2 LITERATURE REVIEW 2.1 Hofstede Cultural Dimension

9 Petra Christian University

2 LITERATURE REVIEW

2.1 Hofstede Cultural Dimension

Geert Hofstede cultural dimension can be used to compare the culture

between countries and it is regarded as the most influential national culture

framework in business literature (Kirkman, Lowe, & Gibson, 2006). National

culture can be an important determinant in differences in management behavior,

which is influences how organization is run (Steenkamp, 2001). In this paper,

Hofstede cultural dimension is important as both subject countries have similarities

in terms of these cultural dimensions which make them comparable. There are six

dimensions of Geert Hofstede cultural dimension (Hofstede, 2017):

1. Power distance: Power distance can be defined as “the extent to which the less

powerful members of institutions and organisations within a country expect and

accept that power is distributed unequally” (Hofstede, 2017). Managers in a

high power distance country tend to manage earnings when they have too much

authority (Dechow, Sloan, & Sweeney, 1996). Both Indonesia and Malaysia

score highly in power distance (78 and 100 respectively) indicating that workers

expect to be directed on what to do and accept the high authority of the

managers. This might also indicate that there is a similar tendency of earnings

management which affects earnings quality in the two countries.

2. Individualism: Individualism relates to the interdependency between the

members of its society. Both Indonesia and Malaysia score low in individualism

(14 and 26 respectively) which indicates a collectivist society. They value

family and loyalty in the society as well.

3. Masculinity: High masculinity society is driven by ambition and competition,

whereas the opposite (feminine) focus more on liking what you do and regards

quality of life as a sign of success. High masculinity leads to an aggressive

accounting manipulation which can lead to lower earnings quality (Khlif, 2016).

Indonesia scores 46 which is considered feminine, while Malaysia scores 50 in

http://www.petra.ac.id

http://dewey.petra.ac.id/dgt_directory.php?display=classification

http://digilib.petra.ac.id/help.html


which it can’t really be determined. However, the score is not far different

indicating similarity in masculinity dimension.

4. Uncertainty avoidance: This dimension refers to “the extent to which the

members of a culture feel threatened by ambiguous situations and have created

beliefs and institutions that try to avoid these” (Hofstede, 2017). It is associated

with an enhanced practice of disclosure (Khlif, 2016). Malaysia scores 36 and

Indonesia scores 48 which indicates a low preference for avoiding uncertainty.

In Indonesia, this means not showing their true emotion to the people

surrounding and keeping the culture of “keeping the boss happy”. In the case of

low uncertainty avoidance, deviation of rules or principles are more tolerated

and punctuality does not come easily.

5. Long term orientation: This dimension determines the way people deal with the

past, present and future. Low long term orientation, such as Malaysia (41),

prefer to maintain time-honored tradition and focus on quick results (i.e.

normative society). Indonesia, scoring 62, shows a slightly different culture

which is a pragmatic society in which traditions can easily change according to

the situation. They place importance on the future by seriously saving, investing

and at times characterized with thrifty characteristics. It is associated with a

higher level of social and environmental disclosure (Khlif, 2016).

6. Indulgence: Indulgence refers to how well people of the society control their

desire. Indonesia scores lowly (38) indicating a more restricted behavior to the

social norm and pessimism on leisure time. On the other hand, Malaysia scored

57, which indicates that people are willing to realize their desires to having fun.

All in all, the result of the Hofstede cultural dimension has shown that out

of six dimensions, four of them are in the same category for the two countries. These

similarities can be translated as well in terms of their behaviors in organizations.

2.2 Corporate Governance

Corporate governance can be defined in various ways depending on the

institution, country and legal tradition (International Finance Corporation, 2014).

The IFC (2014) explains corporate governance as structures and processes which

will accommodate the direction and control of companies. According to the


Organization for Economic Cooperation and Development (OECD), corporate

governance involves relationships between company’s stakeholders, providing

structure in which company’s goal are measured, attained and monitored, rewarding

board and management with proper incentives, and facilitating effective monitoring

(BPP Learning Media , 2015). All of these components aim to encourage firms to

use the available resources as efficient as possible at the best interest of the company

and shareholders (International Finance Corporation, 2014).

The Cadbury Report on financial aspects of corporate governance

commissioned by the UK government identified various stakeholders of a company.

The first stakeholder includes the directors who were held accountable for the

company’s corporate governance. The second includes the shareholders who are

linked to the directors by the financial statement produced by the company. Lastly,

there are other relevant parties to the organization such as employees, customers

and suppliers. It is not always the case that these stakeholders are well and fully

informed about the management of the business. Some companies have the annual

general meeting (AGM) to let the shareholders find out about the company’s

management. However, these AGMs are often poorly attended thus resulting to a

potential conflict of interest between management and shareholders. Therefore, the

corporate governance is crucial as it places a structure in the company to ensure that

the stakeholders’ interests are fully taken into account in the business (BPP

Learning Media , 2015). There are three theories relating to corporate governance

explained in the next sub-chapters.

2.2.1 Agency theory

According to Jensen & Meckling (1976), agency relationship is contract

between one person, regarded as the principal, and another person, known as the

agent. The agent is given authority to conduct service and make decisions in the

behalf of the principal. In a company, shareholder acts as the principal, while

management are the agents (Roberts, 2015). An issue may arise when the agent,

having their own self interest, behave in a way not in accordance or not in the best

interest of the principal. Therefore, principals try to implement controls and

incentives to mitigate this kind of issue. The costs that principals incur monitoring


cost to deter behaviors of agents diverging from the principals’ best interest. There

are three components of agency costs (Jensen & Meckling, 1976):

a. Monitoring expenditures by principal: cost incurred to monitor the activities of

agent in order to hinder deviant activities.

b. Bonding expenditures by agent: ensuring that the agents’ actions are not

harming the principal and giving them compensation when this is done. This is

costs incurred to ensure that agents make decisions which are in the best interest

of the principal.

c. Residual loss: dollar equivalent of the reduction in welfare experienced by

principal due to the divergence between the agents’ decisions and those which

will maximize the principal’s wealth.

