Audit committee characteristics and earnings management in Malaysian Shariah-compliant companies

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1 ABSTRACT Audit committee characteristics and earnings management in Malaysian Shariah-compliant companies Hussain Khalifa Hussain Alkdai (Corresponding Author) PhD candidate, Faculty of Economics and Muamalat, Universiti Sains Islam Malaysia [USIM], Bandar Baru Nilai, 71800, Nilai, Negeri Sembilan, Malaysia Mustafa Mohd Hanefah Professor of accounting, Faculty of Economics and Muamalat [FEM], Universiti Sains Islam Malaysia [USIM], Malaysia Using panel data regression for 270 Malaysian Shariah-compliant companies, this study investigates the effect of audit committee characteristics such as size of audit committee, number of independent non-executive directors, the number of accounting expertise, and the number of Muslim directors in audit committee on earnings management practice. In addition, some control variables such as company s size, company s leverage, company s profitability and size of audit firm (Big4) were regressed. 810 observations were utilised to examine the relationships between the audit committee characteristics and earnings management using the Modified-Jones Model (1995). Furthermore, three panel data estimations namely Pooled OLS, Fixed and Random effects models were conducted. The results indicate that audit committee size has non-significant relationship with the discretionary accruals used as proxy for earnings management. Additionally, there is negative significant relationship with independent non-executive directors in audit committee. Regarding accounting expert s role in mitigating earnings management practice, the results indicate that they are nonsignificantly related. As for the Muslims in audit committee, the result is not consistent with the expected role of Muslims against opportunistic behavior as non-significant relationship is found. Keywords: Audit committee characteristics, earnings management, Malaysian Shariah-compliant companies. 1. INTRODUCTION The corporate governance and its characteristics such as the board of directors and audit committee have received great attention in the recent years by accounting and finance researchers. In this context, many counties around the world have reformed their own corporate governance systems in order to protect the rights of the shareholders. The audit committee as one of corporate governance characteristics can enhance the quality of financial reporting throughout open and candid communication and good working relationships between the companies board of directors, audit committee, internal auditors and external auditors. Furthermore, the integrity, transparency and the quality of financial reports can effectively improve and enhance the investors confidence in the capital markets. By contrast, the financial fraud diminishes their confidence (The Blue Ribbon committee BRC, 1999). Historically, the establishment of audit committees is not something new and in fact was first proposed by the Securities Exchange Commission (SEC) and the New York Stock Exchange (NYSE) in the USA in the 1940s, but was only made compulsory in 1977 (Fisher, 1994, cited in Haniffa, 1999). Furthermore, the wise behind the establishment and development of the audit committee in the USA and Canada according to Dafinone (2001) was to (1) increase confidence in the credibility and objectivity of the financial statements, (2) assist directors in discharging their financial reporting responsibilities, and (3) to strengthen the independence of the external auditors. The effectiveness of audit committee is dependent mainly on four components, the audit committee composition, authority, resource and diligence. Many professional and regulatory bodies worldwide have recommended that members of audit committees should have a specific qualification and expertise to discharge their responsibilities. The SOX act of 2002 for instance requires that each member in the audit committee to be independent and also recommends that at least one member to be an "audit committee financial expert". To be classified as an independent member, the SOX Act states that an audit committee member cannot accept any fees from the company other than for serving as a director, and cannot be an affiliated person of the company or 52

2 any of its subsidiaries. To be qualified as an audit committee financial expert, the audit committee members must understand the economic and accounting principles and standards, comprehend how financial reporting choices and accounting policies can affect a company's financial reports, and possess an understanding of internal controls and procedures in order to safeguard the company s assets and to protect the shareholder rights from any opportunistic behavior such as earnings management and to reduce the occurrence of financial restatement (Almalhuf, 2009). In this vein, Malaysia has taken further steps in order to enhance the foreign investors confidence that was lost after the Asian financial crisis of 1997 in the capital market. One of these steps is the establishment of the framework of corporate governance best practices. The Malaysian code of corporate governance was first issued in March This code emphasises the main oversight duty of the audit committee is to review the scope and the results of the internal auditing function. In the light of the