management,

which is owned by and is the principal fund manager for British Telecom (BT) Pension

schemes, manages over 75 billion euro representing equity investments in over 3,000

companies worldwide and is the largest institutional investor in the UK (Lee, 2003). In

Australia, institutional ownership grew to about 49 percent of the listed equities by 1997

causing the Parliamentary Joint Committee to remove some legal barriers in order for

institutional investors to be more involved in their portfolio firm’s corporate governance

(Koh, 2003).

107

Proponents of the active monitoring hypothesis believe that institutional investors have

greater incentive to actively monitor their investments due to the great amount of wealth

they have invested in the firms. They are viewed as long-term investors with significant

incentives to actively monitor managers (Jung and Kwon, 2002). As sophisticated

investors, institutional investors use financial statement information to plan and evaluate

their investments, making them capable of actively monitoring the quality of financial

reporting and also for disciplining managers who report poor quality accounting numbers

(Velury and Jenkins, 2006). On the other hand, proponents of the private benefit

hypothesis argue that larger investments by institutional investors provide an opportunity to

access private information that may be exploited for self-interested behaviour on the part of

institutions. If this case is true, it is expected that concentrated ownership in the hands of

institutional investors is likely to reduce the quality of reported earnings.

Extending prior research that examines the role of internal governance mechanisms and

earnings management, Mitra and Cready (2005) observe that active monitoring from the

institutional investors also helps to prevent managerial opportunistic reporting behaviour

and improve the quality of governance in the financial reporting process. Based on a

sample of 136 companies belonging to the S&P 500 group and 237 not belonging to the

S&P 500 category, for the eight year period 1991-1998, they find that institutional

shareholders intervene and mitigate the self-serving behaviour of corporate managers in

financial reporting. Further, they find that the inverse relationship between institutional

ownership and current abnormal accruals is dependent on firm size and richness of the

information environment, where the relationship is stronger for smaller firms that are

108

deemed to have an impoverished information environment compared to larger firms that are

deemed to have an information-rich environment.31

A number of studies also report evidence supporting the active monitoring hypothesis of

the effectiveness of institutional owners in monitoring management on several accounting

issues. A study by Han and Suk (1998) and Karamanou and Vafeas (2005) finds a

significant positive relationship between institutional ownership and performance and

higher disclosure quality for the US sample. Karamanou and Vafeas (2005) suggest that

institutional ownership serves as an important complement in disciplining management.

Chiao and Lin (2005) also report a positive relationship between institutional shares and

performance for listed firms in China. Similarly, using a Korean sample, Jung and Kwon

(2002) find earnings become more informative with increases in the holdings of

institutions, supporting the role of institutional investors as an active monitor.

The involvement of institutional investors may improve corporate governance practices by

mitigating the problems associated with conflict between controlling owners and minority

shareholders in Asian firms (Claessen and Fan, 2002). Institutional investors are able to

diligently monitor as they have the resources, expertise and stronger incentives to actively

monitor the actions of management and prevent managers’ opportunistic behaviour (Wan

Hussin and Ibrahim, 2003). Owning substantial shareholdings makes it difficult to sell

shares immediately at the prevailing price, and, therefore, institutional investors have

greater incentive to closely monitor companies with high free cash flow (Chung et al.,

2005).

31

Larger firms have richer information from accounting and non-accounting sources and are subject to monitoring of various parties,

meaning that the incremental effect of monitoring by institutional investors has lesser effect compared to the smaller firms. The effect of the monitoring role by the institutional investors is expected to be larger in smaller firms with a comparatively impoverished information environment and lower visibility in the market.

109

A June 2000 survey of global institutional investor opinion for corporate governance by

McKinsey & Company found that the majority of institutional investors were prepared to

pay a significant premium for the shares of companies that they knew to be well governed.

In fact the findings showed that in East Asian countries, the average premium willing to be

paid by investors was as high as 27.1 percent in Indonesia, 25.7 percent in Thailand, 24.9

percent in Malaysia and 24.2 percent in Korea. Some investors even state that the key

determinants of their investment choice are the governance practices of the companies,

suggesting that institutional investors pay great attention to sound corporate governance

practices.

However, it depends on the relationship between the institutional investors and the

controlling owners, as the rent seeking and relationship based transactions may negate the

institutional investors ability to monitor the controlling owners, and not force them to

disclose all information to the public as their value will also be affected (Claessen and Fan,

2002). Chung et al. (2005) find evidence that institutional shareholders moderate the

discretionary accrual and surplus free cash flow relationship when the surplus free cash

flow is high. The presence of institutional investors with substantial shareholdings restrains

managers from engaging in income increasing discretionary accruals when companies have

high free cash flow, however, when there is no free cash flow agency problems, the

institutional investors do not effectively constrain the management’s use of income

increasing discretionary accrual.

Additionally, Velury and Jenkins (2006) suggest that the general positive relationship

between institutional ownership and earnings quality is affected by increased ownership

concentration. Using four quality dimensions discussed in the FASB conceptual

110

framework to measure earnings quality, they find a positive significant association between

institutional ownership and earnings quality, but, as institutional ownership becomes

concentrated, they find a negative effect of institutional ownership on earnings quality.

Similarly, Koh (2003) reports a non-linear association between institutional ownership and

income increasing discretionary accruals for an Australian sample. She found a positive

association at a lower institutional ownership region, consistent with transient (short-term

oriented) institutional investors creating incentives for managers to manage earnings

upwards. However, at a higher institutional ownership region, her results show a negative

association that supports long-term oriented institutional investors mitigating manager’s

aggressive earnings management.

In Malaysia, the total institutional shareholdings stood at about 13 percent of the total

market capitalization of Bursa Malaysia (for year 2003), representing a higher percentage

of institutional shareholdings compared to other countries in the same region (Abdul

Wahab et al., 2007). In fact the Employee Provident Fund (EPF) accounts for 86 percent of

the total RM173 billion of provident and pension fund (Thillainathan, 1999). Although the

institutional shareholdings are growing in the Malaysian capital market, empirical evidence

on the effect of institutional shareholding and accounting issues are very limited. Abdullah

(1999) is the first to examine the relationship between institutional shareholdings and

accounting earnings quality (measured by earnings response coefficient). He argues that

Malaysian institutional investors prefer short-term investments rather than long-term

achievement, thereby inevitably causing their decision to dispose of their substantial

shareholdings to dramatically depress the market share price and supporting the ‘myopic

investor’ hypothesis. However, although findings by Abdullah (1999) may have been

111

appropriate at that time, recent capital market development initiatives32 have encouraged

greater institutional investor participation as corporate monitoring. Institutional investors

in Malaysia nowadays have become a very large and powerful constitution, playing a very

significant role in corporate governance to protect minority shareholder’s interests.

The greater involvement of institutional investors in the Malaysian capital market, resulting

from corporate governance reforms, provided the motivation for Abdul Wahab et al. (2007)

to examine the relationship between institutional ownership, corporate governance and firm

performance of 435 Malaysian listed firms from 1999 to 2003. Their study provides

evidence of a negative and significant mono-directional causality that runs from

institutional ownership to performance. This suggests that institutional shareholding is a

determinant of poor performance but poor performance is not a determinant of institutional

ownership. Additionally, they find that institutional investors use corporate governance

practice as a measuring tool for their investment decisions, suggesting that firms with better

corporate governance practices attract higher institutional ownership from institutional

investors.

3.5.3 Ethnicity

Besides the conventional corporate governance mechanism of the board of directors and

substitute corporate governance mechanism of ownership structure, culture and religious

traditions have been considered as having an important influence on corporate governance

systems employed in any one country. Politics, cultural and historical roots are always

32

The introduction of the Capital Market Master Plan (CMP) by the Securities Commissions is to chart the direction of the Malaysian

capital market for the next ten years. Out of 152 recommendations dealing with the development of the institutional and regulatory framework for the capital market from 2001 to 2010, ten focus specifically on issues of corporate governance. Corporate governance becomes a key strategic thrust of the CMP and one of the important recommendations by CMP is a mandatory disclosure on the state of compliance with the MCCG 2000.

112

important factors to be considered when discussing the corporate practices of different

countries around the world (Cornelius, 2005). Davis (2005) states that understanding the

institutional arrangement and the cultural influence is important to complement the

deficiencies in current corporate governance research that provide promising areas of future

research in sociological work on corporate governance.

Hofstede (1981, p.24) defines culture as a ‘collective programming of the human mind that

distinguishes the members of one human group from those of another’. Based on the cross-

cultural work of Hofstede (1980; 1983), Gray (1988) proposes a framework linking

Hofstede’s cultural values33 with the development of accounting attitudes and systems

internationally. He posits that the accounting values derived from Hofstede’s (1980)

cultural values influence the development of countries financial reporting systems. A

number of studies have utilized the Hofstede-Gray framework and provide evidence of the

influence of culture on financial reporting systems such as international audit practice

(Cohen et al., 1993), the relevance of an accounting system (Baydoun and Willett, 1995),

financial performance (Flamholtz, 2001), firm-level disclosures (Hope, 2003b), choices of

accounting accruals (Guan et al., 2005) as well as the application of financial reporting

rules (Tsakumis, 2007).

Historical factors and cultural characteristics appear to have a significant impact on

business ethics, corporate practices and the behaviour of board members in Malaysian firms

that have evolved from a traditional family business into public listed corporations (Ow-

Yong and Guan, 2000). Although there are few proxies for culture, ethnicity acts as a

33

Hofstede (1983) obtained data from 116,000 questionnaires answered by employees of a large multinational corporation in fifty

countries and three regions and found four factors underlying differences in nations’ cultural values – individualism, power distance, uncertainty avoidance and masculinity.

113

suitable surrogate for culture in Malaysia, which has a multiracial society, each section of

which still maintains its own unique ethnic identity and values (Haniffa and Cooke, 2005;

Salleh et al., 2006). Table 3.2 provides an interrelationship between societal values and

accounting practices based on two different ethnic groups in Malaysia – Malay and Chinese

as provided by Salleh et al. (2006, p.66).

Table 3.2

The Interrelationship between Societal Values and Accounting Practices

Hofstede Societal Value

Ethnic Groups

Accounting Value Accounting Practice

Power distance Masculinity Uncertainty Avoidance Individualism Power distance Masculinity Uncertainty Avoidance Individualism

Malay

High

Low High

Low

Chinese High

Low Low

High

Low professional Low secrecy High uniformity High conservatism High professional High secrecy Low uniformity Low conservatism

Low compliance with legal requirements High disclosures Less flexibility Less optimism High compliance with legal requirements Low disclosures High flexibility High optimism

Source: Adapted from Salleh et al. (2006).

In Malaysia, Malays and Chinese play a dominant role in politics and economics, regulators

being predominantly Malays and businesses mainly owned by the Chinese (Abdullah,

2006a). A study by Mansor and Kennedy (2000) on the Malaysian culture and the

leadership of organisations notes that Malay cultural values have developed from a history

of communal living and cooperation. The Malays are often cited as being high on

collectivism and the Malay leaders are expected to place their own interests ahead of the

114

group. Although the Malays are the majority ethnic group in Malaysia, the Malays have

been left out of the economic mainstream during the colonial period (Mamman, 2002). In

that sense, the Malays are not found to have the same strong history of entrepreneurial

involvement as other ethnic groups in Malaysia, which translates into a lower level of

performance orientation in their leadership role (Mansor and Kennedy, 2000).

In contrast, the Chinese leaders show remarkably high entrepreneurship with good self-

discipline and strategic thinking (Wah, 2002). The Chinese leaders apply good strategies in

leading organisations and successfully lead and grow their family-managed businesses into

professionally-managed organisations (Wah, 2002). In many East Asian countries, Chinese

family groups have played a dominant role in business (Ball et al., 2003). As reported by

Weidenbaum and Hughes (1996) cited from Ball et al. (2003), the total market

capitalization of the 500 largest public companies in Asia exceeded $400 billion, with the

highest in Hong Kong ($155 billion), followed by Malaysia ($55 billion), Singapore ($42

billion) and Thailand ($35 billion). Though often cited as a minority, the economic power

of ethnic minority Chinese is more than half of the native major population and has been

argued as a source of racial tension in many Southeast Asian countries including Indonesia,

Thailand and Malaysia (Ball et al., 2003).

Table 3.3

Economic Power of Ethnic Minority Ethnic Chinese

in Several East Asian countries in the Mid-1990s

% of population % of market capitalisation

controlled by ethnic Chinese

Malaysia 29 69 Thailand 10 81 Indonesia 3.5 73

Source: Haley and Haley (1999), Adapted from Ball et al. (2003).

115

Following the race riots between the Chinese and the Malays in 1969, the Malaysian

government introduced the National Economic Plan (NEP) to eliminate the identification of

race with economic functions and aimed to achieve 30 percent for indigenous Bumiputera34

equity participation and employment in all sectors of the economy by 1990 (Mamman,

2003). The enactment of this policy, as argued by Tam and Tan (2007, p.208) ‘has

entrenched government intervention in the corporate sector, and business and politics

became intertwined in Malaysia’. In reality, Haniffa and Cooke (2005) argue that the NEP

has resulted in positive discrimination in favour of the Bumiputera (Haniffa and Cooke,

2005). The government has offered the Bumiputera priority for government contracts and

subsidies (Johnson and Mitton, 2003). As a consequence of government favouritism

towards Bumiputera, Chinese companies were starting to appoint influential Bumiputera by

the early 1990s to enjoy the benefit from the government (Mamman, 2003). Nevertheless,

post-NEP reveals that division in economic activities among ethnicities remains and the

income distribution is still uneven between ethnic groups, with Bumiputera mostly in the

lower occupational categories (Tam and Tan, 2007).

Mamman (2003) finds that the ethnicity of managers influences their attitudes to the role of

the government in Malaysia. While Malay managers are more likely to support

government policies, Chinese and Indian managers are more likely to support laissez-faire

economic policies. Ball et al. (2003) argue that intervention from the government creates

political costs for firms-controlled by minority ethnic Chinese that provides incentives for

them to avoid reporting high profits.

34 Similar to a study by Haniffa and Cooke (2005), this study refers to Bumiputera as the Malay group, which forms the majority in business.

116

In a study of the effect of culture and the extent of voluntary disclosure, Haniffa and Cooke

(2002) and Haniffa and Cooke (2005) report a significant and positive association between

Malay dominated boards and disclosure. Haniffa and Cooke (2002) suggest that Malay

directors tend to disclose more compared to Chinese directors based on religious values that

requires the Malay directors, who are all Muslim, to perform business according to Islamic

business ethics. Additionally, further study by Haniffa and Cooke (2005) used the

legitimacy theory to explain the significant relationship between a Malay dominated board

and corporate social reporting. They suggest that the Malaysian government policy that

favours the Bumiputera by discriminating business opportunity based on ethnic group,

influences the Malay directors to use corporate social disclosure as a reactive legitimating

strategy. This is aimed at diverting attention from questionable business practices,

cronyism, nepotism and close affiliation with the government as well as to ensure a

continued influential voice at both governmental and institutional levels (Haniffa and

Cooke, 2005).

The influence of ethnicity is also prevalent in audit fees research in Malaysia (see e.g. Gul,

2006; Yatim et al., 2006). Gul (2006) provides evidence that Bumiputera businesses,

which are commonly associated with politically connected firms, had higher audit fees than

non-Bumiputera firms during the financial crisis period, showing a potential association

between political link companies and ethnic favouritism based businesses in Malaysia.

Yatim et al. (2006), however, find that Bumiputera-controlled firms pay lower audit fees

and practice more favourable corporate governance practices relative to non-Bumiputera

firms. As Yatim et al. (2006) used a sample after the crisis period, their results

complement prior findings by Gul (2006) that showed a significant decline in audit fees for

politically connected firms after the capital controls were introduced in 1998. Additional

117

tests of independent sample t-test and Mann-Whitney U test provide greater evidence that

Bumiputera-controlled firms have greater governance relative to non-Bumiputera-

controlled firms. This suggests that corporate governance practices have changed since the

Bursa Malaysia Listing Requirements 2001, resulting in increased focus on board and audit

committees’ oversight responsibilities.

Focusing on earnings management, a study by Abdul Rahman and Mohamed Ali (2006)

does not document any evidence that the presence of Malay directors on the board of a

company or an audit committee deter opportunistic earnings management. They argue that

the modernisation of Malaysia, as well as the increase in wealth among the Malays since

the introduction of NEP, has led the Malays to be more individualistic, just like the

Chinese, which may possibly have driven their insignificant findings.

It seems that there have been no empirical studies published on the relationship between

ethnicity and earnings quality (to the best knowledge of the researcher). Though prior

literature suggests the importance of addressing the different cultural characteristics of the

financial reporting process (Gray, 1988; Flamholtz, 2001; Ball et al., 2003; Hope, 2003b),

there is no study yet that has addressed this issue by linking the influence of ethnicity to

accounting earnings quality. This will provide an interesting avenue for empirical

examination in future research.

118

3.6 SUMMARY AND CONCLUSION

The first part of this chapter discusses corporate governance practices – its development

worldwide, in the East Asian region as well as in Malaysia. In many aspects, East Asian

countries are very different from the developed, Western countries. The profile of

developed countries corporate shareholdings of dispersed shareholdings is clearly different

from East Asian countries where concentrated shareholdings are more prevalent. The

highly concentrated ownership structure, weak legal systems, lack of investors’ protection,

lack of quality information and lack of developed financial markets are identified as major

problems faced by many Asian countries in strengthening corporate governance. However,

it appears in this chapter that the Malaysian government has been very proactive in the

development of a corporate governance framework in Malaysia to strengthen corporate

governance practices and enhance foreign investors’ confidence in the Malaysian capital

market.

The second part of this chapter reviews prior studies on the relationship between

governance and financial reporting quality. The chapter discusses and illustrates the role of

the board of directors, ownership structure and ethnicity on the financial reporting process.

Thus far, findings from prior studies are inconclusive, especially on the role of the board of

directors as a traditional function of governance mechanism. Issues of concern related to

the scarcity of qualified independent directors in the East Asian markets remain where

family and group ownership are dominant. Whilst East Asian countries continue to adopt

Western codes on corporate governance practices, questions arise whether similar

mechanisms work in East Asian countries, which differ widely with respect to legal,

regulatory, social and cultural factors. While ownership structure and cultural

119

characteristics appear to have a significant impact on corporate practices and the behaviour

of board members in Asian corporations, evidence to date has not been extensively offered

concerning their effects on the quality of financial reporting. Questions whether the

effectiveness of these governance mechanisms extend to the financial reporting quality,

especially on the earnings quality issue, remain untouched in the Malaysian context.

120

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

Beasley (1996) Archival Matched sample of 75 fraud and 75 non-fraud firms of US listed firms. Fraud reported during the period 1981-1991

% of outside members; Growth: Net losses prior to fraud year; Age; Inside ownership; CEO tenure; CEO duality; Block shareholdings; Presence of audit committee (AC); Outside board ownership; Outside tenure; Additional directorships.

Fraud or no fraud % proportion of outside members is lower for firms experiencing financial statement fraud. Supplemental analysis shows that board size, outside board ownership and outside board tenure also effect the likelihood of financial statement fraud. No evidence associated with the presence of AC. Suggestion for future research: 1) test other director characteristics; 2) examine insight processes how directors use to exert control; 3) examine the nature and processes unique to the AC.

Dechow, Sloan and Sweeney (1996)

Archival 92 US listed firms subject to enforcement actions by SEC between 1982 and 1992 and 85 control firms matched by

Governance: Presence of AC, % of inside directors; % of inside board holdings; Outside blockholder; Majority inside directors; CEO

Firms subject or not subject to enforcement actions by the SEC

Firms subject to the enforcement actions by the SEC are more likely to have boards dominated by management, a combined role between CEO and chairman, less audit committee and less outside blockholder. Suggestion for future research: 1) factors managers consider when deciding to manage

121

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

industry, size, and time period.

Duality; Big6 Audit; Board size; Founder CEO.

earnings when raising external financing; 2) factors influencing the disclosure policy between long-term reputation building and short-term earnings manipulation.

Wild (1996) Archival 260 US listed firms for 1966-1980.

AC formations

Earnings quality (EQ) proxy by Earnings Response Coefficient (ERC).

Evidence shows a substantial increase in return variability for earnings reports released after the formation of the AC. The returns variability to earnings report after committee formation is more than 20% greater than prior to formation. Evidence suggests that AC enhances EQ through their effective oversight of the financial reporting process.

Beasley, Carcello, Hermanson and D. Lapides (2000)

Archival 66 companies in 3 industries involving fraud: 25 technology companies, 19 health-care companies, 22 financial services

Characteristics: Audit committee; Internal audits; Board.

Fraud company governance mechanism Vs No-Fraud industry benchmark.

Fraud companies have fewer AC, less independent AC, less independent board and less internal audit support. Companies in technology and health care industries have fewer AC meetings than their industry benchmark. Future research should build and refine fraud prediction model to discriminate

122

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

firms compared to no fraud industry benchmark data.

between fraud and no-fraud firms.

Peasnell, Pope and Young (2000)

Archival 1260 firm-year observations, comprising 811 observations for the pre-Cadbury period (1990-1991) and 872 observations for the post-Cadbury (1994-1995).

Proportion of outside members.

Earnings Management (EM): Income increasing abnormal accruals (Modified Jones model)

No evidence of an association between the composition of BOD and EM in the pre-Cadbury period, but significant association in the post-Cadbury period, which suggests that appropriately structured boards discharge their financial duties more effectively after the publication of Cadbury Report.

Klein (2002) Archival 692 firm-year observations for the period 1991-1992 (US listed firms).

Board independence; AC independence; CEO shareholdings.

EM: Adjusted abnormal accruals (Jones 1991 model & Kasznik 1999 match-portfolio method).

Board independence and AC independence is negatively associated with abnormal accruals. Additionally firms changing from majority to minority outside directors experience large increases in abnormal accruals relative to their counterparts. The authors acknowledge that the result depends on the accuracy of abnormal

123

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

accruals in measuring EM and suggest that future studies find better measures for EM.

Koh (2003) Archival 836 firm-year observations for the period 1993-1997 (Australian listed firms)

Institutional ownership

Income increasing discretionary accruals (Modified Jones model)

The study finds a non-linear relationship between institutional ownership and accrual management. At lower region of ownership, the positive association is found between institutional ownership and income increasing accrual management supporting short-term oriented view. At higher institutional ownership region, a negative association is found, consistent with the long-term oriented view.

Leuz, Nanda and Wysocki (2003)

Archival 70,955 firm-year observations across 31 countries for the period 1990-1999

Outside investor rights; Legal enforcement; Importance of stock market; Ownership concentration

EM: 1. Earnings

smoothing 2. Correlations

between accruals and CFO

3. The magnitude of accruals

4. Loss avoidance

EM appears to be lower in economies with large stock markets, dispersed ownership structure, strong investor rights and strong legal enforcement. Additionally, EM is found to be negatively related to the extent of the quality minority shareholders rights and legal enforcement. The authors acknowledge two caveats: 1) difficulty

124

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

in measuring EM and 2) correlation between institutional factors and investor protection that may affect insiders’ EM incentives.

Xie, Davidson III, DaDalt (2003)

Archival 282 firm-year observations for years 1992, 1994 & 1996 (US listed firms).

Board characteristics; AC characteristics: Executive committee (EC) characteristics.

EM: Discretionary current accrual (Jones 1991 model).

EM is less likely to occur in companies whose board includes more independent outside directors, more directors with corporate experience, larger boards and EC size, higher proportion AC member with corporate or investment banking backgrounds, higher proportion of outside directors on EC and higher frequency of board and AC meetings. The authors acknowledge the endogeneity problems that may influence the board and EM relationships.

Bedard, Chtourou and Courteau (2004)

Archival US firms: 100 firms with the highest income increasing abnormal accruals, 100

AC expertise (Financial, governance and firm-specific); AC independence (Majority

EM: Abnormal accrual (Jones 1991 model).

The presence of financial expert on the AC, multiple directorships held by non-related outside members, a committee composed solely of non-related directors and a clear mandate to oversee the financial reporting process and

125

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

firms with highest income decreasing abnormal accruals, 100 with the lowest abnormal accruals.

independence, 100% independence and stock options); AC activity (Mandate, meetings and size).

audits is negatively related with the likelihood of aggressive EM. The percentage of stock options held by outside directors is positively related to EM. No significant association with regard to audit committee activity. Future research should investigate causality of relationships and use improved measure of EM such as Dechow and Dichev (2002). Future studies could also examine the AC processes that affect financial reporting quality.

Chung, Ho and Kim (2004)

Archival

29,001 firm-year observation for firms trading on the Tokyo Stock Exchange for the period 1975-1998.

Cross-business holdings; Foreign holdings; Bond financing; Keiretsu tie.

EM: Valuation effect of discretionary accruals (Jones 1991 model).

Cross-business shareholding aggravates tunnelling or managerial opportunism through discretionary accruals. Foreign shareholdings and bond financing provide effective monitoring of managerial discretion. No supporting evidence for the monitoring effect of keiretsu membership. The authors suggest extending their study to other

126

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

markets by examining the impact of ownership, financing structures, corporate governance, and other institutional factors on monitoring managerial opportunism.

Davidson III, Jiraporn, Kim and Nemec (2004)

Archival 173 duality-creating succession announcements and 112 non-duality-creating succession management.

CEO duality EM: Modified Jones 1991 model Performance: Prior firm performance

1) Companies whose succession announcement created dual leadership structure had greater measurable earnings management than those with succession creating non-dual structure. 2) Following firms’ poor performance, successors may want to give impression of improved performance. Future research should examine impact of duality in specific situations to provide more important insights.

Park and Shin (2004)

Archival 539 firm year-observations for the period 1991-1997 (Canada listed firms).

Board independence; Presence of financial intermediaries; Institutional shareholders; Board

EM: Abnormal accruals (Jones 1991 model) [Income-increasing (II) and income decreasing (ID) EM].

Outside directors do not reduce abnormal accrual. However, the presence of financial intermediaries and active institutional shareholders restrains abnormal accruals. The authors argue that adding outside directors may not achieve improvement in jurisdiction

127

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

tenure. where ownership is highly concentrated and the outside directors’ labour market may not be well developed.

Uzun, Szewczyk and Varma (2004)

Archival Matched sample of 133 fraud and 133 non-fraud firms of US listed firms. Fraud reported during the period 1978-2001.

Board composition; Audit committee; Compensation committee; Nominating committee.

Fraud or no fraud The board composition and the structure of its oversight committees are significantly related to the incidence of corporate fraud. Specifically, increase in number of independent directors on a board and in the board’s audit and compensation committees, the likelihood of corporate fraud decreased. The findings support recent corporate governance requirements to have a majority of independent directors on board to increase the quality of board and reduce the possibility of corporate fraud.

Chung, Firth and Kim (2005)

Archival 22,576 firm-year observations for the period 1984-1996. (US listed firms).

High free cash flows (SFCF); Big6; Institutional shareholdings; audit tenure.

EM: Discretionary accruals (DAC) (Modified Jones model).

Companies with SFCF use income increasing DAC. Big6 auditors and institutional investors moderate the SFCF-DAC relation, which suggests that external monitoring by Big6 and institutional investors is effective in

128

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

constraining management from making income increasing DAC. No conclusive evidence with regards to auditor tenure.

Davidson, Goodwin-Stewart, Kent (2005)

Archival 434 listed Australian firms for year ending in 2000.

Board independence; Separation of the roles of CEO and Chairman; Presence of audit committee; Presence of internal audit functions; use Big5 auditor.

EM: Absolute level of discretionary accruals (Modified Jones Model)

Majority of NED on the board and on the audit committee is significantly associated with lower likelihood of EM. No significant association with regards to the presence of internal audit function or the use of Big5 auditors. The authors suggest: 1) use other proxies to measure EM; 2) use suitable proxies to operationalise AC functions; 3) test other AC characteristics ( financial expertise, the existence of AC charter, number of meeting with external auditor) and 4) use a more refined measure to proxy internal audit functions.

Mitra and Cready (2005)

Archival 373 firm-year observation for the period 1991 to 1998 (US listed firms).

Institutional ownership.

EM: Abnormal current accruals (Modified Jones model).

Active monitoring from institutional shareholders mitigates EM activity. The institutional monitoring effect is however, more pronounced in small firms relative to large firms. The authors

129

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

argue that firm size and information environment information play crucial roles in determining the effects of governance factor on a firm’s choice and application of accounting technique in financial reporting.

Peasnell, Pope and Young (2005)

Archival 1271 firm-year observations for the period 1993-1995 (UK listed firms).

Board Independence; Board ownership; AC existence.

EM: Abnormal working capital accruals (Modified Jones Model) [Income-increasing (II) and income decreasing (ID) EM].

Higher proportion of outside board members is associated with less II EM. No evidence that the mere presence of AC affects the extent of II and ID manipulations. Future research could examine how board and audit committees work together in monitoring and controlling EM.

Vafeas (2005) Archival 1621 firm-year observations of US listed firms for the period 1994-2000.

Audit committee (AC) characteristics; General governance characteristics.

Low earnings quality proxies by: 1. Small earnings

increases 2. Negative earnings

avoidance.

Lower earnings quality is associated with greater AC insider, less active business executive, less frequency of meetings; higher equity incentives and greater length of board tenure. The author suggests future research examines the long-term impact of corporate governance changes on the

130

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

quality of financial reporting.

Lin, Li and Yang (2006)

Archival 267 US listed companies in year 2000.

Audit committee (AC) characteristics: independence, size, financial expertise, meetings, and ownership.

Earnings quality proxy by earnings restatement.

Larger AC is associated with greater earnings quality. No associations were found with regards to other AC characteristics. Future research should re-examine the issues as the study only focuses on the fiscal year 2000.

Velury and Jenkins (2006)

Archival 4238 firm-year observations for the period 1992-1999.

Institutional ownership; Concentrated institutional ownership.

Earnings quality (EQ) proxies by: 1. Predictive value

(the CFO-earnings relationship)

2. Neutrality (the magnitude of abnormal accruals)

3. Timeliness (the reporting lag from the end of fiscal year to the actual report date)

Positive association between institutional ownership and EQ. Negative association between concentrated institutional ownership and EQ.

131

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

4. Representational faithfulness (the ERC).

Wang, (2006) Archival 207 firms listed

on the S&P 500 index either in 1994 or 2002

Founder family ownership

Earnings Quality (EQ) proxy by: 1. Abnormal

accrual 2. Earnings

informativeness 3. Earnings

persistence

Founding family ownership is associated with higher earnings quality consistent with the alignment effect hypothesis. Future research could examine the effect of founding family firms in smaller publicly-traded firms given the greater percentage of founding family firms.

Doyle, Ge and McVay (2007)

Archival 705 US listed firm for the period 2002-2005.

Material weakness disclosures

Accruals quality (AQ) 1. AQ Dechow and

Dichev (DD) 2002 model

2. Discretionary accruals

3. Average AQ 4. Historical

restatements 5. Earnings

persistence.

Firms with weak internal control over the financial reporting generally have lower accruals quality. Further evidence reveals that the relation is driven by weakness disclosures that relate to overall company-level controls, which may be more difficult to audit around. The results are robust to different proxies of accrual quality.

132

Table 3.4

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Developed Countries

Author (s) Method Sample Independent Variable

Dependent Variable

Results and Future Research

Gul, Srinidhi ant Tsui (2007)

Archival 1508 firm-year observation for the period 2001-2002 (US listed firms).

Female director; Female NED; Proportion of female director; Proportion of female NED.

Earnings quality (EQ): 1. Earnings

benchmark 2. Performance-

adjusted discretionary current accruals

3. Accruals quality.

Firms with female directors, female non-executive directors and firms with higher proportion of female directors are associated with lower earnings management and higher earnings quality.