Principal-agent research identifies two possible problems relating to agent-

principal relationship. Bendickson, et.al (2016) mentionned that principal’s appetite

for risk-sharing is crucial. Principal has entrusted agents with responsibility and

authorities in order to achieve a common goal. However, according to Burnham

(1941), agency problem emerged when an agent acts regarding his own self interest

thus ignoring the best interest of the principal (as cited in Bendickson, Muldoon,

Liguori, & Davis, 2016). The first agency problem emerges when there is a shift in

risk-sharing between the agent and principal which is caused by the deviation of the

agent’s actions. The second agency problem, triggered by the first one, is the

existance of information asymmetry which causes difficulties for the principal to

monitor agent’s behavior (Bendickson, Muldoon, Liguori, & Davis, 2016). Agency

theory states that if agents have a stake in the firm (i.e. ownership of equity), they

are more likely to conduct actions that are alligned with the principal’s interest.

However, the second agency problem arose where there is a perceived inequity

which made the agent act in their own self interest instead of the principal’s.

The second perspective of agency theory, the positivist agency theory,

focuses more on the governance mechanism that will hinder the agency problems

from taking place. In other words, this theory try to explain mechanisms which will

minimize self-serving behavior from the agent (Eisenhardt, 1989 as mentionned in

Bendickson, et.al, 2016). In the context of corporate governance, shareholders act


as the principal while the company directors act as the agents (Roberts, 2015).

Roberts (2015) mentioned that in order to solve the agency problems within

corporate governance, shareholders need to accept certain agency costs by creating

sanctions or incentives to allign interests of the two.

Incentives, as an internal mechanism for board to exercise control over

executives, can be given in the form of share options or long term incentive plans.

For this to work, independent non-executive should be present to monitor

executive’s performance, especially if there is a potential conflict of interest.

Different considerations taken to decide the members of board including the

number of non-executives (independent) board member, separation of chief

executive and non-executive role, creation of audit, remuneration and nomination

committee, also the qualification of the members. All these criteria are in place in

order to ensure the effective running of monitoring the agents’ actions to deter

agency problems (Roberts, 2015).

2.2.2 Stewardship theory

In another perspective, Donaldson & Davis (1994) argued that board may

not be necessary to monitor the performance and actions of the executives as they

are deemed to be trustworthy. In the context of corporate governance, stewardship

theory believes that managers are trustworthy individuals and are good stewards of

the company. This means that managers will work dilligently to achieve high level

of performance, i.e. corporate profit, shareholder return. It also believes that as

managers are good stewards of the company, they will not misappropriate

company’s profit and shareholders’ wealth, as concerned in the agency theory

(Donaldson & Davis, Boards and Company Performance - Research Challenges the

Conventional Wisdom, 1994).

Stewardship theory, fundamentally, is the opposite of agency theory

(Donaldson & Davis, 1991). In addition to that, stewardship theory follows the

model of man. This means it believes that managers are stewards who put

organizational interest first and have high collectivistic behaviors. Their behavior

will not deviate from the interest of the organization and will always make decisions

which maximize the company’s financial performance. Consequently, the


shareholders will also benefit from the thriving financial performance, e.g. through

sales growth, profitability. Stewards also believe that by maximizing the company’s

performance will also at the same time fulfill their personal interest, even though

they do not value this self-interest more than the company’s.

However, the performance of the steward is influenced by the

condusiveness of the structural situation in which he/she is placed in. They value

structures of organization which values more facilitation and empowerment (Davis,

Schoorman, & Donaldson, 1997). A study by Donaldson & Davis (1991)

challenges the theory of CEO duality criteria in the agency theory. Based on their

findings, instead of separating the role of chief executive and board, entrusting an

individual with both role can improve the firm performance. This means that

stewardship theory also believes that organizational financial performance and

shareholders’ wealth can be maximized if the managers are empowered by giving

them unfettered responsibility and authority, instead of continuously monitoring

their decisions and actions (Donaldson & Davis, 1994).

2.2.3 Human Capital Theory

In economic terms, capital refers to factors of production used in the process

of production to create goods and services. The theory of human capital can be

defined in various ways (Adom & Asare-Yeboa, 2016). Human capital can be said

to be based on knowledge and skills obtained by a person through learning activities

(Daeboug, 2009). There are two main components of the concept. The first one is

the capability of someone which was acquired or innate. This includes experiences

such as previous employment experience. The second one refers to the skills which

is acquired through formal education or on-the-job training (Adom & Asare-Yeboa,

2016; Law, 2010; Pierce-Brown, 1998). Men and women may have different ways

of learning due to underlying difference in cognitive functioning, decision making

and conservatism (Peni & Vahamaa, 2010).

The level of human capital a person has can influence their skill and

competence in running business. A study on Ghanaian women entrepreneurs show

that the level of education gives a huge impact on managing their business in terms


of critically analyzing data, ideas and also understanding their environment. (Adom,

et. Al., 2010).

Human capital can be improved by making investments towards it (Kwon,

2009). These investments can be allocated to the three main sources of human

capital which include: abilities which are obtained genetically of through

socialization, schooling and training (Adom, et.al., 2010). Firms with a more stake-

holder oriented corporate governance has been found to invest more heavily on

firm-specific human capital (Odaki & Kodama, 2010).

2.2.4 Principles of Corporate Governance

In 1999, the OECD has issued a number of Principles of Corporate

Governance which was further reviewed in 2004. These principles laid down the

rights of shareholders, the necessity of transparency and disclosure, also sets out

the responsibilities of the board of directors as the ones who manage day-to-day

operation of the company (BPP Learning Media , 2015). These principles include

what the corporate governance framework should achieve:

1. Promoting transparent and efficient markets, consistency with the law and clear

articulation of the division of responsibilities among different supervisory,

regulatory and enforcement authorities

2. Protecting and facilitating the exercise of shareholders rights

3. Ensuring equitable treatment of all shareholders (both minority and foreign

shareholders) in which all shareholders should have the opportunity to obtain

effective redress for violation of their rights

4. Recognizing the rights of stakeholders as established by the law or through

mutual agreements and encouraging active co-operation between corporations

and stakeholders in creating wealth, jobs and sustainability of financially sound

enterprises.

5. Ensuring timely and accurate disclosure on all material matters regarding the

corporation, including financial situation, performance, ownership and

governance of the company.


6. Ensuring strategic guidance of the company, effective monitoring of

management by the board, and the board’s accountability to the company and

the shareholders.