Malaysian code of corporate governance, the audit committee has the full responsibility for reviewing the quarterly and yearly financial statements, and to discuss with the external auditor any issues arising from the audit process. The audit committee also has explicit authority to access to company s financial and non-financial information (Saleh et al., 2007). With regard to the composition of the audit committee, the MCCG and the Kuala Lumpur Stock Exchange KLSE listing requirements have contended that the audit committee in the Malaysian listed companies must consist of a minimum of three audit committee members with a majority of audit committee members to be fully independent from the company management. The requirements also require that the audit committee must have at least one member to be a member of the Malaysian Institute of Accountants (MIA) the Malaysian professional and regulatory body. In Malaysia, the audit committee s role is to review reports from internal and external auditors, to validate scope, evaluate existing policies, establish audit quality and ensure compliance with the policies as well as to ensure that proper processes and procedures are in place to comply with all laws, rules and regulations, directives and guidelines established by the relevant regulatory bodies. More specifically, the audit committee is responsible for reviewing the quarterly results and yearly end financial statements before submission to the board of directors, focusing particularly on the changes in or implementation of major accounting policy changes, the significant and unusual events, ensuring that financial statements are submitted by management on time, the significant adjustments arising from the audit, compliance with accounting standards and other legal requirements (Bursa Malaysia Website, 2012). It is important to mention here that Malaysia with its unique nature as a fast developing country with its own historical background, multiple races, cultures and religions with the majority of its population being Muslims. This has led Malaysia to become a hub for Islamic finance and attract many foreign investors and Islamic banks to operate in this country. To comply with Shariah laws, companies listed in Bursa Malaysia are classified as Shariah-compliant and non-shariah compliant. Shariah-compliant or approved companies are companies that conduct activities which are not contrary to the Islamic principles and have been approved and classified as shariah-compliant companies by the Shariah Advisory Council (Othman et al., 2009). The importance of the Shariah-compliant listed companies in contributing to the Malaysian economic growth is undeniable. The Malaysian shariah-complaint companies include large and small, private and public companies from different sectors namely, the consumer products, industrial products, mining, construction, trading and services, properties, plantation, technology, infrastructure, finance, hotels and closed-end fund. The number has increased steadily after the Asian crisis in 1997 and as at 31 May 2010 the number is 850 companies, which represent 88% from the total number of companies listed in Bursa Malaysia (Bursa Malaysia website, 2010). Thus, this study aims to achieve the following objectives: firstly, to examine the effect of audit committee s size in eliminating earnings management practices among the Malaysian Shariah-compliant companies. Secondly, to study the relationship between discretionary accruals as proxy for earnings management and the present of independent non-executive directors in audit committees. Thirdly, to investigate the effect of directors with accounting background in the audit committee on the earnings management practice. This study contributes to the understanding and knowledge regarding the effect of effective audit committee attributes in minimizing earnings management practice in a fast developing East Asian country like Malaysia and in a very important and fast growing sector Islamic finance and Shariah indexed companies. This study also contributes to the literature by studying the influence of the number of Muslim members in the audit committee on earnings management practices among a sample of 270 Malaysian Shariah-compliant companies for three years from 2007 to It is postulated that the religion of Islam bans any opportunistic behaviour to achieve self interests. In this vein, the Muslim directors are expected to avoid such behaviour by hypothesizing that companies with majority of Muslim directors in the audit committee will resort to less earnings management. Furthermore, this study differs from the related literature by examining the relationship between 53

