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A Panel Data Analysis on the Effects of Independent Directors Characteristics, Ethnicity and the Level of risks on Discretionary Accruals in Malaysian Manufacturing Companies (2003-2009)

July 2011

July 2011

Conference: AFAANZ
At: DARWIN, AUSTRALIA

Authors:

Wan Masliza Wan Mohammad

University of Nottingham, Malaysia Campus

Rashidah Abdul Rahman

King Abdulaziz University

Nik Mohamad Zaki Nik Salleh

Xiamen University

This study examines the association between board characteristics, ethnicity and the level of risks and its effect on discretionary accruals as a proxy of earnings management. The sample of the study comprises of 298 randomly sampled firms over the year 2004 to 2009. The 6 years period of the study covers the revised code of corporate governance in 2007 which requires that the independent should at least be financially literate, possessed qualification and be a member of professional accounting bodies. Contrary to the believe that highly qualified and well experience directors act as a deterrent to earnings management, the results revealed that higher earnings management is associated with more qualified and experienced directors measured by independent directors qualification and CEO tenure. However an independent director who is a member of professional accounting is negatively associated to earnings management. A new finding of this study is the importance of chairman independence. The result revealed that chairman independence is more effective in reducing earnings management in comparison to independent directors. Issue on ethnicity is equally interesting as earnings management is lower when there exist more ethnic board's members. Well balance boards members in term of its ethnic members reduce potential earnings management. Therefore with an institution of more ethnic members in Malaysian manufacturing firms predominantly owned by the Chinese entrepreneurs, may reduce agency conflicts and earnings management. However, the findings of this study also indicate a positive association between Malay directors and earnings management, which require further study on the factors that may have caused the scenario. One possible explanation is that the existence of Malay directors is just to fulfill the KLSE requirement rather than executing the monitoring tasks of the board of directors.

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A Panel Data Analysis on the Effects of Independent Directors

Characteristics, Ethnicity and the Level of risks on Discretionary

Accruals in Malaysian Manufacturing Companies (2003-2009)

ABSTRACT

This study examines the association between board characteristics, ethnicity and the

level of risks and its effect on discretionary accruals as a proxy of earnings

management. The sample of the study comprises of 298 randomly sampled firms over

the year 2004 to 2009. The 6 years period of the study covers the revised code of

corporate governance in 2007 which requires that the independent should at least be

financially literate, possessed qualification and be a member of professional

accounting bodies. Contrary to the believe that highly qualified and well experience

directors act as a deterrent to earnings management, the results revealed that higher

earnings management is associated with more qualified and experienced directors

measured by independent directors qualification and CEO tenure. However an

independent director who is a member of professional accounting is negatively

associated to earnings management. A new finding of this study is the importance of

chairman independence. The result revealed that chairman independence is more

effective in reducing earnings management in comparison to independent directors.

Issue on ethnicity is equally interesting as earnings management is lower when there

exist more ethnic board’s members. Well balance boards members in term of its ethnic

members reduce potential earnings management. Therefore with an institution of more

ethnic members in Malaysian manufacturing firms predominantly owned by the

Chinese entrepreneurs, may reduce agency conflicts and earnings management.

However, the findings of this study also indicate a positive association between Malay

directors and earnings management, which require further study on the factors that

may have caused the scenario. One possible explanation is that the existence of Malay

directors is just to fulfill the KLSE requirement rather than executing the monitoring

tasks of the board of directors.

Keywords: Discretionary Accruals, Corporate Governance, Risk, Ethnicity

JEL Classification: M41

1. Introduction

Corporate governance can be broadly defined as ‘… a set of relationships between a company’s

board, its shareholders and other stakeholders. It also provides it structure through which the

objectives of the company are set, and the means of attaining those objectives, and monitoring

performance, are determined’ (OECD, 1999). The definition serves to demonstrate the

importance roles play by independent directors in accomplishing corporate objectives in which

constant monitoring on firms activities is a key element in achieving those objectives.

As to date numerous research been conducted on the roles played by independent directors,

particularly on its roles to reduce potential earnings management(Norman, Takiah, & Mohd,

2005; Peasnell, Pope, & Young, 2005), improvement in firms performance (Teoh, Welch, &

Wong, 1998) and safeguarding shareholders against firms failure(Laeven & Levine, 2009;

Pathan, 2009).

In order to improve the monitoring function of corporate governance mechanisms in Malaysia,

the Code of Corporate Governance was established in 2000 by the Ministry of Finance. The

Code outlines conditions for the structure and functioning process of the board of directors, and

audit committee, and external auditors in safeguarding the interest of shareholders (Norman, et

al., 2005). Further, the government took the initiative to revise the existing Code and released the

new Code on 1st October 2007. The revision is an important step in improving the substance of

the code particularly in regards to the quality of independent directors and their qualification.

Establishment of internal governance processes is essential to maintain the credibility of firms’

financial statements and safeguarding against earnings manipulation (Dechow, Sloan, &

Sweeney, 1996). Therefore having qualified independent director means that there exist

appropriate “checks and balances” in the firm. On the other hand, a weak governance structure

specifically due to lack of knowledge and expertise may provide an opportunity for financial

statements preparers or managers to involve in irregularities behavior. Managers may prefer to

use discretionary accruals to manage the reported earnings as it is less likely to be detected by

financial statement users.