133

Table 3.5

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from East Asian Countries

Fan and Wong (2002)

Archival 977 firms with a total of 3572 firm-years observations across 7 East Asian economies for the period 1991-1995.

Ownership structure

Earnings informativeness proxy by earnings-return relation.

Concentrated ownership: 1) creates agency conflicts between controlling owners and outside investors 2) is associated with low earnings informativeness. Future research could examine how ownership structures shape accounting policies in emerging markets and transition economies.

Jung and Kwon (2002)

Archival 2820 firm-year observation for the period 1993-1998. (Korean listed firms).

Ownership structure

Earnings informativeness.

Earnings informativeness increases with the holdings of managers, institutional and blockholders. However, no significant relationship between owner-largest shareholding (chaebol firm) and earnings informativeness, which suggests that the negative effects of management entrenchment/ expropriation of minority shareholders offset the positive effects for chaebol firms.

Kao and Chen (2004)

Archival 1097 firms listed on Taiwan stock exchange.

Board size; Ownership of board directors; Outside board size; Ownership of

EM: Absolute value of discretionary accruals (Jones 1991 model).

The size and composition of board are the influential determinants for the monitoring function from the board. No significant association with regards to ownership variables.

134

Table 3.5

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from East Asian Countries

outside directors.

Cho and Kim (2007)

Archival 647 Korean listed companies in 1999.

Outside directors; Ownership concentration; Managerial ownership; Outside blockholder ownership.

Profitability Outside directors had a weak positive impact, and that large shareholders and block shareholder ownership moderated this relationship in a negative fashion. Future research should examine the external institutional environments, such as capital markets and government regulations.

Jaggi, Leung and Gul (2007)

Archival

770 firm-year observations for the period 1998-2000 (Hong Kong listed firms).

H1: Board independence; Family ownership; Family control. H2: Board independence.

H1: EM proxies by: 1. Discretionary

accruals (PACDA) 2. Accrual quality

(AQ) H2: Family or Non-family.

Firms with higher proportion of independent directors are associated with lower PACDA and AQ. However, further analyses provides evidence that the independent directors monitoring effectiveness is reduced in family controlled firms. The results are subject to the validity of PACDA and AQ as proxies for earnings quality and family ownership and family control as proxies for family controlled firms. The authors suggest future studies to extrapolate the result to more recent time.

135

Table 3.6

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Malaysia

Abdullah and Mohd Nasir (2004)

Archival All companies listed on Bursa Malaysia in 1997 except finance and trust companies.

Board independence; Audit committee independence.

Accrual management (Discretionary Accruals)

Neither board independence nor the audit committee independence effectively constrained accrual management levels. Findings of the study cast doubt that independence board as well as independence audit committee can lead to high quality earnings.

Norman, Takiah and Mohid (2005)

Archival 561 Malaysian listed firms in 2001.

Board independence; CEO duality; Board size; Multiple directorships; Managerial ownerships.

EM: Modified Jones model and income-increasing (II) and income decreasing (ID) EM.

CEO duality is positively associated with earnings management. Management ownership is negatively associated with earnings management. Multiple directorships is negatively associated with earnings management while board independence is positively associated with earnings management, proxy only in firms with negative unmanaged earnings. Other independent variables are not significant. Findings of the study indicate the need to strengthen the role of board independence and separation of chairman and CEO roles in Malaysia.

136

Table 3.6

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Malaysia

Abdul Rahman and Mohamed Ali (2006)

Archival 97 Malaysian listed firms over the period 2002-2003.

Board independence; Competence of independence directors; CEO duality; Board size; Independence audit committee; Competence of audit committee member; Audit committee meetings; Concentrated ownership; Proportion of Malay directors on board; Proportion of Malay directors on the audit committee.

EM: Modified Jones model.

Board size is positively associated with earnings management suggesting that larger board size may be difficult to control and brings potential conflicts among directors. Other corporate governance variables are not significant. The study takes view that earnings management is undesirable and is not detrimental to shareholders. Future studies need to examine in depth the extent to which DAC is harmful or beneficial to the shareholders.

Hashim and Susela (2008b)

Archival Top 200 non-financial companies listed on Bursa Malaysia’s Main

Board independence; CEO duality

EM: Modified Jones Model [Income-increasing (II) and income decreasing (ID) EM].

Board independence is positively associated with earnings management when firms undershoot target earnings. Neither board independence nor CEO duality was found significant in other

137

Table 3.6

Summary of Studies Relating to Corporate Governance Mechanisms and Financial Reporting Quality:

Evidence from Malaysia

Board and Second Board for the year 2004.

models tested. Findings of the study cast doubt that independence board as well as the separation between the chairman and the CEO reduces the incidence of earnings management. Suggestions for future research: 1) examine the various components of ownership and its relationship with accrual manipulation; 2) investigate the relationship between financial expertise and earnings management; and 3) employ improved measure of earnings quality such as Dechow and Dichev (2002) accrual quality model.

138

CHAPTER 4

RESEARCH DESIGN AND METHODOLOGY

4.1 INTRODUCTION

There are two main objectives of this chapter. The first objective is to explain the

theoretical framework of the study and develop testable hypotheses in relation to earnings

quality, based on issues identified in the preceding chapter. The second objective is to

explain the process of how the sample is gathered, measured and analysed in the study to

test the hypotheses developed. To meet the research objective, the study used the content

analysis approach using secondary data available from corporate annual reports and the

financial databases.

Based on the review of prior literature in the preceding chapter, Section 4.2 presents and

discusses the theoretical framework of the study. Following the theoretical framework, the

relevant hypotheses are then developed. Section 4.3 discusses the arguments behind the

development of each specific hypothesis. Section 4.4 presents how samples are selected in

the study. Section 4.5 provides an explanation of the measurement used for the dependent

variable followed by an explanation of the measurement used for independent variables and

control variables in Section 4.6. Section 4.7 provides an explanation of the statistical

analysis used in order to test the hypotheses proposed in the study. The chapter ends in

Section 4.8 with a summary and conclusions.

139

4.2 THEORETICAL FRAMEWORK

Figure 4.1 presents the diagrammatic representation of the theoretical framework examined

in the study. The diagram shows all the variables to be investigated in the study. Based on

the agency theoretical framework, this study includes the board of directors’ characteristics

to provide evidence of their monitoring role as a main agent of corporate governance

systems to reduce agency costs and thus enhance the quality of earnings. As corporate

governance varies across institutional environments and reflects differences in ownership

patterns and cultural values, this study includes ownership structure as well as ethnicity to

present institutional characteristics of governance to provide evidence of their impact on

earnings quality.

Referring to the framework, the study examines the relationship between the board of

directors’ characteristics (board independence, CEO duality, board financial expertise,

board governance expertise, board firm-specific expertise), ownership structure (insider

ownership, outsider ownership, family ownership, institutional ownership), ethnicity (racial

composition), which are the independent variables and earnings quality as the dependent

variable.

Controlled variable, i.e. firm size, leverage, firm growth, audit quality and board size are

also included in the analysis. Based on prior studies, these variables are included as they

have been shown to have an impact on earnings quality (Abdullah, 1999; Wang, 2006;

Jaggi et al., 2007).

140

Board Independence (H01A) CEO Duality (H01B) Board Financial Expertise (H01C) Board Governance Expertise (H01D) Board Firm-specific Expertise (H01E)

Insider Ownership (H02A) Outsider Ownership (H02B) Family Ownership (H02C) Institutional Ownership (H02D)

Racial Composition (H03A)

EARNINGS QUALITY

Figure 4.1: Theoretical Representation of Relationships

BOARD OF DIRECTORS

OWNERSHIP STRUCTURE

ETHNICITY

INDEPENDENT VARIABLES DEPENDENT VARIABLE

141

4.3 HYPOTHESES DEVELOPMENT

4.3.1 Board of Directors’ Characteristics

4.3.1.1 Board Independence

Advocates of the agency theory believe that boards comprising of a majority of outside

directors reduces agency conflicts as they provide an effective monitoring tool for the

board (Fama and Jensen, 1983). They argue that the inclusion of outside directors

increases the boards’ ability to be more efficient in monitoring top management and

ensures there is no collusion with top managers to expropriate stockholder wealth as they

have an incentive to develop their reputation as experts in decision control.

Efficient monitoring by non-executive directors who are free from managerial influence,

improves the quality of financial information conveyed to the user of the financial

statement (Higgs Report, 2003). A number of studies in developed countries report that a

higher proportion of independent non-executive directors on the board is associated with

higher financial reporting quality. Consistent with this notion, Beasley (1996), Dechow et

al. (1996), Beasley et al. (2000) and Uzun et al. (2004) find that a higher representation of

outside directors on the board is associated with less likelihood of financial statement fraud.

Similarly, a study by Peasnell et al. (2000), Klein (2002), Davidson et al. (2005) and

Peasnell et al. (2005) find a significant negative relationship between earnings management

and a higher proportion of outside directors, supporting agency theory claims that outside

directors provide an effective monitoring tool for the board to mitigate earnings

management activity.

142

Although there is a clear trend among US and UK firms towards greater outside

representation, several issues have been raised regarding the effectiveness of outside

directors as a governance mechanism (Abdullah, 2004; Park and Shin, 2004; Abdul

Rahman and Mohamed Ali, 2006; Cho and Kim; 2007). Based on the managerial

hegemony theory, it is argued that the capability of independent directors to fulfil their

monitoring role is jeopardized when the management also dominates and controls the board

(Abdul Rahman and Mohamed Ali, 2006). The dominant role played by the CEO in

choosing outside directors’ raises concern about the quality of outside directors to make

independent judgment (Abdullah, 2004; Cho and Kim, 2007). Furthermore, few studies

address the issues of independent directors’ lack of expertise, skills and knowledge to

understand the financial reporting details as they only gain knowledge of the financial

reporting process as a by-product of their board services (Abdul Rahman and Mohamed

Ali, 2004; Park and Shin, 2004).

Evidence from countries with a highly concentrated ownership structure on the association

between board independence and financial reporting quality is inconclusive. On the one

hand, Kao and Chen (2004) and Jaggi et al. (2007) find significant negative evidence

between earnings management and the presence of a higher proportion of outside directors

in Taiwan and Hong Kong samples. This suggests that the inclusion of a larger proportion

of outside members on the board of directors provides better oversight of management to

mitigate earnings management activity. On the other hand, Park and Shin (2004) do not

find empirical support of an association between earnings management and board

independence in Canada, where the ownership structure is highly concentrated and a large

blockholder controls the public traded firms.

143

Further, Abdullah and Mohd Nasir (2004) and Abdul Rahman and Mohamed Ali (2006) do

not find any significant association between the independence of boards and earnings

management in Malaysia. Furthermore, Jaggi et al. (2007) find an insignificant

relationship between the proportion of non-executive directors and accrual quality in high

family-ownership samples of Hong Kong listed companies, which suggests that the

monitoring effectiveness of independent directors is reduced in family controlled firms.

Recently, a study by Haniffa and Cooke (2005), Klein et al. (2005), Norman et al. (2005)

and Hashim and Susela (2008b), provides evidence of a significant contrary sign of the

association between board independence and financial reporting issues and raises doubts as

to whether the requirements for a majority of independent directors is appropriate in

countries with a concentrated ownership structure.

The Malaysian Code on Corporate Governance views that good corporate governance rests

firmly with the board of directors. The Code requires one third of the board to comprise

independent non-executive directors to provide independent judgment of the decision

process. As defined in Chapter 1 of the Listing Requirements of the Bursa Malaysia an

independent director is a director who is independent of the management and free from any

business or other relationship that could interfere with the exercise of independent

judgment or the ability to act in the best interests of an applicant or listed issuer. The

Listing Requirements stipulate that at least two directors or one third of the board,

whichever is higher, must be independent.

Based on the above discussion, the study proposes the following testable null hypothesis:

H01A: There is no association between board independence and earnings quality.

144

4.3.1.2 CEO Duality

In addition to the requirement of a well-balanced board, the MCCG 2000 recommends the

separation of the role between the Chairman and the CEO. This is to avoid a considerable

concentration of power if the two roles are carried out by one individual. The separation of

the position of CEO and Chairman provides an essential check and balance of the

management’s performance. However in the case of CEO duality35, the Code recommends

that strong independence elements must be induced (MCCG, 2000).

The supporters of role separation between the chairman and CEO believe that combining

the two positions compromises a board’s independence and impairs the board’s oversight

and governance roles (Coombes and Wong, 2004; Davidson III et al., 2004; Gul and

Leung, 2004). They contend that the board’s principal role is to oversee the company’s

management and the role of the CEO is to manage the company well, thus protecting the

shareholders’ interest. This is well supported in the agency theory, which suggests that

splitting the two jobs is desirable to make the board more independent (Fama and Jensen,

1983). Nevertheless, advocates of the stewardship theory suggest a combination of the

CEO and chairman to enhance the decision process and implement the company’s

objectives with the minimum interference from the board (Lin, 2005). The combination of

the two roles facilitates decision-making and helps a board stay better informed about

company matters without the confusion of accountability (Coombes and Wong, 2004).

Furthermore, combining the two positions gives the executive greater authority to make

critical decisions (Harris and Helfat, 1998) and be more aware of every decision needed to

improve the firm’s performance (Abdullah, 2004).

35 CEO duality occurs when the chairman of the board is also the CEO of the firm.

145

Davidson III et al. (2004, p.268) state that ‘if duality exacerbates the potential for agency

problems, then the presence of a dual CEO-chair may increase the extent of earnings

management. They argue that CEOs have greater incentive to manage earnings as they are

evaluated and compensated on the basis of the performance of their company. As they do

not have the ability to control stock performance, Davidson III et al. (2004) argue that

CEOs may use accounting-based measures such as earnings management to achieve their

personal goals.

While arguments for separating the roles between the chairman and the CEO roles are

persuasive, existing empirical analyses yield mixed results of the impact of role duality on

financial reporting quality. Kao and Chen (2004), Xie et al. (2003), Davidson et al. (2005)

and Abdul Rahman and Mohamed Ali (2006) do not find an association between CEO

duality and earnings management activity. However, Abdul Rahman and Haniffa (2005)

reveal significant relationship between role duality and performance and report that

companies with a duality function did not perform as well as their counterparts for the

Malaysian sample. Similarly, a study by Norman et al. (2005) reports greater earnings

management associated with firms that combine the roles of chairman and CEO that

support agency theory predictions of increase agency problems associated with dual

governance structure.

Based on both arguments, the study proposes the following testable null hypothesis:

H01B: There is no association between role duality and earnings quality.

146

4.3.1.3 Board Financial Expertise

Whilst agency theorists contend that a key activity of boards is monitoring management,

resource dependence theorists contend that the role of the board extends to that of provider

of resources (Zahra and Pearce, 1989; Hillman and Dalziel, 2003; Nicholson and Kiel,

2007). The boards are viewed as ‘important boundary spanners that make timely

information available to executives’ (Zahra and Pearce 1989, p.297). One of the important

primary benefits that can be provided by boards as a resource provider is through advice

and counsel (Hillman and Daziel, 2003). Daily et al. (2003) suggest that boards of

directors that consist of expert members from financial institutions as well as law firms will

enhance the organisational functioning, performance and survival of the organisation.

Representation from lawyers, financial representatives, top management from other firms,

marketing specialists, former government officers are argued to facilitate advice and

counsel as they bring with them important expertise, experience and skills (Hillman and

Dalziel, 2003).

The ability of non-executive directors to perform a monitoring role, in reducing earnings

management activity, is only pertinent when they are capable of identifying cases of

earnings management that falls within the scope of the board of directors’ expertise

(Peasnell et al., 2000). George (2003) argues that poor financial reporting quality may

result from a board member who has no technical expertise. Xie et al. (2003) and Vafeas

(2005) suggest that independent directors, as well as audit committee members, be

financially literate in enabling them to be effective in understanding and interpreting

financial information, thus reducing earnings management activity and enhancing the

quality of financial reports.

147

The MCCG 2000 requires non-executive directors to have the necessary skills and

experience and be a person of calibre and credibility in order to bring independent

judgment to the board. Additionally, the revised MCCG Code 2007 requires all members

of audit committees to be financially literate. This is so they are able to understand and

interpret financial statements to effectively fulfil their role in monitoring the company’s

system of internal control and financial reporting. The Code also requires at least one audit

committee member to be a member of an accounting association or body.

A study by Bedard et al. (2004), Park and Shin (2004) and Xie et al. (2003) finds that the

presence of a financial expert on the audit committee; the presence of officers from

financial intermediaries on the board; as well as the boards of directors composed of

corporate or investment-banking backgrounds; is negatively associated with the likelihood

of earnings management. Their findings suggest that financial expertise is an important

determinant of board monitoring effectiveness as they have a better understanding of how

earnings are being managed. While the US and Canada studies report a positive impact of

financial expertise on financial reporting quality, a study by Mohd Iskandar and Wan

Abdullah (2004) and Abdul Rahman and Mohamed Ali (2006) do not find any support of

the relationship between financial literacy of audit committee members and financial

reporting quality for the Malaysia sample.

Despite the limitation of prior studies in the Malaysian context, the study proposes the

following testable null hypothesis:

H01C: There is no association between board financial expertise and earnings quality.

148

4.3.1.4 Board Governance Expertise

A study by Bedard et al. (2004), on the effects of audit committee expertise, independence

and activity on aggressive earnings management, suggests that additional directorships36

signal the competence of directors in the managerial labour market and provides a platform

for directors to gain governance expertise. Additional directorships help the directors to be

more transparent as well as more sensitive to protect their reputations, thus, creating an

incentive for them to perform well (Haniffa and Cooke, 2005; Vafeas, 2005). According to

Haniffa and Hudaib (2006), the benefits from cross-directorships come from two different

motives including information exchange motives and control motives. Information

exchange motives relate to the benefits of information sharing where the directors are

exposed to recent economic trends, different management styles as well as different

management policy and practices. While under the control motives, the multiple

directorships serve as a controlling mechanism assisting the directors to offer additional

insights, facilitating comparisons as well enhancing control.

A study by Bedard et al. (2004) and Norman et al. (2005) finds that the greater the

additional number of other directorships held by board members is associated with the

lower the likelihood of earnings management activity of the firm. Although the study by

Haniffa and Cooke (2002) failed to find a significant relationship between cross-

directorships (measured by the ratio of directors on the board with directorships in other

companies to total number of directors) and the level of disclosure in Malaysia, their recent

study on issues relating to corporate social reporting reveals a significant relationship

between chairmen with multiple directorships and corporate social reporting disclosure.

36 Multiple directorships are often discussed in the literature under directorship interlocks (see Zahra and Pearce, 1989; Hillman and Dalziel, 2003).

149

This indicates that cross-directorships held by the chairmen does have important positive

implications for corporate social disclosure practices as they are able to obtain greater

access to information in more than one company, thus ensuring the consistency of

voluntary information between companies they service (Haniffa and Cooke, 2005).

However, it is important to ensure that outside directors have enough time to devote to a

particular firm, as large additional directorships may limit the directors governing

effectiveness as they are not able to understand each business well enough in performing

their monitoring role (Bathala and Rao, 2005; Bedard et al., 2004). Due to competitive

disadvantage, potential conflicts of interests and less commitment, it is possible to predict a

negative impact of multiple directorships on firm performance. Consistent with this notion,

Haniffa and Hudaib (2006) report a negative significant relationship between multiple

directorships and market performance and suggest that the market perceives multiple

directorships as unhealthy and that they do not add value to corporate performance in

Malaysia.

Based on both arguments, the study proposes the following testable null hypothesis:

H01D: There is no association between board governance expertise and earnings

quality.

4.3.1.5 Board Firm-Specific Expertise

Bedard et al. (2004) suggest that firm-specific expertise is acquired through experience as a

member of the board, by developing more knowledge of a company’s operations and its

executive directors. As the independent directors have served the board for a certain

period, they gain better understanding of the firms and its people and develop better

150

governance competencies that influence their monitoring capability towards management

performance (Abdul Rahman and Mohamed Ali, 2006) as well as the firm’s financial

reporting process (Bedard et al., 2004).

Nevertheless, Vafeas (2005) identifies conflicting theoretical views on the impact of

independent director tenure length and board effectiveness. While longer average tenure is

associated with greater experience and knowledge about the firm’s operation, she argues

that too long a board service in the same company will compromise their independence as

they are more likely to befriend management and be less critical about the quality of

financial reporting. Mallette and Fowler (1992) argue that boards with high-tenure

independent directors are more likely to accept the norm of the firm and be more tolerant of

poor management performance and managerial incompetence.

Prior evidence regarding board tenure is inconclusive. A study by Beasley (1996) suggests

that the ability of boards to monitor management effectively is consistent with the

increased number of years they serve. In contrast, Xie et al. (2003) report a positive

instead of negative relationship between board tenure and the level of discretionary

accruals. They suggest that the longer the tenure of directors, the less effective they become

as they may co-opt with management, thus increasing the level of discretionary accruals.

Nevertheless, a study by Mallette and Fowler (1992) does not find any significant

relationship between independent director tenure and ‘poison pill’37 adoption. Bedard et al.

(2004) and Abdul Rahman and Mohamed (2006) also report insignificant findings on the

37 ‘The term actually refers to a family of contingent securities that result in the assumption of unwanted financial obligations by an

acquirer, dilution of the acquirer's equity holdings, or loss of the acquirer's voting rights if the issuing firm becomes a takeover target’ (Mallette and Fowler 1992, p.1010).

151

relationship between board tenure and accrual management for the US and Malaysian

sample. Abdul Rahman and Mohamed Ali (2006) suggest that their insignificant findings

may be due to ineffective monitoring from independent directors who lack expertise,

required skills and knowledge in the business environment.

Despite these conflicting results, the study proposes the following testable null hypothesis:

H01E: There is no association between board firm-specific expertise and earnings

quality.

4.3.2 Ownership Structure

4.3.2.1 Managerial Ownership

They are two conflicting views offered by prior literature on the relationship between

ownership and earnings informativeness, namely convergence of interests and management

entrenchment hypotheses (Jung and Kwon, 2002). One view is based on the agency theory

perspective supported by Jensen and Meckling (1976). Jensen and Meckling (1976)

theorize that managerial ownership helps alleviate manager and shareholder conflicts in

public corporations. They suggest that as the owners’ ownership interest increases,

convergence of interest could occur, thereby reducing agency costs. Investors may

perceive that the owner behaves in a way that maximizes the value of the firm resulting in

fewer contractual constraints to the firm. As such, the owner is less motivated to manage

earnings and maintain higher disclosure quality, resulting in higher earnings quality and

informativeness (Jung and Kwon, 2002).

152

In contrast, the management entrenchment perspective suggests that too much ownership

by inside directors may cause a moral hazard and an information asymmetry problem

between the insider and outside investors (Morck et al., 1988). In this situation,

management entrenchment may occur as the management decisions are more likely to

benefit personal wealth rather than outside investors’ interests. Outside investors find it

very difficult to monitor the management decisions that appear to be less transparent and

credible. As a result, investors impose more contractual constraints on the firms.

Managers who have complete discretionary power may use earnings management to

respond to these accounting constraints, which in turn result in reduced quality of earnings

and informativeness (Jung and Kwon, 2002).

Consistent with the view of incentive alignment effect, a study by Beasley (1996), Norman

et al. (2005) and Peasnell et al. (2005) finds that the greater the level of ownership held by

the board, the lower the likelihood of financial statement fraud and the less earnings

management. Similarly, Han and Suk (1998) and Elsayed (2007) report a positive

relationship between insider ownership and firm performance. A study by Jung and Kwon

(2002) also finds a positive impact of insider ownership and earnings informativeness, thus,

supporting the convergence of interest hypothesis by Jensen and Meckling (1976).

Conversely, Karamaou and Vafeas (2005) report a negative significant association between

insider ownership and financial disclosure quality. In addition, Velury and Jenkins (2006)

report that higher managerial ownership is associated with lower earnings quality (i.e.

reduced earnings and cash flow relation, greater abnormal accruals and longer on average

to announce earnings). Similarly, Haniffa and Hudaib (2006) report a negative and

significant association between managerial ownership and accounting performance, and

153

suggest that the insider model of corporate governance is unsuitable in the Malaysian

business environment due to the risk of misallocation of companies’ resources at the

expense of other shareholders.

Pergola (2005) argues that Beasley’s (1996) study does not distinguish between the inside

and outside stock ownership to see the impact of management’s ability to negate board

effectiveness. Shleifer and Vishny (1997) argue that large outside ownership helps reduce

agency conflicts because they have greater power and incentive to prevent expropriation by

insiders. As the wealth of the independent directors is tied to investors’ wealth, Kang

(2008) suggests a positive contribution from independent directors holding an equity stake

in a firm. Based on the above discussions, the influence of managerial ownership on

earnings quality is investigated separately for inside and outside board ownership.

The study proposes the following testable null hypothesis:

H02A: There is no association between insider ownership and earnings quality.

H02B: There is no association between outsider ownership and earnings quality.

4.3.2.2 Family ownership

Although family shareholdings are relatively uncommon in the US and the UK, family

controlled firms are the norm in the rest of the world (La Porta et al., 1999). Most Asian

firms are characterised as family firms where family control is common in both small and

established firms (Mak and Kusnadi, 2005).

154

A study by Wang (2006) offers two competing views of the effect of founding family

ownership on the supply and demand of quality financial reporting – the entrenchment

effect and the alignment effect. The first view is based on the argument that concentrated

ownership creates incentives for controlling shareholders to expropriate minority

shareholders wealth. Gaining effective control, the family member may extract private

benefits from the firms at the expense of other shareholders and the entrenchment effect

predicts that family firms is associated with lower quality of reported earnings.

On the other hand, the incentive alignment effect predicts that family ownership is

associated with higher quality of reported earnings. As the family members own a large

block of stocks, their interest is more closely aligned to the interests of the firm, which

discourages them from manipulating earnings to avoid potential damage to their family

reputation as well as improving long-term performance of the firms as their wealth is

closely tied to firm value (Wang, 2006).

Consistent with the incentive alignment effect, Wang (2006) reports that founding family

ownership is associated with higher earnings quality, i.e. lower abnormal accruals, greater

earnings informativeness and less persistence of transitory loss components in earnings.

Similarly, findings by Cho and Kim (2007) suggest that large shareholders in Korean firms

still have a positive influence on corporate performance. Using a US sample, McConaughy

et al. (1998) document evidence that family control has a positive impact on firm value and

efficiency, thus, supporting Fama and Jensen’s (1983) suggestion that family relationships

provide improved monitoring.

155

Nevertheless, Choi et al. (2007, p.953) argue that ‘despite initial entrepreneurial

contributions of the founders, it appears that continuing to keep the firm ownership and

management as family affairs has more costs than benefits’. They find a negative and

significant effect of family holdings on firm performance and suggest the likely

entrenchment of family manager-owners. Similarly, a study by Bartholomeusz and

Tanewski (2006) suggests that corporate governance structures adopted by family firms in

Australia create agency costs as the structures are inconsistent with maximizing the value

of the company.

To date, there are relatively limited studies from Malaysia that examine the relationship

between family ownership and financial reporting quality. Studies by Haniffa and Cooke

(2002) and Mohd Ghazali and Weetman (2006) report a negative significant coefficient

between the proportion of family members on the board and the extent of voluntary

disclosures in the annual report of Malaysian companies. The fact that many family

members sit on the board might be the reason for less demand for voluntary disclosure as

they have better access to inside information. Nevertheless, a study by Chu and Cheah

(2006) reports that the effect of family ownership on performance is positive and

significant and suggests that family controlled firms still maintain the passion for

entrepreneurship in Malaysia.

Since there are two different theoretical viewpoints on the role of family ownership and

agency costs, the study proposes the following testable null hypothesis:

H02C: There is no association between family ownership and earnings quality.

156

4.3.2.3 Institutional ownership

Proponents of the private benefits hypothesis suggest that frequent trading and a

fragmented relationship by institutional investors discourages such investors from

becoming actively involved in the corporate governance of their portfolio firms, thus,

encouraging myopic behaviour by portfolio managers (Koh, 2003). The myopic investors

are inherently short-term oriented and focus excessively on current earnings rather than

long-term earnings in determining stock prices.

Conversely, recent studies provide evidence suggesting that institutional investors play an

active role in monitoring and disciplining managerial discretion (active monitoring

hypothesis) (Jung and Kwon, 2002; Karamanou and Vafeas, 2005). The presence of

institutions with large shareholdings can have a direct bearing on the agency costs resulting

from such separation of ownership and control (Koh, 2003). As institutional shareholdings

grow, the exit options become more expensive thereby motivating them to be active in the

monitoring process. Given that they own substantial shareholdings that make it difficult to

sell shares immediately at the prevailing price, the institutional investors have greater

incentives to closely monitor companies with high free cash flow (Chung et al., 2005).

Recent studies support the active monitoring hypothesis of the effectiveness of institutional

owners in monitoring management. Studies such as Han and Suk (1998), Jung and Kwon

(2002), Chiou and Lin (2005), Karamanaou and Vafeas (2005) and Mitra and Cready

(2005) report a positive significant influence of institutional shareholders on the accounting

issues they examined. Karamanou and Vafeas (2005) suggest that institutional ownership

serves as a complementary mechanism in disciplining management.

157

However, a study by Mallette and Fowler (1992) reports that large institutional

shareholdings are associated with poison pills adoption. Though Velury and Jenkins

(2006) report evidence of a positive association between institutional ownership and

earnings quality, their study reveals that concentrated institutional ownership may

negatively affect earnings quality, suggesting that a generally positive association between

institutional ownership and earnings quality is negatively affected by increased ownership

concentration. Velury and Jenkins (2006) argue that as the ownership becomes

concentrated, large institutional shareholdings are more likely to exploit private

information and not be inclined to encourage management to report high quality earnings.

Empirical evidence associated with institutional shareholdings are very limited in the

Malaysian context, although the total institutional shareholdings in Malaysia represent the

highest percentage of institutional shareholdings compared to other countries in the same

region (Abdul Wahab et al., 2007). Institutional investors in Malaysia nowadays have

become a very large and powerful constitution, playing a very significant role in corporate

governance to protect minority shareholder’s interest. Though Abdullah (1999) finds a

significant negative association between institutional investors and accounting earnings

quality (measured by earnings response coefficient) that supports the ‘myopic investor’

hypothesis, recent findings by Abdul Wahab et al. (2007) suggest that institutional

investors use corporate governance practice as a measuring tool for their investment

decisions, where firms with better corporate governance practice attract higher institutional

ownership from institutional investors.

Based on the above discussion, the study proposes the following testable null hypothesis:

H02D: There is no association between institutional ownership and earnings quality.

158

4.3.3 Ethnicity

According to Haniffa and Cooke (2002), it is important to acknowledge the social values in

multiracial countries when each of the racial groups has chosen to maintain its own ethnic

identity and value. Malaysia is a multiracial society with two main groups, i.e. Malay and

Chinese, both of which play an important role in the socio-economics of the country

(Abdullah, 2006a). While Malays form the majority ethnic group, the Chinese have always

been the most economically prominent in Malaysia (Mamman, 2002). Despite their

smaller population, the Chinese owned 69 percent of the total share capital of Malaysian

companies (in the mid-1990), which is argued to contribute as a source of racial tension in

Malaysia (Ball et al., 2003).

To address the economic imbalance, the government of Malaysia issued the National

Economic Policy (NEP) in 1969 to eliminate the identification of race with economic

function (Haniffa and Cooke, 2005). To effectively implement the NEP, the government

passed the Industrial Coordination Act (ICA) in 1975 startling Chinese investors, ‘who

viewed it as a direct and unfair advancement of Malay interest’ (Mamman 2002, p.6). The

implementation of NEP is argued to be a form of institutionalised positive discrimination

towards Bumiputera that affects corporate behaviour in the Malaysian business

environment (Haniffa and Cooke, 2005).