3 earnings management (proxied by the discretionary accruals) and audit committee characteristics using three panel data estimations (pooled OLS, fixed effects and random effects models). The remainder of the paper is organized in five sections as follows. The next section reviews the relevant literature on issues regarding earnings management and the role of audit committee as a corporate governance mechanism in safeguarding the company s assets in enhancing the external auditor s independence. The third section explains the research methodology, data collection and research sample selection. Section four discusses data analysis and the fifth section provides the results and conclusion for the research. 2. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT Earnings management is the possible outcome of some degree of flexibility and discretion the companies managers have in reporting their financial performance. Furthermore, the judgments in financial reporting and structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence the contractual outcomes that depend on reported accounting numbers is referred to commonly as earnings management (Healy and Wahlen,1998). In this context, Schipper (1989) defines this practice as purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain. The literature has provided an evidence for the expected economic influences that can explain the motivations behind the earnings management practices worldwide. Firstly, managers with accounting based bonus plans have an incentive to report higher earnings in order to maximize their rewards (the management compensation plan hypothesis). Secondly, managers in companies of high financial leverage have motivation to report higher earnings to avoid breach of debt covenant restrictions (the debt/equity hypothesis). Thirdly, managers of large politically visible companies have motivation to report lower earnings to minimize the possibility of wealth (the political cost hypothesis) (Abdul Rahman et al., 2005). Similarly, Dechow et al., (1995) have argued that managers engage in earnings manipulation in order to attract capital and in order to avoid violation of contracts. 2.1 Effectiveness of audit committee There is no specific scientific precise definition for the audit committee, but it differs by different professional environment, as well as interests. It was defined by the Bank of Britain as "a subcommittee of the board of directors that is responsible to follow-up financial matters in the company and to assist the board in making financial decisions, in which the board may not have the time and expertise to know its details." Additionally, it was defined by the American Institute of Certified Public Accountants (AICPA) as "the management by which can mitigate and curb illegal behavior used by the senior management of companies." Size of Audit committee (ACS) The size of audit committee is referred to as the number of directors appointed to be members in the audit committee, in this regard there could be small, medium and large audit committees. The Blue Ribbon Committee (BRC) report of 1999 released the usefulness of having an audit committee and recommended that an effective audit committee of listed companies should comprise at least three directors. The Malaysian Code of Corporate Governance and the listing requirements of Bursa Malaysia require that the audit committee to have at least three directors (Saleh, et al., 2007). These recommendations reflect the assumption that size is a very important attribute of the effective audit committees. Although the size of audit committee is affected mainly by the size of the company and its board of directors, a larger audit committee may not necessarily cause in more effective functioning as a larger audit committee may lead to unnecessary debates and delay the decisions (Lin et al., 2008). According to Abdellatif (2009), the larger size of the audit committee can mitigate effectively asymmetric information during the seasoned equity offerings. Since, by earnings management managers aim to mislead users of financial statements by providing them with false information about a company s true financial position and operating performance, the larger audit committee may play a vital role in constraining the occurrence of earnings management. A negative significant relationship was found between the size of audit committee and earnings management practice according to the findings of Yang and Krishnan (2005). Thus, there should be a positive effect of large audit committees on financial reporting quality. By contrast, Xie, et al., (2003) found no significant relationship between audit committee size and discretionary current accruals as proxy for earnings management. Despite the conflict in the previous studies results, this study hypothesizes that a larger audit committee is likely to be more effective compared with the smaller audit committee; the intuition behind that is with a larger audit committee, the responsibilities, skills, background and power would be increased to enhance their oversight roles. H1: the larger the audit committee, the less earnings management practice. 54

4 2.1.2 Audit committee independence (ACI) The notion of being an independent director according to the Listing Requirement of Bursa Malaysia is referred to as the directors who are free from any relationship and independent from the company s management or having no shares in the company and having no relationship with any major shareholders, officers and executive directors. A number of studies have documented evidence on the association between audit committee independence and earnings quality. Xie et al., (2003) mentioned that the more independent audit committee is argued to provide better governance compared to less independent audit committee. Similarly, Klein (2002) found a significant negative relationship between the percentage of number of independent director over the total number of directors in the audit committee and earnings management practice. As mentioned earlier, the Bursa Malaysia requires all public listed companies to have an audit committee with a minimum of three