2.2.5 Board of Director as a Mechanism of Corporate Governance

In order to ensure good corporate governance in an organization, there are

some mechanisms which can be implemented. These mechanism is divided into

internal and external mechanism. Internal mechanism is implemented to enforce

accountability by the discretion of the individual organization (Altuner, Tuna, &

Can Güleç, 2015). Internal mechanism includes the creation of board of directors,

audit committee, internal auditors, external auditors and management (Hashim &

Devi, 2015). On the other hand, external mechanism is present to establish

frameworks for the internal mechanism that can be implemented by organizations.

This include parties such as legal system, courts, financial analysts, and legislators

(Altuner, Tuna, & Can Güleç, 2015).

As explained in the background, this research will focus on one of the

internal mechanisms of corporate government which is the board of directors. The

board of directors holds an important role in the company as they own the highest

control over the company’s management team. They have the right to monitor the

decisions made by the management as well as to approve new or changes in

company policies (Fama & Jensen, 1983). Board of director is also established with

the aim of protecting the interest of the owners (shareholders) (Haji & Ghazali,

2013). The following subchapters will discuss further about the components of

board of director mechanism highlighted in this paper.

Board Size

Board size refers to the number of people sitting as the board member.

Numerous studies have included board size as one of the indicators of internal

mechanism of corporate governance (Jensen, 1993; Bushman, Chen, Engel, &

Smith, 2004; Taktak & Mbarki, 2014). The size of the board can influence how

effective it is in running their roles to ensure a good corporate governance

implementation.


Jensen (1993) and Bushman, et.al (2004) stated that a large number of

people sitting as the board of directors can hinder effective coordination and

communication. As a result, it is difficult to achieve consensus and make decisions.

When this happens, managers could exploit this opportunity to dominate the

directors and utilize managerial discretion for their own self-interest Therefore, as

Jensen (1993) mentioned, smaller board size is more effective in its monitoring and

oversight duties.

On the other hand, there are also some studies supporting a larger number

of board of director. A large board size can pool different expertise, knowledge and

experiences which the organization can benefit from (Jian & Ken, 2014; Xie, et.al,

2003 as mentioned in Taktak & Mbarki, 2014). The variety of different expertise

and knowledge can make up for individual deficiencies in skills in the context of

collective decision making. Larger boards also have an advantage of increased

monitoring capacity in handling organizational activities (Haji & Ghazali, 2013).

Board Independence

Board independence refers to the proportion of independent directors in the

board of director. It is expressed in the formula below:

2.1 Board Independence Equation

Board independence = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑛𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑑𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑠

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑠 (2.1)

Fama (1980), as cited in Haji & Ghazali (2013), stated that independent

directors have a major role in ensuring that the rights of the shareholders are

protected by preventing agency problems and opportunistic behaviors, including

prevention of discretionary practices that reduces earnings quality (Haji & Ghazali,

2013; Taktak & Mbarki, 2014). In other words, independent director helps the board

to effectively does its role. Independent directors, or sometimes also referred to as

outside directors, have the task of monitoring opportunistic behaviors associated

with insiders (Haji & Ghazali, 2013).

In another case, the presence of independent director can pressure

companies to take a more proactive approach in disclosure. This is also supported


by the knowledge and expertise owned by the independent directors (Hashim &

Rahman, n.d). Independent directors also are more likely to suppress discretionary

practices in companies as they exercise control and discipline more effectively than

the non-independent ones (Taktak & Mbarki, 2014).

The company is also benefited from the presence of independence not only

from their additional knowledge and expertise, but also from the independent

judgment that it brings to the board team. In order to be effective, it was mentioned

that at least 30% of the board should be composed of independent non-executive

director (Buniamin, Johari, Rahman, & Rauf, 2012).

Managerial Ownership

As an attempt to overcome agency problems, executives or members of

board of directors own a part of the company’s shares. The rationale behind this

incentive is that the interests of managers and external shareholders can be aligned

when managers own a stake at the company’s shareholding (Yang, Lai, & Tan,

2008). In other words, managerial ownership of shares is one of corporate

governance internal mechanism that can be used to reduce agency problem.

Therefore, it is implied that higher managerial ownership can lower agency-

principal conflict as managers would have more incentive to maximize job

performance. When job performance translates to a maximized company

performance, the executives will benefit as well through the ownership of shares

(Haji & Ghazali, 2013).

Despite that, managerial ownership should be done in moderation. An

excessive managerial ownership can have an adverse impact on the firm. As they

have more stake in the company, managers may take on aggressive decisions in

order to maximize personal benefit, for instance adopting accounting policies to

window-dress financial performance (Jung & Kwon, 2002). This is also known as

the entrenchment effect. Through the high ownership of shares, managers can

guarantee their own future employment benefits thus can deviate from an effective

alignment of interest between the shareholders and the executives (Hashim & Devi,

2015). Managerial ownership is calculated by the use of the formula below:

2.2 Managerial Ownership Equation


Managerial ownership = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑤𝑛𝑒𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑑𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑠

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠 (2.2)

Board Gender Diversity

Board diversity relates to the variation of characteristics of the board

members. This can be translated into diversity of ethnic, gender, age, education

background or even personality. However, this study will only focus on the impact

of board gender diversity.

Boardroom diversity in terms of gender diversity has shown an increasing

trend in the S&P 500 firms. Nearly one-third of the new directors in S&P 500

companies are women and this is the highest it has ever been so far. In 2016, 76%

companies include two or more women in the board and one-quarter have three

women directors. This has showed an improvement in the presence of female

directors in the context of U.S. companies (Spencer Stuart , 2017).

Nevertheless, according to a global survey by Spencer Stuart (2016)

boardroom diversity quotas are not receiving enough support. Almost a third

quarter of the surveyed directors denied support for boardroom diversity quota. The

survey showed that half of the female director respondents support them but only

9% of male directors showed support on this matter (Spencer Stuart, 2016). Aside

from that, it is possible that female directors may not be given enough influence to

play a role in influencing earnings quality (Abdullah & Ismail, 2016) or not enough

quota to influence IC (Swartz & Firer, 2005).

Presence of female director can be beneficial to the board. They may present

different attitudes towards risk in the company. Compared to male directors,

Spencer Stuart survey reported that women directors placed higher concerns over

risk which can lead to less aggressive decision making. The risk included in the

survey were concerns about activist invertors, cybersecurity, and to the regulatory

risk and supply chain matters (Spencer Stuart, 2016).