The capabilities of Bumiputera-controlled firms and politically connected firms are often

cited for poor performance and poor corporate governance practice in Malaysia (Johnson

and Mitton, 2003; Gul, 2006; Yatim et al., 2006). In the early phase of the Asian 1997

financial crisis, evidence suggests that politically connected firms had poorer stock returns

(Johnson and Mitton, 2003) and higher audit fees (Gul, 2006) compared to non-politically

159

connected firms. Further analysis by Gul (2006) documents a positive significant

association between firms with Bumiputera ownership and audit fees. His findings suggest

that Bumiputera firms are perceived to have greater agency costs than non-Bumiputera

firms (i.e. Chinese firms).

Nonetheless, studies by Haniffa and Cooke (2002) and Haniffa and Cooke (2005) suggest

that Bumiputera firms use voluntary disclosures as a legitimating strategy to please the

various interest groups, including ensuring a continued influential voice at both

governmental and institutional levels. Haniffa and Cooke (2002) and Haniffa and Cooke

(2005) find that Malay dominated boards are positively related to voluntary disclosure and

corporate social disclosure in Malaysia. Haniffa and Cooke (2005, p.417) suggest that

‘board dominated by Malays adopt a reactive legitimating strategy to change perceptions

and divert the attention of its various stakeholders away from the close-relationship they

enjoy with government by increasing social responsibility disclosures’. Supporting these

studies, Yatim et al. (2006) document evidence that Bumiputera-controlled firms practice

favourable corporate governance practices relative to their non-Bumiputera counterparts.

Although contradictory with earlier findings by Johnson and Mitton (2003), their findings

suggest that corporate governance practices have changed in Malaysia following the

corporate governance reforms in 2001.

Ball et al. (2003) argue that firms controlled by ethnic minorities are more likely to

encounter political costs from reporting high profits and as a consequence, minority ethnic

Chinese have political incentives to avoid reporting large profits. Yet, the empirical

evidence is lacking. Abdul Rahman and Mohamed Ali (2006) do test the relationship

between ethnicity and earnings management but do not find any significant evidence. No

160

other study in the Malaysian context has tested the influence of ethnic domination on

earnings quality.

Based on the above discussion, the study proposes the following testable null hypothesis:

H03A: There is no association between racial composition and earnings quality.

4.4 SAMPLE SELECTION

The initial sample of the study consists of all companies that were listed on the Main Board

of Bursa Malaysia for the period 1998 to 2006. At the end of 2006, there were 649

financial and non-financial companies listed on Bursa Malaysia’s Main Board. Due to

different statutory requirements and materially different types of operations, all banks,

insurance and unit trust companies were excluded from the population of interest (Klein,

2002; Davidson et al., 2005; Peasnell et al., 2005; Abdul Rahman and Mohamed Ali,

2006). In addition, utility companies were also excluded from the population of interest

because they possess different incentives and opportunities to manage earnings (Peasnell et

al., 2000; Bedard et al., 2004; Abdul Rahman and Mohamed Ali, 2006). After eliminating

55 financial companies and 2 utility companies, the sample size was reduced to 592 non-

financial companies.

The data collected for this study comprises two categories: dependent and independent

variables. The dependent variable is earnings quality measured by standard deviation of

accrual quality residuals. The independent variables consist of board of directors’

characteristics, ownership structure and ethnicity. Earnings quality accounting data was

extracted from financial databases such as the DataStream and the Perfect Analysis. Any

161

missing financial data from the databases was obtained manually from the respective

annual reports. Information pertaining to board of directors’ characteristics, ownership

structure and ethnicity of the directors was manually-collected by examining the

disclosures made in annual reports available on the Bursa Malaysia website

(www.bursamalaysia.com).

Table 4.1

Derivation of Sample, 1998 to 2006

Total

Total number of companies listed on the Main Board of Bursa Malaysia as at 31st December 2006 Less:

Banks, insurance and unit trusts Utility companies Companies that exist after year 1998 Companies with less than 8 observations Companies with incomplete data (unavailable 2006 annual report, de-listed companies within years 1998-2006 and unavailable financial and corporate governance data)

Final sample

649

55 2

168 8

139

277

There are strict data requirements for the accrual quality estimation that requires at least

five year’s residual value (Dechow and Dichev, 2002; Francis et al. 2005). For a sample of

three years period, nine years complete accounting data, t = 1998-2006 is required to

estimate accrual quality. For that reason, the number of data observations is further

reduced to 424 non-financial companies with complete financial data from 1998 to 2006

for current assets, current liabilities, cash, change in debt in current liabilities, cash flow

from operations, revenues and property, plant and equipment. A firm is included in the

year t sample if data is available for year’s t-4 to t. Any firms that were de-listed within

162

years 1998 to 2006 were also excluded from the population of interest due to incomplete

data.

Consistent with prior research (Davidson et al., 2005; Abdul Rahman and Mohamed Ali,

2006), industries with less than eight firms were also eliminated from the analysis38.

Further, 139 companies were excluded as the required financial and corporate governance

data was not available, resulting in a final sample of 277 non-financial companies listed on

seven sectors39 of Bursa Malaysia’s Main Board from 2003 to 2005. Giving a total of 831

firm-year observations with complete data for earnings quality, board of directors’

characteristics, ownership structure and ethnicity.

Table 4.2

Sector Representation of the Sample Companies

Number of Companies %

Construction 19 6.86 Consumer product 46 16.60 Industrial product 87 31.41 Plantations 24 8.66 Properties 25 9.03 Technology 9 3.25 Trading/services 67 24.19 Total 277 100.00

There are two distinct approaches to resolve research problems in social science – the

qualitative approach and the quantitative approach. As far as this study is concerned, the

quantitative approach that fall under the mainstream accounting research paradigm is used

to achieve the objective of the research questions being addressed. Most of the data in this

study is secondary in nature collected from corporate annual reports and financial

38 Industries with less than 10 observations are excluded to ensure efficiency in accruals model estimation (Jones, 1991). 39 There are 15 sectors quoted on the main board of Bursa Malaysia (i.e. industrial sector, consumer sector, trading/services sector, construction sector, plantations sector, finance sector, infrastructure project companies sector, hotels sector, properties sector, mining sector, technology sector, trust sector, closed end fund sector, reits sector, ETF sector).

163

databases. In the mainstream accounting research, the hypotheses are derived from a

comprehensive review of academic literature and are expressed in the form of mathematical

model. The data collection will be highly structured and will be analyzed by mathematical

and statistical technique (Chua, 1986).

4.5 MEASUREMENT OF DEPENDENT VARIABLE: EARNINGS QUALITY

To measure earnings quality, this study applies Dechow and Dichev (2002) accrual quality

model and modified Dechow and Dichev (2002) model (Francis et al., 2005), which has

recently been considered as a better proxy for earnings quality (Jaggi et al., 2007). This

measure is based on the observation that accruals map into cash flow realizations and

regardless of managerial intent, accrual quality is affected by the measurement errors in

accruals. The nature of accruals that are frequently based on the assumptions and estimates

create estimation errors that need to be corrected in the future.

In the Dechow and Dichev (2002) study, the estimated residuals from firm specific

regressions of working capital accruals, on past, present, and future cash flow from

operation, captures the total accruals estimation error by management and are viewed as an

inverse measure of earnings quality. However, the Dechow and Dichev (2002) model does

not distinguish between intentional and unintentional estimation errors because regardless

of managerial intent, accrual quality would be systematically related to firm and industry

characteristics. The approach taken is to assess accruals as a whole as both estimation

errors imply a lower quality of earnings.

164

The Dechow and Dichev (2002) model is measured by estimating the following regression

(all variables are scaled by average assets):

∆∆∆∆TCAj,t = ϕϕϕϕ0,j + ϕϕϕϕ1,j CFOj,t-1 + ϕϕϕϕ2,j CFOj,t + ϕϕϕϕ3,j CFOj,t+1 + ννννj,t (4.1)

Where:

∆TCAj,t = Firm j’s total current accruals in year t, = (∆CAj,t - ∆CLj,t - ∆Cashj,t +

∆STDEBTj,t);

∆CAj,t = Firm j’s change in current assets between year t-1 and year t;

∆CLj,t = Firm j’s change in current liabilities between year t-1 and year t;

∆Cashj,t = Firm j’s change in cash between year t-1 and year t;

∆STDEBTj,t = Firm j’s change in debt in current liabilities between year t-1 and year t;

Assetsj,t = Firm j’s average total assets in year t and t-1; and

CFOj,t = Firm j’s net cash flow from operation in year t.

For a more complete characterization of the relation between accruals and cash flow,

McNichols (2002), in her discussion paper of the quality of accruals and earnings by the

Dechow and Dichev (2002) model suggests two additional variables i.e. change in revenue

and property, and plant and equipment (PPE). She argues that these two additional

variables are important in forming expectations about current accruals, over and above the

effects of operating cash flows. McNichols (2002) opines that combining Dechow and

Dichev (2002) model and Jones (1991) model variables (i.e. change in revenue and PPE),

significantly increases the explanatory power of the accrual quality model.

165

Following prior study by Francis et al. (2005), Boonlert-U Thai et al. (2006), Doyle et al.

(2007) and Jaggi et al. (2007), this study also employs the modified Dechow and Dichev

(2002) model to complement the original Dechow and Dichev (2002) model. The modified

Dechow and Dichev (2002) model is measured by estimating the following regression (all

variables are scaled by average assets):

∆∆∆∆TCAj,t = ϕϕϕϕ0,j + ϕϕϕϕ1,j CFOj,t-1 + ϕϕϕϕ2,j CFOj,t + ϕϕϕϕ3,j CFOj,t+1 + ϕϕϕϕ4,j ∆∆∆∆REVj,t + ϕϕϕϕ5,j PPEj,t +

ννννj,t (4.2)

Where:

All variables are measured as in equation 1 except:

∆REV j,t = Firm j’s change in revenues in year t-1 and t; and

PPE j,t = Firm j’s gross value of PPE in year t.

For each firm-year, equations 4.1 and 4.2 are estimated cross-sectionally for all firms

(minimum of eight firms within each industry group) using rolling 7-year windows. These

estimations yield five firm- and year-specific residuals, νj,t, t = t-4,…t, which form the basis

for the accrual metric. Accrual Quality j,t = σ (νj,t), is equal to the standard deviation of the

firm j’s estimated residuals. Larger standard deviations of residuals correspond to poorer

accrual quality and vice versa. Following DeFond et al. (2007) the standard deviation

score is multiplied by -1 so that a higher score indicates higher earnings quality (EQ).

166

4.6 MEASUREMENT OF INDEPENDENT VARIABLES

This section gives an operational definition of each independent variable identified in the

hypotheses. The independent variables are segregated into three main components: board

of directors’ characteristics, ownership structure and ethnicity.

4.6.1 Board of Directors’ Characteristics

Board Independence (BIND) is measured by the proportion of independent non-executive

directors on the board, expressed as a percentage. In the context of Malaysia, there are

three types of directors, namely, independent non-executive directors, non-independent

non-executive directors and executive directors. Given that some non-independent non-

executive directors are independent, whereas others are not (non-independent non-

executive directors are sometimes a family member), following prior work by Che Haat

(2006), this study focuses solely on independent and non-independent directors instead of

executive and non-executive directors.

CEO Duality (CEODUAL) occurs when the chairman of the board is also the CEO of the

firm. In Malaysia, the MCCG 2000 recommends a separation of roles between the CEO

and the chairman of the board. In this study, the variable takes a value of one if the roles of

the chairman and CEO are combined; otherwise it takes a value of 0. This measurement is

similar to the study by Peasnell et al. (2000; 2005) and Che Haat (2006).

167

Board Financial Expertise (FINEXP) is measured by the proportion of directors with

financial expertise on the board expressed as a percentage. The revised MCCG Code 2007

requires at least one audit committee member to be a member of an accounting association

or body. In this study, the proportion of board members holding a membership of an

accounting association or body on a board is used to measure board financial expertise.

Board Governance Expertise (CROSS) is measured by the proportion of directors with

directorships in other companies on the board expressed as a percentage. The board cross-

directorships is used to measure board governance expertise. This measurement is similar

to the prior study by Haniffa and Cooke (2002) in the Malaysian context.

Board Firm-Specific Expertise (TENURE) is measured by the average number of years of

board services of independent non-executive directors. Similar to Bedard et al. (2004) and

Abdul Rahman and Mohamed Ali (2006), the average number of years of board service of

independent non-executive directors is used to measure firm-specific expertise in this

study.

4.6.2 Ownership Structure

Managerial ownership is measured using the percentage of shares owned by independent

non-executive directors, executive directors and non-independent non-executive directors.

To provide a more comprehensive analysis, the variable managerial ownership is

segregated into inside and outside ownership similar to the prior study by Abdullah (2004,

2006b). While the study by Abdullah (2004, 2006b) segregates between executive and

non-executive director ownership, this study focuses on inside and outside board

168

ownership, given the same reason when measuring board independence as some non-

independent non-executive directors are not truly independent from the management. In

this study, Insider Ownership (INSIDEOWNS) is measured using the percentage of shares

held by the inside board members’ including executive directors and non-independent non-

executive directors while Outsider Ownership (OUTOWNS) is measured using the

percentage of shares held by the independent non-executive directors. The measure

includes both direct and indirect interests in the company (Che Ahmad et al., 2003).

Family ownership (FAMCONTROL) is measured using the ratio of family members on the

board to the total number of directors (Haniffa and Cooke, 2002 and Mohd Ghazali and

Weetman, 2006). Each listed company in Malaysia is required to disclose the director’s

information in the annual report, including any family relationship with any directors

and/or substantial shareholders of the company.

Institutional Ownership (INSTITUTIONAL) is measured using the proportion of shares

owned by the five largest institutional investors to total number of shares issued (Abdul

Wahab et al., 2007). The five largest institutional investors include Employee Provident

Fund (EPF), Lembaga Tabung Angkatan Tentera (LTAT), Lembaga Tabung Haji (LTH),

Social Security Organization (SOCSO) and Permodalan Nasional Berhad (PNB).

4.6.3 Ethnicity

Racial Composition (RCOMP) is measured using the ratio of Bumiputera directors on the

board to the total number of directors. This measurement is similar to the study by Haniffa

and Cooke (2002) and Abdul Rahman and Mohamed Ali (2006).

169

4.6.4 Controlled Variables

As prior studies, this study includes firm size, leverage, firm growth, audit quality and

board size as controlled variables in the regression model given the evidence of the

association between these variables and earnings quality.

The natural log of total assets is included in the regression to control for the firm size effect

(Peasnell et al., 2005; Abdul Rahman and Mohamed Ali, 2006; Jaggi et al., 2007). Size

(LNSIZE) denotes the size of the company in terms of total assets. A larger firm size is

expected to have better earnings quality as they are closely monitored by the external

capital markets (Park and Shin, 2004) and are less likely to engage in earnings management

(Klein, 2002; Peasnell et al., 2005; Abdul Rahman and Mohamed Ali, 2006). A positive

relationship between firm size and earnings quality is predicted.

Leverage (LEV) is measured as the ratio of total liabilities to total assets and is used to

control for the liquidity of the firm. With respect to leverage, firms with higher leverage

are expected to have lower earnings quality as firms that are currently facing financial

constraints have greater incentives to manage earnings upward to avoid potential loss by

disclosing financial problems that will result in a lower quality of financial reports (Park

and Shin, 2004). A study by Klein (2002) and Davidson et al (2005) reports a positive

significant association between leverage and earnings management activity.

Return on Assets (ROA) is used to control for the growth rate and firm performance. ROA

is measured as the ratio of net income, before extraordinary items, to the total assets (Abdul

Rahman and Mohamed Ali, 2006; Jaggi et al., 2007). Firms with low firm performance

170

have more incentive to engage in earnings management (Abdul Rahman and Mohamed Ali,

2006). A positive relationship between firm performance and earnings quality is predicted.

The Big 4 (BIG4) audit firms are used to measure Audit Quality and are expected to have a

positive impact on earnings quality as they have more expertise and resources (Davidson et

al., 2005) and specialists and brand name (Balsam et al., 2003) compared to smaller audit

firms for detecting earnings management activity. BIG4 is a dichotomous variable Big4

and non-Big4. In this study, the variable takes a value of one if the company is audited by

a Big4 firm; otherwise it takes a value of 0. This measurement is similar to the study by

Davidson et al. (2005) and Abdul Rahman and Mohamed Ali (2006).

Additionally, given the evidence on the association between board size and earnings

management (Abdul Rahman and Mohamed Ali, 2006; Xie et al., 2003; Peasnell et al.,

2000; 2005) this study also controls for Board Size (BDSIZE). BDSIZE is measured by the

total number of board members (Abdul Rahman and Mohamed Ali, 2006). Xie et al.

(2003) argue that larger boards may be better in preventing earnings management

compared to smaller boards as larger boards are more likely to have independent directors

with corporate and financial expertise. However, Abdul Rahman and Mohamed Ali (2006)

argue that coordinating and processing problems become more difficult when the boards

are too large. This makes larger boards more ineffective in performing monitoring

functions. Following the Malaysian scenario, a negative relationship between board size

and earnings quality is predicted. Finally, this study also includes the dummy variables for

years to control for the effect of the time period.

171

Table 4.3

Summary of the Operationalisation of the Research Variables

Variables Acronym Operationalisation

Dependent Variable: Earnings Quality

EQ

The standard deviation of the firm j’s estimated

residuals, from years t-4 to t from annual cross-sectional estimations of the Dechow and Dichev (2002) accrual quality model

Independent Variables: Board Independence

BIND

The proportion of independent non-executive

directors to the total number of directors on the board of the company

CEO Duality

CEODUAL

Dichotomous with 1 if the roles of the chairman and CEO are combined and 0 otherwise

Board Financial Expertise FINEXP

The proportion of directors on the board with financial expertise to the total number of directors on the board of the company

Board Governance Expertise

CROSS The proportion of directors on the board with directorships in other companies to the total number of directors on the board of the company

Board Firm-Specific Expertise

TENURE

The average number of years of board service of independent non-executive directors on the board of the company

Insider Ownership

INSIDEOWNS The percentage of shares held by inside board members including executive directors and non-independent non-executive directors to total number of shares issued

Outsider ownership OUTOWNS

The percentage of shares held by independent non-executive directors to total number of shares issued

Family Control on Corporate Board

FAMCONTROL

The ratio of family members on the board to the total number of directors on the board of company

Institutional Ownership

INSTITUTIONAL

The percentage of shares owned by the five largest institutional investors to total number of shares issued

Racial Composition

RCOMP

The ratio of Bumiputera directors on the board to the total number of directors on the board of the company

Controlled Variables: Size

LNSIZE

Natural log of total assets

Leverage LEV The ratio of total liabilities to total assets Return on Assets ROA The ratio of net income to total assets Audit Quality BIG4 Dichotomous with 1 if the company is audited by

Big 4 audit firms and 0 otherwise Board Size BDSIZE Total number of directors on the board of the

company

172

4.7 REGRESSION MODEL

This study used a linear multiple regression analysis to test the association between the

dependent variable of earnings quality and the independent variable of board of directors’

characteristics, ownership structure and ethnicity. All the data was analysed using the

Statistical Package for Social Science (SPSS) version 15.0 and EViews 5.0. The following

multiple regression model was utilised to determine the extent of the influence of each of

the variables in the study on the earnings quality:

EQ = ββββ0 + ββββ1 BIND + ββββ2 CEODUAL + ββββ3 FINEXP + ββββ4 CROSS + ββββ5 TENURE + ββββ6

OUTOWNS + ββββ7 INSIDEOWNS + ββββ8FAMCONTROL + ββββ9 INSTITUTIONAL + ββββ10

RCOMP + ββββ11 LNSIZE + ββββ12 LEV+ ββββ13 ROA + ββββ14 BIG4 + ββββ15 BDSIZE + ββββ16

DUM_YR04 + ββββ17 DUM_YR05 + εεεε (4.3)

Where:

EQ = Measured by accrual quality based on Dechow and

Dichev (2002) model40

BIND = Proportion of independent non-executive directors to the total

number of directors on the board of the company

CEODUAL = Dummy variable, 1 if the roles of the chairperson and CEO are

combined, 0 if otherwise

FINEXP = Proportion of directors on the board with financial expertise to the

total number of directors

40 Dechow and Dichev (2002) model is explained in section 4.5

173

CROSS = Proportion of directors on the board, with directorships in other

companies, to the total number of directors

TENURE = Average number of years of board service of independent non-

executive directors

INSIDEOWNS = Percentage of shares held by the executive directors and non-

independent non-executive directors

OUTOWNS = Percentage of shares held by the independent non-executive

directors

FAMCONTROL = Proportion of family members on the board to the total number of

directors on the board of the company

INSTITUTIONAL = Proportion of shares owned by institutional investors to total

number of shares issued

RCOMP = Total number of directors on the board of the company

SIZE = Natural log of total assets

LEV = Ratio of total liabilities to total assets

ROA = Ratio of net income to total assets

BIG4 = Dummy variable, 1 if audited by Big 4 audit firms, 0 if otherwise

BDSIZE = Total number of directors on the board of the company

ε = Error term

174

Since multivariate analysis is used to test the hypotheses, assumptions of multicollinearity,

normality, homoscedasticity and linearity were also tested. To test the multicollinearity

assumption, the Pearson correlation matrix was computed to examine the correlation

between the independent variables. An analysis of residuals, plots of the studentised

residuals against predicted values as well as the Q-Q plot were conducted to test for

homocedasticity, linearity and normality. Results of standard tests on skewness and

kurtosis indicate a problem with the normality assumptions for few variables. However,

Hair et al. (2006) suggest that researchers can be less concerned with non-normal variables

as the sample sizes become larger (i.e. sample sizes of 200 or more)41. All the regression

results were reported using t-statistics with White adjustment to correct for the possibility

of heteroscedasticity (Chung et al., 2004).

To test the hypotheses, multivariate regressions for each model were conducted for each

year (2003-2005) as well as for the pooled data for all three years. At first, the basic model

as proposed in equation 4.3 was regressed. Subsequently, a modified regression model,

which was developed by changing the methodology of measuring certain variables, was

tested. The reason for modifying the basic model was to determine whether the earlier

findings were significantly different when the methodology of measuring certain variables

was altered, thus helping to determine the stability of the findings.

41 Larger sample sizes reduce the detrimental effects of non-normality and significant departure from normality may be negligible for sample sizes of 200 or more (Hair et al., 2006).

175

4.8 SUMMARY AND CONCLUSION

The first part of this chapter discusses the theoretical framework of the study. Three main

independent variables are identified, which are board of directors’ characteristics,

ownership structure and ethnicity to predict their influence on the quality of earnings.

There are three main hypotheses developed with some further segregated to reflect

individual independent variables.

The second part of this chapter discusses the research method applied in this study. In

order to meet the overall research objectives, this study adopts a quantitative research based

on the content analysis approach. A sample of 277 firms listed on the Main Board of Bursa

Malaysia from year 2003 to 2005, giving a total of 831 firm-year observations has been

selected in the study to see the impact of the internal governance structure, ownership

structure and ethnicity on earnings quality. Accrual quality is used to represent the

measure for earnings quality in this study. With respect to independent variables, board

composition and board expertise will represent the board of directors’ characteristics;

managerial ownership, family ownership and institutional ownership will represent the

ownership structure; and finally, racial composition of directors will represent the ethnicity

of directors in Malaysia. To test the hypotheses, this study used a linear multiple

regression analysis, conducted for each year (2003-2005) as well as for the pooled data for

all three years. The next chapter presents and discusses the findings of the study.

176

CHAPTER 5

RESULTS AND DISCUSSIONS

5.1 INTRODUCTION

The objective of this chapter is to report and discuss the findings of this study. The chapter

is organised as follows. Section 5.2 presents the descriptive statistics of the continuous and

dichotomous variables used in the regression tests. Section 5.3 examines the correlation

between the independent variables utilising the Pearson product moment correlation

analysis. Section 5.4 reports the results of the multiple regression analysis of the model

tested. To ascertain the credibility of the initial analysis, Section 5.5 presents the results of

several additional tests that were conducted to determine the sensitivity and the robustness

of the regression analysis earlier. Section 5.6 discusses the overall findings of the study.

The chapter ends with Section 5.7 – summary and conclusion.

5.2 DESCRIPTIVE STATISTICS

Table 5.1 and Table 5.2 present the descriptive statistics of the continuous and dichotomous

variables used in the regression tests for each year (2003-2005) as well as for the pooled

data for all three years.

177

Table 5.1

Descriptive Statistics of Continuous Variables

All

Mean

Median

Standard Deviation

Minimum

Maximum

N=831

2003

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2004

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2005

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

Original Earnings -0.765 -0.759 -0.752 -0.783 Quality (EQORI) -0.580 -0.578 -0.553 -0.609 0.681 0.697 0.701 0.646 -5.280 -5.280 -4.820 -4.030 -0.040 -0.080 -0.050 -0.040 Modified Earnings -0.766 -0.761 -0.753 -0.785 Quality (EQMOD) -0.577 -0.588 -0.541 -0.606 0.681 0.696 0.698 0.649 -5.370 -5.370 -4.880 -4.180 -0.040 -0.040 -0.070 -0.100 Board Independence 0.414 0.404 0.415 0.423 (BIND) 0.375 0.375 0.375 0.400 0.111 0.108 0.112 0.114 0.170 0.170 0.250 0.200 0.860 0.830 0.860 0.830

178

Table 5.1

(continued)

All

Mean

Median

Standard Deviation

Minimum

Maximum

N=831

2003

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2004

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2005

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

Board Financial Expertise 0.190 0.192 0.191 0.188 (FINEXP) 0.167 0.167 0.167 0.167 0.110 0.111 0.105 0.113 0.000 0.000 0.000 0.000 0.600 0.600 0.600 0.600 Board Governance 0.546 0.543 0.545 0.549 Expertise (CROSS) 0.556 0.556 0.556 0.500 0.283 0.288 0.279 0.281 0.000 0.000 0.000 0.000 1.000 1.000 1.000 1.000 Board Firm-Specific 6.6 6.1 6.6 7.0 Expertise (TENURE) 5.8 5.2 5.7 6.3 4.3 4.4 4.4 4.1 0.2 0.2 0.9 0.3 29.3 28.5 28.3 29.3

179

Table 5.1

(continued)

All

Mean

Median

Standard Deviation

Minimum

Maximum

N=831

2003

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2004

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2005

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

Insider Ownership 28.32 29.34 27.68 27.94 (INSIDEOWNS) 29.26 29.71 29.18 28.81 23.79 23.86 23.37 24.19 0.00 0.00 0.00 0.00 98.36 98.36 82.18 84.43 Outsider Ownership 0.31 0.29 0.30 0.35 (OUTOWNS) 0.00 0.00 0.00 0.00 0.96 0.98 0.89 1.00 0.00 0.00 0.00 0.00 9.90 9.90 7.76 7.67 Family Ownership 0.188 0.190 0.191 0.183 (FAMCONTROL) 0.000 0.000 0.000 0.000 0.213 0.216 0.212 0.210 0.000 0.000 0.000 0.000 0.750 0.750 0.710 0.710

180

Table 5.1

(continued)

All

Mean

Median

Standard Deviation

Minimum

Maximum

N=831

2003

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2004

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2005

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

Institutional Ownership 5.79 5.83 5.72 5.81 (INSTITUTIONAL) 3.20 3.34 3.03 3.29 7.58 7.61 7.97 7.16 0.00 0.00 0.00 0.00 67.83 59.51 67.83 37.98 Racial Composition 0.437 0.437 0.439 0.435 (RCOMP) 0.375 0.375 0.375 0.375 0.268 0.271 0.266 0.268 0.000 0.000 0.000 0.000 1.000 1.000 1.000 1.000

Firm Size (SIZE) 1.4256E9 1.3731E9 1.4036E9 1.5001E9 4.7886E8 4.6035E8 4.7493E8 5.0871E8 3.09056E9 3.13624E9 2.92558E9 3.21249E9 1.82E7 2.00E7 1.91E7 1.82E7 3.27E10 3.27E10 2.65E10 2.89E10

181

Table 5.1

(continued)

All

Mean

Median

Standard Deviation

Minimum

Maximum

N=831

2003

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2004

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

2005

Mean

Median

Standard Deviation

Minimum

Maximum

N=277

Leverage (LEV) 0.487 0.487 0.484 0.490 0.452 0.447 0.454 0.453 0.512 0.467 0.521 0.548 0.000 0.020 0.020 0.000 7.790 6.660 7.100 7.790 Firm Growth (ROA) 0.029 0.030 0.035 0.024 0.034 0.035 0.037 0.032 0.151 0.078 0.186 0.167 -2.310 -0.460 -1.600 -2.310 2.010 0.440 2.010 0.620 Board Size (BDSIZE) 7.9 8.0 7.9 7.8 8.0 8.0 8.0 8.0 2.0 2.0 2.0 1.9 3.0 3.0 4.0 3.0 16.0 16.0 15.0 15.0

182

Table 5.2

Descriptive Statistics of Dichotomous Variables

All

N=831

2003

N=277

2004

N=277

2005

N=277

Dichotomous

Variables 1 0 1 0 1 0 1 0

CEO Duality (CEODUAL)

109 (13.1%)

722 (86.9%)

37 (13.4%)

240 (86.6%)

36 (13%)

241 (87%)

36 (13%)

241 (87%)

Audit Quality (BIG4)

617 (74.2%)

214 (25.8%)

208 (75.1%)

69 (24.9%)

208 (75.1%)

69 (24.9%)

201 (72.6%)

76 (27.4%)

As reported in Table 5.1, the mean and median value of earnings quality for the original

and the modified Dechow and Dichev model for pooled data are -0.765, -0.580 and -0.766,

-0.577, respectively. The maximum value and the standard deviations of residuals for the

original and the modified model are -0.040, -0.040 and 0.681, 0.681, respectively. Both

models show almost equivalent values for the descriptive analysis.

In terms of board composition, 87 percent of companies meet the recommendation of the

MCCG 2000 to have at least one third of the board comprising independent non-executive

directors. The average, 41.4 percent, of the proportion of independent non-executive

directors indicates the domination of insiders in the board composition of companies in

Malaysia. However, it can be seen that the mean percentages of independent non-executive

directors on the board has increased from 40.4 percent in 2003 to 42.3 percent in 2005.

As depicted in Table 5.2, the number of companies with role duality is relatively small with

the mean for the entire three-year period being 13.1 percent, indicating that role duality is

not common in Malaysian corporations. This suggests that the recommendation contained

in the MCCG 2000 for the separation of the CEO and the Chairman role were complied

183

with by most Malaysian corporations. Similar to studies by Abdul Rahman and Mohamed

Ali (2006) and Haniffa and Hudaib (2006), the average board size of Malaysian companies

is eight directors. The size is within the range recommended by Jensen (1993) for board

effectiveness.

With respect to board financial expertise, each company has at least 1 to 2 members of the

board with financial expertise as represented by a median value of 0.167. Surprisingly, the

mean percentage of board members with financial expertise decreased from 19.2 percent in

2003 to 18.8 percent in 2005. In terms of board cross-directorships, more than half the

board members (54.6 percent) hold additional directorships in other firms. The average

length of tenure for independent directors serving in companies in Malaysia is seven years

with a maximum value of 29 years. The average tenure increased gradually from 2003 to

2005, suggesting that the same independent directors continue to serve the same companies

throughout the period.