Board of directors’ role is to ensure that the firm prepare the financial statement according to the

approved accounting standards and comply with Malaysian Securities Commission guidelines. In

order for the board of directors to function effectively, there are few characteristics being

suggested within the structure of corporate governance. One of the characteristics that have been

discussed extensively recently is about having outside directors on the board. This is stipulated in

The Malaysian Code of Corporate Governance (MCCG, 2007) which requires that a board

should consist of at least one-third of the board membership. Whereas, Rule 9 of the Bursa

Malaysia listing requirement states that:

“Every listed company should have independent directors, that is directors that are not officers of the company;

who are neither related to its officers nor represent concentrated or family holdings of its shares; who, in the view

of the company’s board of directors, represents the interest of the public shareholders, and are free of any

relationships that would interfere with the exercise of independent judgment.”

The need for independent directors originates from the separation of ownership and control and

issues surrounding the protection of shareholders interest. As argued by Agency Theory,

management that were entrusted with the stewardship of the company are conscientiously driven

to self-preservation (Jensen & Meckling, 1976) thus the best way to monitor directors are to have

effective regulation in ensuring shareholders value are protected (La Porta, Lopez-de-Silanes,

Shleifer, & Vishny, 2000).This is because any act or behavior by management which is in

contrary to the objective of the shareholder will be borne by the shareholders. At the expense of

shareholders, manager may try to maximize their own utility and will not act in the best interest

of the shareholders (Godfrey, Hodgson, & Holmes, 2000). In improvising the principal-agent

relationship between principal (shareholders) and agent (managers), the monitoring costs1 and

the bonding costs2 will be assumed by the principal to ensure that the objective of the principal is

aligned to the objective of the agent. If there exists the gap between the agent and principal, it

may lead to the possible existence of earnings management through fraudulent reporting.

1 Monitoring costs ar e the costs of monitoring t he agents’ behavior. They are expenditures by the principal to measure, observe and

control the agent’s behavior (Godfrey, et al., 2000)

2The costs of bonding the agent’s interest with those of the principal’s, for example voluntary disclosure of financial information as

this act will constraints the managers’ against any opportunistic behavior (Godfrey, et al., 2000)

Most of the previous studies have focused on the existence rather than characteristics of the

independent directors. Since Malaysia is a multi race countries we will explore more on the

characteristics of the directors on race diversion and their qualification and how these

characteristics reduces the level of earnings management. This is an extension to a study of

ethnicity as several studies has revealed that bumiputera controlled firms has weaker governance

practices (Yatim, Kent, & Clarkson, 2006). If weaker governance is associated with bumiputera

controlled firms, possibility of earnings management is more persevere in ethnic firms. On the

other perspective, Consequently issues on ethnicity may impair the auditor independence in

regards to auditors conflicts as most Chinese firms employed Chinese auditors (Ahmad,

Houghton, & Yusof, 2006). It may also lead to earnings management as auditor independence is

impaired where issues of ethnicity are concerned. Though, Abdul Rahman and Ali (2008) fail to

find an association between earnings management and ethnicity. This paper will explore on the

ethnic issues with larger sample size and details characteristics of the independent directors.

Comparatively, Abdul Rahman and Ali (2008) study have focused only on 3 years periods and

there is only 97 companies selected for the research.

This study extends prior study by examining the relationship between independent directors’

qualification, ethnicity and the level of risks and its effect on discretionary accruals. The

objective of this study is to establish the relationship between the independent director’s

qualification, ethnicity and the level of risks on potential earnings management in Malaysian

manufacturing companies.

Manufacturing sectors are chosen due to the emphasis on Malaysian government through New

Economic Policies (NEP), which is succeeded by New Economic Model in 2010. The

government gave top priority to the promotion of the manufacturing sector, emphasizing export-

oriented industrialization over import-substitution industrialization(Koon, 1997).An emphasis on

manufacturing sectors increases the competitiveness of the manufacturing sectors across other

sectors in Malaysia. Interestingly enough most manufacturing firms are predominantly owned by

Chinese, and the effects of having independent Malay in the board, are seem to be another act of

independent. As argued by Che Ahmad et al (2006) as most Chinese firms prefer Chinese

auditors, thus there is a question of independence if all majorities of the boards are Chinese.

2.0 Literature Review and Hypothesis Development

The board is responsible for determining the company’s aims and the strategies, plans, and the

policies to achieve those aims; monitoring progress in the achievement of those aims; and

appointing key personnel with suitable leadership qualities . In addition, directors are responsible

to ensure that financial statements are prepared according to approved accounting standards

(MASB). Therefore, the board should carry out their role effectively in order to produce of high

quality of financial reports to users. Fama and Jensen (1983) states that creating a board that is

effective in monitoring management actions depend on the characteristics and composition of

members on the board of directors. MCCG (2007) requires that the board should compose of at

least one-third of independent non-directors and directors should be persons of caliber,

credibility and have the necessary skill and experience. Therefore, independent non-executive

directors who posses characteristics such as expertise, independence, objectivity and legal power

may become potentially governance mechanism to alleviate agency costs and protect

shareholders wealth. Base on the above arguments, this study attempts to examine the

relationship between the characteristics of board of directors of Malaysian public listed

companies and earnings management.