members. In the Malaysian context, the study conducted by Saleh et al., (2007) provides evidence that the fully independent audit committee is a very active mechanism against opportunistic earnings management practice. Therefore, it is logical to anticipate that the independence of audit committee is associated negatively with the earnings management practice. H2: the independence of audit committee is negatively related with earnings management Accounting background directors in audit committee (ACEX) The experience and knowledge in accounting and auditing related issues is considered as an important dimension for an audit committee, this advantage can help the audit committee members to be more conversant with financial and operational reports that enable them to execute their oversight duties effectively (Mat Zain, 2005). It is worldwide accepted that the key duty of the audit committee is to review the financial reporting process to ensure the best quality, thus the availability of an accounting and auditing expertise in the audit committee would increase the efficiency of the audit committee s performance. A number of studies have documented a negative association between the financial and accounting expertise in the audit committee and earnings management (Bedard et al., 2004). Similarly, Xie et al., (2003) found that audit committee members with accounting and financial knowledge are associated with companies that have smaller discretionary current accruals as proxy for earnings management. Furthermore, the revised Malaysian code of corporate governance (2007) requires all audit committees members to be able to read, analyze, and interpret financial statements to enable them to discharge their duties effectively. Based on the above mentioned recommendations and research findings, this study proposes that the audit committee with accounting expertise would lead to less earnings management practice. H3: the larger the proportion of professional accountants in the audit committee, the less earnings management practice Muslim directors in audit committee (MAC) It is widely acknowledged that the presence of more Muslim members with their knowledge regarding Islamic accounting and finance on the corporate audit committee increases the diversity of the backgrounds, skills and experience of its members, which may increase the effectiveness of decision-making process. Sharia laws require Muslims to adopt Islamic instructions in all aspects of their lives and dealings, and these regulations are enforced by Islam. As a result, Sharia is taken to cover all the main principles that set out the way different treatments should be conducted in the light of the framework of Islamic rules. Muslim managers believe that they are held answerable to their stakeholders in addition to their answerability to Allah in the hereafter life; therefore, they ought to do what is necessary to discharge their accountability. The obligation originates from this accountability, requiring the managers to maintain the property and the resources under their responsibility and use them efficiently, honestly and with integrity to serve the owners interests, to ensure that there is no maladministration and to desist from going beyond the interests of the shareholders and the community. Sharia also stipulates that consultants should have certain skills and features: they should be honest, capable, qualified and expert, in addition to undertaking their responsibility to perform their functions in an appropriate way in order to discharge their duties (Falgi. 2009). It is clear that the reasons behind practicing earnings management are for opportunistic purposes. Islam is against opportunism and forbids Muslims from opportunistic behaviours (Abdul Rahman et al., 2005). H4: the larger the proportion of Muslim directors in the audit committee, the less earnings management. 3. RESEARCH METHODOLOGY AND SAMPLE SELECTION This study is carried out among the Malaysian Shariah-compliant listed companies; data for this study was obtained from secondary sources comprising of 270 companies listed in Bursa Malaysia. This sample was chosen based on certain criteria. It is important to mention here that, the companies which do not have electronic 55

5 website in the Bursa Malaysia, companies which did not publish its annual reports for the years from 2007 to 2009, companies that have been classified as Shariah complaint companies after 2007, banks & financial companies, insurance companies, companies whose websites were under maintenance during the data collection period, and companies that had difficulties in downloading its annual reports as well as the companies that have missing data in the DataStream database were excluded from the research population in order to chose the appropriate research sample. 3.1 Research model The discretionary accruals is used here as a proxy for the earnings management which is measured after subtracting the non-discretionary accruals from the total accruals (DA = TA NDA). While the total accruals (TA) are the difference between net income and the operating cash flows, the DA is the residual (ε) of the Modified-Jones Model (1995) in the following equation. TA i,t /A i,t-1 = β1(1/a i,t-1 ) + β2(δ Rev i,t / A i,t.-1 Δ REC i, t /A i, t.