Several studies have included board gender diversity as a part of indicators

of corporate governance internal mechanism (Abdullah & Ismail, 2016; Buniamin,

Johari, Rahman, & Rauf, 2012; Gavious, Segev, & Yosef, 2012; Hashim & Devi,


2015; Gavious, Segev, & Yosef, 2012; Peni & Vahamaa, 2010). Peni & Vahamaa

(2010) stated that men and women may have different attitudes and practices in

their management behaviors. This is because of the fact that there are certain

differences on their behavior due to underlying difference in cognitive functioning,

leadership style, communication, decision making and conservatism. This can lead

to different attitudes and practices on the quality of financial reporting (Peni &

Vahamaa, 2010). Board gender diversity is determined by the following ratio:

2.3 Board Gender Diversity Equation

Board gender diversity = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑓𝑒𝑚𝑎𝑙𝑒 𝑑𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑠

𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑠 (2.3)

2.2.6 Corporate Governance in Indonesia and Malaysia

Indonesia

In 1997-1998, Indonesia has suffered through a severe financial crisis. One

of the causes of this crisis was the poor implementation of corporate governance

practice. Therefore, it was deemed urgent that there is a need to develop and

improve compliance of corporate governance benchmarking with the international

best practices (International Finance Corporation, 2014).

Indonesia Financial Services Authority (OJK) has played an important role

in committing to promote the good practice of corporate governance in Indonesia

in the hope of creating a more stable financial environment. Together with the

International Financial Corporation Advisory services, a corporate governance

manual was created to provide a robust framework for good practices of corporate

governance for corporations (International Finance Corporation, 2014). This

manual includes improvements of the role of board of commissioners, board of

directors, shareholder rights, material corporate transaction, disclosure and

transparency and also internal control.

The Indonesian corporate governance code was built based upon the OECD

principles and covers the following four principles (International Finance

Corporation, 2014):


a. Fairness

Rights of all shareholders should be protected by the corporate governance

framework. It should also ensure an unbiased treatment to all shareholders

including minority and foreign shareholders. More specifically, these

shareholders should be able to gain a rightful compensation if their rights were

violated.

b. Responsibility

The law has tried to ensure the protection of stakeholders by establishing some

sets of rules. This should be recognized by the corporate governance framework.

In addition to that, the framework should actively encourage cooperation

between companies and stakeholders in creating jobs, wealth and sustainable and

financially sound enterprises.

c. Transparency

A timely and accurate disclosure should be made by the company relating to all

material matters that occur. All material matters can be relating to company’s

financial situation, performance, governance structure or ownership. This should

be emphasized as well by the corporate governance framework.

d. Accountability

Accountability refers to the strategic guidance of the company. The framework

should ensure that the board is effective in doing its role of monitoring the

management. The board should be accountable to both company and

shareholders.

Indonesia follows the two-tier board structure. This two-tier board structure

means that companies are required to separate the role of CEO and the Chair of the

Board (Organization for Economic Co-operation and Development, 2017). These

two roles are separated in the creation of the board of commissioners and board of

directors. Board of commissioners act as a superintendent of the company. It holds

a strategic role in overseeing the policy and implementation of those policies by the

management running the company, also advising the board of directors. Their task

is also called the business oversight as they monitor the survival, growth and

business practice of the company. On the contrary, board of director has full

responsibility on the day-to-day management of the company. It acts as the agents


in the company and has a role in supervising the assets of the company and utilizing

the resources of the company in order to benefit the company. The board of

directors also act as representatives of the company, both internally and externally.

There is a minimum of 2 directors in the board, in which 30% of the board

member should be independent. Independent, in this case, refers to people who are

not related to the management (by birth or marriage), major shareholders,

employees of affiliated company and representatives of companies which have

significant dealings with the subject company. The directors have a maximum of 5-

year appointment period (Organization for Economic Co-operation and

Development, 2017).

In terms of support of board gender diversity, Indonesia does not have a

requirement of disclosure of gender composition statistics regarding its board

members as well as senior management. There has not been a quota or target as

well in order to achieve a balance in gender diversity (Organization for Economic

Co-operation and Development, 2017).

Due to the separation of board in Indonesia, this study will separate the

composition of board according to the two-tier structure. The indicators of board of

commissioners and board of directors will be separated. For instance, board size for

Indonesian context would be translated to two indicators: board of directors size

and board of commissioners size.

Malaysia

After the Asian financial crisis in 1997, there was an urgent need to rebuild

the confidence of investors. Therefore, in 2000, the Malaysian Code of Corporate

Governance (MCCG) was first proposed. The code was revised in 2007 in order to

further emphasize on the independent directors’ roles. It is hoped that this will

create improvement in transparency and the good practice of corporate governance

(Mohammad, Wasiuzzaman, & Salleh, Board and audit committee effectiveness,

ethnic diversification and earnings management: a study of the Malaysian

manufacturing sector, 2016). In 2012, the MCCD was further revised to make

several improvements. The newest revision focused on strengthening the board

structure and composition which recognized the director’s role as active fiduciaries.


Not only are directors responsible for optimizing firm performance, but also for

ensuring compliance with laws and ethical values as well as maintaining an

effective structure of management of risk and internal control (Securities

Commissions Malaysia, 2012). The MCCG is built upon the following eight

principles:

a. Establishing clear roles and responsibilities

Clear functions reserved for the board and those delegated to management

should be established by the board. In addition, the board has to establish clear

ethical standards and ensure compliance of the code of conduct. Sustainability

should be a part of the company’s strategies as well. Access to information and

advice should be structured in a clear procedure. Also, a competent company

secretary should support the board in its role. Lastly, the board should

formalize, conduct periodical review, and publicize its board charter

b. Strengthen composition

A nominating committee should be established by the board in which it should

consist of non-executive directors and majority of whom must be independent.

The task of this nominating committee is to create, maintain and review criteria

used in recruiting and annual assessment of directors. Transparent

remuneration policies should be established as well in order to attract and retain

directors.

c. Reinforce independence

There should be an annual assessment of its independent directors in which

majority of the board should consist of independent directors. The chairman

must be a non-executive member of the board and is not an independent

director.

d. Foster commitment

The board has responsibility to set out protocols for accepting new

directorships as well as expectations of time commitment for the members. It

should also make sure that access to continuing education programs to be given

to its members.


e. Uphold integrity in financial reporting

The audit committee holds a crucial role in ensuring the compliance of

financial statement to the applicable financial standard. The suitability and

independence of external auditors should also be assessed through a set

policies and procedures by the audit committee.

f. Recognize and manage risks

A sound framework of risk management should be established. This includes

the creation of internal audit function which reports directly to the Audit

Committee.

g. Ensure timely and high quality disclosure

This principle ensures that the board create an appropriate disclosure policies

and procedures. Information technology could be utilized in order to

disseminate information effectively.

h. Strengthen relationship between company and shareholders

The board has a task to be proactive in encouraging shareholders to participate

in general meetings. This also include promoting effective communication and

engagement with them.