2.1 The roles of Independent Directors and Chairman Independence

‘Independence’ is generally being taken as a meaning that there are no relationships or

circumstances which could affect the directors’ judgements. The issue of independence has been

emphasized in various codes and reports. Cadbury (1992) states that non-executive directors

should be independent of management and free from any business or other relationship which

could materially interfere with the exercise of their independent judgement. The OECD (1999)

also publishes the same recommendation that is the board independence usually requires that a

sufficient number of board members not to be employed by the company and not be closely

related to the company or its management through significant economic, family or other ties. In

Malaysia, the Listing Requirement of Bursa Malaysia defines independent directors as a director

who is independent from the management, free from any business or other relationship which

could interfere with the exercise of independent judgement.

Previously managers are being appointed as directors (insiders) of the firms due to their

advantages of having more information about the organization compared to outside directors.

However, domination by insiders may lead to expropriation of wealth to managers at the expense

of the shareholders (Beasley, 1996). This is consistent with the argument made by Fama and

Jensen (1983) who state that the inclusion of outsiders on the board increases a board’s ability to

be more efficient in monitoring its top management and to ensure there is no expropriate

stockholder wealth as they have incentive to develop their reputation as expert in decision

control.

Several previous studies explore the relationship between the composition of independent non-

executive directors and earnings management. Peasnell, Pope and Young (2005) examine

whether board monitoring influences Discretionary working capital accrual activity that is

potentially costly to market participants. They find that firms with a higher proportion of outside

board members are negatively related to the income-increasing Discretionary accruals. As a

result, they conclude that outside directors appear to play an important monitoring role in terms

of helping to uphold the integrity and credibility of published financial statement(Jaggi, Leung,

& Gul, 2009). Jaggi, Leung and Gul (2009) find a high proportion of independent directors of

Hong Kong public listed companies have a negative relation with earnings management. In the

same vein, it may be concluded that firms with high proportion of independent directors produce

high quality of earnings. In a study which involves a cross sectional analysis of 434 public

listed firms in Australia, Davidson, Stewart and Kent (2005) find that a majority of non-

executive directors on the board is significantly associated with a lower of earnings management

which is measured by the absolute level of discretionary accruals. The practice of earnings

management is systematically related to the strength of internal corporate governance

mechanisms(Davidson, Goodwin-Stewart, & Kent, 2005).Board independence is the most

effective deterrent of fraudulent financial reporting. This is consistent with the idea that

independent directors have strong incentives to enhance financial reporting quality or maintain it

at an acceptable level to avoid being sued(Piot & Janin, 2007).

In contrast to the above findings and also to the prediction of agency theory, Studies have shown

that there is a positive relationship between independent non-executive directors and earnings

management.(Abdul Rahman & Mohamed Ali, 2006; Hashim & Devi, 2008). These bring in the

arguments on the effectiveness of the revised code 2007 and its impact on the business operation

and possible earnings management.Based on the arguments of agency theory, we predict that

high proportion of independent directors on the board would perform an important role in

monitoring earning management

H1: The proportion of independent non-executive directors is negatively related to earnings

management.

Another issue that has been discussed in the past literatures is about the status of the chairman.

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

will be a useful check on the over-ambitious plans of the Chief Executive Officer. However,

Davidson et al., (2005) find no evidence of a negative relationship between an independent board

chair and earnings management. Independent board chair is an important element in improving

the performance of firms(Rechner & Dalton, 1991).In addition to that, advocates of independent

chairman argued that effective corporate governance is more pervasive in firms that has

independent chairman rather than CEO duality; yet many firms choose instead to allow the

CEO to serve as board chairperson (CEO duality)(Rechner & Dalton, 1991). In their study

Rechner and Dalton (1991) examine the differential financial implications of these choices

for 141 corporations over a 6-year time period. The findings from the study indicate

significant improvement in performance on firms that are opting for independent leader ship

rather CEO duality.

H2: The firm where the chairman holds by independent director is negatively related to earnings

management

2.2 Board Financial Expertise

It is important for board of directors to have necessary skill, experience and expertise to execute

their tasks effectively. This concept can be referred to resource dependency theory which states

that the directors’ resource role as a source of advice and counsel for the chief executive officer

is important in bringing valued resources to the firms (Daily, Dalton, & Cannella Jr., 2003).

Hillman and Dalziel (2003) argued that representation from lawyers, financial institutions, top

management from other firms, marketing specialists and former government officers may offer

high-quality advice and counsel to the organization as they bring with them indispensable

expertise, skills and experience(Hillman & Dalziel, 2003).

One of the main duties of the directors is to ensure that the manager prepare the financial

statements according to the approved accounting standards. Section 166A(3) of Companies Act

1965 clearly states that “[T]he directors of the company shall ensure that the accounts of the

company and, if the company is a holding company for which consolidated accounts are

required, the consolidated accounts of the company, laid before the company at its annual

general meeting, are made out in accordance with applicable accounting standards.” MASB also

requires that directors make a statement in an annual report that the accounts are prepared in

accordance to the approved accounting standards. In order to carry out the task effectively

directors need to have the relevant expertise and knowledge. MCCG (2007) recommends that the

nominating committee should consider the candidates’ skill, knowledge, expertise, experience,

professionalism and integrity. Besides that MCCG (2007) also requires that all members of the

audit committee should be financially literate and at least one should be a member of an

accounting association or body. This requirement is to ensure that the directors would be able to

understand and interpret financial statement accurately as part of their duties to monitor the

firm’s internal control system.