-l ) + aβ3(ppe i,t / A i, t-1 ) + ε i,t TA Non-discretionary accruals DA Where: Δ REV t is revenues in year t less revenue in year t-1, Δ REC t is net receivables in year t less net receivable in year t-1, ΔPPE t is gross property plant and equipment at the end of year t, and A t-1 is total assets at the end of year t-1. DA i,t = α i,t + β1(acs i,t ) + β2(aci i,t ) + β3(acex i,t ) + β4(mac i,t ) + ε i,t (1) Control Variables: A number of control variables are included in the regression, namely, company s size, leverage, the company s profitability and the size of the audit firm. Size (LOGTA): Jensen and Meckling (1976) assumed that large sized firms have the incentive to disclose more financial and non- financial information to avoid political costs represented in the form of tight regulations and increasing tax and social obligations. According to the agency theory, larger firms disclose more information as they have higher agency costs and they are more sensitive to political cost. The literature has provided many ways to measure the company s size, among these include; number of shareholders, number of employees, total market value of the company, and sales volume and total assets (Iskander, 2008). In this study the company s LOG of the total assets is used as a proxy for the company s size. Profitability (COPRO): The profitability of the firm is mainly based on the revenues and the expenses of the entire accounting period, therefore profitability could be a major factor in the decision to produce summarized version of the annual reports (Iskander, 2008). The profitability of a company is a reflection of the firm's performance for a specific year. Therefore, previous researches have suggested that mangers tend to release good news compared to bad news. Furthermore, managers who report high earnings tends to disclose more information to obtain personal advantages (Bribesh,2006). Hossain (2008) too mentioned that many researchers have found a positive relationship between profitability and the extent of disclosure. The profitable firms choose to disclose more voluntary accounting information to distinguish themselves from the less profitable ones. Stakeholder theory assumes that firms with high profitability induce management to disclose more information to attract the shareholders towards their high performance to increase their compensation. On the other hand, low profitable companies avoid disclosing more information to hide their poor performance. The literature have provided different ways to measure the company s profitability, among them are return on total assets, return on net assets, and return on equity. Burns (1985) cited in Nguyen (2001) confirmed that the return on total assets is the best measure of a firm s efficient use of assets because it is independent of financing methods, while return on equity is a measure of the profit return to shareholders. Return on total assets is used in this study as a proxy to the company s profitability. Leverage (LEV): The third control variable in this study is leverage. The ratio of total debt to total assets is employed in most studies and also in this study to measure leverage ratio. Audit firm size (AUDBIG): It has been suggested by previous studies that large and well-known auditing firms have the incentive to disclose more information than others (Bribesh, 2006). However, a number of international audit firms have 56

6 representatives who are selected based on national reputation, training and experience of senior audit personnel, and quality of audit services. Furthermore, large audit firms are more likely to influence corporations to disclose additional information, because they play an important role in limiting opportunistic behaviour of management, thereby reducing the agency costs borne by shareholders. Moreover, the previous studies have shown that large auditing firms are more effective in curbing opportunistic earnings management and are more conservative than small auditing firms (Roslinda, 2009). This study adopts the same method employed by previous studies to code this variable as a dummy variable valued (1) if the auditor is one of the big 4 firms and valued (0) otherwise. The model after adding the control variables is as follows: DA i,t = α i,t + β1(acs i,t ) + β2(aci i,t ) + β3(acex i,t ) + β4(mac i,t ) + β5(logta i,t) + β6(lev i,t ) + β7(copro i,t ) + β8(audbig i,t ) + ε i,t..(2). 3.2 Descriptive statistics The result of descriptive statistics show the average of audit committee directors is 3.27 directors, and 82.3% of this number is considered independent. Furthermore, the biggest number of the directors was 5. In contrast, the smallest contained just 2 directors. The result regarding the minimum of the percentage of independent members in the audit committee is displayed in Table 1 (see appendixes), and this did not meet the requirement of the Malaysian code of corporate governance because some companies only had 20% independent directors in the audit committee. The table also shows that 43% of the audit committee comprise of accounting expertise. A few companies in the study did not meet the Bursa Malaysia listing requirement by having at least one qualified accountant as a member of the audit committee. Only 43.5% of the audit committee consists of Muslims and some companies did not have any Muslims in the audit committee. Furthermore, 61.4% of the companies included in this research were audited by Big 4 audit firms (Ernst & Young (E&Y), PricewaterhouseCoopers (PWC), KPMG and Deloitte as opposed to 38.6% of the companies employing non-big 4 audit accounting firms as their external auditors. 