With regards to insider ownership (executive and non-independent non executive directors’

interest), the percentage ranges from zero to 98.36 percent with an average value of 28.32

percent. This average is similar to the studies done by Che Ahmad et al. (2003) and

Vethanayagam et al. (2006) for Malaysian listed companies. Independent non-executive

directors’ interest (outsider ownership) in Malaysia only holds a small percentage of

ownership ranging from zero to 9.90 percent with an average value of 0.31 percent.

184

In terms of family domination, the proportion varies from zero to about 75 percent, with an

average proportion of family members of about 18.8 percent. There are almost equivalent

numbers in terms of family and non-family controlled firms in the sample, where 51.1

percent have no family members sitting on the corporate board while 48.9 percent have at

least two or more family members sitting on the corporate board. The percentage of

institutional shareholdings for the sample ranges from zero to 67.83 percent, with average

shareholdings of about 5.79 percent. This average is similar to the study done by Abdul

Wahab et al. (2007) for Malaysian listed companies for the period 1999 to 2003.

With respect to the ethnicity of directors, Bumiputera42 (Malay) directors represent an

average of 43.7 percent of all directors on the board of the sample companies, indicating

non-Bumiputera (Chinese) directors’ domination in the board composition of Malaysian

corporations. The average of 43.7 percent is higher than that reported by Salleh et al.

(2006), 38 percent but lower than that found by Abdul Rahman and Mohamed Ali (2006),

48 percent.

The mean firm size, as represented by total assets of the firm, is RM 1,425,600,000. The

averages for firm leverage and return on assets is 48.7 percent and 2.9 percent, respectively,

which is slightly higher than those documented by Haniffa and Hudaib (2006). The

averages for firm leverage and return on assets in their samples was 41.8 percent and 2.6

percent, respectively. Finally, 74.2 percent of companies are audited by a Big 4 audit firm,

which is lower than that reported by Salleh et al. (2006), 80 percent, but higher than

reported by Yatim et al. (2006), 68.8 percent.

42 In this study Bumiputera refers to the Malay group and non-Bumiputera to the Chinese group, which forms the majority in business.

185

Table 5.3: Pearson Product Moment Correlation Coefficient (N=831)

EQ

OR

I

EQ

MO

D

BIN

D

CE

OD

UA

L

FIN

EX

P

CR

OS

S

TE

NU

RE

INS

IDE

OW

NS

OU

TO

WN

S

FA

MC

ON

TR

OL

INS

TIT

UT

ION

AL

RC

OM

P

LN

SIZ

E

LE

V

RO

A

BIG

4

BD

SIZ

E

EQORI 1

EQMOD 1

BIND -.103** -.098** 1

CEODUAL .010 .014 .074* 1

FINEXP -.019 -.020 .104** -.046 1

CROSS .130** .118** .134** -.049 .167** 1

TENURE .180** .173** .023 .049 -.166** .139** 1

INSIDEOWNS .027 .036 -.119** .165** -.128** -.176** -.014 1

OUTOWNS .088* .077* .015 .067 -.103** .028 .122** .127** 1

FAMCONTROL .198** .197** -.208** .176** -.212** -.240** .114** .490** .150** 1

INSTITUTIONAL .106** .099** -.042 -.004 -.050 .125** .144** -.181** .063 -.049 1

RCOMP -.047 -.045 .265** -.134** .036 .148** -.077* -.294** -.098** -.393** .117** 1

LNSIZE .083* .073* .086* -.013 .133** .386** .232** -.210** -.050 -.134** .251** .070* 1

LEV -.023 -.007 -.041 -.019 .035 .051 -.030 -.077* -.024 -.088* -.018 .033 .107** 1

ROA -.004 -.003 .040 .022 .051 .022 .097** .002 .039 .043 .072* -.023 .095** -.133** 1

BIG4 .013 .006 .011 -.016 .065 .167** .081* -.092** -.006 -.128** .102** -.041 .073* .011 .033 1

BDSIZE .067 .054 -.267** -.090** -.141** .081* .061 .013 .174** .114** .185** -.004 .261** .022 .086* .045 1

**Correlation is significant at the 0.01 level; *Correlation is significant at the 0.05 level

186

5.3 CORRELATION ANALYSIS

To examine the correlation between the independent variables, a Pearson product moment

correlation (r) was computed. As illustrated in Table 5.3, board independence (BIND),

board governance expertise (CROSS), board firm-specific expertise (TENURE), family

control on corporate board (FAMCONTROL) and institutional ownership

(INSTITUTIONAL) are significantly related to both original and modified earnings quality

(ρ < 0.01). Outsider ownership (OUTOWNS) and size (LNSIZE) are also significantly

related to both original and modified earnings quality (ρ < 0.05). Other independent

variables and control variables are not correlated with earnings quality. The coefficient of

correlation between board independence and earnings quality is however negative, which

requires further explanation.

Board independence (BIND) is found to be correlated with financial (FINEXP) and

governance expertise (CROSS), suggesting that a higher proportion of independent

directors is related to directors with greater skills and expertise. Additionally, a significant

and positive correlation between board independence (BIND) and racial composition

(RCOMP) indicates the domination of Malay directors in the composition of independent

directors in Malaysian corporations. It is interesting to note that there is a significant

positive correlation between board governance expertise (CROSS) with board financial

expertise (FINEXP) and board firm-specific expertise (TENURE) supporting the view that

additional directorships signal the competence of directors (i.e. their skills and experience)

in the managerial labour market (Bedard et al., 2004).

187

With respect to the ownership variables, both insider ownership (INSIDEOWNS) and

family ownership (FAMCONTROL) are significantly correlated to most of the variables

tested in the study. The variables are negatively and significantly correlated with the

following: board independence (BIND), board financial expertise (FINEXP), board cross-

directorships (CROSS), institutional ownership (INSTITUTIONAL) and racial

composition (RCOMP). In contrast, there is a significant positive correlation between

insider ownership (INSIDEOWNS) and family ownership (FAMCONTROL) with CEO

duality (CEODUAL). The evidence suggests that the higher the interests held by the

managerial or family directors, the lower the number of independent directors; the lower

the number of directors with expertise, the greater the number of Chinese directors and the

more likely for the firm to combine the position of the CEO and the chairman (i.e. CEO

duality). CEO duality is found to be common when Chinese directors dominate the

composition of the board of directors as evidenced by the significant negative correlation

between racial composition (RCOMP) and CEO duality (CEODUAL).

Some interesting findings are also revealed with regards to interests by institutional

investors (INSTITUTIONAL). The variable is positively and significantly related to board

governance expertise (CROSS), board firm-specific expertise (TENURE) and racial

composition (RCOMP). The findings suggest that the presence of institutional investors

with substantial shareholdings is correlated with directors with experience in Malaysian

corporations. Additionally, it appears that greater institutional investments in companies

with the board of directors are dominated by Malay directors. Not surprisingly, there is a

negative and significant correlation between institutional shareholdings

(INSTITUTIONAL) with insider ownership (INSIDEOWNS) and family ownership

(FAMCONTROL), indicating less institutional shareholdings in highly concentrated firms.

188

With respect to the correlation among variables, the correlation matrix confirms that no

multicollinearity exists between the variables as none of the variables correlates above 0.80

or 0.90. All variables have a correlation of less than 0.50.

5.4 MULTIVARIATE ANALYSIS

Table 5.4 summarises the results for each year (2003-2005) as well as for the pooled data

for all three years from the multiple regression analysis linking board of directors’

characteristics, ownership structure, ethnicity and earnings quality (measured by original

Dechow and Dichev (2002) accrual quality model).

The F-value for each year as well as for the pooled data is statistically significant at the 1

percent level. The adjusted R2 for each of the three years is 10.99 percent, 8.64 percent,

6.22 percent for the year 2003, 2004 and 2005, respectively and 9.17 percent for the

combined three-year period. The statistics show that that the model explained 9.17 percent

of the total variance in the earnings quality, which is very low. Although the adjusted R2

may be considered low, it is slightly higher than that reported in the previous Malaysian

study by Abdullah (1999), who examined the relationship between corporate governance

mechanisms and earnings quality measured by the earnings response coefficient (ERC),

which was 7.1 percent. Other Malaysian studies that test the relationship between

corporate governance mechanisms and earnings management also report low adjusted R2

such as studies by Abdullah and Mohd Nasir (2004) and Abdul Rahman and Mohamed Ali

(2006), which were 5.33 percent and 12.8 percent, respectively.

189

Table 5.4: Multiple Regression Results – Basic Model

MODEL 1: EQORI = ββββ0 + ββββ1 BIND + ββββ2 CEODUAL + ββββ3 FINEXP + ββββ4 CROSS + ββββ5 TENURE + ββββ6

OUTOWNS + ββββ7 INSIDEOWNS + ββββ8FAMCONTROL + ββββ9 INSTITUTIONAL + ββββ10 RCOMP + ββββ11

LNSIZE + ββββ12 LEV+ ββββ13 ROA + ββββ14 BIG4 + ββββ15 BDSIZE + ββββ16 DUM_YR04 + ββββ17 DUM_YR05 + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) -1.171 -2.962** -0.171 -0.233 -1.602 -2.568*** -1.768 -2.638***

BIND -0.596 -1.920* -0.436 -0.779 -0.454 -0.804 -0.878 -1.657*

CEODUAL -0.029 -0.461 0.124 1.436 -0.122 -1.023 -0.085 -0.782

FINEXP 0.230 1.026 0.235 0.634 0.474 1.169 0.115 0.309

CROSS 0.365 3.576*** 0.577 3.173*** 0.439 2.324** 0.087 0.561

TENURE 0.020 3.991*** 0.026 3.003*** 0.018 2.199** 0.012 1.279

INSIDEOWNS -0.002 -1.370 -0.004 -2.004** -0.001 -0.505 0.001 0.467

OUTOWNS 0.036 2.015** 0.010 0.383 0.044 1.278 0.032 1.114

FAMCONTROL 0.807 5.931*** 0.857 3.235*** 1.001 3.968*** 0.583 3.264***

INSTITUTIONAL 0.006 1.758* 0.008 1.589 0.005 0.971 0.002 0.354

RCOMP 0.107 0.991 0.177 0.901 0.152 0.793 0.026 0.153

LNSIZE 0.009 0.428 -0.044 -1.148 0.025 0.745 0.044 1.327

LEV -0.025 -0.539 -0.029 -0.467 -0.084 -0.758 0.051 1.218

ROA -0.167 -0.601 0.380 0.930 -0.169 -0.348 -0.161 -0.693

BIG4 -0.001 -0.024 -0.020 -0.215 0.004 0.036 0.024 0.260

BDSIZE -0.008 -0.628 -0.028 -1.281 -0.016 -0.586 0.016 0.872

DUM_YR04 0.001 0.010

DUM_YR05 -0.035 -0.638

Adjusted R2 0.091 0.110 0.086 0.062

F-Value 5.930*** 3.772*** 2.740*** 2.221***

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. EQORI = measured by accrual quality based on original Dechow and Dichev (2002) model, BIND = Board independence, CEODUAL = CEO duality, FINEXP = Board financial expertise, CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP = Racial composition, LNSIZE = Size, LEV = Leverage, ROA = Return on assets, BIG4 = Audit quality, BDSIZE = Board size.

190

5.4.1 Board of Directors’ Characteristics and Earnings Quality

From the analyses conducted, it was found that three out of the five characteristics of board

of directors tested in the study are significantly associated with earnings quality. The

results presented in Table 5.4 show significant associations between board independence

(BIND), board governance expertise (CROSS), board firm-specific expertise (TENURE)

and earnings quality. Neither CEO duality (CEODUAL) nor board financial expertise

(FINEXP) was found to be significant.

Contradictory to the prediction of the agency theory, this study finds a significant negative

association between board independence (BIND) and earnings quality (H01A) in 2005 as

well as for the pooled data (ρ < 0.10). It suggests that firms with lower board

independence have higher earnings quality. The findings are, however, consistent with

recent findings by Haniffa and Cooke (2005), Norman et al. (2005), Ibrahim and Abdul

Samad (2007) and Hashim and Susela (2008b) in the Malaysian context that report a

significant but contrary sign between the proportion of independent non-executive directors

and the accounting issues they examined. Klein et al. (2005) raise the issue of the

applicability of the agency theory assumptions on the monitoring role by outside directors

in countries with a concentrated ownership structure, especially in the hands of family

members. As the ownership and control is tighter in family firms, they argue that the

demand for outside directors becomes less. Other studies such as Eng and Mak (2003) and

Gul and Leung (2004), who also report a contrary significant relationship between outside

directors and disclosures, suggest that outside directors may act as a substitute for

monitoring through public disclosure (substitution effect).

191

The relationship between CEO duality (CEODUAL) and earnings quality is negative and

supports the contention of separation between the position of the chairman and the CEO.

However, the coefficient is not statistically significant, hence, hypothesis H01B cannot be

rejected. The result was consistent with prior findings by Abdullah and Mohd Nasir (2004)

and Abdul Rahman and Mohamed Ali (2006) who found an insignificant association

between CEO duality and discretionary accruals for the Malaysian sample. As the

corporate board are controlled by management, Petra (2005) argues that an independent

chairperson has a discernable impact on management decisions.

It is found that the board governance expertise (CROSS) proxy by proportion of directors

on the board with directorships in other companies and the board firm-specific expertise

(TENURE) proxy by average number of years of board service of independent non-

executive directors are highly significant at the 1 percent level for the pooled data as well

as for the 2003 and 2004 samples, thus allowing this study to reject hypotheses H01D and

H01E. Both results show a positive and highly significant relationship between governance

expertise and firm-specific expertise with earnings quality. The greater the number of

board committee members holding additional directorships in other firms enhances the

quality of financial reporting of the firm as they gain governance expertise through the

knowledge they acquire in other firms (Bedard et al., 2004).

Additionally, the results provide strong support of the relationship between firm-specific

expertise and earnings quality, as can be seen in Table 5.4, which reveals a highly

significant relationship between board tenure and earnings quality. Experience as a board

member in the same company for a longer period of time helps independent directors gain

firm-specific expertise of the company’s operation and its other executive directors (Bedard

192

et al., 2004). The increase in the number of years independent directors serve in the firm

gives them the ability to effectively monitor the management, which results in a higher

quality of financial reporting. Although governance expertise and firm-specific expertise

of boards is found to be highly significant, this study does not find any association between

board financial expertise (FINEXP) and earnings quality, hence hypothesis H01C cannot be

rejected. The finding is, however, consistent with Mohd Iskandar and Wan Abdullah

(2004) and Abdul Rahman and Mohamed Ali (2006) for Malaysian cases.

5.4.2 Ownership Structure and Earnings Quality

Regarding managerial ownership, this study finds a conflicting direction on the association

between insider and outsider ownership with earnings quality. While outsider ownership

(OUTOWNS) is positively and significantly (ρ < 0.05) associated with earnings quality for

the pooled data, the relationship between insider ownership (INSIDEOWNS) and earnings

quality is, however, negative and significant (ρ < 0.05) in 2003. Though both results are

only partially significant, hypotheses H02A, of no association between insider ownership and

earnings quality and H02B, of no association between outsider ownership and earnings

quality is rejected.

The negative and significant result between insider ownership and earnings quality

supports the entrenchment hypothesis, which suggests too much equity interests may

entrench managers to expropriate shareholder’s wealth (Morck et al., 1988; Jung and

Kwon, 2002). In contrast, the positive and significant result between outsider ownership

and earnings quality conforms to the agency theory prediction of incentive-alignment

effects of equity ownership (Jensen and Meckling, 1976). As the outside board ownership

193

increases, the interest of outside directors is more closely aligned with the owners of the

firms, thus providing them greater incentive to enhance the quality of earnings.

Interestingly, in the case of family ownership, this study finds a strong positive significant

association between the family ownership (FAMCONTROL) proxy by the proportion of

family members on the board to the total number of directors and earnings quality for each

year as well as for the pooled data. In all models, the family control board is found to be

highly significant at the 1 percent level, thus H02C is rejected. This supports the notion that

the presence of family members reduces agency costs, possibly because they have greater

expertise concerning the firm’s operations to effectively monitor the firm’s activities. The

result of this study is consistent with the prior study by Chu and Cheah (2006) that reported

a positive and significant relationship between family ownership and performance in

Malaysia.

Consistent with expectations, this study finds a positive significant (ρ < 0.10) association

between institutional ownership (INSTITUTIONAL) and earnings quality (H02D) for the

pooled data. The result confirms the active monitoring hypothesis, which suggests

institutional investors are likely to actively monitor their investments due to the large

amount of wealth they invested (Velury and Jenkins, 2006). This study provides evidence

that concentrated shareholdings, in the hands of institutional investors, afford greater

incentives to closely monitor firms’ activities.

5.4.3 Ethnicity and Earnings Quality

The relationship between racial composition (RCOMP) and earnings quality is positive,

suggesting that greater earnings quality is associated with a Malay dominated board.

194

However, the coefficient is not statistically significant, hence, hypothesis H03A cannot be

rejected. The result was consistent with prior findings by Abdul Rahman and Mohamed

Ali (2006) who found an insignificant association between racial composition and

discretionary accruals for the Malaysian sample.

5.4.4 Controlled Variables and Earnings Quality

With regards to controlled variables, none of the variables were significantly related to

earnings quality. It is expected that larger sized firms will have better earnings quality as

they are closely monitored by the external markets, while the Big 4 audit firms are expected

to enhance the quality of reported earnings as they have more expertise and resources

compared to smaller audit firms for detecting earnings management. Both size (LNSIZE)

and audit quality (BIG4) variables were positive in sign but were not significant.

The effect of leverage (LEV) and board size (BDSIZE) are predicted to be negative.

Leverage was used to control firms that are currently facing financial difficulties and firms

with higher leverage are expected to have lower earnings quality. Board size, as measured

by the total number of board members, was used to control for the board size effect. A

negative association between board size and earnings quality is predicted as larger boards

are expected to be ineffective in performing monitoring functions due to the coordinating

and processing problems when the boards are too large. Although LEV and BDSIZE were

negative in sign, both variables were not significant. Finally, the effect of return on assets

(ROA) to control for the growth rate and firm performance is found to be negative but not

significant. The negative coefficient differs from the prior prediction of a positive

relationship between firm performance and earnings quality.

195

5.5 ADDITIONAL ANALYSES

To ascertain the credibility of initial analysis, several additional tests were carried out. The

additional tests were conducted to determine the sensitivity of the results as well as to

determine the robustness of the findings reported earlier in Section 5.4. The first test

repeats the regression model (Model 1) allowing for a possible non-linear relationship

between board independence and earnings quality. Then, the basic model is further tested

by creating a new variable, a non-executive chairman, to examine the influence of the

chairman’s position in improving board effectiveness. The basic model is further re-

examined using a different proxy to measure board financial expertise and racial

composition. Finally, to test the robustness of the regression analysis performed earlier, the

original Dechow and Dichev (2002) model is replaced by the modified Dechow and Dichev

(2002) accrual quality model and the discretionary component of the accrual quality model

(Francis et al., 2005) in the regression analysis as other proxies for earnings quality.

5.5.1 Alternative Measurement for Board Independence

Thus far, the variable board independence (BIND) is treated as a linear variable. The

result, as shown in Table 5.4, suggests that board independence is significantly associated

with earnings quality but in the opposite direction as predicted by the agency theory. It is

possible that the relationship between board independence and earnings quality is non-

linear. Studies by Bhagat and Black (2002) and Garg (2007) suggest that different

proportions of independent directors may differently impact firm performance. For

example, Bhagat and Black (2002) suggest that firms may achieve the benefit of firm-

specific knowledge when they have a significant number of inside directors – for example

30 percent – but the benefits may be detrimental when there are too many.

196

Klein (2002) reports that firms with a majority-independent board (i.e. 51 percent or more)

produce the highest relationship with abnormal accruals. Although it may be valuable to

have a majority of independent directors, Garg (2007) documents that the impact of board

independence on firm performance is less when the proportion of board independence is

greater than 60 percent. He argues that overall insignificant results concerning board

independence are due to the sample of firms where board independence is less than 30

percent and more than 60 percent.43 Furthermore, Bhagat and Black (2002) raise their

concern of firms having a supermajority-independent board with too few inside directors.

Though having inside directors are sometimes conflicted, they argue that having a

reasonable number of inside directors could add value.

Following the recent study by Garg (2007), variable board independence is classified into

three categories. Category 1 representing cases where board independence is less than 33

percent (BIND_DUM_1), category 2 representing cases where board independence is

greater than 33 percent and up to 50 percent (BIND_DUM_2) and category 3 representing

cases where board independence is greater than 50 percent (BIND_DUM_3). This study

used dummies to test the effect of different categories of board independence on earnings

quality. As there are three dummy variables, the number of dummies used is one less than

the number of categories of board independence (m-1). The coefficients are estimated first

by leaving out the dummy variable for category 1 (BIND_DUM_1) and using dummies for

categories 2 (BIND_DUM_2) and 3 (BIND_DUM_3). The results are shown in Table 5.5.

43 Garg (2007) documents a strong positive significant relationship between board independence and firm performance when firms have a board independence greater than 33 percent and up to 50 percent and between 50 percent and up to 60 percent. No significant impact on firm performance when the board independence is less than 33 percent or greater than 74 percent.

197

Table 5.5: Multiple Regression Results – Board Independence using Dummies

MODEL 2: EQORI = ββββ0 + ββββ1 BIND_DUM_2 + ββββ2 BIND_DUM_3 + ββββ3 CEODUAL + ββββ4 FINEXP + ββββ5 CROSS + ββββ6

TENURE + ββββ7 OUTOWNS + ββββ8 INSIDEOWNS + ββββ9 FAMCONTROL + ββββ10 INSTITUTIONAL + ββββ11 RCOMP + ββββ12

LNSIZE + ββββ13 LEV+ ββββ14 ROA + ββββ15 BIG4 + ββββ16 BDSIZE + ββββ17 DUM_YR04 + ββββ18 DUM_YR05 + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) -1.559 -3.995*** -0.502 -0.727 -1.835 -2.861** -2.356 -3.639***

BIND_DUM_2 0.169 2.378** 0.159 1.292 0.083 0.735 0.280 2.015**

BIND_DUM_3 -0.031 -0.291 0.111 0.634 -0.076 -0.411 -0.065 -0.338

CEODUAL -0.043 -0.665 0.103 1.241 -0.127 -1.040 -0.100 -0.866

FINEXP 0.181 0.820 0.211 0.569 0.429 1.089 0.011 0.030

CROSS 0.358 3.497*** 0.584 3.206*** 0.429 2.265** 0.063 0.417

TENURE 0.020 3.949*** 0.027 3.001*** 0.018 2.136** 0.011 1.199

INSIDEOWNS -0.001 -1.162 -0.004 -1.860* -0.001 -0.452 0.001 0.682

OUTOWNS 0.025 1.438 0.000 -0.009 0.036 1.112 0.019 0.674

FAMCONTROL 0.837 6.200*** 0.863 3.224*** 1.020 4.155*** 0.682 3.827***

INSTITUTIONAL 0.006 1.763* 0.008 1.637 0.005 0.955 0.003 0.450

RCOMP 0.083 0.749 0.119 0.597 0.139 0.689 0.029 0.172

LNSIZE 0.007 0.366 -0.045 -1.197 0.023 0.706 0.041 1.266

LEV -0.006 -0.134 -0.003 -0.046 -0.064 -0.585 0.049 1.208

ROA -0.168 -0.623 0.356 0.865 -0.168 -0.355 -0.164 -0.803

BIG4 -0.008 -0.155 -0.026 -0.287 -0.004 -0.039 0.022 0.246

BDSIZE 0.000 -0.034 -0.020 -0.947 -0.011 -0.409 0.028 1.510

DUM_YR04 -0.001 -0.022

DUM_YR05 -0.041 -0.756

Adjusted R2 0.970 0.108 0.085 0.087

F-Value 5.951*** 3.092*** 2.601*** 2.648***

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. EQORI = measured by accrual quality based on original Dechow and Dichev (2002) model, BIND_DUM_2 = Board independence greater than 33 percent and up to 50 percent, BIND_DUM_3 = Board independence is greater than 50 percent, CEODUAL = CEO duality, FINEXP = Board financial expertise, CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP = Racial composition, LNSIZE = Size, LEV = Leverage, ROA = Return on assets, BIG4 = Audit quality, BDSIZE = Board size.

198

As reported in Table 5.5, the F-value for each year as well as for the pooled data is

statistically significant at the 1 percent level. The adjusted R2 for each of the three years is

10.82 percent, 8.49 percent, 8.72 percent for the year 2003, 2004 and 2005, respectively

and 9.70 percent for the combined three-year period.

It is interesting to note that using dummy variables to divide board independence into

different categories, to some extent, changes the results of the relationship between board

independence and earnings quality. Other individual results do not change significantly

from the earlier model as reported in Table 5.4.

As shown in Table 5.5, no significant coefficients are obtained for board independence for

category 3 (BIND_DUM_3), which is firms having board independence greater than 50

percent, for each year as well as for the pooled data. In contrast, the study finds significant

positive coefficients in respect of board independence for category 2 (BIND_DUM_2),

which is firms having board independence greater than 33 percent and up to 50 percent.

The positive and significant coefficient is found in 2005 as well as for the pooled data. The

estimated coefficient of board independence for category 2 is statistically significant at the

5 percent level in 2005 and for the pooled data.

The regressions are again estimated by excluding the dummy for category 3 and including

the dummy for category 1 (BIND_DUM_1), which is firms having board independence

less than 33 percent. The results report no significant associations with regards to the

proportion of board independence less than 33 percent in any of the regressions. Similar

results are obtained with regards to board independence for category 2 (BIND_DUM_2).

199

To further investigate this issue, the study adds a squared term for board independence

(BIND2) to the basic model in Table 5.4 to test whether the relation between board

independence and earnings quality is non-linear. Results reported in Table 5.6 indicate that

both the estimated coefficient of board independence (BIND) and the square of board

independence (BIND2) are statistically significant at the 5 percent level in 2005 and 1

percent level for the pooled data.44 Other individual results are not significantly different

from the earlier model and all the variables that are significant in Table 5.4 remain

significant. In fact, the adjusted R2 shows a modest increase for each year as well as for the

pooled data compared to the one found in the basic model.

Given the estimated values for the BIND and BIND2 coefficients, the turning point of the

relation between board independence and earnings quality is:

For 2005: Maximisation point = -b2/2b3 = -6.559 / (2*-7.473) = 43.88% ≈ 44%

For pooled data: Maximisation point = -b2/2b3 = -5.247 / (2*-5.975) = 43.91% ≈ 44%

The results suggest that as board independence increases the sample firms report higher

earnings quality, consistent with the agency theory prediction. However, when board

independence reaches beyond 44 percent, a negative association between board

independence and earnings quality emerges. In other words, the results suggest that firms

with board independence greater than 44 percent will begin to report lower earnings

quality. The results generally confirm the earlier results for testing board independence

using the dummies variable, which suggests a non-linear relationship between board

independence and earnings quality.

44 Consistent with Bhagat and Black (2002) and Choi et al. (2007), the study includes a squared term for board independence in the regression model.

200

Table 5.6: Multiple Regression Results – Square of Board Independence

MODEL 3: EQORI = ββββ0 + ββββ1 BIND + ββββ2 BIND2 + ββββ3 CEODUAL + ββββ4 FINEXP + ββββ5 CROSS + ββββ6 TENURE + ββββ7

OUTOWNS + ββββ8 INSIDEOWNS + ββββ9 FAMCONTROL + ββββ10 INSTITUTIONAL + ββββ11 RCOMP + ββββ12 LNSIZE + ββββ13

LEV+ ββββ14 ROA + ββββ15 BIG4 + ββββ16 BDSIZE + ββββ17 DUM_YR04 + ββββ18 DUM_YR05 + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) -2.461 -3.966*** -1.026 -0.846 -2.974 -2.566*** -3.389 -3.498***

BIND 5.247 2.540*** 3.320 0.771 5.657 1.454 6.559 2.041**

BIND2 -5.975 -2.662*** -3.941 -0.830 -6.187 -1.455 -7.473 -2.165**

CEODUAL -0.022 -0.363 0.113 1.333 -0.098 -0.792 -0.074 -0.747

FINEXP 0.231 1.028 0.276 0.718 0.443 1.091 0.088 0.239

CROSS 0.345 3.424*** 0.573 3.118*** 0.436 2.328** 0.016 0.112

TENURE 0.020 3.929*** 0.027 2.990*** 0.018 2.148** 0.011 1.159

INSIDEOWNS -0.002 -1.477 -0.004 -2.011** -0.001 -0.636 0.001 0.486

OUTOWNS 0.024 1.431 0.005 0.191 0.031 0.988 0.015 0.528

FAMCONTROL 0.796 5.867*** 0.835 3.053*** 1.008 4.036*** 0.585 3.422***

INSTITUTIONAL 0.005 1.701* 0.008 1.538 0.005 0.917 0.003 0.414

RCOMP 0.106 0.985 0.163 0.823 0.151 0.796 0.040 0.241

LNSIZE 0.007 0.353 -0.042 -1.076 0.022 0.648 0.039 1.224

LEV -0.017 -0.381 -0.024 -0.369 -0.063 -0.588 0.044 1.219

ROA -0.227 -0.813 0.240 0.549 -0.225 -0.459 -0.235 -0.985

BIG4 -0.005 -0.095 -0.021 -0.224 -0.010 -0.108 0.027 0.300

BDSIZE -0.005 -0.379 -0.028 -1.322 -0.008 -0.315 0.022 1.263

DUM_YR04 -0.003 -0.061

DUM_YR05 -0.043 -0.791

Adjusted R2 0.116 0.116 0.107 0.108

F-Value 7.040*** 3.269*** 3.074*** 3.094***

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. EQORI = measured by accrual quality based on original Dechow and Dichev (2002) model, BIND = Board independence, BIND2 = Square of board independence, CEODUAL = CEO duality, FINEXP = Board financial expertise, CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP = Racial composition, LNSIZE = Size, LEV = Leverage, ROA = Return on assets, BIG4 = Audit quality, BDSIZE = Board size.

201

5.5.2 Position of Chairperson – Non-executive Chairman

Consistent with prior studies such as Xie et al. (2003), Kao and Chen (2004) and Abdul

Rahman and Mohamed Ali (2006), this study does not find any significant association

between CEO duality and earnings quality. Perhaps, the insignificant findings may be due

to the failure of the chairman to challenge the CEO and to be independent from the

management. As proposed by Felton and Wong (2004), the main contributor to the success

of the split-leadership structure is to appoint an appropriate person for the chairman and the

CEO post. It is important for the chairman to be independent from operational roles and

have integrity and leadership ability to effectively monitor the CEO.

Felton and Wong (2004) suggest that an ideal chairman should come from a company’s

current non-executive directors. The best candidate for the chairman post is an independent

director who has served on the board for several years (Coombes and Wong, 2004), has a

good knowledge of the industry (Carrot, 2008) and has the time available to properly

discharge their duties (Condit and Hess, 2003). Nonetheless, it is preferable for a non-

executive chairman not to be the former CEO of the firm to avoid conflict in defining the

role (Conger and Riggio, 2007; Carrott, 2008).

While findings from the study by Haniffa and Cooke (2002) suggest that a non-executive

chairperson in Malaysia obtains greater utility by keeping private information secret, the

relationship between a non-executive chairperson and earnings quality is not known. To

examine whether the presence of a non-executive chairperson improves earnings quality,

this study includes a dummy variable that takes a value of one if the chairman of the board

is a non-executive director; otherwise it takes a value of 0. If the assumption is true, the

coefficient of NEDCHAIR is expected to be positive and significant.