Several studies have made recommendation for the board to have the relevant expertise so that

they could perform their duties effectively and also suggest that board of directors comprises of

independent directors with financial expertise perform the monitoring duties more effectively

because they have a better knowledge on how earnings are being managed by managers(Barton,

Coombes, & Wong, 2004; Xie, Davidson III, & DaDalt, 2003). Their finding is consistent with

Agrawal and Chadha (2005) who report that that the probability of earnings restatement is lower

in firms whose boards have an independent director with a background in accounting or

finance(Agrawal & Chadha, 2005).

H3: There is negative relationship between board financial expertise and earnings management.

H4: There is negative relationship between independent directors being a member of

professional accounting bodies and earnings management.

2.3 Boards Meeting

There are two views arise from previous literatures with respect to the number of board meetings

as a corporate governance mechanism. The first view is that board meetings are beneficial in

terms of effective management monitoring, strategy discussion and implementation and ability

for directors to consult together and share opinions ((Vafeas, 1999). This is supported by

Adelopo and Jallow (2008) who state that board meeting frequency signals board activity and

may indicate a measure of its effectiveness(Adelpop & Jallow, 2008). An implication of this

argument is that directors in boards who meet more frequently are more likely to perform their

duties in accordance with shareholders’ interests (Vafeas, 1999). Higher board meetings

frequency, all things being equal may improve board propensity to detect financial reporting

irregularities, improve business monitoring, enhance board strategic functions and may mediate

lapses in internal control and risk management procedures (Adelopo et. al., 2008). As a result the

function of board meeting frequency as one of corporate governance mechanisms is consistent

with agency theory.

The second view states that higher board activity in a firm is a likely to relate with firm’s poor

performance. Vafaes (1999) find that more frequent board meetings followed poor performance

and they heralded improvements in profitability. In fact, Jensen (1993) argues that boards should

be relatively inactive, and the fact that boards regularly meet might indicate presence of

problems. However Xie et al (2003) comments that a board that seldom meets may not focus on

these issues and may perhaps only rubber-stamp management plans.

Xie et al. (2003) find that the frequency of board meetings is negatively associated with earnings

management practices in the US firms listed in the Standard & Poor 500 index. They suggest that

board activity influences members’ ability to serve as effective monitors.

The MCCG recommends that boards should meet regularly. The Code does not set the number of

meetings, but it states that the board should disclose the number of board meetings and the

details of attendance of each individual director held a year. The next hypothesis is as follows:

H5: There is a significant positive relationship between the number of board meetings and

earnings management.

2.3 Board Characteristics (Malay Directors and Ethnicity)

Malaysia is a multiracial society comprises of two major ethnics, i.e. Malay and Chinese.

According to Mamman (2002) even though Malays form the majority of the population, Chinese

dominate most of the economic activities. Based on the societal values suggested by Hofstede

(1991), Haniffa and Cooke (2002) find that the Chinese are more individualistic and more

secretive in their disclosure partly due to their entrepreneurial skills that have a greater influence

on the Malaysian economy. In contrast, they also find that Malaysian firms dominated by Malay

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

business ethics that encourages transparency in business, thus may have fewer tendencies to

manage earnings(Abdul Rahman & Mohamed Ali, 2006; Haniffa & Cooke, 2002). Hambrick

and Mason (1984) has developed the Upper Echelon Theory which states that the top

management team comprises with greater demographic diversity has a greater power to influence

the decision making which contribute to better firm’s performance. The result from Marimuthu

(2008) study on the top 100 non-financial companies listed on the Bursa Malaysia supports the

theory. The study finds that there is a positive relationship between ethnic diversity and firm’s

performance. Therefore, based on Upper Echelon Theory the study predicts that the presence of

Malay directors on the board of a company and on audit committees may deter opportunistic

earnings management:

H6.: There is a significant negative relationship between discretionary accruals (DAC) and the

proportion of Malay directors on the board.

H7.: There is a significant negative relationship between discretionary accruals (DAC) and the

existence of ethnic directors on the board.

2.4 Risks (Equity Volatility and Z-Score)

In establishing the relationship between earnings management and risk, rational investor

hypothesis, explains that the level of discretionary accruals has no impact on the market

valuation of bank risk. However, naive investor hypothesis claims naive investors would

misinterpret high reported earnings as being favorable information about the institution, and

undervalue its risk. If this is true, the discretionary portion of accruals should be negatively

associated with the level of company’s risk (Yasuda, Okuda, & Konishi, 2004). Hence, the

alternate hypothesis is as follows:

H8.: There is a significant negative relationship between discretionary accruals (DAC) and the

level of risks(equity volatility).