3.3 Testing for normality: The P value of Jarque-Bera test indicated that data were not normally distributed. Consequently, The Normal Scores using Van Der Waerden's Formula was utilized to overcome the violations of the normality assumptions. This transformation technique was commonly used in the previous published studies on corporate governance (Abdellatif, 2009). After the transformation process, data were found to be normally distributed and parametric analysis was undertaken. 3.4 Testing for the Multi-collinearity The Variance Inflation Factors (VIF) was employed to test for multi-collinearity. Based on its results displayed in table 2 (see appendixes), all VIF values are very close to the value of 1. Therefore, it can be concluded that there is no multi-collinearity problem between the independent variables. The highest Variance Inflation Factor (VIF) was only An analysis to the relationship between earnings management and audit committee characteristics: Table 3 (see appendixes) displays the regression results between the discretionary accruals as proxy for earnings management and the audit committee characteristics for three estimation methods in the panel data statistics, namely, the pooled OLS, the fixed effects (FE) and the random effects (RE) methods. It can be clearly seen from table 3 that adding the control variables to the AC s characteristics equation improves the fitness of the model. The R 2 values in the full model for the three methods pooled OLS, FE and RE respectively were 16.26%, 45% and 16.26%, and are higher than those in the model without the control variables in equation 1 (2.226%, 43.75% and 2.02%) respectively. In addition, the F statistics values in the full model are improved after adding the control variables to the models and all of them are statistically significant. To choose between pooled OLS regression compared to fixed effects model, the redundant fixed effects tests are employed. The statistic values and the associated p-values shown in table 4 (see appendixes) strongly reject the null hypothesis that the effects are redundant. This indicates the presence of strong cross section and period effects. Therefore, the cross section and period fixed effects model is preferable over the Pooled OLS model. The Hausman test was employed to choose between the fixed effects and the random effect models. The results are shown in table 5(see appendixes). The decision to choose between the fixed effect and the random effect methods is depend on the probability of chi 2 of the Hausman test. This test prefers the random effect model in the case that the p value is larger than significant level of 5%, and on the other hand prefers the fixed effect model when the p value is less than 5%. According to the results of the Hausman test, it can be concluded based 57

7 on the P value of chi 2 which is 0.83% indicating non-significance and therefore the fixed effects estimation is the appropriate model to be employed in this study. 3.6 Testing for the presence of Autocorrelation (the fixed effects model) Reviewing the regression results displayed in table 3, it indicates clearly that the Durbin-Watson (DW) statistic value of which is between 4 and the 4-d u values. This indicates that there is a first order autocorrelation in the model. Consequently, further steps were undertaken to overcome the autocorrelation problem. 3.7 Testing for the presence of Heteroskedasticity (the fixed effects model) Several heteroscedasticity s diagnostic tests have been suggested in the econometrics literature. By contrast, the most widely used two tests for the heteroscedasticity are (1) the white (1980) test and the Bresusch-Pagan Lagrange Multiplier (LM) (1979) test (Hussain, 2005). Basically, these tests are based on the residuals, which are used to investigate the heteroscedasticity of the true disturbances. The white test is used in this study to detect the presence of heteroscedasticity. Furthermore, White (1980) test is also a Lagrange multiplier measure, this statistic is distributed as χ 2 2 under the null hypothesis of homoscedasticity. The null hypotheses can be rejected when the LM- statistical (Obs*R 2 ) is bigger than χ 2 (0.95,43) indicating that there is evidence of heteroscedasticity. The chi square critical value is Comparing the LM statistical value of (98.832) in the table 6 (see appendixes) with the chi square critical value (59.3) indicates rejecting the null hypothesis of equal variance of residual across the companies, providing a strong evidence of the presence of heteroscedasticity in the regression model. Consequently, further corrective measures were taken in order to eliminate this problem. The GLS weight and White standard errors & covariance were used to overcome the problems of heteroskedasticity and autocorrelation. The results of relationship between audit committee characteristics and discretionary accruals as proxy for earnings management after heteroscedasticity and autocorrelation correction are displayed in the table 7 (see appendixes). 