202

Table 5.7: Multiple Regression Results – Non-executive Chairman

MODEL 4: EQORI = ββββ0 + ββββ1 BIND + ββββ2 NEDCHAIR + ββββ3 FINEXP + ββββ4 CROSS + ββββ5 TENURE + ββββ6

OUTOWNS + ββββ7 INSIDEOWNS + ββββ8FAMCONTROL + ββββ9 INSTITUTIONAL + ββββ10 RCOMP + ββββ11

LNSIZE + ββββ12 LEV+ ββββ13 ROA + ββββ14 BIG4 + ββββ15 BDSIZE + ββββ16 DUM_YR04 + ββββ17 DUM_YR05 + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) -1.294 -3.129*** -0.227 -0.297 -1.797 -2.743*** -1.883 -2.692***

BIND -0.621 -1.996** -0.416 -0.734 -0.527 -0.944 -0.911 -1.685*

NEDCHAIR 0.105 1.842* 0.025 0.253 0.163 1.550 0.116 1.207

FINEXP 0.154 0.692 0.220 0.604 0.347 0.863 0.035 0.094

CROSS 0.339 3.314*** 0.563 3.121*** 0.397 2.097** 0.062 0.390

TENURE 0.021 4.037*** 0.027 3.044*** 0.019 2.252** 0.012 1.290

INSIDEOWNS -0.001 -1.197 -0.004 -1.873* -0.001 -0.413 0.001 0.540

OUTOWNS 0.033 1.941** 0.012 0.454 0.041 1.197 0.028 0.987

FAMCONTROL 0.847 5.905*** 0.894 3.188*** 1.055 3.960*** 0.615 3.261***

INSTITUTIONAL 0.006 1.810* 0.008 1.686* 0.005 0.974 0.002 0.388

RCOMP 0.102 0.961 0.160 0.834 0.168 0.870 0.018 0.105

LNSIZE 0.014 0.649 -0.040 -1.024 0.032 0.936 0.048 1.404

LEV -0.024 -0.512 -0.030 -0.493 -0.080 -0.745 0.051 1.216

ROA -0.188 -0.679 0.363 0.894 -0.190 -0.391 -0.199 -0.840

BIG4 -0.005 -0.099 -0.019 -0.206 -0.003 -0.029 0.016 0.174

BDSIZE -0.011 -0.809 -0.031 -1.436 -0.018 -0.696 0.014 0.782

DUM_YR04 0.000 0.005

DUM_YR05 -0.036 -0.653

Adjusted R2 0.096 0.107 0.094 0.067

F-Value 6.196*** 3.196*** 2.908*** 2.314***

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. EQORI = measured by accrual quality based on original Dechow and Dichev (2002) model, BIND = Board independence, NEDCHAIR = Non-executive chairman, FINEXP = Board financial expertise, CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP = Racial composition, LNSIZE = Size, LEV = Leverage, ROA = Return on assets, BIG4 = Audit quality, BDSIZE = Board size.

203

The results presented in Table 5.8 show that the variable non-executive director as a

chairman (NEDCHAIR) is significant at the 10 percent level for the pooled data. The

remainder of the coefficients show similar results to those found in Table 5.4. The F-value

for each year as well as for the pooled data is statistically significant at the 1 percent level.

As predicted, the coefficient for NEDCHAIR is found to be positive and significant. The

results indicate that companies with such a chairman are associated with higher earnings

quality than companies with a chairman who is an executive director. The findings are

consistent with recent recommendations by various policy groups to strengthen board

leadership by appointing an independent chair. For example, a Conference Board

Commission and a Blue Ribbon Commission on the National Association of Corporate

Directors in the US recommended that all boards appoint an independent leader of the

board (Bertsch, 2006). Similarly, the UK Combined Code states that a chairman should be

independent at the time of appointment to ensure the success of a split-leadership structure

(Felton and Wong, 2004).

204

5.5.3 Alternative Measurement for Board Financial Expertise – Dichotomous

Variable

In the basic model, the board financial expertise (FINEXP) is treated as a continuous

variable. Perhaps, the results on board financial expertise may have been better if the

variable is treated as a dichotomous variable. Furthermore, the Bursa Malaysia listing

requirements require that at least one member of the audit committee is a member of the

Malaysian Institute of Accountants. However, the listing requirements stipulate that if they

are not a member of the Malaysian Institute of Accountants, they must have at least three

years working experience and must have passed the examinations specified in Part 1 of the

1st Schedule of the Accountants Act 1967 or must be a member of one of the associations

of accountants as specified in Part 11 of the 1st Schedule of the Accountants Act 1967.45

As shown in the descriptive statistics in Table 5.1, on average, Malaysian firms have

followed the requirement of having at least one member of the board being a member of an

accounting association or body. Therefore, to carry out additional analysis, this study uses

a dummy variable to represent firms with a qualified accountant. Consistent with the prior

study by Abdul Rahman and Mohamed Ali (2006), the variable board financial expertise is

measured using an indicator variable with the value of one if at least one member is a

qualified accountant and 0 otherwise. A dummy variable labelled as FINEXP_DUM is

incorporated into the regression model. If the assumption is true, the coefficient of

FINEXP_DUM is expected to be positive and significant. The results are shown in Table

5.8.

45http://www.bursamalaysia.com/website/bm/rules_and_regulations/listing_requirements/downloads/LRMBSB_Amend_corporate_governance_280108.pdf

205

Table 5.8: Multiple Regression Results – Dummy of Board Financial Expertise

MODEL 5: EQORI = ββββ0 + ββββ1 BIND + ββββ2 CEODUAL + ββββ3 FINEXP_DUM + ββββ4 CROSS + ββββ5 TENURE + ββββ6

OUTOWNS + ββββ7 INSIDEOWNS + ββββ8FAMCONTROL + ββββ9 INSTITUTIONAL + ββββ10 RCOMP + ββββ11

LNSIZE + ββββ12 LEV+ ββββ13 ROA + ββββ14 BIG4 + ββββ15 BDSIZE + ββββ16 DUM_YR04 + ββββ17 DUM_YR05 + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) -1.169 -2.859*** -0.035 -0.048 -1.698 -2.583*** -1.830 -2.626***

BIND -0.590 -1.902* -0.419 -0.751 -0.450 -0.790 -0.868 -1.643

CEODUAL -0.031 -0.491 0.138 1.548 -0.138 -1.152 -0.087 -0.796

FINEXP_DUM 0.002 0.017 -0.219 -1.948** 0.134 0.666 0.098 0.572

CROSS 0.375 3.600*** 0.603 3.208*** 0.452 2.364** 0.082 0.525

TENURE 0.019 3.716*** 0.022 2.642*** 0.018 2.094** 0.013 1.289

INSIDEOWNS -0.002 -1.408 -0.004 -1.984** -0.001 -0.498 0.001 0.408

OUTOWNS 0.035 2.000** 0.011 0.386 0.040 1.198 0.031 1.075

FAMCONTROL 0.793 5.997*** 0.834 3.246*** 0.980 3.983*** 0.585 3.354***

INSTITUTIONAL 0.006 1.714* 0.008 1.597 0.005 0.862 0.002 0.317

RCOMP 0.101 0.941 0.171 0.876 0.146 0.771 0.026 0.152

LNSIZE 0.012 0.577 -0.039 -1.064 0.030 0.896 0.044 1.304

LEV -0.025 -0.541 -0.035 -0.567 -0.077 -0.728 0.052 1.242

ROA -0.155 -0.541 0.413 1.005 -0.149 -0.309 -0.187 -0.773

BIG4 0.001 0.017 -0.020 -0.219 0.010 0.100 0.025 0.274

BDSIZE -0.010 -0.761 -0.024 -1.040 -0.022 -0.839 0.013 0.688

DUM_YR04 0.000 0.004

DUM_YR05 -0.036 -0.652

Adjusted R2 0.091 0.114 0.084 0.064

F-Value 5.859*** 3.378*** 2.683*** 2.248***

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. EQORI = measured by accrual quality based on original Dechow and Dichev (2002) model, BIND = Board independence, CEODUAL = CEO duality, FINEXP_DUM = Board financial expertise (dummy), CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP = Racial composition, LNSIZE = Size, LEV = Leverage, ROA = Return on assets, BIG4 = Audit quality, BDSIZE = Board size.

206

As reported in Table 5.8, the overall results as well as the individual results do not change

significantly from the basic model (Model 1). As for the results regarding the board

financial expertise, treating the board financial expertise variable as a dummy variable does

not influence earnings quality significantly. Specifically, the results show no significant

coefficient with regards to the association between board financial expertise

(FINEXP_DUM) and earnings quality for pooled data as well as for the 2004 and 2005

samples. Although the coefficient of FINEXP_DUM is significant at the 5 percent level in

2003, the coefficient is negative, which differs from the prior prediction of a positive

relationship between board financial expertise and earnings quality. This suggests that at

least one member of the board being a member of an accounting association or body is not

an effective measure to achieve board financial expertise.

5.5.4 Alternative Measurement for Racial Composition – Dichotomous Variable

In the earlier analysis, the racial composition (RCOMP) variable is treated as a continuous

variable. It appears that using the ratio of Bumiputera directors on the board to the total

number of directors to measure racial composition is not significantly associated with

earnings quality. To further investigate this issue, this study explores the possibility of

Bumiputera directors influence on earnings quality when they act as a majority on the

board. The Bumiputera directors may not be effective in performing their monitoring role

when they are a minority compared to when they are the majority46. To test whether racial

composition is a better proxy for a majority representation of Malay directors, this study

uses 51 percent as a cut off point. The variable takes a value of one if 51 percent or more

of Malay directors sit on the board; otherwise it takes a value of 0.

46 Prior literature cited the Malay group as high on collectivism compared to the Chinese group (Haniffa and Cooke, 2002; 2005, Salleh et al., 2006).

207

Table 5.9: Multiple Regression Results – Dummy of Racial Composition

MODEL 6: EQORI = ββββ0 + ββββ1 BIND + ββββ2 CEODUAL + ββββ3 FINEXP + ββββ4 CROSS + ββββ5 TENURE + ββββ6

OUTOWNS + ββββ7 INSIDEOWNS + ββββ8FAMCONTROL + ββββ9 INSTITUTIONAL + ββββ10 RCOMP_DUM + ββββ11

LNSIZE + ββββ12 LEV+ ββββ13 ROA + ββββ14 BIG4 + ββββ15 BDSIZE + ββββ16 DUM_YR04 + ββββ17 DUM_YR05 + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) -1.105 -2.807*** -0.118 -0.160 -1.497 -2.447** -1.726 -2.581***

BIND -0.521 -1.684* -0.357 -0.636 -0.368 -0.648 -0.815 -1.575

CEODUAL -0.035 -0.563 0.114 1.364 -0.133 -1.091 -0.086 -0.794

FINEXP 0.211 0.953 0.219 0.593 0.457 1.139 0.095 0.256

CROSS 0.374 3.609*** 0.580 3.145*** 0.450 2.354** 0.098 0.628

TENURE 0.020 3.907*** 0.026 2.990*** 0.018 2.154** 0.012 1.197

INSIDEOWNS -0.002 -1.505 -0.004 -2.016** -0.001 -0.609 0.001 0.354

OUTOWNS 0.033 1.883* 0.008 0.294 0.041 1.208 0.031 1.074

FAMCONTROL 0.758 5.985*** 0.814 3.243*** 0.942 4.083*** 0.545 3.175***

INSTITUTIONAL 0.006 1.910* 0.008 1.662* 0.006 1.095 0.003 0.424

RCOMP -0.018 -0.338 0.033 0.337 -0.006 -0.070 -0.057 -0.614

LNSIZE 0.007 0.337 -0.044 -1.155 0.022 0.658 0.042 1.278

LEV -0.025 -0.536 -0.027 -0.450 -0.084 -0.759 0.049 1.158

ROA -0.171 -0.618 0.328 0.832 -0.158 -0.322 -0.174 -0.759

BIG4 -0.009 -0.164 -0.033 -0.357 -0.007 -0.072 0.020 0.218

BDSIZE -0.007 -0.506 -0.026 -1.212 -0.014 -0.528 0.017 0.952

DUM_YR04 0.000 0.007

DUM_YR05 -0.036 -0.664

Adjusted R2 0.090 0.107 0.083 0.064

F-Value 5.856*** 3.196*** 2.683*** 2.249***

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. EQORI = measured by accrual quality based on original Dechow and Dichev (2002) model, BIND = Board independence, CEODUAL = CEO duality, FINEXP = Board financial expertise, CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP_DUM = Racial composition (dummy), LNSIZE = Size, LEV = Leverage, ROA = Return on assets, BIG4 = Audit quality, BDSIZE = Board size.

208

The results reported in Table 5.9 indicate that none of the coefficients of racial composition

treated as the dummy variable (RCOMP_DUM) are statistically significant for each year

(2003-2005) as well as for the pooled data for all three years. Other individual results are

not significantly different from those in the earlier models.

From the results presented in Table 5.9, it is shown that three out of four coefficients of

racial composition are negative, and, thus, contradictory with the earlier assumption of

Malay directors influencing earnings quality when they act as a majority on the board.

Nonetheless, the insignificant coefficient is consistent with prior studies by Abdul Rahman

and Mohamed Ali (2006) and Salleh et al. (2006). Abdul Rahman and Mohamed Ali

(2006) argue that the modernisation of Malaysia, as well as the increase in wealth among

the Malays, since the introduction of NEP, has led the Malays to be more individualistic,

just like the Chinese, which may possibly have driven their insignificant findings.

5.5.5 Multiple Regression Results without Controlled Variables

Results reported in all regression models earlier suggest that none of the controlled

variables – firm size (LNSIZE), leverage (LEV), firm growth (ROA), audit quality (BIG4)

and board size (BDSIZE) have any significant impact on earnings quality. Thus, to

determine the stability of the findings, the multiple regression results are re-examined by

leaving out all of the controlled variables from the regression analysis of the basic model.

The results are shown in Table 5.10.

209

Table 5.10: Multiple Regression Results – Without Controlled Variables

MODEL 7: EQORI = ββββ0 + ββββ1 BIND + ββββ2 CEODUAL + ββββ3 FINEXP + ββββ4 CROSS + ββββ5 TENURE + ββββ6

OUTOWNS + ββββ7 INSIDEOWNS + ββββ8FAMCONTROL + ββββ9 INSTITUTIONAL + ββββ10 RCOMP + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) -1.100 -7.150*** -1.260 -4.532*** -1.320 -4.703*** -0.733 -3.133***

BIND -0.565 -1.854* -0.310 -0.562 -0.353 -0.626 -0.963 -1.920*

CEODUAL -0.025 -0.403 0.135 1.557 -0.120 -1.029 -0.085 -0.798

FINEXP 0.237 1.085 0.223 0.632 0.489 1.193 0.069 0.184

CROSS 0.369 4.063*** 0.491 3.082*** 0.457 2.753*** 0.176 1.231

TENURE 0.020 4.354*** 0.025 3.283*** 0.019 2.571*** 0.014 1.506

INSIDEOWNS -0.002 -1.400 -0.004 -1.965** -0.001 -0.490 0.000 0.196

OUTOWNS 0.031 1.846* 0.010 0.363 0.033 1.054 0.036 1.278

FAMCONTROL 0.799 5.851*** 0.852 3.123*** 0.986 3.866*** 0.575 3.252***

INSTITUTIONAL 0.006 1.785* 0.006 1.243 0.006 1.086 0.004 0.596

RCOMP 0.104 0.975 0.148 0.775 0.133 0.679 0.029 0.171

Adjusted R2 0.097 0.112 0.095 0.065

F-Value 9.902*** 4.464*** 3.907*** 2.927***

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. EQORI = measured by accrual quality based on original Dechow and Dichev (2002) model, BIND = Board independence, CEODUAL = CEO duality, FINEXP = Board financial expertise, CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP = Racial composition.

210

As noted in Table 5.10, the overall results without the controlled variables do not change

significantly from the basic model with controlled variables. In fact, the findings suggest

consistent results with regards to direction and significance level for each of the

coefficients of the tested variables. Furthermore, it can be seen that the adjusted R2 and the

F-value for each year (2003-2005), as well as for the pooled data for all three years without

the controlled variables, experienced a modest increase compared to the one with

controlled variables as shown in the basic model (Table 5.4). The findings thus indicate

that the five controlled variables, i.e. firm size, leverage, growth, audit quality and board

size may be excluded in the analysis of earnings quality due to their insignificant role.

5.5.6 Modified Dechow and Dichev (2002) Model as Dependent Variable

Apart from using Dechow and Dichev (2002) accrual quality model as a measure of

earnings quality, another alternative is to use the modified Dechow and Dichev (2002)

accrual quality model proposed by McNichols (2002). The modified Dechow and Dichev

(2002) accrual quality model includes two additional variables, i.e. change in revenue and

property, plant and equipment (PPE), in the original accrual quality model proposed by

Dechow and Dichev (2002). McNichols (2002), in her discussion of the quality of accruals

and earnings, shows that combining the original Dechow and Dichev (2002) model and

Jones (1991) model variables significantly increases the explanatory power of the accrual

quality model.

To test the robustness of the analysis reported earlier, the original Dechow and Dichev

(2002) model is replaced by the modified Dechow and Dichev (2002) accrual quality

model as the dependent variable in the basic model. The results are presented in

Table 5.11.

211

Table 5.11: Multiple Regression Results – Modified Dechow and Dichev Model

MODEL 8: EQMOD = ββββ0 + ββββ1 BIND + ββββ2 CEODUAL + ββββ3 FINEXP + ββββ4 CROSS + ββββ5 TENURE + ββββ6

OUTOWNS + ββββ7 INSIDEOWNS + ββββ8FAMCONTROL + ββββ9 INSTITUTIONAL + ββββ10 RCOMP + ββββ11

LNSIZE + ββββ12 LEV+ ββββ13 ROA + ββββ14 BIG4 + ββββ15 BDSIZE + ββββ16 DUM_YR04 + ββββ17 DUM_YR05 + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) -1.115 -2.857*** -0.221 -0.300 -1.498 -2.432** -1.685 -2.536***

BIND -0.571 -1.788* -0.387 -0.670 -0.435 -0.744 -0.878 -1.619

CEODUAL -0.024 -0.360 0.106 1.207 -0.107 -0.871 -0.067 -0.565

FINEXP 0.211 0.957 0.242 0.655 0.429 1.072 0.096 0.263

CROSS 0.345 3.338*** 0.545 2.993*** 0.405 2.139** 0.082 0.514

TENURE 0.020 3.969*** 0.025 2.972*** 0.018 2.183** 0.013 1.321

INSIDEOWNS -0.001 -1.058 -0.004 -1.802* -0.001 -0.390 0.001 0.660

OUTOWNS 0.029 1.505 0.013 0.480 0.041 1.187 0.014 0.387

FAMCONTROL 0.791 5.658*** 0.841 3.114*** 0.988 3.832*** 0.562 2.966***

INSTITUTIONAL 0.006 1.718* 0.008 1.567 0.005 0.961 0.002 0.314

RCOMP 0.115 1.058 0.167 0.835 0.174 0.913 0.033 0.192

LNSIZE 0.007 0.326 -0.041 -1.065 0.020 0.611 0.041 1.255

LEV -0.002 -0.040 -0.013 -0.224 -0.048 -0.524 0.064 1.399

ROA -0.138 -0.510 0.313 0.769 -0.124 -0.254 -0.154 -0.715

BIG4 -0.007 -0.130 -0.031 -0.326 0.002 0.016 0.020 0.218

BDSIZE -0.012 -0.866 -0.029 -1.291 -0.019 -0.742 0.011 0.610

DUM_YR04 0.002 0.034

DUM_YR05 -0.034 -0.626

Adjusted R2 0.082 0.096 0.072 0.051

F-Value 5.387*** 2.953*** 2.447*** 1.997***

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. EQMOD = measured by accrual quality based on modified Dechow and Dichev (2002) model, BIND = Board independence, CEODUAL = CEO duality, FINEXP = Board financial expertise, CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP = Racial composition, LNSIZE = Size, LEV = Leverage, ROA = Return on assets, BIG4 = Audit quality, BDSIZE = Board size.

212

The F-value for each year, as well as for the pooled data for the multiple regression results

using the modified Dechow and Dichev (2002) model as a dependent variable, is

statistically significant at the 1 percent level. The adjusted R2 for each of the three years is

9.60 percent, 7.29 percent, 5.14 percent for the year 2003, 2004 and 2005, respectively and

8.24 percent for the combined three-year period. The overall results, as depicted in Table

5.11, are consistent with the prior analysis using the original Dechow and Dichev (2002)

accrual quality model, except for the outsider ownership variable, which is now statistically

insignificant. Other individual results are almost a replication of the results in Table 5.4.

Nevertheless, the results suggest that the use of the original Dechow and Dichev (2002)

model as the dependent variable instead of the modified Dechow and Dichev (2002) model

produces better regression results as the former model resulted in a higher reported F-value

and adjusted R2 than the latter model.

5.5.7 Discretionary Component of Accrual Quality Model as Dependent Variable

The original Dechow and Dichev (2002) model does not distinguish between intentional

and unintentional estimation errors and following the modified accrual quality model of

Francis et al. (2005), further analysis distinguishes between accrual quality driven by

economic fundamentals (innate accrual quality) and management choices (discretionary

accrual quality). Prior literature on the relation between accruals and cash flows (see e.g.

Penman and Zhang, 2002; Bernard and Skinner, 1996; Healy and Wahlen, 1999) includes

the uncertainty in a firm’s environment and managerial intervention that surround the

financial reporting process as important factors that need to be considered when evaluating

a firm’s financial reporting quality.

213

Francis et al. (2005) view innate factors as relatively slower to change compared with

discretionary components. They use five innate factors suggested by Dechow and Dichev

(2002) as affecting innate accruals quality including firm size, standard deviation of cash

flow from operations, standard deviation of sales revenue, length of operating cycle and

incidence of negative earnings realization. However, in the case of Malaysia, the length of

the operating cycle variable is not available during the study period. Listed companies in

Malaysia were only required to disclose the length of operating cycle in the annual report

following the adoption of International Financial Reporting Standards (IFRS) in 2006.

Similar to the prior study by Jaggi et al. (2007), this study drops the length of operating

cycle from the regression because of the data unavailability. To distinguish between innate

and discretionary accruals quality, the innate components of accruals quality is regressed

on the annual regressions of accruals quality as follows:

AQj,t = λλλλ0 + λλλλ1 SIZEj,t + λλλλ2j σ(CFOj,t) + λλλλ3 σ (SALESj,t,)+ λλλλ4 NEGEARNj,t + µµµµj,t (5.1)47

The predicted value from each regression yields an estimate of the innate portion of firm j’s

accrual quality in year t,

InnateAQj,t = λλλλ0 + λλλλ1 SIZEj,t + λλλλ2j (CFOj,t) + λλλλ3 σ (SALESj,t,)+ λλλλ4 NEGEARNj,t (5.2)

The residual from equation 5.1 is the estimate of the discretionary component of the firm

j’s accrual quality in year t, DiscAQj,t = µµµµj,t. Similar to the original Dechow and Dichev

(2002) model, larger standard deviation of residuals correspond to poorer accrual quality

and vice versa. To ensure consistency with the earlier models, following DeFond et al.

(2007), the standard deviation score of discretionary accruals is multiplied by -1 so that

higher scores indicate higher earnings quality. The results are presented in Table 5.12.

47 Where, SIZE is the log of total assets; σCFO is the standard deviation of cash flow from operations calculated over the past seven years; σSALES is the standard deviation of sales revenue calculated over the past seven years; and NEGEARN = the number of years, out of the past seven, where firm j reported NIBE<0.

214

Table 5.12: Multiple Regression Results –

Discretionary Component of Accrual Quality Model

MODEL 9: DISCAQ = ββββ0 + ββββ1 BIND + ββββ2 CEODUAL + ββββ3 FINEXP + ββββ4 CROSS + ββββ5 TENURE + ββββ6

OUTOWNS + ββββ7 INSIDEOWNS + ββββ8FAMCONTROL + ββββ9 INSTITUTIONAL + ββββ10 RCOMP + ββββ11

LNSIZE + ββββ12 LEV+ ββββ13 ROA + ββββ14 BIG4 + ββββ15 BDSIZE + ββββ16 DUM_YR04 + ββββ17 DUM_YR05 + εεεε

All 2003 2004 2005

Coefficients t-stat Coefficients t-stat Coefficients t-stat Coefficients t-stat

(Constant) 0.492 0.910 1.193 1.294 0.286 0.318 -0.153 -0.145

BIND -0.862 -1.800* -0.624 -0.739 -0.697 -0.810 -1.236 -1.463

CEODUAL 0.022 0.227 0.209 1.663* -0.081 -0.439 -0.060 -0.318

FINEXP 0.081 0.253 0.119 0.218 0.411 0.731 -0.096 -0.172

CROSS 0.544 3.565*** 0.835 3.180*** 0.632 2.293** 0.153 0.618

TENURE 0.022 3.091*** 0.028 2.229** 0.022 1.818* 0.014 0.956

INSIDEOWNS 0.017 0.576 -0.005 -1.618 0.000 -0.147 0.002 0.653

OUTOWNS -0.001 -0.741 0.003 0.076 0.025 0.492 -0.004 -0.071

FAMCONTROL 1.038 5.140*** 1.084 2.762*** 1.293 3.546*** 0.771 2.678***

INSTITUTIONAL 0.004 0.762 0.008 1.042 0.003 0.345 -0.002 -0.172

RCOMP 0.326 2.027** 0.356 1.215 0.463 1.652* 0.169 0.644

LNSIZE -0.038 -1.300 -0.077 -1.482 -0.037 -0.745 0.007 0.140

LEV 0.053 0.940 0.053 0.657 -0.026 -0.208 0.126 1.459

ROA -0.489 -1.385 -0.471 -0.759 -0.381 -0.622 -0.528 -1.209

BIG4 -0.015 -0.181 -0.048 -0.349 -0.011 -0.074 0.034 0.233

BDSIZE -0.020 -1.147 -0.039 -1.397 -0.029 -0.884 0.006 0.205

DUM_YR04 0.000 -0.005

DUM_YR05 -0.004 -0.050

Adjusted R2 0.059 0.071 0.046 0.023

F-Value 4.085*** 2.415*** 1.895** 1.443

N 831 277 277 277

Notes: The reported t-statistics are white-adjusted values to control for heteroscedasticity. ***Significant at 0.01 level; **Significant at 0.05 level; *Significant at 0.1 level. DISQAQ = measured by discretionary component of accrual quality model, BIND = Board independence, CEODUAL = CEO duality, FINEXP = Board financial expertise, CROSS = Board governance expertise, TENURE = Board firm-specific expertise, INSIDEOWNS = Insider ownership, OUTOWNS = Outsider ownership, FAMCONTROL = Family control on corporate board, INSTITUTIONAL = Institutional ownership, RCOMP = Racial composition, LNSIZE = Size, LEV = Leverage, ROA = Return on assets, BIG4 = Audit quality, BDSIZE = Board size.

215

Table 5.12 depicts the results of the multiple regression analysis with the discretionary

component of accrual quality (DISCAQ) as the dependent variable. The overall results are

consistent with prior analysis using both the original and the modified Dechow and Dichev

(2002) model as the dependent variable. Similar to the earlier findings reported in Tables

5.4 and 5.11, the results using the discretionary component of accrual quality as the

dependent variable show a significant association between board independence (BIND),

board governance expertise (CROSS), board firm-specific expertise (TENURE) and family

controlled on corporate board (FAMCONTROL) and earnings quality. The direction of

coefficients remains the same and the level of significance is almost identical with the

earlier findings.

Perhaps, the most interesting finding, using the discretionary component of accrual quality

as the dependent variable, is the influence of the ethnic composition of directors (RCOMP)

on earnings quality. While none of the earlier analyses reveal any significant findings on

the association between ethnic composition and earnings quality, segregating accrual

quality into innate and discretionary accruals reveals a positive and significant relationship

between a higher proportion of Bumiputera directors on the board and earnings quality in

2004 (ρ < 0.10) as well as for the pooled data (ρ < 0.05). The positive result implies

greater earnings quality when the majority of directors on the board are Malay directors.

The positive and significant result between racial composition and earnings quality

supports the political cost theory argument that suggests greater earnings management

associated with ethnic minority Chinese. As firms controlled by ethnic minorities are more

likely to encounter political costs from reporting high profits, Ball et al. (2003) suggest that

minority ethnic Chinese have political incentives to avoid reporting large profits.

216

5.6 DISCUSSIONS

5.6.1 Board of Directors’ Characteristics and Earnings Quality

5.6.1.1 Board Independence

Contrary to the prediction of the agency theory, this study finds a significant negative

association between board independence (BIND) and quality of reported earnings in all

models reported in the study. The findings of this study suggest that a lower proportion of

independent directors is associated with higher earnings quality, which is contradictory to

the agency theory prediction and most prior findings from the developed markets. This

finding is, however, similar to the earlier paper by Norman et al. (2005) and Hashim and

Susela (2006; 2008b), which found a positive instead of a negative relationship between

board independence and earnings management for Malaysian companies.

Furthermore, the study by Haniffa and Cooke (2005) also reports a significant but contrary

sign between the proportion of independent non-executive directors and the extent of

corporate social disclosure for Malaysian companies. Recent studies by Klein et al. (2005)

and Ibrahim and Abdul Samad (2007) also reveal a significant but contrary sign between

board independence and performance in Canadian and Malaysian samples and suggest that

the agency theory assumptions on the monitoring role of independent directors may not

fully apply to countries with a highly concentrated ownership structure, especially for

family firms. It appears in the study of Klein et al. (2005) that family firms are penalised

for having a board that is independent from the management thereby obviating the need for

a high level of board independence in Canada.

217

The findings of this study warrant further investigation, especially on the composition of

the board of directors, given the evidence that only 41.4 percent of independent non-

executive directors sit on the board with the majority dominated by inside management.

The study by Vethanayagam et al. (2006) reports a mean of 39 percent of independent non-

executive directors comply with the one third listing requirements using 2003 as the

sample. Perhaps, the most important issue addressed by Vethanayagam et al. (2006) is that

the domination of inside directors on boards in Malaysia raises questions regarding the

quality and accountability of independent directors when some independent directors are

not truly independent of management.

In the Malaysian context, Che Ahmad et al. (2003) suggest that in respect of diversification

strategy, the presence of independent directors does not seem to influence the decision

process. This may either be because they do not have contact with the daily operation of

the firm or that they have limited qualifications and are merely appointed based on the

relationship with the CEO of the firm. Similarly, Abdullah (2004) and Abdul Rahman and

Mohamed Ali (2006) argue that the capability of independent directors to fulfil their

monitoring role is jeopardised when the management also dominates and controls the

board.

Moreover, a study by Bhagat and Black (2002) addresses the concern of personal

relationships between outside directors and the CEO, which may affect their independence.

Due to the dominant role played by CEOs in the director selection process, it is argued that

outside directors are incapable of providing independent judgment and raises concern about

the quality of independent directors (Abdullah, 2004). A recent study by Nowak and

McCabe (2007) on the perception of directors about their access to information for their

218

role as directors in Australia reveals that independent directors perceive that the CEO and

executive directors have the controlling power over information, which brings into question

full and free access to information for independence monitoring as well as controlling and

decision making by independent directors.

Haniffa and Cooke (2005), Abdul Rahman and Mohamed Ali (2006) and Vethanayagam et

al. (2006) also argue that Malaysian independent directors lack expertise, skills and

knowledge to understand financial reporting details, which explains their insignificant

findings concerning the relationship between board independence and the accounting issues

they examine. Rather than focusing solely on a majority of independent directors,

Nicholson and Keil (2007) argue that the right combination of director skills is important to

contribute to the performance of the organisation. Perhaps, contributions from

management directors serve more important contributions to manage and monitor the

operations of the organisation due to their direct involvement with day-to-day corporate

activities (Petra, 2005). He argues that the inclusion of outside independent directors who

do not have exposure to day-to-day activities of the firm and have limited involvement with

corporate activities, might hamper the efficient operation of a board of directors.