Laeven and Levine (2009) discuss that banks risk taking is influenced by the governance

structure of a particular banks. Their study focus primarily on the potential conflicts between

bank managers and owners over risk, and assess whether bank risk taking varies with the

comparative power of shareholders within the corporate governance structure of each

bank(Laeven & Levine, 2009,pp 259).

In extending their research, this study will look into the effect of the level of risks (measured by

the volatility of return on asset) as potential explanation for managers’ tendency to manage

earnings. Therefore we hypothesize that:

H9.: There is a significant positive relationship between discretionary accruals (DAC) and the

level of company’s fundamental risks (Z-score).

2.5 Control Variables (Board Size, Big 4, Leverage, Tenure and Total Assets)

Board size is measured by the total number of board members (Abdul Rahman and Ali, 2006).

The Malaysian Stock Exchange Corporate Governance Guide (2009) does not state the optimum

size of the board of directors however, it stresses that the establishment of small board

committees would become impracticable. The MCCG (2000) also states that the board of

directors should carefully determine the optimum number of board member to ensure that there

are enough members to discharge responsibilities and perform related duties. These two

statements indicate that smaller boards may potentially have a negative impact on the quality of

financial reporting. Xie et al. (2003) argue that larger board size prevents earnings management

better compared to smaller boards because larger boards normally comprise of independent

directors with necessary expertise and experiences. Contrary to the findings, Abdul Rahman and

Ali (2006) found a positive association between board size and the level of discretionary

accruals. Since similar environment between this study and Abdul Rahman and Ali (2006), we

hypothesize that:

H10: There is a significant positive relationship between discretionary accruals (DAC) and the

size of the directors on the board.

External auditor is another corporate governance mechanism used by the firm to mitigate

earnings management. It shows that the auditor has a major role in monitoring the client’s

disclosure policies and practices. Prior research argues that the large audit firms are perceived to

perform higher quality audits compared to smaller audit firms (DeAngelo, 1981) The reasons are

because they have more resources and expertise to detect earnings management, as well as to

protect their reputation from their clients. Therefore, it is expected that there is a negative

relationship between Big 4 audit firm and earnings management.

H11: There is a significant negative relationship between discretionary accruals (DAC) and Big

4 audit firms.

Leverage is measured as the ratio of total liabilities to total assets and used to capture the

incentives to practice earnings management when close to debt covenant violations (Klien,

2002). Park and Shin (2003) comment that firms with higher leverage and expected to have low

earnings are potentially to have greater incentives to manage earnings upward. This is because

they want to avoid from disclosing their financial problems and exhibit low performance in the

financial report(Park & Shin, 2003). Their comment is supported by the argument made by Piot

and Janin (2007) who argue that firms may resort to income-increasing accounting practice in

order to show a favourable performance when negotiating with lenders(Piot & Janin, 2007).

H12: There is a significant negative relationship between discretionary accruals (DAC) and level

of firms’ leverage.

Non-executive directors’ experience on the company’s board allows them to develop some

monitoring competencies while providing them with better knowledge of the company and its

executive directors (Bedard, Chtourou, & Courteau, 2004). Thus, they become more capable of

overseeing the firm’s financial reporting process effectively. This statement is consistent with the

finding of Kosnik (1987) who states that the longer the average tenure of non-executive

directors, the more likely the company is to resist hostile takeover bids(Kosnik, 1987). Abdul

Rahman and Mohamed Ali (2006) also report that independent directors who are on the board

for a number of years may increase governance competencies as well as provide additional

knowledge and expertise to the firm, thus are competent of monitoring management

performance. Beasley (1996) finds significant negative relationship between the average tenure

of outside directors and financial statement fraud. Therefore, he suggests that as the numbers of

years of the board service for non-executive directors’ increases, the likelihood of financial

reporting fraud decreases. This indicates that non-executive directors may improve their skill,

knowledge and experience about the firms’ activities as their tenure increases and as a result may

monitor management more effectively.

However, Abdul Rahman et al., (2006) do not find any significant relationship between average

tenure of independent directors and earnings management. They argue that due to independent

directors in Malaysia not acquiring the necessary expertise, skills and knowledge thus reflect in

ineffectively in performing their monitoring function. The argument could be acceptable because

the study use the sample for the period 2002 and 2003 in which there is no requirement in

MCCG (2000) that requires all members of the audit committee should be financially literate and

at least one should be a member of an accounting association or body. The requirement to have

all members of the audit committee be financially literate and at least one should be a member of

an accounting association or body is only be mentioned in MCCG (2007). It is hope that with

this amendment in the MCCG the competency of directors may increase as the numbers of years

they served on the board increases. Therefore, the study hypothesis that:

H13: Earnings management is negatively associated with director’s tenure.

Previous studies reported Becker a significant negative association between DAC and cash

flow(Becker, Defond, Jiambalvo, & Subramanyam, 1998; Dechow, et al., 1996). This is

particularly so in the event where companies are close to debt covenant restrictions, quite often

the level of cash flow is also low. Hence, managers are more inclined to manage earnings

upwards(Abdul Rahman & Mohamed Ali, 2006).Cash flow reserves and the size of the firms

may have a potential effect on firms intention to manage earnings .Base on the premise that

smaller firms are less scrutinized by authorities and is therefore more inclined to manage

earnings (Abdul Rahman & Mohamed Ali, 2006; Xie, et al., 2003), we hypothesize that:

H14: Earnings management is negatively associated with the size of the firms.