Malaysia follows the one-tier board structure with the minimum of 2

directors in the board (Organization for Economic Co-operation and Development,

2017). In a unitary (one-tier) board structure, the board represents the highest

element of a company’s internal corporate governance system. The members of this

board of directors are appointed by the shareholders. A CEO usually sits on the

board together with other directors, thus emphasizing the need of independence

directors to ensure effective monitoring in the company management. In a unitary

board structure also, the issue of board structure and diversity is more crucial as a

lot of times its composition is biased towards a particular gender, age or ethnicity

(Abdullah & Ismail, 2013).

At least one-third of the board members or two members should be an

independent director. The criteria of independent director is the same with

Indonesian definition which exclude people related to the management (by birth or

marriage), major shareholders, employees of affiliated company and

representatives of companies which have significant dealings with the subject


company. The directors have a maximum of 3-year appointment period

(Organization for Economic Co-operation and Development, 2017).

In terms of support of board gender diversity, Malaysia has a requirement

of disclosure of gender composition statistics regarding its board members as well

as senior management. There is a target of achieving a board gender balance which

is 30% of board member should be female by 2016 (Organization for Economic

Co-operation and Development, 2017).

2.3 Intellectual Capital

The term intellectual capital has been put under discussion for several years

and it has been closely associated with the intangible asset of an organization.

Intellectual capital can be described as a pool of company’s intangible asset which

allows them to perform numerous functions. There is an on-going debate on the

definition of intangible asset itself (Iazzolino & Laise, 2013). According to Itami

(1988) intangible asset is related to “resources which are based on information or

which incorporate it” (as cited in Iazzolino & Laise, 2013). Another explains

intangible asset as means to create future income without the use of tangible or

physical resources. Intangible assets can be in form of managerial capabilities,

company reputation, internal control and even organization culture (Iazzolino &

Laise, 2013). According to Choudhury (2010) intangible assets can be divided into

human capital, organizational capital and social capital.

There are several explanations on the definition of intellectual capital itself.

Brooking (1996) tried to explain the concept of intellectual capital. Intellectual

capital may refer to knowledge in form of implicit or explicit information. It can

also be a process of transformation by using means of research, development and

organization learning. Intellectual capital can also be explained in the concept of

knowledge products such as patents or trademark (Brooking, 1996). Pulic (2008)

stated that intellectual capital is a set of knowledge workers instead of a collection

of different assets. He believes that it is the employees of the company who has the

capability to transform knowledge into products of services which adds value.

As mentioned by Iazzolino & Laise (2013), intellectual capital can be used

as a strategic asset which relates to specific and valuable knowledge to the


organization. In the setting of a growing complexity of technology and where

knowledge plays a big role in the business setting, the efficient management of

intellectual capital becomes more crucial (Iazzolino & Laise, 2013). The next two

sub-chapters will discuss about theory complementing intellectual capital

(resource-based and competence-based theory) and the third sub-chapter will

discuss the measurement of intellectual capital.

2.3.1 Resource-based Theory

According to Porter (1985), creating competitive advantage has been a

central focus of strategic management. In this context, research-based theory (RBT)

provided a framework used to analyze sources and sustainability of a firm’s

competitive advantage (Barney, 1991 as cited in Smith, et.al., 1996). RBT helps to

address issues relating to how firms can benefit from their resources and capability

in a most effective and efficient way to ensure competitive advantage (Galabova &

Ahonen, 2011). It is more internally focused and dependent on resources and

capabilities (Galabova & Ahonen, 2011; Warnier, Weppe, & Lecocq, 2013).

Competitive advantage, based on this theory, is derived from strategic resources

and it is sustainable so long as it is valuable, rare, inimitable and non-substitutable

(Smith, Vasudevan, & Tanniru, 1996; Sanchez, 2015). In other words, it not only

involves the resources to deliver products, but also those not easily copied by

competitors (Galabova & Ahonen, 2011). An extended model of RBT by Warnier,

et.al. (2013) has categorized resources into three types:

1. Strategic resources: It refers to resources which are rare in the market and this

type of resource is widely studied in RBT. A strategic resource can be either

present internal of the firm or available in the market as strategic factors. In any

case, it is deemed strategic when it is perceived to create a superior performance

thus competitive advantage. After it is identified, firms attempt to acquire or

duplicate them. Some resources that are widely studied as strategic resources

include human capital, experience, social capital, innovation and also reputation.

When a strategic resource is related to processes of accumulation, it is difficult

to imitate. In addition to that, strategic resources available in the market may

not be equally strategic for all companies working in a particular industry. This


depends on each firm’s capacity in maximizing the value of that particular

resource.

2. Ordinary resources: Ordinary resources include all of the firm’s assets. This

includes resources commonly available in the market. It does no improvement

to firm performance however it assists to achieve competitive parity. Despite

this, it ensures operations to function properly in the day-to-day business setting

and its absence can create loss to the firm and destroy value. Therefore, it is

worth noting as a part of the resource-based theory. Ordinary resources can also

be the basis of firm’s performance due to its replicability making it possible for

firm to duplicate in new business units or countries. In addition, it can also be

closely involved in the creation of new business models.

3. Junk resources: These resources are a lot of times overlooked by companies as

they are considered value decreasing. They also include processes in companies

which may have failed to be implemented or ones which have turned obsolete.

Most companies would try to dispose of these resources however some may try

to acquire these as it may have a potential to create competitive advantage.

RBT faces three major limitations (Smith, Vasudevan, & Tanniru, 1996;

Warnier, Weppe, & Lecocq, 2013). The first one, its earliest literatures focused on

tangible assets under the firm control and focused more on individual resource’s

potential. This suppresses the ability to explore more on competitive advantage

through synergy of multiple sources interactions. To solve this issue, it is important

to clarify and operationalize concept of “resource bundles” (Barney, 1991 as cited

in Smith, et.al, 1996). Secondly, RBT focused more on the result than the process

whereas building competitive advantage takes time. Lastly, there is no clear

definition on what sustainability means. Barney (1991) stated that it is sustainable

when competitors are not able to imitate firm’s strategy. This means they eliminate

the time range involved in creating the sustainability. In reality, it is difficult to

determine whether competitors are actually able to fully implement the same

strategy that brings competitive advantage to our firm or not (Warnier, Weppe, &

Lecocq, 2013).