As discussed in Chapter 3, Coffee (2005) addresses the issues regarding the differences in

the structure of ownership between countries with a dispersed and concentrated ownership

structure, which accounts for differences in corporate scandals implying that governance

reforms adopted in the United State may not be appropriate to countries with a concentrated

ownership system. This is further supported by Barton et al. (2004) who observe that the

requirement for a majority of independent directors seems to be unrealistic for Asian

219

corporations, which have lack of qualified independent directors and are controlled by a

single majority owner.

Corresponding with observations by Barton et al. (2004), and a recent empirical study by

Garg (2007) in the additional analyses, this study documents that having a majority of

independent directors does not have any impact on earnings quality. In fact, the evidence

suggests that the impact of board independence on earnings quality is non-linear.

Specifically, the study found no significant difference in earnings quality with firms having

a board independence of less than 33 percent and greater than 50 percent. The results,

however, strongly suggest a positive and significant relationship between board

independence and earnings quality in firms having a board independence between 33

percent and 50 percent.

The results of the additional analyses raise concern regarding the appropriateness of policy

directives that call for a majority independent directors in countries with a concentrated

ownership structure, especially when it is in the hands of family members (Cheung and

Chan, 2004; Barton et al., 2004; Klein et al., 2005; Ibrahim and Abdul Samad, 2007). In

countries where the alignment of ownership and control is tighter, Klein et al. (2005)

propose a stewardship theory as an alternative theory to the agency approach. The

stewardship theory sees the managers as trustworthy individuals and good stewards of the

resources making independence of directors less of an issue. In the stewardship model, the

role of the board is facilitative rather than monitoring and controlling (Nowak and McCabe,

2003) and suggests that board structures that comprise a majority of inside directors

(Nicholson and Kiel, 2007) may possibly explain the negative coefficient of board

independence found in this study.

220

Another explanation for negative findings found in this study may be due to the

measurement issue of board independence. In this study, the variable board independence

is measured by the proportion of independent non-executive directors to the total number of

directors on the board of the company. As found in this study, most firms in the sample

surpassed one-third threshold (as also noted by Abdullah, 2004). Hence, this leads to

speculation as to whether the one-third requirement actually works and suggested by

Abdullah (2004) although they appear independent they may not be truly independent. This

calls for re-examination of the proxies for independence as suggested by Abdullah (2004),

Klein et al. (2005) and Cho and Kim (2007).

Cho and Kim (2007) document that about 50 percent of Korean listed companies complied

with the requirement of the stock exchange to have at least 25 percent of outside directors

on the board by the second year of its introduction by the Korean Stock Exchange.

However, the use of the ratio of outside directors as a measure for board independence is

meaningless as they found outside directors did not actively attend board of directors’

meetings. Bhagat and Black (2002, p.239) argue that ‘if the shift in board composition

responds to external pressure, then it may be neither efficient nor an endogenous response

to firm characteristics’. Thus, this study suggests that more refined measures such as

participation rate of independent directors in board of directors’ meeting, distinguishing

between ‘independent’ and ‘grey’ directors are required to account for board independence

in the future to enable researchers to resolve this issue.

221

5.6.1.2 CEO Duality

Although separating the roles of the chairman and the CEO seem appropriate, it would not

necessarily lead to independence of the board as the chairman without a commitment is not

likely to put independence to good use (Coombes and Wong, 2004). This study does not

find any significant association between CEO duality (CEODUAL) and earnings quality.

Though the coefficient of CEO duality is negative, which supports the contention of the

separation of roles between the chairman and the CEO, none of the analyses reveal a

significant association concerning the impact of CEO duality on earnings quality,

suggesting that the separation of roles as predicted by the agency theory is not supported in

this study. Felton and Wong (2004) state that experience in the UK suggests that splitting

the roles of chairman and CEO to follow the recommendation of the Cadbury Report is not

workable when chairmen-CEOs give up the CEOs job but stay on as chairman or a

chairman-CEO gives up the chairmanship but continues to serve as CEO. It appears in this

study that more than one third of the chairmen are also an executive director of the

company, which possibly contributes to the insignificant relationship between no role

duality and earnings quality. Furthermore, the data gathered in this study suggests that

some chairmen are former CEOs of the firm (as well as also being the founder of the firm)

and became chairman when their son took over as the new CEO of the firm, raising

concerns about independent management.

Another apparent reason that contributes to the insignificant findings of this study is

attributed to the chairman’s lack of independence and lack of knowledge of company

affairs. For making the split work, it is important for the boards to distinguish between the

roles of the chairman and the CEO – the chairman runs the board while the CEO manages

the company (Felton and Wong, 2004). Nonetheless, in Malaysia, the appointment of

222

chairman is more likely to be the reason of signalling theory. Most Chinese firms appoint a

Bumiputera (Malay) chairperson with the intention to praise the government that

discriminate business opportunities based on ethnic grouping, which favours the

Bumiputera (Mamman, 2003). The Chinese directors choose to work closely with

Bumiputera political patrons to have a close affiliation with the government and to achieve

business success in Malaysia (Gomez and Jomo, 1999). The appointment of an influential

Bumiputera as chairman in Chinese controlled companies who lacks skills and knowledge

of business may contribute to the failure of role separation between the chairman and CEO.

The chairman is not classified as truly independent, thus hindering the effectiveness of role

separation.

As suggested by Coombes and Wong (2004), in order for the separation of roles to be

effective, a dynamic boardroom culture is needed where the chairman must be able to

challenge the CEO without fear of giving offence. An ideal chairman (ideally independent

directors) is one that has enough time to devote to the job, has a good knowledge of the

industry, has served on the board for several years and should not be the current CEO, or

another executive, in order to be more objective of the policies and the strategies of the

company (Coombes and Wong, 2004). In an additional analysis, it appears that the

presence of a non-executive chairman has a positive impact on earnings quality. Carrott

(2008, p.12) states that ‘the creation of the separate role of chairman must be right not just

for the company but for the person’. It is important for the non-executive chairman to have

strong leadership capabilities to encourage the board’s oversight and advisory roles as well

as to gain the respect of both senior management and employees (Condit and Hess, 2003).

This study suggests that a non-executive director as a chairman plays an important role in

enhancing the board’s independence, thus improving earnings quality.

223

5.6.1.3 Board Financial Expertise

This study does not find a significant association between board financial expertise

(FINEXP) and earnings quality in the basic model as well as in the alternative models.

Although the coefficient of board financial expertise is significant in 2003, in the additional

analyses using a dummy variable to measure board financial expertise (FINEXP_DUM),

the coefficient is negative, which differs from prior predictions of a positive relationship

between board financial expertise and earnings quality. Thus, this study concludes that the

requirement that at least one member of the board must be a member of an accounting

association or body does not lead to higher earnings quality.

The findings of this study are not consistent with prior studies such as Bedard et al. (2004),

Park and Shin (2004) and Xie et al. (2003), which find that lower earnings management is

associated with the presence of a financial expert on the board. Nonetheless, the results of

this study are similar to prior studies by Abdul Rahman and Mohamed Ali (2006) for

Malaysian companies. In their study, they assessed the competence of the audit committee

using a dummy variable with an indication of 1 if at least one member is a qualified

accountant. They did not find sufficient evidence regarding audit committee financial

expertise and argue that the establishment of audit committees has yet to achieve its

intended goal in Malaysia. Results reported in the additional analysis of this study also find

an insignificant relationship between board financial expertise and earnings quality using a

dummy variable as a proxy for financial expertise. While this study tries to provide a

broader scope by testing the financial expertise of the entire board and its relationship to

firms’ earnings quality by looking at the proportion of board members who are member’s

of an accounting association to the total number of board members, it appears that the

relationship is not significant as predicted.

224

One plausible explanation for the insignificant finding between board financial expertise

and earnings quality is the significant dominance of non-executive directors and audit

committees that are not financially literate on the board. Furthermore, the descriptive

analysis previously provides evidence of an average of only one to two board members

holding membership of a professional accounting body, irrespective of the size of the firm.

It is argued that directors who do not understand the accounting numbers may not be able

to ask the right questions nor will they understand the answers, which may possibly explain

the insignificant findings of this study.

Another reason why board financial expertise does not improve earnings quality may be

due to the measurement variable. This study only focuses on the board members who are

qualified accountants. Perhaps, each director comes from a different professional category

that could add value to the firm. For example, in a Korean study, Choi et al. (2007) focus

on different professional backgrounds of directors to investigate the effects of director’s

quality on the firm performance. They examine different professional backgrounds of

outside directors such as lawyers, accountants, bankers, politicians, government officials,

academicians as well as executives of affiliated and non-affiliated firms. Their results

show a positive contribution of executives of non-affiliated firms and academicians on firm

performance. As supported by the resource dependency theory, both insiders and outsiders

on boards have important human capital to provide advice and counsel (Hillman and

Dalziel, 2003). Representation from lawyers, financial representatives, top management

from other firms, marketing specialists, former government officers are argued to facilitate

advice and counsel as they bring with them important expertise, experience and skills

(Hillman and Dalziel, 2003). Perhaps, investigation on the different professional

background of directors will provide an interesting avenue for future research.

225

5.6.1.4 Board Governance Expertise

From the analyses conducted in all models, it is found that board governance expertise

(CROSS) proxy by proportion of directors on the board with directorships in other

companies is highly significant at the 1 percent level. The results show positive and

significant results between board governance expertise and earnings quality. The greater

the number of the board’s committee holding additional directorships in other firms (i.e.

interlocking directorates) enhances the quality of financial reporting of the firm as they

gain governance expertise through knowledge they acquire in other firms (Bedard et al.,

2004). The result of this study is consistent with the prior study by Norman et al. (2005)

that reported a positive contribution from directors with multiple directorships in mitigating

earnings management in Malaysia. They suggest that the experience of directors with

multiple directorships is important as a monitoring mechanism in mitigating earnings

management activity.

The finding of this study supports the resource dependency theory that suggests

interlocking directorates provide important channels of communication and conduct

information between the firm and external organisations (Zahra and Pearce, 1989; Hillman

and Dalziel, 2003; Phan et al., 2003). Resource dependence theorists suggest that interlock

directors help the firm interface with both its general as well as its competitive

environments (Zahra and Pearce, 1989). Interlocks help directors to ensure coordination

among firms, reduce transaction costs as well as enhance a firms’ reputation (Zahra and

Pearce, 1989; Phan et al. 2003). Furthermore, Nicholson and Kiel (2007) suggest that the

ability of the board to link with the external environments provide significant resources for

the corporations thus assisting firms to perform well.

226

5.6.1.5 Board Firm-Specific Expertise

Interestingly, this study consistently finds a significant association between the board firm-

specific expertise (TENURE) proxy by the average number of years of board service of

independent non-executive directors and earnings quality in the basic model as well as in

the alternative models. The results show a positive and significant result between firm-

specific expertise and earnings quality. The results provide strong support for the

relationship between firm-specific expertise and financial reporting quality where all

models show a highly significant relation between board tenure and earnings quality.

Experience as a board member in the same company for a longer period of time helps

independent directors gain firm-specific expertise of the company’s operation and its other

executive directors (Bedard et al., 2004). The longer the span of time the independent

directors serve in the firm gives them the ability to effectively monitor the management,

which results in a higher quality of financial reporting.

The positive relationship between board tenure and earnings quality in this study supports

prior findings by Beasley (1996) who found that a decrease in the likelihood of financial

statement fraud is associated with an increase in the number of years of board service as

outside directors. He suggests that the ability of boards to monitor management effectively

is consistent with the increased number of years they serve. Consistent with Beasley

(1996), this study suggests that independent directors in Malaysia develop better firm-

specific expertise when they have served the board for a longer period, thus influencing

their monitoring capability towards the firm’s financial reporting process.

227

5.6.2 Ownership Structure and Earnings Quality

5.6.2.1 Managerial Ownership

The agency theory addresses the role of the ownership structure as a complementary

mechanism to a board’s effectiveness. Unlike the conflict of interest between outside

shareholders and managers in a diffused ownership, such as that commonly found in the

UK and US, the agency problem shifts to conflicts between the controlling owners and

minority shareholders in Asia where an ownership concentration structure is more common

(Claessens and Fan, 2002). The controlling owners, who are often also the managers, gain

effective control of a corporation and have the power to determine how the company is run

and may expropriate the rights of minority shareholders.

In respect of the managerial ownership variable, this study finds interesting findings of the

relationship between insider and outsider ownership with earnings quality. The coefficient

of outside board ownership (OUTOWNS) is consistently positive and significantly

associated with earnings quality as predicted. The finding supports the agency theory

prediction of the incentive alignment effect. As the outside board ownership increases, the

interest of outside directors are more closely aligned with owners of the firms, thus

providing them greater incentive to increase the quality of earnings.

The finding of a positive relationship between outside board ownership and earnings

quality is consistent with those reported by Beasley (1996), Norman et al. (2005) and

Peasnell et al. (2005). Beasley (1996) finds that as outside directors’ ownership increases,

the likelihood of financial statement fraud also decreases. Similarly, Norman et al. (2005)

and Peasnell et al. (2005) report less earnings management practices when the managerial

equity ownership increases, thus supporting the convergence of interest hypothesis by

228

Jensen and Meckling (1976). Furthermore, the study by Bhagat and Black (2002)

documents that independent directors are more effective when they are motivated by

substantial ownership. Since they found that independent directors who hold significant

shares add value to the firm, they suggest that policy makers should insist that independent

directors should own more shares in order to improve firm performance.

While outside board ownership is significant and positively associated with earnings

quality, the role of inside board ownership (INSIDEOWNS) is found to be negatively

associated with earnings quality thereby supporting the entrenchment hypothesis. The

result of this study is not surprising as inside board members in Malaysia hold a very large

equity stake compared to the outside board members. Consistent with Velury and Jenkins

(2006), this study suggests that too much insider ownership is likely to entrench the

managers resulting in a negative relationship between insider ownership and earnings

quality. Furthermore, supporting the entrenchment effect of ownership, the study by

Karamanou and Vafeas (2005) also reports a lower likelihood of a management forecast

and lower forecast precision associated with higher inside ownership.

The findings of this study also extend the recent work by Haniffa and Hudaib (2006),

which reported a negative and significant association between managerial ownership and

accounting performance. Haniffa and Hudaib (2006) suggest that the insider model of

corporate governance is unsuitable in the Malaysian business environment due to the risk

of misallocation of companies’ resources at the expense of other shareholders.

229

5.6.2.2 Family Ownership

Interestingly, in the case of family ownership, this study finds a positive significant

association between the family ownership proxy by the proportion of family members on

the board to the total number of directors (FAMCONTROL) and earnings quality. In all

models, the family control board is found to be highly significant at the 1 percent level.

The findings of this study support Fama and Jensen’s (1983) suggestion that family

relationships provide improved monitoring.

The results are consistent with recent US evidence that indicates that higher earnings

quality is associated with founding family ownership (Wang, 2006). Other studies such as

McConaughy et al. (1998) and Wiwattanakantang (2001) also suggest that family firms

have a performance advantage over non-family firms. Wiwwattanakantang (2001)

documents that family controlled firms in Thailand do not display lower performance

compared to foreign controlled firms and firms with no controlling shareholders,

suggesting that family members provide good monitoring and incentive alignment to the

other stakeholders.

Additionally, the results of this study support the notion that the presence of family

members reduces agency costs as they have greater expertise concerning the firm’s

operations to effectively monitor the firm’s activities. Furthermore, Ibrahim and Abdul

Samad (2007) report that family firms in Malaysia experience lower agency costs

compared to non-family firms by retaining a small number of board members, minimizing

outside directors as well as adopting the role duality in their firms. As discussed earlier, the

World Bank Report (1999) shows that the majority of shares (67.2 percent) in Malaysia are

in family hands and family firms are growing to the second generation, which supports the

230

view that family firms reduce agency costs as they strive to maximize the long-term wealth

of their firms in order to protect their family’s name and reputation. Furthermore, the new

Asian manager is young, versatile and more likely to have been educated abroad, which

brings Western thinking in doing business as well as making them acknowledge the cost

associated with opacity.

As suggested by Bertrand and Schoar (2006, p.76), ‘family ties serve as a second-best

solution in countries with weak legal structures, since trust between family members can be

a substitute for missing governance and contractual enforcement’. As found earlier in this

study, the relationship between board independence and earnings quality is negative. The

findings suggest that the presence of a higher proportion of independent board members

does not lead to higher earnings quality. These findings are perhaps consistent with the

substitution effect proposed by Bertrand and Schoar (2006) on the role of family members.

In family firms, family members are more trusted to run the board making greater

representation from outside directors less of an issue.

5.6.2.3 Institutional Ownership

Consistent with expectations, this study finds a positive significant association between

institutional ownership (INSTITUTIONAL) and earnings quality. The result confirms the

active monitoring hypothesis, which suggests institutional investors are likely to actively

monitor their investments due to the large amount of wealth they invested (Velury and

Jenkins, 2006). Furthermore, the government’s commitment to the establishment of the

MSWG to encourage shareholder activism appears to have a positive effect on the financial

reporting quality in Malaysia.

231

Similar to prior studies by Chung et al. (2002; 2005), Koh (2003) and Velury and Jenkins

(2006), this study provides evidence that concentrated shareholdings, in the hands of

institutional investors, afford greater incentives to closely monitor firms’ activities. Prior

studies by Chung et al. (2002, 2005) suggest that external monitoring by institutional

investors is effective in mitigating earnings management activity. They argue that

institutional investors with substantial shareholdings have the resources and incentives to

monitor and constrain the self-serving behaviour of corporate managers, thus limiting

earnings management behaviour.

The evidence of a significant association between institutional ownership and earnings

quality in this study extends the earlier findings by Velury and Jenkins (2006). The study

by Velury and Jenkins (2006) reports a positive and significant association between

institutional ownership and several attributes of earnings quality (i.e. predictive value

measure, neutrality measure, timeliness measure and representational faithfulness

measure). Using US samples, their study suggests that institutional investors have both the

incentive and power to monitor and encourage a high quality of reported earnings as well

as to discipline managers who report low quality accounting numbers.

The involvement of institutional investors’ not only improves corporate governance

practices but also contributes to the higher financial reporting quality in Malaysia. The

findings of this study could further be supported by long-term oriented institutional

investors. As discussed by Koh (2003), as institutional shareholdings grow, the exit option

becomes more expensive. They invest in firms with the intention of holding their

ownership stake over a long time horizon, and, therefore, have greater incentive to monitor

those firms.

232

5.6.3 Ethnicity and Earnings Quality

Using the original and modified Dechow and Dichev (2002) accrual quality model to

measure earnings quality, this study does not find a significant relationship between boards

dominated by Malay directors (RCOMP) and earnings quality. Nonetheless, interesting

findings were found when the study segregated the accrual quality model into innate and

discretionary accruals. Using the discretionary component of the accrual quality model as

innovated by Francis et al. (2005), this study documents a positive and significant

relationship between RCOMP and earnings quality in 2004 as well as for the pooled data at

the 10 percent level and the 5 percent level.

The positive result implies greater earnings quality when the majority of directors on the

board are Malay directors. The positive and significant result between racial composition

and earnings quality supports the political cost theory that suggests that firms controlled by

ethnic minorities are more likely to encounter political costs from reporting high profits

(Ball et al., 2003). The introduction of NEP, which is viewed by the Chinese investors as a

direct and unfair advancement of Malay interests (Mamman, 2002), has resulted in the

firms controlled by ethnic minority Chinese avoiding the reporting of large profits and

thereby reducing the quality of earnings. Furthermore, Haniffa and Cooke (2002, p.317)

suggest that ‘the governmental focus on culture may solicit a response to secrecy from

those who feel threatened’. They found less voluntary disclosure associated with boards

dominated by Chinese directors. Their recent study on the relationship between culture and

corporate social reporting also documents similar findings and suggests that disclosure

cannot be cultural free and is largely attributed to government policy (Haniffa and Cooke,

2005).

233

Another explanation for a positive significant relationship between a board dominated by

Malay directors and earnings quality in this study can be drawn from the legitimacy theory.

Haniffa and Cooke (2005) suggest that the Malaysian government policy that favours the

Bumiputera by discriminating business opportunity based on ethnic group, influences the

Malay directors to use corporate social disclosure as a reactive legitimating strategy. As

stated by Haniffa and Cooke (2005), Malay dominated boards adopt reactive legitimating

strategy to divert attention from questionable business practices, cronyism, nepotism and

close affiliation with the government as well as to ensure a continued influential voice at

both governmental and institutional levels.

5.7 SUMMARY AND CONCLUSION

In this chapter, the findings of the present study are presented based on various analyses

conducted. A number of additional analyses including examining the non-linearity of

board independence; using different measurements of CEO duality, financial expertise and

racial composition; testing the basic model without the controlled variables as well as

applying the modified Dechow and Dichev (2002) accrual quality model and discretionary

component of accrual quality model (Francis et al., 2005) as dependent variables, are

conducted to test the stability and the robustness of the findings.

The regression analyses consistently show that the effect of board independence on

earnings quality is statistically significant, but in the opposite direction to that predicted by

the agency theory. Nonetheless, the findings are consistent with recent findings in the

Malaysian context such as Haniffa and Cooke (2005) and Ibrahim and Abdul Samad (2007)

who report a significant but opposite direction for the relationship between board

234

independence and the accounting issues they examined. The result of this study suggests

that firms with lower board independence have higher earnings quality.

The effect of role duality shows consistently negative but insignificant findings in all

regression models tested. Though not significant, the finding is consistent with most prior

studies in developed countries (e.g. Xie et al., 2003; Davidson et al., 2005) and developing

countries (e.g. Kao and Chen, 2004; Abdul Rahman and Mohamed Ali; 2006; Che Haat,

2006). As the board is already independent from the management it is suggested that role

duality has no substantial impact on financial reporting quality, especially in Malaysian

corporations where role duality is uncommon. Furthermore, this study further documents

that the presence of non-executive chairman has a positive impact on earnings quality, thus,

supporting the role of an independent chairperson.

The effect of having expert board members on the board leads to higher earnings quality as

showed by all regression models tested in the study. The finding on the influence of having

a board member with governance and firm-specific expertise consistently shows a positive

and significant impact on earnings quality. Surprisingly, the effect of having a board

member with financial expertise on the audit committee does not lead to higher earnings

quality.

With regards to managerial ownership, this study reports conflicting results on the

relationship between insider ownership and outsider ownership with earnings quality.

While inside board ownership shows a consistently negative and significant impact on

earnings quality, outside board ownership is positive and significantly associated with

earnings quality. While the role of outside board ownership supports the incentive

235

alignment effect of ownership suggested by Jensen and Meckling (1976), on the other

hand, the role of insider ownership is consistent with the management entrenchment

perspective that suggests too much ownership by inside directors may cause a moral hazard

and an information asymmetry problem between the insider and outside investors (Morck

et al., 1988).

The effect of family control on the corporate board shows consistently positive and highly

significant results in all regression models tested, supporting Chu and Cheah’s (2006)

study, which suggests that family-controlled firms in Malaysia still maintain a passion for

entrepreneurship. Additionally, the study also consistently reports a positive significant

association between institutional ownership and earnings quality and suggests that

concentrated shareholdings in the hands of institutional investors, exhibit greater incentives

to closely monitor firms’ activities.

Interestingly, in the additional analysis using the discretionary component of accrual

quality as a measure for earnings quality, this study finds a significant and positive

relationship between racial composition and earnings quality. The finding suggests that

higher earnings quality is associated with firms dominated by Malay directors.

Finally, the overall results using the modified Dechow and Dichev (2002) accrual quality

model as well as the discretionary component of the accrual quality model (Francis et al.,

2005) are consistent with the prior analysis using original Dechow and Dichev (2002)

model, thus suggesting the robustness of the analyses in the study. Having presented and

discussed the findings, the next chapter draws the conclusions, implications, limitations as

well as suggestions for future research of the study.

236

CHAPTER 6

SUMMARY AND CONCLUSION

6.1 INTRODUCTION

The purpose of this chapter is to reflect on the findings and discuss the contribution and

limitations of the study as well as suggestions for future research. The final chapter is

organised as follows. Section 6.2 summarises the overall findings of this study. Section 6.3

addresses the potential implications of the study, followed by a discussion on research

limitations in Section 6.4. Section 6.5 offers several possible avenues for further research.

Section 6.6 concludes the chapter with brief conclusions.

6.2 SUMMARY

The deepening of the globalization phenomenon request for a convergence between codes

of governance makes the empirical examination of corporate governance issues from East

Asian countries very important. Although Asian political culture and business systems

vary from Western economies, there is demand from investors worldwide for well-

governed companies and investors are willing to pay a high premium for companies (in

both emerging and developed markets) with good corporate governance (McKinsey and

Company, 2002). Thus, to ensure the flow of foreign capital it is important for East Asian

countries, including Malaysian corporations and government, to continue to ascertain their

options for improved governance systems.

237

This study examines the effect of the board of directors’ characteristics (i.e. board

independence, CEO duality, board financial expertise, board governance expertise, and

board firm-specific expertise) ownership structure (i.e. managerial ownership – inside and

outside board ownership, family ownership, and institutional ownership), ethnicity (i.e.

racial composition) on the reported earnings quality in Malaysia. The motivation behind

this study is the emphasis of the Malaysian government on the positive contribution of

good corporate governance practices on the financial reporting quality of Malaysian

corporations.

There are many proxies to determine earnings quality which are persistence, predictability,

smoothness, discretionary accruals and accrual quality model. To measure earnings quality,

this study employs the accrual quality model developed in Dechow and Dichev (2002) and

modified in McNichols (2002) and Francis et al. (2005) which has recently been considered

as a better proxy for earnings quality (Francis et al., 2004; Doyle et al., 2007; Jaggi et al.,

2007). The model builds on the argument that the beneficial role of accruals is reduced by

estimation errors and takes the view that earnings that map closely into cash are more

desirable. This measure does not rely solely on earnings management or assumptions in

determining the quality of earnings and can capture both biased discretionary accruals and

unintentionally poorly estimated accruals, which will result in lower financial reporting

quality – specifically earnings quality.

To see the impact of the board of director’s characteristics, ownership structure, ethnicity

and earnings quality, a total of 831 non-financial companies listed on Bursa Malaysia’s

Main Board, over the period 2003-2005, with complete data for earnings quality, board of

directors’ characteristics, ownership structure and earnings quality were selected. A

238

quantitative research based on the content analysis approach has been adopted to answer

ten specific hypotheses developed in this study.

From the analyses conducted, it was found that three out of the five characteristics of board

of directors tested in the study are significantly associated with earnings quality. The

results show significant associations between board independence, board governance

expertise, board firm-specific expertise and earnings quality. Neither CEO duality nor

board financial expertise (FINEXP) is found to be significant in this study.

While the agency theory predicts a positive relationship between a higher proportion of

independent board directors on board and financial reporting quality, this study finds a

significant but negative association between board independence and earnings quality. It

suggests that firms with lower board independence have higher earnings quality. Though

contradictory with the agency theory prediction, the findings of this study are consistent

with recent studies by Eng and Mak (2003), Gul and Leung (2004), Haniffa and Cooke

(2005), Norman et al. (2005), Klein et al. (2005) and Hashim and Susela (2008b) that

report a significant but contrary sign between the proportion of independent non-executive

directors and the accounting issues they examined. The findings of this study may be

attributable to the ownership structure of Malaysian corporations, which are concentrated in

the hands of family members, making greater representation from independent directors,

who it is argued lack financial sophistication and expertise, less of an issue. Consequently

this raises concerns of the effectiveness of some requirements such as calls for a majority

of independent directors when there is a scarcity of qualified independent directors and also

given the fact that family controlled firms are dominant in Asian corporations.

239

Although splitting the roles of the chairman and the CEO seem more appropriate, this study

does not find any significant relationship between CEO duality and earnings quality. The

findings also cast doubts on the appropriateness of the MCCG 2000 recommendation for

role separation. As suggested by Coombes and Wong (2004), it is important for companies

to have ideal chairmen to function more effectively. If the board is able to find an ideal

candidate who is independent and has enough time to devote to the job, the separation of

the role between the chairman and the CEO will be more effective. Perhaps, for making

the split work, Malaysian boards should follow the UK Combined Code that requires the

chairman to be independent at the time of appointment.

To focus beyond the directors’ monitoring role, this study applies the resource dependency

theory to explain the link between the board of directors’ expertise and earnings quality.

Generally, this study finds that board expertise is one of the most important determinants of

financial reporting quality in Malaysia. Specifically, this study finds a positive significant

relationship between additional board directorships and the average tenure of independent

directors that captures governance and firm-specific expertise and earnings quality. Larger

additional directorships of board members and longer average tenure of independent

directors enhance the boards monitoring role to produce higher quality financial reporting.

While board governance and firm-specific expertise is found to be significantly related to

earnings quality, this study does not find a significant association between board financial

expertise and earnings quality. Perhaps, insignificant findings of the relationship between

board financial expertise and earnings quality in this study may be due to a measurement

issue. The measure of board financial expertise in this study is based merely on the

director’s qualification as a qualified accountant. A more refined measure is required to

240

account for board financial expertise, such as a director’s working experience in the

accounting field.

The most important findings of this study are related to the role of family ownership and

institutional ownership and its influence over the quality of reported earnings. Though

prior studies such as Bartholomeusz and Tanewski (2006), Choi et al. (2007) and Jaggi et

al. (2007) reveal that family controlled firms are associated with higher agency costs, the

findings of this study reveal that family ownership and institutional ownership plays a

significant role in explaining the quality of reported earnings in Malaysia. Similar to the

findings of Cho and Kim (2007) for a Korean sample as well as Chu and Cheah (2007) for

a Malaysian sample, this study finds a positive contribution from family firms that act as a

substitute for traditional corporate governance mechanisms. The findings suggest that the

presence of a higher proportion of family on the corporate board is likely to enhance the

earnings quality reported by the firms. Additionally, this study finds that an increase in

institutional shareholdings has a positive role in determining the quality of earnings in

Malaysia. It appears that concentrated shareholdings by institutional investors provides an

incentive for diligent monitoring as they have the resources, expertise and stronger

incentive to actively monitor the actions of management and improve the quality of

financial reporting as supported by the active monitoring hypothesis.

With regards to the ownership held by both inside and outside directors, this study

documents modest support for the relationship between managerial ownership and earnings

quality. Nonetheless, the evidence in this study suggests that the impact of inside and

outside board ownership on earnings quality are conflicting. While outsider ownership is

significant and positively associated with earnings quality, which supports the incentive

241

alignment effect, the role of insider ownership is found to be significant and negatively

associated with earnings quality supporting the entrenchment hypothesis.

Though this study does not document any significant relationship between racial

composition and earnings quality using the original and modified Dechow and Dichev

(2002) accrual quality model to measure earnings quality, segregating the accrual quality

model into innate and discretionary accruals reveals a positive and significant impact of

boards dominated by Malay directors on earnings quality. The positive and significant

result between ethnicity and earnings quality in this study supports the political cost theory,

which suggests that firms controlled by ethnic minorities are more likely to encounter

political costs from reporting high profits (Ball et al., 2003). Nonetheless, since the earlier

models do not document any significant relationship between racial composition and

earnings quality, it is possible that other factors such as politically connected firms or

government linked companies could mitigate the relationship between ethnicity and

earnings quality that have not been captured in this study and provide an interesting avenue

for future research.