4. FINDINGS, DISCUSSION AND CONCLUSION This study attempts to examine the effects of audit committee characteristics as corporate governance mechanisms on the discretionary accruals as proxy for earnings management. The study was based on a sample of 270 Sharia-compliant companies for a period of three years from 2007 to The results were obtained by using three panel data estimations; Pooled OLS, Fixed effects and random effects methods to investigate the impact of the four independent variables of audit committee on discretionary accruals as dependent variable. The results are as follows: contrary to the first hypothesis which states that the size of the board of directors is negatively related to earnings management, the findings reveal that there is an insignificant positive relationship between earnings management and the size of the audit committee, indicating that the larger the audit committee, the more earnings management practice in the companies. This implies that audit committee size is not a significant factor in mitigating earnings management practice. Regarding the relationship between the number of independent non-executive directors on the audit committee and the tendency to practice earnings management, the results indicate that they are negatively related. The result of this study supports the previous studies evidence of a positive association between audit committee independence and earnings quality (Klein, 2002 and Xie, et al., 2003). We can conclude that audit committee independence is an effective monitoring mechanism to reduce opportunistic earnings management practice. The study also found that there is an insignificant negative relationship between the proportion of accounting expertise among the audit committee members and earnings management. This may not be the actual situation in other developed countries, thus further research to investigate the relationship between the availability of the independent accounting expertise members in the audit committee and earnings management practice must be undertaken not only in Malaysia but in other developing countries. Finally, regarding the presence of the Muslim directors on the audit committee and the earnings management practice, the findings indicate an insignificant positive relationship between the percentage of the Muslim directors in audit committee to the total number of the directors on the board and earnings management. This result is consistent with Abdul Rahman, et al., (2005), who found that there is no statistical evidence to support that the Muslim-managed companies resort to less earnings management than the non-muslim-managed companies in Malaysia. Earnings management is normally undertaken by the management team including financial directors or managers rather than the members of the audit committee. Even though companies can have many Muslim members in the audit committee, it is not a guarantee that earnings management practice will not take place. Furthermore, this finding also justifies that the number of independent Muslim members in the audit committee is more effective than just having more Muslim directors in the audit committee. 58

8 Among the four control variables namely, company s size, leverage, profitability and the size of the audit firm (Big4), only two control variables are found to have significant relationships with earnings management. A significant negative relationship was found between the earnings management and the company s size and this result strongly support the results of Klein (2002). By contrast, a significant positive relationship was found between the earnings management practice and the company s leverage. The results also reveal that the company s profitability and the size of the audit firm were found to be insignificantly related to earnings management practice. Practically, the findings of this study provide some meaningful insights for the decision makers and policy makers such the Securities Commission of Malaysia, as well as the investors in terms of the role of corporate governance in enhancing the reliability of the financial reporting process and the information content of accounting earnings. Investors and shareholders too should be aware of management s capacity to alter accounting earnings for opportunistic purposes. The results of this study provide strong evidence for the regulators to identify the corporate governance characteristics that are important in enhancing the reliability of information. This empirical evidence can be used as a base for new corporate governance regulations and revisions for the existing corporate governance system, because, the best corporate governance regulations would be based on evidence from empirical studies rather than based on political motivated debates. That would give the regulators with sufficient justification and support to impose additional corporate governance requirements. REFERENCES Abdellatif, Ahmed Elbadry Mohamed (2009). Corporate Governance Mechanisms and Asymmetric Information: An Application on the U. K. Capital Market, PhD thesis, University of Surrey, UK. Abdul Rahman, Dowds and Cahan (2005). Earnings management practices among Muslim and non-muslim managers In Malaysia, IIUM Journal of Economics and Management, 13 (2): Al saedi, Alaa A Salih, (2010). The effect of dividend policy on market value UK empirical study, PhD thesis, Durham University, UK. Almalhuf, Abdoalhakim Albashir (2009). Perceptions of Libyan external auditor independence, PhD thesis. Liverpool John Moores University, UK. Asteriou and Hall (2007). Applied Econometrics A modern Approach using EViews and Microfit (Revised Edition), Palgrave Macmillan, The USA. Bedard, Chtourou, and Courteau (2004). The Effect of Audit