3.0 Research Methodology

The previous literature has published several approaches to determine the existence of earnings

management such as aggregate accruals, specific accruals, earnings distribution and specific

activities. Aggregate accruals approach is widely used by researcher to detect earnings

management. The approach use discretionary accruals also known as Discretionaryaccruals as a

proxy. The total accruals are regressed on selected variables to determine non-discretionary

accruals. The difference between total accruals and non-discretionary accruals is discretionary

accruals. There are many models that have been developed using total accruals to test earnings

management. The first model is Healy Model used the mean of total accruals scaled by lagged

assets from the estimation period as the proxy of non-discretionary accruals (Healy, 1985). The

second model is DeAngelo Model which uses the last period’s total accruals as the measure of

non-discretionary accruals (DeAngelo, 1986 ). The third model is Jones Model which relates

total accruals to the change in revenue and the level of gross property, plant and equipment

(Jones, 1991). The fourth model is Industry Model which uses the median value of total accruals

scaled by lagged assets. The Model assumes that variations in the determinations of non-

discretionary accruals are common across firms in the same industry. The fifth model is

Modified Jones Model which is proposed by Dechow et al. (1995). The adjustment to the

original Jones Model is that the change in revenues is adjusted for the change in receivables in

the event period.

The second approach to measure earnings management is a specific accrual. McNicholes (2000)

argues that the approach can be applied in industries whose business practice causes the accruals

in question to be material and a likely object of judgement and discretion(McNichols, 2000).

The third approach to determine the existence of earnings management is earnings distribution.

For example, Degeorge et al., (1999) investigate discontinuities of reported earnings based on

three thresholds namely zero earnings, last year’s earnings and this year’s earnings. They find

that there are fewer observations than expected for earnings amounts just below the zero earnings

and last years’ earnings thresholds(Degeorge, Patel, & Zeckhauser, 1999).

The fourth approach to measure the existence of earnings management is a specific approach.

Researchers investigate how managers in sample firms manage earnings management through

certain activities. For example earnings management through focus on R&D strategies, disposal

of assets and price discounts offering (Bartov, 1993; Bushee, 1998; Roychowdhury, 2006).

3.1 Earnings Management Measurement (DAC)

This study uses discretionary accruals as the primary measure of earnings management. The

Jones (1991) model explains the use of discretionary accruals in determining the occurrence of

earnings management in a firm. One common approach is to decompose total accruals into non-

discretionary (expected) and discretionary (unexpected portions). The expected portion results

from changes in firms’ economic environment and is not much up to the management’s

discretion. The unexpected portion is the outcome of discretionary manipulation by the

management. The Jones (1991) model assumes that a high level of discretionary accruals (DAC)

suggests that a firm is engaging in earnings management. The Jones (1991) later being further

improved and known as the modified Jones (1991). Even though the ability of this model in

measuring earnings management has been challenged by some researchers, Dechow et al. (1995)

and Guay et al. (1996) found that the model is the most powerful in detecting earnings

manipulation in the event of managers exercising their discretion over revenue recognition.

Discretionary accrual model involves first the computation of total accruals, therefore total

accruals models are presented first, followed by discretionary accrual model. The balance sheet

approach for the computation of total accruals, TA, is as follows:

∆CAit – ∆CLit- ∆Cashit + ∆STDit- DEPit (1)

Where,

TAit

total accruals for firm i in year t;

∆CAit

change in the current assets for firm i in year t;

∆CLit

change in current liabilities for firm i in year t;

∆Cashit

change in cash and cash equivalent for firm i in year t;

∆STDit

change in current maturities of long-term debt for firm i in year t;

DEPit

depreciation and amortization expense for firm i in year t.

TAt/Ait-1

α1 (1/Ait-1) + β1 (∆REVit / Ait-1) + β2 (PPEit/ Ait-1) +ε (2)

Where,

Ait-1 = total asset for firm i at the end of year t-1;

∆REVit = revenue for firm i in year t less revenues year t-1;

PPEit

= gross property, plant and equipment for firm i at the end of year t;

α1, β1, β2 = represent the OLS estimates of α1, β1, β2;

ε = residual.

The fitted value (denoting the estimated parameters by α1, β1, β2) obtained from the above

regression measures nondiscretionary accruals:

NDAit =

α1 (1/Ait-1) + β1 [(∆REVit-∆RECit )/ Ait-1)] + β2 (PPEit / Ait-1) (3)

The residual measures discretionary accruals:

DAit

= TAit/Ait-1 – NDAit (4)

Because our emphasis is on earnings management per se, and not on the direction of the

earnings management, the measure abstracts from the sign of the accruals by using the absolute

value of discretionary accruals.

3.2 Model Specification

0 1 2 3 4 5 6

7 8 9 10 11 12

13 14

DAC a INTERCEPT a OUT+a CHAIRINDEP+a QUALI+a BO

DMEM+a BODMEET+a MALAYDIRECTOR

+a MAJORETHNIC+a EQUITYVOLATILITY+a Z_SCORE+a BRDSZ+a BIG_4+a LEVERAGE

+a TENURE+a TOTALASSET+

= +

The dependent variables are discretionary accruals (refer to Section 3.1). The data collected for

all the variables are from the annual reports of the banks and EMIS (Emerging Market

Information System).