2.3.2 Competence-based Theory

In the perspective of competence-based, a firm’s existence, structure and

boundaries are associated with the skills, knowledge of the individuals and teams

which are maintained and nurtured by that organization (Hodgson, 1998). The

theory of competence-based has evolved over centuries and there are variety of

approaches that can be adopted.

The first prominent author writing about competence-based theory was

Adam Smith in his Wealth of Nations (1776). He stated that workers could

specialize and enhance their skills when labors are divided. They could learn skills

by doing the work and therefore an increase in productivity can be achieved. Adam

Smith took a dynamic approach of this theory as he believed these skills are

continuously grown, developed and enhanced (Smith, 1970 as cited in Hodgson,

1998). However, Smith did not take account factors of corporate culture and the

role of generating, transmitting and protecting knowledge. The next prominent

author was Frank Knight (1921) where he put an emphasis on the presence of

uncertainty. According to Knight (1921), competence-based theory deals with how

organizations group activities together, including controlling those activities in

order to deal with uncertainty.

The third author was Penrose (1959) in which she stated that in the

competence-based theory of the firm, a firm is regarded as a combination of

competences which includes a collection of productive resources in which its usage

is controlled by administrative decisions. She placed an emphasis on the dynamic

development on tacit knowledge and other capabilities, as well as the growth of the

firm. Just as Smith (1970), Penrose (1959) also argued that people learn by doing

thus their knowledge will increase as experience increases as well (Penrose, 1959

as cited in Hodgson, 1998).

2.3.3 Measurement of Intellectual Capital using VAIC model

There are different methods to measure intellectual capital. Summarized by

Jurczak (2008), there are four methods of measuring intangibles which includes

direct intellectual capital methodology, market capitalization methodology, return

on asset methodology and score card methodology. Each of these methods has its


own advantages and disadvantages, however the fundamental problem for research

of these method is their comparability. The degree of customization makes it

difficult for the results of these methods to be compared among companies or

industries (Jurczak, 2008).

Ante Pulic (1998) developed another model in order to measure intellectual

capital called the Value Added Intellectual Coefficient (VAIC). Different research

studying the relation between corporate governance, intellectual capital and

earnings quality have also used this model (Mojtahedi, 2013; Darabi, Rad, &

Ghadiri, 2012; Appuhami & Bhuyan, Examining the influence of corporate

governance on intellectual capital efficiency Evidence from top service firms in

Australia, 2015; Bohdanowicz, 2014; Saleh, Rahman, & Hassan, 2009). The

rationale behind this model is that it is important to be able to measure productivity

even for knowledge workers. Thus, a methodology is needed to measure the

efficiency of this intellectual work just as how physical work efficiency is similarly

measured (Pulic A. , 2008). Pulic proposed the idea of using the value added (VA)

on cost of labor ratio to measure the productivity of knowledge workers. It is

implied in this model that the impact of knowledge of human resources can be

quantified in terms of value creation (Iazzolino & Laise, 2013).

To understand the VAIC model, it is important to first understand the

underlying theory of intellectual capital that the VAIC model uses. The Skandia

Navigator divides intellectual capital into: human capital and structural capital.

Figure 2.1 Skandia Navigator Components of Capital

Source: Iazzalino & Laise (2013)

Pulic started with this model and made some changes. According to the

Skandia Navigator, human capital (HC) includes everything relating to the


capabilities of employees whereas the term structural capital (SC) refers to

intangible assets such as patents, brands or processes. Pulic (2008) stated that

intellectual capital, instead of being a collection of asset, refers to the employees

who are able to convert acquired skill and knowledge into value adding products

and services. Therefore, HC in Pulic’s case refer to the cost of knowledge workers

as they are the main value creators for the economy. HC is treated as an investment

of knowledge creation. In other words, HC is able to create value to the company

(VA).

Pulic defines structural capital (SC) as the residual of VA less HC, which

also translates to the conditions allowing the knowledge workers to create value

(Iazzolino & Laise, 2013). SC includes knowledge that stays within the firm such

as organizational processes, mechanism, structures as well as procedures

(Appuhami & Bhuyan, 2015). Putting it simply, it can be written down into the

formula of

2.4 Value Added Equation

VA = HC + SC (2.4)

The relationship between VAIC model and VA itself is that a high VAIC

indicates the company utilizes its potential for value creation the better (Appuhami

& Bhuyan, 2015). The VAIC model itself is calculated based on two types of capital

efficiency which are intellectual capital efficiency (ICE) and capital employed

efficiency (CEE). Breaking it down, ICE is influenced by the human capital

efficiency (HCE) and structural capital efficiency (SCE). Therefore, VAIC results

from the sum of HCE, SCE and CEE. The VAIC model uses financial statements

in order to calculate the three efficiency coefficient used.

According to Pulic (2004) value added, as the indicator of business’ ability

to create value, is calculated according to the Value Added income statement. It is

the difference between output, i.e. total sales and output, and cost of bought in

materials, components and services. In the financial statement, VA can be

computed using the formula:


2.5 Value Added Equation (2)

VA = P + A + D + EC (2.5)

Legend: P = operating profit; A = total amortization; D = total depreciation; EC =

employee expenses

Next, in measuring VAIC a measurement of each of the efficiency

component is needed. The first one is intellectual capital efficiency (ICE) which is

divided into human capital and structural capital efficiency.

Human capital efficiency refers to how much value added can be created

from investments on the employee, i.e. employee costs, are included in human

capital efficiency. On the other hand, structural capital has a reversed proportion to

human capital which indicate that a higher human capital contributing to the value

added, the smaller share of structural capital it has. Structural capital efficiency can

be influenced by knowledge management, organization culture, as well as

organization process efficiency (Mohammadi, Sherafati, & Ismail, 2014).

2.6 HCE Equation

HCE = VA / HC (2.6)

2.7 SCE Equation

SCE = SC / VA (2.7)

Where:

2.8 SC Equation

SC = VA – HC (2.8)

Legend: HCE = Human Capital Efficiency; SCE = Structural Capital Efficiency;

VA = Value Added; HC = Total salaries and wages; SC = Structural Capital.