Committee Expertise, Independence, and Activity in Aggressive Earnings Management, Auditing: A Journal of Practice & Theory. (23)2: BRC (1999). Report and recommendations of the Blue Ribbon Committee on improving the effectiveness of corporate audit committees, Blue Ribbon Committee, New York Stock Exchange and National Association of Securities Dealers. New York, USA. Bribesh, Fathi Naser (2006). The Quality of Corporate Annual Reports: Evidence from Libya, PhD Thesis, University of Glamorgan,UK. Dafinone, Daphne (2001). The Effectiveness of Audit Committees: An Analysis of Governance Mechanisms as Surrogates for Effectiveness, PhD thesis, City University, UK. Dechow, Sloan, and Sweeney (1995). Detecting earnings management, the accounting review, 70 (2): Falgi, Khalid I, (2009). Corporate Governance in Saudi Arabia: A Stakeholder Perspective, PhD Thesis, University of Dundee, UK. Haniffa, Roszaini Mohamad, (1999). Culture, Corporate Governance and Disclosure in Malaysian Corporations. PhD thesis, University of Exeter, UK. Hart, O (1995). Corporate governance: some theory and implications, The Economic Journal. 105(403): Healy and Wahlen (1998). A review of the earnings management literature and its implications for standard setting. Harvard Business School Working Paper, Harvard University. Hossain, Mohammed (2008). The Extent of Disclosure in Annual Reports of Banking Companies: The Case of India. The European Journal of Scientific Research.23(4): Hussain. Mohmad Isa, (2005). Determination of capital structure and prediction of corporate financial distress, PhD thesis, Universiti Putra Malaysia (UPM), Malaysia. Iskander, Amir Emil (2008). The relationship between auditing expectation gap and voluntry sorporate disclosure Egyptian evidence, PhD Thesis, University of Durham, UK. Jensen and Meckling (1976). Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics. 3(4): Klein, April (2002). Audit Committee, Board of Director Characteristics, and Earnings Management. Journal of Accounting and Economics. 33(3): Lin, Xiao and Tang (2008). The roles, responsibilities and characteristics of audit committee in China. Accounting, Auditing & Accountability Journal. 21(5):

9 Mat Zain, Mazlina (2005). The impact of audit committee and internal audit attributes on internal audit contribution to financial statement audit and audit fees: perceptions of Malaysian internal auditors, PhD theses, Griffith University, Australia Nguyen, Kieu Minh (2001). Financial management and profitability of small and medium enterprises, DBA Thesis, Southern Cross University, Australia. Othman, Thani and Ghani (2009). Determinants of Islamic Social Reporting Among Top Shariah-Approved Companies in Bursa Malaysia, Research Journal of International Studies, Issue 12: Ramadan, Abdulhadi (2009). Determinants of capital structure and the firm's financial Performance: An application on the UK capital market, PhD thesis, University of Surrey, UK. Roslinda, (2009). The relationship between corporate governance and accounting conservatism. PhD Thesis. University of New South Wales, Australia. Saleh, Iskandar and Rahmat (2007). Audit committee characteristics and earnings management: evidence from Malaysia, The Asian Review of Accounting, 15 (2): Saleh, Iskandar and Rahmat (2007). Audit committee characteristics and earnings management: evidence from Malaysia, Asian Review of Accounting, 15 (2): Schipper, K (1989), Earnings management. Accounting Horizon. 3(4): Xie, Davidson and Dadalt (2001). Earnings management and corporate governance: the roles of the board and audit committee. Working Paper. Illinois University, USA. Yang and Krishnan (2005). Audit committees and quarterly earnings management, International Journal of Auditing. 9(3): APPENDIXES Table 1: Descriptive statistics: Variable Mean Median Max Min S.D Skew Kurtosis Jarque-Bera Probability ACS ACI AUDEX MAC LOGTA LEV CORPO AUDBIG Table 2: Results for Multi-collinearity Variable ACS ACI AUDEX MAC LOGTA LEV COPRO AUDBIG Variance Inflation Factors Tolerance VIF Table 3: Results of relationship between earnings management and audit committee characteristics: Equation 1 Equation 2 Pooled OLS FE RE Pooled OLS FE RE C (0.7833) (0.8551) (0.7957) (0.7992) (0.9139) (0.8009) ACS (0.5957) (0.7677) (0.7454) (0.4303) (0.9536) (0.4344) ACI (0.0001) (0.0644) (0.0002) (0.0025) (0.1007) (0.0027) AUDEX (0.6982) (0.3709) (0.5636) (0.1142) (0.4444) (0.1174) MAC (0.1788) (0.4512) (0.2673) (0.1369) (0.3226) (0.1404) LOGTA (0.0000) (0.1027) (0.0000) LEV

10 COPRO AUDBIG (0.0000) (0.0077) (0.0000) (0.6824) (0.6605) (0.1822) (0.7451) (0.685) (0.6633) R DW F stat (0.0000) (0.0000) (0.0000) ( ) (0.0000) (0.0000) Table 4: Summary of redundant fixed effect tests Effects tests Statistics d.f. Prob Cross-section F Cross-section Chi-square Period F Period Chi-square Cross-section / Period F Cross-section / Period chi-square (269,530) 269 (2,530) 2 (271,530) 271 Table 5: Summary of Correlated Random Effects- Hausman Test Chi-Sq statistic Chi-Sq. d.f. Prob Table 6: White test for heteroscedasticity heteroscedasticity Test: White F-statistic Prob. F(43,766) Obs*R-squared Prob. Chi-Square(43) Table 7: The results after heteroscedasticity and autocorrelation correction, dependent variable (DA) coefficient std. error t-ratio p-value Const ACS ACI AUDEX MAC LOGTA LEV COPRO AUDBIG Sum squared resid S.E. of regression R-squared Adjusted R-squared F Stat P-value(F) Durbin Watson (DW)