3.2.1 Independent Directors Characteristics

OUT is the proportion of independent directors in the company. CHAIRINDEP is the nominal

data indicating 1 if the chairman is independent directors and 0 otherwise. QUALIFICATION is

nominal data , 1 indicate that one of the independent directors has at least a degree in

accounting, finance and economics or professional qualification, 0 indicate otherwise. BODMEM

is nominal data indicating 1 if any of the independent directors are member of professional

accounting bodies, 0 indicate otherwise. BODMEET is the number of meeting.

3.2.2 Ethnicity

MALAYDIRECTOR is the percentage of Malay directors on the board. MAJORETHNIC is the

nominal data indicating 1 if the number of bumiputra directors are greater than non-bumiputra

directors, 0 indicate otherwise.

3.2.3 Risks

EQUITYVOLATILITY is the volatility of the equity returns of the company, computed using

daily data over the period 2004–2009. Z_SCORE is the companies’ return on assets divided by

the standard deviation of asset return over the period 2004-2009.

3.2.4 Control Variables

BRDSZ is the number of directors in the board. BIG_4 is an Indicator variable with the value of

“1” if audited by Big4 and “0” otherwise. LEVERAGE is current liabilities over total assets.

TENURE is the total number of years of service of the CEO. TOTALASSET are natural log

transformation of total assets.

4.0 Preliminary Data Analysis

The sample consists of 1,370 firm-year observation between years 2004-2009. There six

industries within the manufacturing firms chosen based on Emerging Market Information System

(EMIS);

i. Apparel Manufacturing

ii. Automotive and Transportation

iii. Equipment Manufacturing

iv. Cement and Concrete Product Manufacturing

v. Beverage and Tobacco Product Manufacturing

vi. Chemical Manufacturing

vii. Computer and Electronic Product Manufacturing

viii. Electrical Equipment, Appliance, and Component Manufacturing

ix. Fabricated Metal Product Manufacturing

x. Food Manufacturing, Furniture and Related Product Manufacturing

[Table 1 about here]

There are a total of 298 companies selected randomly from these sectors. The total number of

companies in Bursa Malaysia is 794 companies, therefore this study represent 37.5% of the

population under study. In table 1, we use Kruskal-Wallis test (H-test) which is an extension of

the Wilcoxon test. This to test whether there is a statistically significant difference between all

the variables, pre and post the revised Malaysia Code of Corporate Governance (2007).Factor

codes are used to break-up the (ordinal) data in one variable into different sample subgroups. If

the null-hypothesis, (P<0.10), then the conclusion is that there is a statistically significant

difference between all the variables, pre and post the revised Malaysia Code of Corporate

Governance (2007). Based on the Kruskal-Wallis test (H-test), all of the variables under this

study has p-value less that 10% except for boardsize (BRDSZ), big 4 auditor (BIG_4) and

chairman independence (CHAIRINDEP).Ceteris Paribus, it can be concluded that most of the

variables have changed after the incorporation of Malaysia Code of Corporate Governance

(2007).

4.1 Descriptive Statistics

[Table 2 about here]

From table 2, the discretionary accruals (DAC) range from -4.210362 to 9.5865 while the mean

is -0.021359. The number of independent directors (OUT) ranges from 1 to 7 independent

directors in a particular company. Thus the average number of independent directors is

approximately 3.In regards to the number of meeting (BODMEET) the highest number meetings

are 27 whilst the lowest is 0, this when the company has just been incorporated for the year and

yet to finalize on its meetings. Thus the number of meetings in most companies averaging around

5 meetings per year. The average numbers of Malay directors (MALAYDIRECTOR) are from 2

to 3 directors, whilst the mean is around 2 Malay directors for each company. The equity

volatility (EQUITYVOLATILITY) ranges from 1.64 to 0. The zero figures indicates companies

that the same return across the years. The Z-score (Z_SCORE) has shown an average of -

0.197433 to 0.095308, implying volatility in the average return of total assets across the

manufacturing companies. The board size (BRDSZ) has a maximum of 16 board members whilst

the smallest is 3 members in a board. The level of leverage (LEVERAGE) is extremely high

especially during 2008 crisis with 298% to only 26%. The high level of leverage is due to lower

exports of the manufacturing products and heavy reliance on debt as part of their financing.

The average total assets is RM 767,842 millions, the highest being RM 1.03 billion and the

lowest RM 190,816. The average tenure of the CEO is approximately 7.57 years, with the

maximum number of years is 43 years and the minimum is 0 years. The value of 0 year indicates

CEO who has joined the company on a particular year and has not completed its full year.

4.2 Panel Data Regression

Since the sample under this study are pooled data (pooling of time series and cross sectional

observation), panel data regression seems to be the most appropriate techniques in running the

data. By combining time series of cross section observations, panel data is argued to be more

informative and robust due to a greater degrees of freedom and variation in data (Gujarati, 2003).