6.3 IMPLICATIONS OF STUDY

1. Implications for Theory

The findings of this study generally show that both board independence and CEO

duality is not related to earnings quality as predicted by the agency theory. In fact,

the study documents a negative and significant relationship between board

independence and earnings quality that challenges the normative advice of good

242

governance, particularly in relation to a greater representation of independent

directors on the board.

Daily et al. (2003) argue that governance literature stems from a wider range of

theoretical perspectives such as the resource dependency theory, the legalistic

perspective, the institutional theory as well as the stewardship theory and that these

theoretical perspectives are intended to complement the agency theory. As suggested

by Rhoades et al. (2001), it is important for the researcher to study the role of the

board of directors through multiple theoretical approaches. It appears in this study

that the results relating to the role of the board of directors’ independence is more

consistent with the stewardship theory. While the agency theory supports the role of

the board for monitoring and control, the stewardship theory sees the role of

managers as facilitative (Nowak and McCabe, 2003), therefore suggesting board

structures that are dominated by inside directors (Nicholson and Kiel, 2007).

Furthermore, the overall significant impact of board expertise on earnings quality

supports the resource dependency theory, which suggests the role of the board of

directors as a resource provider (Zahra and Pearce, 1989; Hillman and Dalziel, 2003;

Nicholson and Kiel, 2007). Although the agency theory predictions dominate

corporate governance studies, delineating other alternative theories such as the

stewardship theory and the resource dependency theory will be an important step

towards gaining further understanding of the relationship between board effectiveness

and financial reporting quality.

243

2. Implications for Policymakers

To establish the link between a board’s effectiveness and earnings quality the findings

of this study warrant further investigation of the nature of the roles played by

independent non-executive directors, CEOs and chairmen of companies in the

financial reporting process. Since Malaysian independent directors are argued to

have a lack of expertise, skills and knowledge to understand financial reporting

details, it is important for Bursa Malaysia to ensure that all directors fully attend the

Mandatory Accreditation Programme and Continuing Education Programme to

enhance the competency and professionalism of the directors in performing and

thereby enabling them to discharge their duties more effectively. The steps taken by

Bursa Malaysia requiring listed companies to disclose whether their directors have

attended such training in the annual reports for financial year-end of 31 December

2005 onwards may be seen as a step in the right direction.

Additionally, as a family controlled board is found to be associated with higher

earnings quality, the Malaysian policy maker must analyse whether the requirement

for Malaysian firms to have a dispersed ownership structure as well as a board

dominated by outside directors is appropriate for Malaysian corporate governance

settings. The government should consider that family firms in Malaysia have

performed an entrepreneurial role in the development of the Malaysian economy.

Given the fact that family controlled firms are dominant in Asian corporations, the

findings of this study support the call to address the implementation of corporate

governance mechanisms that are most appropriate for the institutional context of a

particular country.

244

3. Implications for Management and Shareholders

The results presented in this study could be useful to management and shareholders

who are concerned with improving financial reporting quality and corporate

governance practices in their firms. It should create awareness for both management

and shareholders of the importance of best corporate governance practices in

enhancing the quality and credibility of their financial reporting quality.

4. Implications to Academic

The findings of this study are useful in establishing a starting point for empirically

exploring the importance of various boards of directors’ characteristics, ownership

structure and ethnicity in Malaysia. The results presented in this study could be

useful to academic researchers studying corporate governance and earnings quality

worldwide. Instead of focusing solely on the role of boards and earnings quality, this

study provides evidence that other factors, such as ownership structure and ethnicity,

also have an influence on the quality of financial reporting and are worth extending to

other markets in the future, especially in emerging markets and transition economies.

245

6.4 LIMITATIONS OF THE STUDY

The above results are however subject to a few limitations. The main limitations of the

study are listed below:

1. The corporate governance data in this study only covers three years period (2003-

2005), and therefore, may not be generalised for other periods such as period prior to

corporate governance reforms or during the crisis. The sample cannot be further

extended to include period prior to corporate governance reforms or during the crisis

partly because of data unavailability for some corporate governance variables as well as

accrual quality variable. Generalising the results to other years should be viewed with

some caution.

2. The companies that were included in the sample were not selected on a random

sampling. Rather, the companies were selected based upon the data availability in

calculating the accrual quality variable. There are strict requirements for the accrual

quality estimation that requires a minimum of seven years complete financial data that

biases the sample toward surviving firm. Sample firms in this study tend to be larger

and more successful than firms that do not meet this data requirement.

3. Prior literature suggests that the effects of corporate governance do differ by ownership

category (Klein et al., 2005). However, this study does not distinguish between

corporate governance employed by different ownership categories as the main objective

of this study is to examine the relationship between corporate governance and earnings

quality for all listed companies on Bursa Malaysia’s Main Board. There are

246

possibilities that the governance structure adopted by each firm depends on the

ownership characteristics of the firm.

6.5 SUGGESTIONS FOR FUTURE RESEARCH

Extension to the current study is possible in the following areas:

1. Abdullah and Mohd Nasir (2004) suggest that an insignificant relationship between

board independence and financial reporting quality may be explained by the

significant role of audit committees in Malaysia. Since the role of overseeing the

financial reporting process has been delegated to the audit committee, he argues that a

larger number of independent non-executive directors do not help to improve earnings

quality as their discussions are more related to the long-term aspects of the company

rather than financial reporting issues. A study on the impact of audit committee

effectiveness on earnings quality is warranted for future research to further enhance

the findings from this study. With respect to board independence, further

investigation is needed to assess the effectiveness of the independent directors’

monitoring role because of unsatisfactory results from this study. Future research

could, perhaps, distinguish between ‘independent’ and ‘grey’ directors in the

Malaysian context, such as Beasley’s (1996) study of US firms, to provide a more

precise measure of board independence and its relationship to financial reporting

quality.

247

2. As the current study used an OLS regression model to examine the relationship

between the board of directors’ characteristics, ownership structure and earnings

quality, future studies may test the link using the two-stages least square (2SLS),

similar to that used by Choi et al. (2007). The use of the 2SLS regression model will

allow researchers to address the endogeneity issue associated with the relationships

examined in this study.

3. Although this study focuses on a specific country study, which is Malaysia, there is a

possibility of replicating the present study in institutional environments having

characteristics similar to that of the present study. For example, features such as

concentrated ownership structure as well as ethnic minority Chinese domination in

businesses also exist in other East Asian countries such as Singapore, Indonesia,

Thailand and Hong Kong. Perhaps, a multi-country study that incorporates a larger

sample of firms from across different countries can provide more powerful tests of the

relationships examined in the study. Additionally, perhaps a longer longitudinal

study may give better benefits in analysing the relationship to provide greater support

of the association between corporate governance and earnings quality.

4. Since this study finds a highly significant relationship between family controlled

firms and earnings quality, future research might investigate the relation between

corporate governance mechanisms and their effect on family controlled and non-

family controlled firms. Furthermore, the correlations among variables, as presented

in Chapter 5, reveal that the family board control variable is correlated with most of

the test variables in this study. A separate test on family controlled and non-family

controlled firms might give a more comprehensive overview of the role of corporate

248

governance in countries with a concentrated ownership structure in the hands of

family members such as East Asian countries.

5. This research is situated in the positivist paradigm, which relies mainly on the

quantitative based research approach. Perhaps future research might follow up this

study using interpretive or critical perspective to delve into issues not clearly

explainable in this thesis. By studying the process variables and investigating what

boards do, this can help us to understand the processes through which the board of

directors affect financial reporting quality.

6. It would be useful for future studies to examine politically connected firms in order to

understand how businesses operate in Malaysia. Johnson and Mitton (2002) report

that firms with political connections had worse stock returns in the early phase of the

Asian financial crisis compared to the non-political firms in Malaysia. It is possible

that politically and non-politically connected firms in Malaysia have a different

impact on the quality of earnings.

7. Finally, future studies could test the relationship examined in this study using

different proxies of earnings quality such as performance-adjusted current

discretionary accruals as suggested by Kothari et al. (2005) as well as the income

increasing and income decreasing earnings management model as suggested by

Burgstahler and Dichev (1998). As researchers do not identify a uniform method to

measure earnings quality, testing the relationship using different proxies of earnings

quality could validate the existing findings of this study.

249

6.6 CONCLUSION

The present study was pursued as an attempt to investigate the roles of the board of

directors, ownership structure and earnings quality for Malaysian public listed companies.

Generally, this study suggests that corporate governance does matter in Malaysia.

However, not all elements of measured governance are important as the study finds no

evidence that board composition (i.e. board independence and CEO duality) is valued as a

governance mechanism. Nevertheless, the study provides strong support for the role of

board expertise (i.e. governance and firm-specific expertise) and ownership structure (i.e.

outside board ownership, family ownership and institutional ownership) in enhancing the

quality of financial reporting quality in Malaysia. Perhaps, this study is the first to report a

significant association between the ethnicity variable and earnings quality that explicates

the distinctive institutional context of Malaysia.

The findings of the study serve as a wake-up call for setting in motion the reform process

for improved management and more accountable boards. While confirming findings of one

prior study, it does raise concerns as to whether the best practice corporate governance

mechanisms, as determined by the Western world, are applicable to the Asian business

environment. As different countries exhibit different governance structures as a result of

different institutional environments, to merely adopt UK and US styles of corporate

governance structures in emerging countries should be revised. The key evidence of the

association between ownership structure and earnings quality in Malaysia suggests the

prominent impact of ownership structure and financial reporting quality.

250

REFERENCES

Abdullah, A. (1992). The influence of ethnic values on managerial practices in Malaysia. Malaysian Management Review. 27 (1). 3-18

Abdullah, S.N. (1999). The role of corporate governance and ownership structure on accounting earnings quality. Unpublished PhD Dissertation. Universiti Utara Malaysia.

Abdullah, S.N. (2004). Board composition, CEO duality and performance among Malaysian listed companies. Corporate Governance. 4 (4). 47-61

Abdullah, S.N. and Mohd Nasir, N. (2004). Accrual management and the independence of the board of directors and audit committees. IIUM Journal of Economics and

Management. 12 (1). 49-80

Abdullah, S.N. (2006a). Board structure and ownership in Malaysia: The case of distressed listed companies. Corporate Governance. 6 (5). 582-594

Abdullah, S.N. (2006b). Directors’ remuneration, firm’s performance and corporate governance in Malaysia among distressed companies. Corporate Governance. 6 (2). 162-174

Abdul Rahman, R. (2006). Effective Corporate Governance, 1st edition. University Publication Centre (UPENA), Universiti Teknologi Mara, Malaysia.

Abdul Rahman, R. and Abu Bakar, A. (2004). Earnings management and Malaysian corporate acquisitions. Malaysian Accounting Review. 3 (1). 29-42.

Abdul Rahman, R. and Mohamed Ali, F.H. (2006). Board, audit committee, culture and earnings management: Malaysian evidence. Managerial Auditing Journal. 21 (7). 783-804

Abdul Rahman, R. and Haniffa, R.M. (2005). The effect of role duality on corporate performance in Malaysia. Corporate Ownership and Control. 2 (2). 40-47

Abdul Wahab, E.A., How, J.C.Y and Verhoeven, P. (2007). Institutional investors, corporate governance and firm performance in Malaysia. 2nd

Journal of Contemporary

Accounting and Economic. Symposium Proceedings. 1-53

251

Agrawal. A. and Knoeber C. R. (1996). Firm performance and mechanisms to control agency problems between managers and shareholders. Journal of Financial and

Quantitative Analysis. 31(3). 377-397.

Aguilera. R.V. (2005). Corporate governance and director responsibility: An institutional comparative perspective. British Journal of Management. 16. 39-53

Ali, A. (1994). The incremental information content of earnings, working capital from operations and cash flows. Journal of Accounting Research. 32(1).61-74

Al-Attar, A. and Hussain, S. (2004). Corporate data and future cash flows. Journal of

Business Finance & Accounting. 31(7) & (8). 861-903

Altamuro, J., Beatty, A.L. and Weber, J. (2005). The effects of accelerated revenue recognition on earnings management and earnings informativeness: Evidence from SEC staff accounting bulletin no.101. The Accounting Review. 80 (1). 373-401

Amernic, J.H. and Robb, S.W.G. (2003).“Quality of earnings” as a framing device and unifying theme in intermediate financial accounting. Issues in Accounting Education. 18 (1). 1-21

Anderson, U., Kadous, K. and Koonce, L. (2004). The role of incentives to manage earnings and quantification in auditors’ evaluations of management-provided information. Auditing: A Journal of Practice and Theory. 23 (1). 11-27

Arya, A., Glover, J.C. and Sunder, S. (2003). Are unmanaged earnings always better for shareholders? Accounting Horizons. Supplement. 111-116

Atkinson, A.A and Salterio, S. (2004). Shaping good conduct. Accountants Today. October. 34-37

Ayres, F.L. (1994). Perceptions of earnings quality: What managers need to know. Management Accounting. March. 27-29

Baber, W.R., Kang, S.H. and Kumar, K.R. (1998). Accounting earnings and executive compensation. Journal of Accounting and Economics. 25. 169-193

252

Bain, A. (2004). Effective oversight by governing bodies. In Corporate governance: An

International Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 230-253

Ball, R., Robin, A. and Wu, J.S. (2003). Incentive versus standards: Properties of accounting income in four East Asian countries. Journal of Accounting and Economics. 36. 235-270

Ball, R. and Shivakumar, L. (2005). Earning quality in UK private firms: Comparative loss recognition timeliness. Journal of Accounting and Economics. 39. 83-128

Balsam, S., Krishnan. J. and Yang, J. S. (2003) Auditor industry specialization and earnings quality. Auditing: A Journal of Practice & Theory. 22 (2).71-97

Barrier, M. (2002).The crisis in governance. Internal Auditor. August. 50-53.

Barth, M.E., Beaver, W.H. and Landsman, W.R. (2001). The relevance of the value relevance literature for financial accounting standard setting: Another view. Journal of

Accounting and Economics. 31. 77-104

Barth, M.E., Cram, D.P. and Nelson, K.K. (2001). Accruals and the prediction of future cash flows. The Accounting Review. 76(1). 27-58

Bartholomeusz, S. and Tanewski, G.A. (2006). The relation between family firms and corporate governance. Journal of Small Business Management. 44(2). 245-267

Barker, R. (2004). Reporting Financial Performance. Accounting Horizons. 18(2). 157-172

Barton, D., Coombes, P. and Wong, S.C.Y. (2004). Asia’s governance challenge. The

McKinsey Quarterly. 2. 55-61.

Bartov, E., Goldberg, S.R. and Kim, M. (2001). The valuation relevance of earnings and cash flows: An international perspective. Journal of International Financial

Management and Accounting. 12 (2). 103-132

Basu, S. (1997). The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics. 24. 3-37

253

Bathala, C.T. and Rao, R.P. (1995). The determinants of board composition: An agency theory perspective. Managerial and Decision Economics. 16(1). 59-69

Baydoun, N. and Willett, R. (1995). Cultural relevance of Western accounting systems to developing countries. ABACUS. 31(1).67-92

Beasley, M.S. (1996). An empirical analysis of the relation between the board of director composition and financial statement fraud. The Accounting Review. 71 (4). 443-465

Beasley, M.S., Carcello, J.V., Hermanson, D.R. and Lapides, P.D. (2000). Fraudulent

financial reporting: Consideration of industry traits and corporate governance mechanisms. Accounting Horizons. 14 (4). 441

Bedard, J., Chtourou, S.M. and Courteau, L. (2004). The effects of audit committee

expertise, independence and activity on aggressive earnings management. Auditing: A

Journal of Practice & Theory. 23 (2). 13-35 Bellovary, J.L., Giacomino, D.E. and Akers, M.D. (2005). Earnings quality: It’s time to

measure and report. The CPA Journal. November. 32-37 Bender, R. (2004). Why do companies use performance-related pay for their executive

directors? Corporate Governance: An International Review. 12 (4). 521-533 Bernard, V. L. and Skinner, D. (1996). What motivates managers’ choice of discretionary

accruals? Journal of Accounting and Economics. 22 (1-3). 313-325 Bernard, V.L. and Stober, T.L. (1989). The nature and amount of information in cash flows

and accruals. The Accounting Review. (4). 624-652

Bernstein, L.A. and Siegel, J.G. (1979). The concept of earnings quality. Financial

Analysts Journal. 72-75

Bertrand, M. and Schoar, A. (2006). The role of family in family firms. Journal of

Economic Perspectives. 20(2). 73-96

Bertsch, K. (2006). Trends for non-executive chairs and lead directors. The Corporate

Board. 27 (161). 5-9

Bhagat, S. and Black, B. (2002). The non-correlation between board independence and long-term performance. Journal of Corporation Law. 27(2). 231-273

Bhattacharyay, B.N. (2004). Strengthening corporate governance in developing countries in Asia: Prospects and problems. In Corporate governance: An International Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 1-12

254

Bidin, A. (2004). Corporate social responsibility and the position of directors’ duties and stakeholders within the corporate governance framework: A legal perspective. In Corporate governance: An International Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 89-113

Bliss, M.A., Muniandy, B. and Majid, A. (2007). CEO duality, audit committee effectiveness and audit risks: A study of the Malaysian market. Managerial Auditing

Journal. 22 (7). 716 - 728

Boonlert-U-Thai, K., Meek, G.K. and Nabar, S. (2006). Earnings attributes and investor-protection: International evidence. The International Journal of Accounting. 41. 327-357

Bowen, R.M., Burgstahler, D. and Daley, L.A. (1986). Evidence on the relationships between earnings and various measures of cash flow. The Accounting Review. 61. 713-725

Bradley, N. (2003). Corporate governance: A risk worth measuring. Selected Issues in

Corporate Governance: Regional and Country Experiences. United Nations Conference on Trade and Development, New York and Geneva. 30-35

Brown, P.R. (1999). Earning management: A subtle (and troublesome) twist to earning quality. Journal of Financial Statement Analysis. 4 (2). 61-63

Burgstahler, D. and Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics. 24. 99-126

Bushman, R.M and Smith, A.J. (2001). Financial accounting information and corporate governance. Journal of Accounting and Economis. 32. 237-333

Cadbury Committee Report (1992). The Financial Aspects of Corporate Governance. Gee and Co. Ltd. London.

Carrott, G.T. (2008). The task of board chairmanship. The Corporate Board. 29 (172). 12-16

CFA Institute. (2005). The Corporate Governance of Listed Companies: A Manual for

Investors. CFA Center for Financial Market Integrity.

255

Chan, H., Faff, R. and Ramsay, A. (2005). Firm size and the information content of annual earnings announcements: Australian evidence. Journal of Business Finance and

Accounting. 32 (1) & (2). 211-253

Charitou, A. and Clubb, C. (1999). Earnings, cash flow and security returns over long return intervals: Analysis and UK evidence. Journal of Business Finance and

Accounting. 26 (3) & (4). 283-312

Charitou, A., Clubb, C. and Andreou, A. (2000). The value relevance of earnings and cash flows: Empirical evidence for Japan. Journal of International Financial Management

and Accounting.11 (1). 1-22

Che Ahmad, A., Ishak, Z. and Abd Manaf, N.A. (2003). Corporate governance, ownership

structure and corporate diversification: Evidence from the Malaysian listed companies. Asian Academy of Management Journal. 8 (2). 67-89

Che Haat, M.H. (2006). The effect of corporate governance on transparency and

performance of Malaysian companies. Unpublished PhD Dissertation. Universiti Teknologi Mara, Malaysia.

Cheng, A. and Yang, S. (2003). The incremental information content of earnings and cash

flows from operations affected by their extremity. Journal of Business Finance and

Accounting. 30 (1) & (2). 73-114 Cheung, S.Y.L. and Chan, B.Y. (2004). Corporate governance in Asia. Asia-Pacific

Development Journal. 11(2). 1-31 Chiou, J.R. and Lin, Y.H (2005). The structure of corporate ownership: A comparison of

China and Taiwan’s security markets. The Journal of American Academy of Business,

Cambridge. 2. 123-127 Cho, D.S. and Kim, J. (2007). Outside directors, ownership structure and firm profitability

in Korea. Corporate Governance: An International Review. 15 (2). 239-250 Choi, J.J, Park, S.W. and Yoo, S.S. (2007). The value of outside directors: Evidence from

corporate governance reform in Korea. Journal of Financial and Quantitative Analysis. 42(4). 941-962

Christensen, T.E., Hoyt, R.E. and Paterson, J.S. (1999). Ex ante incentives for earnings management and the informativeness of earnings. Journal of Business Finance and

Accounting. 26 (7) & (8). 807-832

Chu, E.Y. and Cheah, K.G. (2006). Does ownership structure matter? Evidence from Malaysian equity market. Corporate Ownership and Control. 4(1). 77-90

256

Chua W.F. (1986). Radical developments in accounting thoughts. The Accounting Review. 61(4). 601-632

Chung, R., Firth, M. and Kim, J.B. (2005). Earning management, surplus free cash flow and external monitoring. Journal of Business Research. 58. 766-776

Chung, R., Ho, S. and Kim, J.B. (2004). Ownership structure and the pricing of

discretionary accruals in Japan. Journal of International Accounting, Auditing &

Taxation. 13. 1-20 Claessens, S. and Fan, J.P.H. (2002). Corporate governance in Asia: A survey.

International Review of Finance. 3 (2). 71-103 Claessens, S., Djankov, S. and Lang, L. (2000). The separation of ownership and control in

East Asian corporations. Journal of Financial Economics. 58. 81-112 Cohen, J., Krishnamoorthy, G. and Wright, A. (2004). The corporate governance mosaic

and financial reporting quality. Journal of Accounting Literature. 23. 87-152 Cohen, J.R., Pant, L.W. and Sharp, D.J. (1993). Culture-based ethical conflicts confronting

multinational accounting firms. Accounting Horizons. 7(3). 1-13 Coffee, J.C. Jr. (2005). A theory of corporate scandals: Why the USA and Europe differ.

Oxford Review of Economic Policy. 21(2). 198-211 Combined Code on Corporate Governance. (1999). The combined code on corporate

governance. Financial Reporting Council, London. Condit, M.B. and Hess, E.D. (2003). Is it time for the non-executive chairman? The

Corporate Board. 24 (138). 7-10 Conger, J.A. and Riggio, R.E. (2007). Best practices in boardroom leadership. The

Corporate Board. 28 (162). 16-21 Cooke, T. E., (1989). Voluntary disclosure by Swedish companies. Journal of International

Financial Management and Accounting. 1 (2). 1-25

Coombes, P. and Wong, S.C.Y. (2004). Chairman and CEO – One job or two? The

McKinsey Quarterly. 43-47

Cornelius, P. (2005). Good corporate practices in poor corporate governance systems.

Corporate Governance. 5(3). 12-23 Cornell, B. and Landsman, W.R. (2003). Accounting valuation: Is earnings quality an

issue? Perspectives. 20-28

Coppens, L. and Peek, E. (2005). An analysis of earnings management by European private firms. Journal of International Accounting, Auditing and Taxation.14. 1-17

257

Daily, C.M., Dalton, D.R. and Cannella Jr., A.A. (2003). Corporate governance: Decades of dialogue and data. Academy of Management Review. 28(3). 371-382

Dalton, D.R, Daily, C.M., Johnson, J.L. and Ellstrand, A.E. (1999). Number of directors and financial performance: A meta-analysis. Academy of Management Journal. 42(6). 674-686

Davidson, R., Goodwin-Stewart, J. and Kent, P. (2005). Internal governance structures and

earnings management. Accounting and Finance. 1-27 Davidson III, W.N., Jiraporn, P., Kim, Y.S. and Nemec, C. (2004). Earnings management

following duality-creating successions: Ethnostatistics, impression management and agency theory. Academy of Management Journal. 47 (2). 267-275

Davidson III, W.N., Worrell, D.L. and Nemec, C. (1998).CEO duality, succession-planning

and agency theory: Research agenda. Strategic Management Journal. 19 (9). 905-908 Davis, G.F. (2005). New directions in corporate governance. Annual Review of Sociology.

31. 143-162. Davis-Friday, P.Y., Eng, L.L. and Liu, C.S. (2006). The effects of the Asian crisis,

corporate governance and accounting system on the valuation of book value and earnings. The International Journal of Accounting. 41. 22-40

Dechow, P.M. and Dichev, I.D. (2002). The quality of accruals and earnings: The role of

accrual estimation errors. The Accounting Review. Supplement. 77. 35-59 Dechow, P.M., Kothari, S.P. and Watts, R. L. (1998). The relations between earnings and

cash flows. Journal of Accounting and Economics. 25. 133-168 Dechow, P.M. and Schrand, C.M. (2004). Earnings Quality, 1st edition. United States of

America: The Research Foundation of CFA Institute. Dechow, P.M. and Skinner, D.J. (2000). Earnings management: Reconciling the views of

accounting academics, practitioners and regulators. Accounting Horizons. 14 (2). 235-250

Dechow, P.M., Sloan, R.G. and Sweeney, A.P. (1995). Detecting earnings management.

The Accounting Review. 70 (2). 193-225 Dechow, P.M., Sloan, R.G. and Sweeney, A.P. (1996). Causes and consequences of

earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research. 13(1). 1-36

DeFond, M., Hung, M. and Trezevant, R. (2007) Investor protection and the information

content of annual earnings announcements: International evidence. Journal of

Accounting and Economics. 43. 37-67

258

DeGeorge, F., Patel, J. and Zeckhauser, R. (1999). Earnings management to exceed thresholds. Journal of Business. 72 (1). 1-33

DeMiguel, A., Pindado, J. and DeLaTorre, C. (2005). Ownership structure and

performance: A comparison of different corporate governance systems. Corporate

Ownership and Control. 2(4). 76-85 DeZoort, F.T., Hermanson, D.R., Archambeault, D.S. and Reed, S.A. (2002). Audit

committee effectiveness: A synthesis of the empirical audit committee literature. Journal of Accounting Literature. 21. 38-75

DeZoort, F. T. and Salterio, S.E. (2001). The effects of corporate governance experience

and financial reporting and audit knowledge on audit committee member’s judgment. Auditing: A Journal of Practice & Theory. 20 (2).31-47

DiMaggio, P.J. and Powell, W.W. (1983). The iron cage revisited: Institutional

isomorphism and collective rationality in organizational fields. American Sociological

Review. 48. 147-160 Dosh, C. (2006). Board meeting still a strategic sourcing exception. Business Travel News.

December. 23 Doyle, J.T., Ge, W. and McVay, S. (2007). Accruals quality and internal control over

financial reporting. The Accounting Review. 82(5). 1141-1170 Du, J. and Dai, Y. (2005). Ultimate corporate ownership structures and capital structures:

Evidence from East Asian economies. Corporate Governance. 13(1). 60-71 Economy Planning Unit (2004). Malaysia: 30 years of poverty reduction, growth and

racial harmony. Case Studies. Shanghai Poverty Conference, Scaling Up Poverty Reduction. Retrieved September, 4, 2008, from http://www.epu.jpm.my/New%20Folder/dr%20fadil.pdf

Eisenhardt, K.M. (1989). Agency theory: An assessment and review. Academy of

Management Review. 14(1). 57-74 Elsayed, K. (2007). Does CEO duality really affect corporate performance? Corporate

Governance. 15(6). 1203-1214 Eng, L.L. and Mak, Y.T. (2003). Corporate governance and voluntary disclosure. Journal

of Accounting and Public Policy. 22. 325-345 Erickson, M. and Wang, S.W. (1999). Earnings management by acquiring firms in stock

for stock mergers. Journal of Accounting and Economics. 27. 149-176 Exposure Draft Conceptual Framework for Financial Reporting. (2008). The Objective of

Financial Reporting and Qualitative Characteristics and Constraints of Decision-

Useful Financial Reporting Information. Financial Accounting Standards Board.

259

Fama, E. (1980). Agency problems and theory of the firms. Journal of Political Economy. 88(2). 288-307

Fama, E. and Jensen, M. (1983). Separation of ownership and control. Journal of Law and

Economics. 26 (2). 301-325 Fan, J.P.H. and Wong, T.J. (2002). Corporate ownership structure and the informativeness

of accounting earnings in East Asia. Journal of Accounting and Economics. 33. 401-425

Fan, J.P.H. and Wong, T.J. (2003). Do external auditors perform a corporate governance

role in emerging markets? Evidence from East Asia. Malaysian Accounting Review. 2 (1). 13-45

Felton, R.F. (2004). Splitting chairs: Should CEOs give up the chairman’s role? The

McKinsey Quarterly. 4. 49-57 Felton, R.F. and Wong, S.C.Y. (2004). How to separate the roles of chairman and CEO.

The McKinsey Quarterly. 59-69 Finger, C.A. (1994). The ability of earnings to predict future earnings and cash flow.

Journal of Accounting Research. 32(2). 210-223 Flamholtz, E. (2001). Corporate culture and the bottom line. European Management

Journal. 19 (3). 268-275 Francis, J., LaFond, R., Olsson, P.M. and Schipper, K. (2004). Cost of equity and earnings

attributes. The Accounting Review. 79 (4). 967-1010.

Francis, J., LaFond, R., Olsson, P.M. and Schipper, K. (2005). The market pricing of accrual quality. Journal of Accounting and Economics. 39 (2). 295-327

Friedman, M. (1970). The social responsibility of business is to increase its profits. The

New York Times Magazine. September 13. 32-33. FSRC Report. (2006). Common Findings of Financial Statements Review Committee.

Malaysian Institute of Accountants, Malaysia. Retrieved April, 20, 2008, from http://www.mia.org.my/mia/stoppress/detail.asp?id=356

Garcia Lara, J.M., Garcia Osma, B. and Mora, A. (2005). The effect of earning

management on the asymmetric timeliness of earnings. Journal of Business Finance

and Accounting. 32 (3) & (4). 691-726 Garg, A.K. (2007). Influence of board size and independence on firm performance: A study

of Indian companies. The Journal of Decision Makers. 32(3). 39-60 Garrod, N. and Hadi, M. (1998). Investor response to cash flow information. Journal of

Business Finance and Accounting. 25 (5) & (6). 613-630

260

George, N. (2003). Audit committees: The solution to quality financial reporting? The CPA

Journal. 73 (12). 6-9 Godfrey, J. (2004). Financial reporting and auditing: Corporate governance lessons. In

Corporate governance: An International Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 176-197

Godfrey, J, Hodgson, A. and Holmes, S. (2000). Accounting theory. 4th ed. John Wiley &

Sons Australia, Ltd. Gomez, E.T. and Jomo, K.S. (1999). Malaysia’s political economy: Politics, patronage and

profits. 2nd edition. Cambridge: Cambridge University Press. Goodwin, J. and Seow, J.L. (2002). The influence of corporate governance mechanism on

the quality of financial reporting and auditing: Perceptions of auditors and directors in Singapore. Accounting and Finance. 42. 195-223

Gramling, A.A, Maletta, M.J., Schneider, A. and Church, B.K. (2004) The role of the

internal audit in corporate governance: A synthesis of the extant internal auditing literature and directions for future research. Journal of Accounting Literature. 23. 194-244

Grant, T.C., Depree, C.M. and Grant, G.H. (2000) Earnings management and the abuse of

materiality. Journal of Accountancy. 41-44 Gray, S.J. (1988). Towards a theory of cultural influences on the development of

accounting systems internationally. ABACUS. 24(1). 1-15 Green, J.P. (1999). The impact of the quality of earnings on the valuation relevance of cash

flow disclosures. British Accounting Review. 31. 387-413 Guan, C.K. and Ow-Yong, K. (2004). Financial disclosure in Malaysia: A case study of

commercial bank’s corporate reporting. In Corporate governance: An International

Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 198-229

Guan, L. Pourjalali, H., Sengupta, P. and Teruya, J. (2005). Effect of cultural environment on earnings manipulation: A five Asia-Pacific country analysis. Multinational Business

Review. 13(2). 23-41 Gujarati, D.M. (2003). Basic econometric International Edition. 4th ed. McGraw-Hill, Inc.,

New York. Gul, F.A. (2006). Auditors’ response to political connection and cronyism in Malaysia.