Intellectual capital efficiency (ICE) is obtained by adding HCE and SCE:

2.9 ICE Equation

ICE = HCE + SCE (2.9)


In order to maximize value creation, financial capital is also needed in

addition to the knowledge capital measured in the ICE. Therefore, the value creation

of intellectual capital should take account the capital employed efficiency (CEE),

which is the financial resources needed to support the value creation. Capital

employed can also refer to the investment made in terms of its physical assets

(Darabi, Rad, & Ghadiri, 2012). CEE is important as in the manufacturing business,

the efficiency of its physical asset can influence the success of its business process

(Gan & Saleh, 2008).

2.10 CEE Equation

CEE = VA / CE (2.10)

Legend: CEE = Capital Employed Efficiency; VA = Value Added; CE = Total

equity + total debt

Finally, the overall value creation of efficiency combines all the three

indicators above. The formula of VAIC is

2.11 VAIC Equation

VAIC = ICE + CEE = HCE + SCE + CEE (2.11)

This aggregated indicator presents a more comprehensive perspective on the

overall efficiency in a company as well as its intellectual capability. A high

coefficient of VAIC represents a higher creation of value by making use of all of

its resources namely its financial, physical and also intellectual capital.

2.4 Earnings Quality and Earnings Management

Accounting policies and standards such as the IFRS and GAAP have

attempted to remove inconsistencies in the accounting framework leading to a better

comparability between companies, industries and capital markets. It also tries to

provide a more robust revenue-recognition and requirement of better disclosure

(Schoroeder & Clark, 2009). On the other hand, companies are faced with pressures

to meet or even beat market expectations in order to increase shares price and

manager’s compensation. Therefore, companies resort to the use of income

management in order to meet these expectations. Regulators have raised concern


that management’s focus can shift from conducting good business practices simply

to meet these expectations. As a result, the quality of earning and financial reporting

has eroded (Kieso, Weygant, & Warfield, 2011).

Earnings quality refers to the correlation between a company’s economic

income and its income reported by the accounting (Schoroeder & Clark, 2009). A

high quality of earning is crucial for analysts as it represent a full and transparent

information which will not confuse or mislead the users of the financial reports

(Weygandt, Kimmel, & Kieso, 2013). Due to the problems mentioned previously,

accounting income may not be the best indicator for a company’s cash flow or

financial robustness (Schoroeder & Clark, 2009). This quality of earnings can be

influenced by earnings management practices. Earning management can prove to

be detrimental to earnings quality when it distorts information in a way that

decreases its usefulness to predict future cash flow and income. This can destroy

market’s trust where this bond between the shareholders and company should have

been kept strong (Kieso, Weygant, & Warfield, 2011).

Earning management is “the planned timing of revenues, expenses, gains

and losses to smooth out bumps in earnings” (Kieso, Weygant, & Warfield, 2011).

Earnings management occurs when there is an opportunity to make accounting

decisions that change the reported income of a firm. In addition, it occurs when firm

management exploits those opportunities (Weil, 2009). Other than that, earnings

management can be used for earning smoothing which means that executives alter

earnings upward or downward to avoid steep fluctuation of earnings which can

conceal an unstable financial condition of the firm (Matsumoto, 2002). In addition

to that, earning management aims to influence the short-term reported income. The

more company engage in earnings management, the less reliable the earnings

quality of that company is (Schoroeder & Clark, 2009). This issue of earnings

quality has raised an issue in which management are too busy managing income

instead of the actual business (Weygandt, Kimmel, & Kieso, 2013).

According to Schoroeder & Clark (2009), there are different methods to

assess earnings quality and observe the red flags of earnings management. Firstly,

different accounting principles can have an effect of inflating company’s earnings.


Therefore, by comparing the accounting principles employed by the company with

those of competitors’ or industry’s one can indicate whether there is an attempt of

earnings management. In addition to that, recent changes in accounting principles

and estimates should be monitored on their effect to earnings.

Moreover, managing expenses is one of the common ways for management

to influence earnings quality. Discretionary expenditures can be compared over the

years to determine whether the timing of expenses influence the earnings, for

instance the decision to incur a major marketing expenditure (Weil, 2009). This

would also be possible through the use of LIFO cost flow assumption where a year-

end-purchases can affect income in the desired manner. The timing which the

management decide to make a purchase can manage company’s earnings to become

either lower or higher (Weil, 2009).

Furthermore, accounting methods can be used to manage company’s

earnings as well. One of the methods include the abuse of accounting estimates

which are usually left to the discretion of the management, such as percentage of

allowance of uncollectible receivables. This gives the management a window of

opportunity to select a range of number which can influence the company’s net or

comprehensive income.

2.4.1 Motivation for Earnings Management

Watts and Zimmerman (1986) came up with a positive accounting theory

where the theory tried to uncover factors of economy or certain characteristics of

business unit which can be linked to the behavior of those in charge with a firm’s

financial statement. More specifically, the theory tried to explain several

motivations that executives may have in mind when implementing accounting

policies. This flexibility in choosing certain accounting practices may give

opportunity for managers to select the ones which can help them achieve a certain

goal. There are three hypothesis regarding the motivations of managers in

implementing certain accounting practices (as cited in Aryani, 2011):

1. The bonus plan hypothesis states that managers are motivated by bonus plans

to use accounting estimates or methods that will increase reported income in

the current period. This can be done by manipulating the timing of earnings


from the future to be recognized in the current period. This behavior is due to

the fact that most executives would prefer to get higher income in the current

period. In other words, earnings management can act as a tool to maximize

executive’s personal wealth at the expense of shareholders (Holthausen, 1990;

Christie & Zimmerman, 1994; Beneish, 2001 as mentioned in Peni & Vahamaa,

2010).

2. The debt to equity hypothesis (debt covenant hypothesis) states that managers

are more likely to increase reported income through accounting practices when

the firm has a high debt to equity ratio. Executives would want to manage their

earnings in order to postpone the company’s current liability to the next period.

Earnings management in this case can also be done in order to fulfill a debt

covenant that the firm is bound to.

3. The political cost hypothesis states that larger firms, as opposed to small firms,

have bigger tendency to use accounting policies which will decrease earnings.