The data was run initially using pooled regression techniques. The data revealed that there is

autocorrelation using Lagrange multiplier (LM) test ( p-value is 0.000). Further analysis also

revealed that there is heterocedasticity problems using Breusch-Pagan-Godfrey (BPG) test (p-

value is 0.000) (Baltagi, 2005; Gujarati, 2003).Another postestimation tests also show the

presence of heteroskedasticity (Modified wald test, Prob>chi2 = 0.000). Since all tests have p-

value which is less than 10%, pooled regression is inappropriate for the test as pooled regression

techniques may distort the exact relationship of the variables under this study due to the

correlation between errors component. Thus, a Generalized Least Square(GLS) estimator is used

to correct for the problems of heteroscedasticity, autocorrelation and contemporaneous

correlation (Beck & Katz, 1995; Magalhaes & Africano, 2007). By using this model, the results

will be more robust as GLS corrects for both autocorrelation and heteroskedasticy, thus

correcting for the correlation across time periods and cross sectional units. This will improve the

efficiency of the coefficients of each variable under this study. Further analysis on the correlation

matrix reveals that there is no correlation between variables under this study (refer Table 3).

4.2.1 Panel Data Regression on Control Variables

[Table 4 about here]

We first run a panel data regression of DAC on the control variables. The results revealed that all

of the control variables are significant at 1% except for log total assets (TOTALASSET) which

are significant at10% level. As predicted, bigger board size is highly associated with earnings

management. The results is inconsistent with the finding of Xie et al (2003), however

considering that there is different sample in both of the study, the different environment may

have an influence on potential earnings management. However the findings of this study are

consistent with Abdul Rahman and Ali (2006) who found a positive association between board

size and the level of discretionary accruals. Thus the findings support our tenth hypothesis:

H10: There is a significant positive relationship between discretionary accruals (DAC) and the

size of the directors on the board.

The second hypothesis for control variables H11: There is a significant negative relationship

between discretionary accruals (DAC) and Big 4 audit firms is not supported as our findings

strongly indicate that the relationship is positive. This is again consistent with findings of Abdul

Rahman and Ali (2006), that discretionary accruals is positively associated with the level of Big

5 auditors. The arguments may be that they have more resources and expertise to manipulate the

accounting figures due to strong footage in the market.

The third hypothesis H12: There is a significant negative relationship between discretionary

accruals (DAC) and level of firms’ leverage, also contradicts with the prediction as leverage is

negatively associated with earnings management. Companies with lower level of leverage are

prone to manage earnings, perhaps due to less contractual monitoring on the part of debt holders.

Similar results were also found in Rahman and Ali (2006).

The fourth hypothesis for the control variables, H13: Earnings management is negatively

associated with director’s tenure, contradicts with our prediction as longer tenure is positively

associated with earnings management. This is possibility so, as our TENURE is measured as the

number years the CEO has been on the board which is in contrast to Rahman and Ali (2006),

which used the average tenure of all the directors on the board. The results indicate that to the

contrary of the arguments of Bedard, Chtourou, & Courteau (2004), that well experienced

directors are inclined to use their experience to manage earnings rather than monitoring

competencies.

The fifth hypothesis for the control variables, H14: Earnings management is negatively

associated with the size of the firms is significant at 10%. This is consistent to our prediction that

smaller firms which are less scrutinized by authorities and are more inclined to manage

earnings (Abdul Rahman & Mohamed Ali, 2006; Xie, et al., 2003).

[Table 5 about here]

4.2.2The roles of Independent Directors and Chairman Independence (Hypotheses 1 and 2)

Our analysis fails to find any association between earnings management and the percentage of

independent directors as p-value is greater than 10% so we failed to reject the null hypothesis..

So our first hypothesis H1: The proportion of independent non-executive directors is negatively

related to earnings management is rejected at 10% significant level.

However we have found interesting findings that the level of earnings management is negatively

associated Chairman Independence (CHAIRINDEP). This finding supports that independence

chairman fulfils the monitoring roles over-ambitious plans of the Chief Executive Officer. This

also supports that effective corporate governance is more pervasive in firms that has

independent chairman(Rechner & Dalton, 1991). The findings from the study indicate significant

reduction in earnings management on firms that that have the leadership of independence

chairman. Thus our second hypothesis is supported at 1% significant level.

H2: The firm where the chairman holds by independent director is negatively related to earnings

management

4.2.3 Board Financial Expertise (Hypotheses 3 and 4)

In contrary to the prediction, we found positive relationship between earnings management and

independent director’s qualification, therefore we fails to accept our third alternatives hypothesis

that,.H3: There is negative relationship between board financial expertise and earnings

management. .Consistent with the number of tenure findings (H13), longer tenure and more

qualification is not an indication of proper monitoring against earnings management. Since we

define qualification as those having knowledge inn accounting, finance and economics, the next

findings revealed that at 1% significant level, independent directors that are a member of

professional accounting bodies are better in reducing earnings management. Therefore our fourth

hypothesis H4: There is negative relationship between independent directors being a member of

professional accounting bodies and earnings management, is supported. The findings imply that

ethics are the issues of concern in the corporate world rather than qualification alone.

Qualification may in certain circumstances lead to more earnings manipulation rather than

monitoring devices. As those possessed with professional accounting qualification have more

tendencies to follows the right ethics of accounting bodies which is reflected in the lower level of