Journal of Accounting Research. 44(5). 931-963 Gul, F.A. and Leung, S. (2004). Board leadership, outside directors’ expertise and

voluntary disclosures. Journal of Accounting and Public Policy. 23. 351-379

261

Gul, F.A., Srinidhi, B. and Tsui, J. (2007). Do female directors enhance corporate board monitoring? Some evidence from earnings quality. Working paper. The Hong Kong Polytechnic University.

Hair,J.F, Black,W.C., Babin, R.E., Anderson, R.E. and Tatham, R.L. (2006). Multivariate

data analysis. 6th ed. Pearson Education, Inc., New Jersey. Halim, R. (2001). My say: Malaysian corporate governance: The solution. The Edge Daily.

July, 2. Retrieved August, 2, 2005, from http://www.theedgedaily.com/cms Hamzah, M.Y.Z., Ahmad Saufi, R. and Wafa, S. A. (2002). Leadership style preferences of

Malaysian managers. Malaysian Management Review. 37 (1). Han, K.C. and Suk, D.Y. (1998). The effect of ownership structure on firm performance:

Additional evidence. Review of Financial Economics. 7(2). 143-155. Haniffa, R.M. and Cooke, T.E. (2002). Culture, corporate governance and disclosure in

Malaysian corporations. ABACUS. 38 (3). 317-349 Haniffa, R.M. and Cooke, T.E. (2005). The impact of culture and governance on corporate

social responsibility. Journal of Accounting and Public Policy. 24. 391-430 Haniffa, R. and Hudaib, M. (2006). Corporate governance structure and performance of

Malaysian listed firms. Journal of Business Finance & Accounting. 33 (7) & (8). 1034-1062

Harris, D. and Helfat, C.E. (1998). CEO duality, succession, capabilities and agency

theory: Commentary and research agenda. Strategic Management Journal. 19 (9). 901-904

Hashim, H.A. and Susela, D. (2008a). Board characteristics, ownership structure and

earnings quality: Malaysian evidence. Research in Accounting in Emerging Economies. 8. 97-123. ISSN: 1479-3563 /doi:10.1016/S1479-3563(08)08004-3

Hashim, H.A. and Susela, D. (2008b). Board independence, CEO duality and accrual

management. Asian Journal of Business and Accounting. 1(1). 27-46. ISSN: 1985-4064

Healy, P. M. (1985). The effect of bonus schemes on accounting decisions. Journal of

Accounting and Economics. 7. 85-107

Healy, P.M. and Wahlen, J.M. (1999). A review of the earnings management literature and

its implications for standard setting. Accounting Horizons. 13 (14). 365-383

Hermanson, D.R. (2003). Does corporate governance really matter? What the research tells us. Internal Auditing. 18 (2). 44-45

262

Higgs Report. (2003). Good practice suggestions from the Higgs Report. Financial Reporting Council, London.

Hillman, A.J and Dalziel, T. (2003). Board of directors and firm performance: Integrating agency and resource dependence perspectives. Academy of Management Review. 28(3). 383-396

Hofstede, G. (1980). Culture’s consequences: International differences in work-related

values. Newbury Park, CA: Sage.

Hofstede, G. (1981). Culture and organization. International Studies of Management and

Organization. X (4). 46-74

Hofstede, G. (1983). National cultures in four dimensions: A research theory of cultural differences among nations. International Studies of Management and Organization. XIII (1-2). 15-41

Holland, D. and Ramsay, A. (2003). Do Australian companies manage earnings to meet simple earnings benchmarks. Accounting and Finance. 43. 41-62

Hope, O.K. (2003a). Disclosure practices, enforcement of accounting standards and analysts’ forecast accuracy: An international study. Journal of Accounting Research. 41 (2). 235-272

Hope, O.K. (2003b). Firm-level disclosures and the relatives roles of culture and legal origin. Journal of International Financial Management and Accounting. 14(3). 218-248

Hopt, K.J. and Leyens, P.C. (2004). Board models in Europe – Recent developments of internal corporate governance structures in Germany, the United Kingdom, France and Italy. ECGI-Law Working Paper No.18/2004. Retrieved Sept 3, 2008, from

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=487944&rec=1&srcabs=663504

Hossain, M., Perera, M.H.B. and Rahman, A.R. (1995). Voluntary disclosure in the annual

reports of New Zealand companies. Journal of International Financial Management

and Accounting. 6(1). 69-87 Hossain, M., Tan, L.M. and Adams, M. (1994). Voluntary disclosures in an emerging

capital market: some empirical evidence from companies listed on the Kuala Lumpur Stock Exchange. The International Journal of Accounting. 29. 334-351

263

Ibrahim, H. and Abdul Samad, F. (2007). Agency costs, corporate governance mechanisms and performance of public listed family firms in Malaysia. 7th International Business

Research Conference. University Technology Sydney, Australia, 3-6 December. Symposium Proceedings. 1-17

International Federation of Accountants. (2003). Rebuilding public confidence in financial

reporting: An international perspective. New York, USA.

Jackson, S.B. and Pitman, M.K. (2001). Auditors and earnings management. CPA Journal. 71 (7). 39-44

Jaggi, B. and Leung, S. (2007). Impact of family dominance on monitoring of earnings management by audit committee: Evidence from Hong Kong. Journal of International

Accounting, Auditing and Taxation. 16. 27-50

Jaggi, B., Leung, S. and Gul, F.A. (2007). Board independence and earnings management in Hong Kong firms: Some evidence on the role of family ownership and family board control. Working paper. Department of Accounting and Information System, Rutgers University.

Jensen, M.C. (1986). Agency costs of free cash flow, corporate governance and takeovers. American Economic Review. 76(2). 323-329

Jensen, M.C. (1993). The modern industrial revolution, exit and failure of internal control system. The Journal of Finance. 48. 831-880

Jensen, M.C. and Meckling, W.H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics. 3(40). 305-360

John, K. and Senbet, L.W. (1998). Corporate governance and board effectiveness. Journal

of Banking & Finance. 22. 371-403

Johnson, S. and Mitton, T. (2003). Cronyism and capital controls: Evidence from Malaysia. Journal of Financial Economics. 67. 351-382

Jones, J.J. (1991). Earnings management during import relief investigations. Journal of

Accounting Research. 29 (2). 193-228

264

Jong, A.D., Dejong, D.V., Roosenboom, P. and Mertens, G. (2005). Royal Ahold: A failure of corporate governance. ECGI-Finance Working Paper No. 67/2005. Retrieved Sept 3, 2008, from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=663504

Jordan, C. (1999). Corporate governance in Asia and the Asian financial crisis: Evidence

of the impact and current trends. Remarks delivered at the conference on ‘Corporate Governance in Asia: A comparative Perspective’, Seoul. March 3-5.

Jung, K. and Kwon, S.Y. (2002). Ownership structure and earnings informativeness: Evidence from Korea. The International Journal of Accounting. 37. 301-325

Kang, E. (2008). Director interlocks and spillover effects of reputational penalties from financial reporting fraud. Academy of Management Journal. 51(3). 537-555

Kao, L. and Chen, A. (2004). The effects of board characteristics on earnings management.

Corporate Ownership & Control. 1 (3). 96-107 Klapper, L.F. and Love, I. (2004). Corporate governance, investor protection and

performance in emerging markets. Journal of Corporate Finance. 10. 703-728 Klein, A. (2002). Audit committee, board of director characteristics and earnings

management. Journal of Accounting and Economics. 33. 375-400 Klein, P., Shapiro, D and Young, J. (2005). Corporate governance, family ownership and

firm value: the Canadian evidence. Corporate Governance: An International Review. 13(6). 769-784

Karamanou, I. and Vafeas, N. (2005). The association between corporate boards, audit

committees and management earnings forecast: An empirical analysis. Journal of

Accounting Research. 43(3). 453-486 Koh, P.S. (2003). On the association between institutional ownership and aggressive

corporate earnings management in Australia. The British Accounting Review. 35(2). 105-128

Kormendi, R. and Lipe, R.C. (1987). Earnings innovations, earnings persistence and stock

returns. Journal of Business. 60 (3). 323-345 Kothari, S.P., Leone, A. J. and Wasley, C E. (2005). Performance matched discretionary

accrual measures. Journal of Accounting and Economics. 39. 163-197 Kuppusamy, K. (2004). Understanding risk indicators for audit committee effectiveness. In

Corporate governance: An International Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 140-153

265

Ku Ismail, K.I. and Abdullah, S.N. (1999). Earnings quality and accounting conservatism: A survey on Malaysian financial analysts. Malaysian Management Review. 34(2).

La Porta, R., Lopez De Silanes, F. and Shleifer, A. (1999). Corporate ownership around the

world. The Journal of Finance. 54 (2). 471-517 Lashgari, M. (2004). Corporate governance: Theory and practice. The Journal of American

Academy of Business, Cambridge. 46-51 Lee, P. (2003). The need for and value of good governance: An institutional investors’

view. Selected Issues in Corporate Governance: Regional and Country Experiences.

United Nations Conference on Trade and Development, New York and Geneva. 11-20

Leng, A.C.A. (2004). The impact of corporate governance practices on firms financial performance: Evidence from Malaysian companies. ASEAN Economic Bulletin. 21(3). 308-318

Leuz, C., Nanda., D. and Wysocki, P.D. (2003). Earnings management and investor

protection: An international comparison. Journal of Financial Economics. 69. 505-527 Lev, B. (1989). On the usefulness of earnings and earnings research: Lesson and directions

from two decades of empirical research. Journal of Accounting Research. 27. Supplement. 153-192

Lev, B. (2003). Corporate earnings: Facts and fictions. Journal of Economic Perspectives.

17(2). 27-50 Lev, B. and Zarowin, P. (1999). The boudaries of financial reporting and how to extend

them. Journal of Accounting Research. 37(2). 353-385 Levitt, A. (1998). The numbers game. Remarks delivered at the NYU centre for Law and

Business, New York. September 28. Li, J. (1994). Ownership structure and board composition: A multi-country test of agency

theory predictions. Managerial and Decision Economics. 15. 359-368 Liew, P.K. (2007). Corporate governance reforms in Malaysia: The key leading players’

perspectives. Corporate Governance. 15(5). 724-740. Lim, L.Y. (1998). Cultural attributes of Malays and Malaysian Chinese: Implications for

research and practice. Malaysian Management Review. 33 (2). Lin, J.W., Li, J.F. and Yang, J.S. (2006). The effect of audit committee performance and

earnings quality. Managerial Auditing Journal. 21(9). 921-933 Lin, Y.F. (2005). Corporate governance, leadership structure and CEO compensation:

Evidence from Taiwan. Corporate Governance. 13(6). 824-835

266

Lipe, R.C. (1986). The information contained in the components of earnings. Journal of

Accounting Research. Supplement. 24. 37-64 Lipe, R.C. (1990). The relation between stock return and accounting earnings given

alternative information. The Accounting Review. 65 (1). 49-71 Lo. K. (2007). Earnings management and earnings quality. Journal of Accounting and

Economic. Doi.10.1016/j.jacceco.2007.08.002 Long, T. Dulewicz, V. and Gay, K. (2005). The role of the non-executive director: Findings

of an empirical investigation into the differences between listed and unlisted UK boards. Corporate Governance. 13(5). 667-679

Louis, H. (2004). Earnings management and the market performance of acquiring firms.

Journal of Financial Economics. 74. 121-148 Louis, H. and Robinson, D. (2005). Do managers credibly use accruals to signal private

information? Evidence from the pricing of discretionary accruals around the stock split. Journal of Accounting and Economics. 39. 361-380

Malaysian Code on Corporate Governance (2000). Finance Committee on Corporate

Governance, Securities Commission, Kuala Lumpur. Malaysian Institute of Corporate Governance website. Retrieved July 26, 2005, from

http://www.micg.net/

Mak, Y.T. and Kusnadi, Y. (2004). Size really matters: Further evidence on the negative relationship between board size and firm value. Pacific-Basin Finance Journal. 1-18

Mak, Y.T. and Li, Y. (2001). Determinants of corporate ownership and board structure: Evidence from Singapore. Journal of Corporate Finance. 7(3). 235-256

Makar, S.D., Alam, P. and Pearson, M.A. (2000). Earnings management: When does

juggling the numbers become fraud? The White Paper. 14 (1). Mallette, P. and Fowler, K.L. (1992). Effects of board composition and stock ownership on

the adoption of “poison pills’. Academy of Malanagement Journal. 35(5). 1010-1035 Mallin, C. (2003). The relationship between corporate governance, transparency and

financial disclosure. Selected Issues in Corporate Governance: Regional and Country

Experiences. United Nations Conference on Trade and Development, New York and Geneva. 1-10

Mamman, A. (2002). Managerial views on government intervention in Malaysia: The

relevance of ethnic and employment backgrounds. Asia Pacific Business Review. 9 (1). 1-20

267

Mansor, N. and Kennedy, J. (2000). Malaysian culture and the leadership of organizations: A globe study. Malaysian Management Review. 35 (2).

Marquardt, C.A. and Wiedman, C.I. (2004). The effect of earnings management on the value relevance of accounting information. Journal of Business Finance and

Accounting. 31 (3) & (4). 297-332

Mat Zain, M. and Subramaniam, N. (2004). Audit committees, internal audit quality and external auditors’ reliance on internal audit work: A Malaysian study. In Corporate

governance: An International Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 114-139

McCabe, M. and Nowak, M. (2008). The independent director on the board of company directors. Managerial Auditing Journal. 23 (6). 545-566

McConaughy, D.L., Walker, M.C., Henderson Jr., G.V. and Mishra, C.S. (1998). Founding family controlled firms: Efficiency and value. Review of Financial Economics. 7 (1). 1-19

McKinsey & Company. (2002). Global investor opinion survey: Key findings. McKinsey & Company, London.

McNichols, M.F. (2000). Research design issues in earnings management studies. Journal

of Accounting and Public Policy. 19. 313-345

McNichols, M.F. (2002). Discussion of the quality of accruals and earnings: The role of

accruals estimation errors. The Accounting Review. Supplement. 77. 61-69 Mir, A.E. and Seboui, S. (2006). Corporate governance and earnings management and the

relationship between economic value added and created shareholder value. Journal of

Asset Management. 7 (3/4). 242-254 Mitra, S. and Cready, W.M. (2005). Institutional stock ownership, accrual management and

information environment. Journal of Accounting, Auditing and Finance. 20(3). 257-286 Mitton, T (2002). A cross-firm analysis of the impact of corporate governance on the East

Asian financial crisis. Journal of Financial Economics. 64. 215-241 Mohd Amin, I. and Ramoo, N. (2001). The Malaysian Accounting Standards Board

(MASB): Keepers of Malaysian Accounting Standards. Akauntan Nasional. May. 32-34 Mohd Ghazali, N.A. (2007). Ownership structure and corporate social responsibility

disclosure: Some Malaysian evidence. Corporate Governance. 7 (3). 251-266

268

Mohd Ghazali, N. A. and Weetman, P. (2006). Perpetuating traditional influence: Voluntary disclosure in Malaysia following the economic crisis. Journal of

International Accounting, Auditing and Taxation. 15. 226-248 Mohd Iskandar, T. and Wan Abdullah, W.Z. (2004). Audit committee and the selection of

external auditors: The Malaysian evidence. Malaysian Accounting Review. 3(1). 123-136

Morck, R., Shleifer, A. and Vishny, R. (1988). Management ownership and market

valuation: An empirical analysis. Journal of Financial Economics. 20. 293-316 Morris, R.D. (1987). Signalling, accounting theory and accounting policy choice.

Accounting and Business Research. 18 (69). 47-56 Muller, K. (2003). Corporate governance and globalization: The role and responsibilities of

investors. Selected Issues in Corporate Governance: Regional and Country

Experiences. United Nations Conference on Trade and Development, New York and Geneva. 21-29

Nam, S.W and Nam, I.C. (2004). Corporate governance in Asia: Recent evidence from

Indonesia, Republic of Korea, Malaysia and Thailand. Asian Development Bank

Institute. 1-211 Nicholson, G.J and Kiel, G.C. (2007). Can directors impact performance? A case-based test

of three theories of corporate governance. Corporate Governance. 15(4). 585-608 Ng, K.C. (1998). Models of corporate governance and transparency. Paper presented at the

seminar ‘Global Lessons in Banking Crisis Resolution in East Asia’, Singapore. May 12-13.

Ng, C.Y.M. (2005). An empirical study on the relationship between ownership and

performance in a family-based corporate environment. Journal of Accounting, Auditing

and Finance. 121-146 Norman, M.S., Takiah, M.I. and Mohid, R. (2005). Earnings management and board

characteristics: Evidence from Malaysia. Jurnal Pengurusan. 24. 77-103 Nowak, M.J. and McCabe, M. (2003). Information costs and the role of the independent

corporate directors. Corporate Governance. 11(4). 300-307 Organisation for Economic Co-operation and Development (OECD). (2004). OECD

principles of corporate governance. 1-66. Retrieved April, 15 2007, from http://www.oecd.org/dataoecd/32/18/31557724.pdf

O’Sullivan, N. (2000). The impact of board composition and ownership on audit quality:

Evidence from large UK companies. British Accounting Review. 32. 397-414 Ow-Yong, K. and Guan, C.K. (2000). Corporate governance codes: A comparison between

Malaysia and the UK. Conference Papers. 8 (2). 125-132

269

Park, M.S. and Park, T. (2004). Insider sales and earning management. Journal of

Accounting and Public Policy. 23. 381-411 Park, Y.W. and Shin, H.H. (2004). Board composition and earnings management in

Canada. Journal of Corporate Finance. 10. 431-457 Paul Raj, A. (2005). Accountants, auditors under spotlight. Business Times. August 19. 4 Peasnell, K.V., Pope, P.F. and Young, S. (1998). A new model board. Accountancy. 122

(1259). 91 Peasnell, K.V., Pope, P.F. and Young, S. (1999). Who are they? Accountancy. 123 (1267).

106 Peasnell, K.V., Pope, P.F. and Young, S. (2000). Accrual management to meet earnings

targets: UK evidence pre and post Cadbury. British Accounting Review. 32. 415-445 Peasnell, K.V., Pope, P.F. and Young, S. (2003). Managerial equity ownership and the

demand for outside directors. European Financial Management. 9 (2). 231-250 Peasnell, K.V., Pope, P.F. and Young, S. (2005). Board monitoring and earnings

management: Do outside directors influence abnormal accruals? Journal of Business

Finance & Accounting. 32 (7) & (8). 1311-1346 Penman, S.H. and Zhang, X. (2002). Accounting conservatism, the quality of earnings and

stock returns. The Accounting Review. 77(2). 237-264 Pergola, T.M. (2005). Management entrenchment: Can it negate the effectiveness of

recently legislated governance reform? The Journal of American Academy of Business

Cambridge. 6 (2). 177-183 Pergola, T.M., Joseph, G.W. and Jenzarli, A. (2006). Effects of corporate governance and

board equity ownership on earnings quality. Working Paper Series. Retrieved November 30, 2006, from: http://SSRN_ID927110_code665872.pdf

Petra, S.T. (2005). Do outside independent directors strengthen corporate board? Corporate

Governance. 5 (1). 55-64 Phan, P.H., Lee, S.H. and Lau, S.C (2003). The performance impact of interlocking

directorates: The case of Singapore. Journal of Managerial Issues. 15(3). 338-352 Phan, P.H. and Yoshikawa, T. (2000). Agency theory and Japanese corporate governance.

Asia Pacific Journal of Management. 17(1). 1-27 Pomerleano, M. (1998). Corporate finance lessons from the East Asian crisis. Public Policy

for the Private Sectoc.The World Bank Group, Washington. Note No.155. 1-8

270

Pourjalali, H., Mohd Iskandar, T. and Aman, A. (2002). Earnings management: Background, criticism and answers. Malaysian Accounting Review. 1 (1). 37-50

Rachagan, S. (2004). How to meet shareholder and regulatory demand through good

governance: The new imperative. In Corporate governance: An International

Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 13-48 Ramasamy, S. (2004). My say: Malaysia’s corporate governance challenge. The Edge

Daily. July 13. Retrieved May 8, 2005, from http://www.theedgedaily.com/cms Ravendran, A. (2005). A new era in internal audit. Accountants Today. May. 8-10 Razman, S.R. and Mohd Iskandar, T. (2004). The effectiveness of the audit committee in

monitoring the quality of corporate reporting. In Corporate governance: An

International Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 154-175

Reilly, S. (2003). Competency and training. Selected Issues in Corporate Governance:

Regional and Country Experiences. United Nations Conference on Trade and Development, New York and Geneva. 36-38

Renton, T. (2003). Training of directors. Selected Issues in Corporate Governance:

Regional and Country Experiences. United Nations Conference on Trade and Development, New York and Geneva. 39-47

Report on Corporate Governance. (1999). Finance Committee on Corporate Governance. Securities Commission, Kuala Lumpur.

Revised Malaysian Code on Corporate Governance (2007). Available online at http://www.micg.net/brochure/cg2007.pdf

Rhoades, D.L, Rechner, P.L. and Sundaramurthy, C. (2001). A meta-analysis of board leadership structure and financial performance: Are “two heads better than one”? Corporate Governance: An International Review. 9 (4). 311-319

Richardson, S. (2003). Earnings quality and short sellers. Accounting Horizon. Supplement.

49-61 Roosenboom, P., Goot, T. and Mertens, G. (2003). Earnings management and initial public

offerings: Evidence from Netherlands. The International Journal of Accounting. 38. 243-266

Salleh, Z., Stewart, J. and Manson, S. The impact of board composition and ethnicity on audit quality: Evidence from Malaysian companies. Malaysian Accounting Review. 5(2). 61-83

271

Saudagaran, S.M. (2003). The accounting world post-Enron, Tyco, Vivendi, Worldcom, Xerox…: Reflections on being part of the solution. Malaysian Accounting Review. 2(1). 2-12.

Saudagaran, S.M. and Diga, J.G. (1998). Accounting harmonization in ASEAN: Benefits,

models and policy issues. Journal of International Accounting, Auditing and Taxation.

7 (1). Saudagaran, S.M. and Diga, J.G. (2000). The Institutional Environment of Financial

Reporting Regulation in ASEAN. The International Journal of Accounting. 35 (1). 1-26 Schipper, K. (1989). Commentary on earnings management. Accounting Horizons. 91-102 Schipper, K. and Vincent, L. (2003). Earnings quality. Accounting Horizons. Supplement.

97-110 Scott, W.R. (1987). The adolescence of institutional theory. Administrative Science

Quarterly. 32. 493-511 Scott, W.R. (1995). Institutions and organizations. Thousands Oaks, CA: Sage. Scott, W.R. (2004) Chapter prepared for Great Minds in Management: The Process of

Theory Development, Ken G. Smith and Michael A. Hitt, eds. Oxford UK: Oxford University Press. Retrieved May 10, 2008, from http://www.si.umich.edu/ICOS/Institutional%20Theory%20Oxford04.pdf,

Selarka, E. (2005). Ownership concentration and firm value: A study from the Indian

corporate sector. Emerging Markets Finance and Trade. 41 (6). 83-108 Shanmugan, B. and Nair, M. (2004). The question of ethic within corporate governance. In

Corporate governance: An International Perspective. Malaysia: Malaysian Institute of Corporate Governance Publication. 49-88

Shaw, K.W. (2003). Corporate disclosure quality, earnings smoothing and earnings’

timeliness. Journal of Business Research. 1043-1050 Shen, C.H. and Chic, H.L. (2005). Investor protection, prospect theory, and earning

management: An international comparison of the banking industry. Journal of Banking

and Finance. 1-23 Shleifer, A. and Vishny, R.W. (1997). A survey of corporate governance. The Journal of

Finance. 52. 737-783 Siegel, J.G. (1982). The quality of earnings concept – A survey. Financial Analysts

Journal. 60-68 Spagnolo, G. (2005). Managerial incentives and collusive behavior. European Economic

Review. 49. 1501-1523

272

Starovic, D. (2004). Performance reporting to boards. Accountants Today. April. 16-17 Stunda, R.A. and Typpo, E. (2004). The relevance of earnings and funds flow from

operations in the presence of transitory earnings. Journal of Real Estate Portfolio

Management. 10 (1). 37-45 Sulaiman, M. and Willett, R. (2003). Using the Hofstede-Gray framework to argue

normatively for an extension of Islamic corporate reports. Malaysian Accounting

Review. 2(1). 81-105 Suchman, M.C. (1995). Managing legitimacy: Strategic and institutional approaches.

Academy of Management Review. 20 (3). 571-610 Susela, S.D. (2003). Corporate governance as an evolutionary process: A Malaysian

perspective. Selected Issues in Corporate Governance: Regional and Country

Experiences. United Nations Conference on Trade and Development, New York and Geneva. 53-59

Tam, O.K. and Tan, M.G. (2007). Ownership, governance and firm performance in

Malaysia. Corporate Governance. 15(1). 208-222 Teets, W.R. (2002). Quality of earnings: An introduction to the issues in accounting

education special issue. Issues in Accounting Education. 17 (4). 355-360 The Green Book. (2006). Enhancing board effectiveness. Putrajaya Committee on GLC

High Performance, Malaysia. The World Bank Report. (2005). Report on the Observance of Standards and Codes

(ROSC) – Corporate Governance Country Assessment Malaysia. June. 1-38. Retrieved April 15, 2007, from http://www.worldbank.org/ifa/rosc_cg.html

Thillainanthan, R. (1999). Corporate governance and restructuring in Malaysia – A review

of markets, mechanisms, agents and the legal infrastructure. Paper prepared for the joint World Bank and OECD Survey of Corporate Governance. Retrieved April 10, 2007, from http://www.oecd.org/dataoecd/7/24/1931380.pdf

Thompson, P. (2003). Time to disclose what directors reap. Akauntan Nasional.

January/February. 29-31 Tolbert, P.S. and Zucker, L.G. (1983). Institutional sources change in the formal structure

of organizations: The diffusion of civil service reforms, 1880-1935. Administrative

Science Quarterly. 28. 22-39 Tsakumis, G. (2007). The influence of culture on accountants’ application of financial

reporting rules. ABACUS. 43(1). 27-48 Turley, S. and Zaman, M. (2004). The corporate governance effects of audit committee.

Journal of Management and Governance. 8. 305-332

273

Uzun, H., Szewczyk, S.H and Varma, R. (2004). Board composition and corporate fraud. Financial Analyst Journal. 33-43

Vafeas, N. (2005). Audit committees, board and the quality of reported earnings.

Contemporary Accounting Research. 22(4). 1093-1122 Velury, U. and Jenkins, D.S. (2006). Institutional ownership and the quality of earnings.

Journal of Business Research. 59. 1043-1051 Vethanayagam, J., Yahya, S. and Haron, H. (2006). Independent non-executive directors,

managerial ownership and firm performance in Malaysian public listed companies. Proceeding Symposium on Accountability, Governance and Performance. Griffith University, 2006. Available online at http://www.griffith.edu.au/school/gbs/afe/symposium/2006/

Wah, S.S. (2002). Chinese classical leadership revisited: Lessons for the contemporary

leader. Malaysian Management Review. 37 (1). Wang, D. (2006). Founding family ownership and earnings quality. Journal of Accounting

Research. 44(3). 619-656 Wan Hussin, W.N. (2003). My say: Foundations of corporate governance. The Edge Daily.

September 30. Retrieved August 2, 2005, from http://www.theedgedaily.com/cms Wan Hussin, W.N. and Ibrahim, M.A. (2003). Striving for quality financial reporting.

Akauntan Nasional. March. 18-24 Watkins, A.L., Hillison, W. and Morecroft, S.E. (2004). Audit quality: A synthesis of

theory and empirical evidence. Journal of Accounting Literature. 23. 153-193 Watson, A., Shrives, P. and Marston, C. (2002). Voluntary disclosure of accounting ratios

in the UK. British Accounting Review. 34. 289-313 Watts, R.L. and Zimmerman, J.L. (1978). Towards a positive accounting theory of the

determination of accounting standards. The Accounting Review. 53 (1). 112-134. Whittered,G., Zimmer, I. and Taylor, S. (2000) Financial Accounting – Incentives Effects

and Economic Consequences. 5th ed. Harcourt Australia Pty Limited. Wiedman, C. (2002). The power of auditors. CA Magazine. 135 (10). December. 39-42 Wiwattanakantang, Y. (1999). An empirical study on the determinants of the capital

structure of Thai firms. Pacific-Basin Finance Journal. 7(3/4). 371-403 Wiwattanakantang, Y. (2001). Controlling shareholders and corporate value: Evidence

from Thailand. Pacific-Basin Finance Journal. 9(4). 323-362 Wild, J.J. (1994). Managerial accountability shareholders: Audit committees and the

explanatory power of earnings for returns. British Accounting Review. 26. 353-374

274

Wild, J.J. (1996). The audit committee and earnings quality. Journal of Accounting,

Auditing and Finance. 247-276 Witherell, B. (2002). Corporate governance and responsibility: Foundation of market

integrity. Observer. 234. 7-9 Xie, B., Davidson III, W.N. and DaDalt, P.J. (2003). Earnings management and corporate

governance: The role of the board and the audit committee. Journal of Corporate

Finance. 9. 295-316 Yatim, P., Kent, P. and Clarkson, P. (2006). Governance structures, ethnicity and audit fees

of Malaysian listed firms. Managerial Auditing Journal. 21 (7). 757-782 Yoshikawa, T. and McGuire, J. (2008). Change and continuity in Japanese corporate

governance. Asia Pacific Journal of Management. 25 (1). 5-24 Zahra, S.A. and Pearce, S.A. (1989). Board of directors and corporate financial

performance: A review and integrative model. Journal of Management. 15(2). 291-244 Zattoni, A and Cuomo, F. (2008). Why adopt codes of good governance? A comparison of

institutional and efficiency perspectives. Corporate Governance: An International

Review. 16 (1).1-15 Zulkafli, A.H., Abdul-Samad, M.F. and Ismail, M.I. (2005). Corporate Governance in

Malaysia.1-18. Retrieved August 2, 2005, from http://www.micg.net/research.htm

275

LIST OF PUBLICATIONS

PROFESSIONAL JOURNAL

Hashim, H.A. and Susela, D. (2008a). Board characteristics, ownership structure and

earnings quality: Malaysian evidence. Research in Accounting in Emerging Economies. 8. 97-123. ISSN: 1479-3563 /doi:10.1016/S1479-3563(08)08004-3

Hashim, H.A. and Susela, D. (2008b). Board independence, CEO duality and accrual

management. Asian Journal of Business and Accounting. 1(1). 27-46. ISSN: 1985-4064 CONFERENCE PROCEEDINGS

Hashim, H.A. and Susela, D. (2006). The impact of board characteristics on earnings

quality: Evidence from Malaysian listed companies. Proceeding Eighteenth Asian-Pacific Conference on International Accounting Issues, October 15-18, 2006, Maui, Hawaii.

Hashim, H.A. and Susela, D. (2008). Corporate governance, ownership structure and

earnings quality. Proceeding International Conference on Accounting and Business, June 6-8, 2008, Shanghai, China.

Hashim, H.A. and Susela, D. (2008). Board independence, expertise and earnings quality.

Proceeding Accounting Association of Australia and New Zealand Conference, July 6-8, 2008, Sydney, Australia.