In firms with high political cost, executives might prefer to recognize more

profits in the future with the hope of attracting attention from consumers and

media. This can also be done prior to important company event such as an

initial public offering (Yang, Lai, & Tan, 2008).

2.4.2 Techniques for Earnings Management

According to Arthur Levitt (as mentioned in Schoroeder & Clark, 2009)

there are five techniques of earnings management which can threaten earnings

quality, thus the integrity of financial reporting

1. “Taking a bath”

This technique of earnings management is used when the company decides to

go on restructurisation by reporting an excessive loss. The aim of this technique

is to increase profit in the future.

2. “Creative acquisition accounting”

This earning management technique attempts to avoid expense in the future.

The company will only recognize expense at one time for activities that are

actually in-process such as research and development

3. “Cookie jar reserves”


This technique uses an inappropriate timing of sales return or warranty cost

recognition. During good times, the managers will overstate sales return and

warranty cost and during bad times, the overstatement previously used will be

used. As a result, the sales will be smoothened and there will be less fluctuation

in the net sales figure.

4. “Abusing materiality concept”

Abusing materiality concept techniques makes use of the loophole in the

material value used by the auditor. In a lot of cases, auditors would pay more

attention to transactions above the material limit used by the company.

Therefore, managers try to hide fraud by breaking it down to several

transactions with an amount below the material level. When being assessed

individually, the transactions don’t look significant however the aggregate

could be beyond the material limit.

5. “Improper recognition of revenue”

This technique recognizes revenue during the period in which benefits the

company instead of during the actual period of recognition. When a company

needs to inflate sales in the current period, it will recognize sales from a future

period and vice versa.

2.4.3 Indicator of Earning Quality

Different models have been developed to identify practices of earnings

management. These models include aggregate accrual model, specific accruals

model and distribution of earnings after management model. However, out of the

three, aggregate accrual model is discovered to be able to detect earnings

management the best (Aryani, 2011). Accrual is a mechanism of earnings

management which is not affected by current cash flow. This also provides the

opportunity for management to use their discretion in recognizing transactions (Al-

Thuneibat, Al-Angari, & Al-Saad, 2016). The accrual model, as mentioned in

Aryani (2011), is in line with accrual based accounting used in businesses and it

uses all components of financial statements to detect earnings management.

Total accruals in a company can be divided into discretionary and non-

discretionary accruals (Dechow, Sloan, & Sweeney, 1995). Non-discretionary


accruals are normal accruals that is used in the creation of financial statement. On

the contrary, discretionary accruals are the ones related to the manipulation of

financial statement. Discretionary accruals are used by manager’s discretion in a

way that is beneficial for the company or even for the self-interest of the managers

(Thomas & Zhang, 2000).

There are various models of aggregate accrual models and they have

evolved over the years. This includes the Healy model (1985), the DeAngelo Model

(1986), the Jones Model (1991), the Modified Jones Model, and the Industry Model

(Dechow, Sloan, & Sweeney, 1995). These models can be used to proxy non-

discretionary accruals. Previous studies have used the Modified Jones model in

order to measure earnings management (Al-Thuneibat, Al-Angari, & Al-Saad, 2016;

Swastika, 2013; Yang, Lai, & Tan, 2008; Saleem & Alzoubi, 2016; Hashim & Devi,

2015). This paper will measure earnings quality as the absolute value of the

discretionary accruals projected by the Modified Jones model (Abdullah & Ismail,

2016; Darabi, Rad, & Ghadiri, 2012; Mojtahedi, 2013).

Modified Jones model is effective at modelling time-series process thus

suitable to be used in this paper (Yang, Lai, & Tan, 2008). It has also been

mentioned as a powerful model that can detect earnings management by measuring

unexpected accruals better compared to other models (Dechow, Sloan, & Sweeney,

1995). The Jones model, which is the basis of the Modified Jones model, has

managed to overcome previous model’s limitation where it assumed that non-

discretionary accruals are constant. It has been able to control for the impact of

fluctuation of firm’s economic conditions on non-discretionary accruals. The

Modified Jones model solved an issue with the Jones model where it assumed that

revenue is discretionary whereas in reality earnings management can be conducted

by managing accruals regarding credit sales. This model uses an assumption that

credit sales changes are results from earnings management as it is easier to manage

accruals using credit sales compared to revenue from cash sales. In other words, the

modified Jones model is more superior in detecting EM through discretionary

accruals as it takes solves the limitations of assumptions regarding both

discretionary and non-discretionary accruals from the previous model (Dechow,

Sloan, & Sweeney, 1995).


The first step to measure discretionary accrual is to begin calculating the

total accruals. The Healy model (1985) is used as it detects earnings management

by calculating the amount of total accruals. The formula is as follows:

2.12 Total Accruals Equation

Total accruals (TAit) = Net income before extraordinary items – Cash flow

from operations for the period (2.12)

Next, the following formula of Modified Jones (1995) is used in order to separate

discretionary and non-discretionary accruals (Al-Thuneibat, Al-Angari, & Al-Saad,

2016). The following formula is used to find the coefficients:

2.13 Equation for finding coefficient TA

T𝐴𝑖𝑡

𝐴𝑖,𝑡−1= α1 (

1

𝐴𝑖,𝑡−1) + 𝛼2 (

(∆𝑅𝐸𝑉𝑖𝑡− ∆𝑅𝐸𝐶𝑖𝑡)

𝐴𝑖,𝑡−1) + 𝛼3 (

𝑃𝑃𝐸𝑖𝑡

𝐴𝑖,𝑡−1) + 𝜀 (2.13)

The coefficients will be substituted to the following equation to find the non-

discretionary accruals and finally discretionary accruals.

2.14 Non-discretionary Accruals Equation

N𝐴𝑖𝑡

𝐴𝑖,𝑡−1= 𝛼1 (

1

𝐴𝑖,𝑡−1) + α2 (

(∆𝑅𝐸𝑉𝑖𝑡− ∆𝑅𝐸𝐶𝑖𝑡)

𝐴𝑖,𝑡−1) + 𝛼3 (

𝑃𝑃𝐸𝑖𝑡

𝐴𝑖,𝑡−1) (2.14)

2.15 Discretionary Accruals Equation

𝐷𝐴𝑖𝑡 = 𝑇𝐴𝑖𝑡 − 𝑁𝐷𝐴𝑖𝑡 (2.15)

Notes:

TAit = Total accruals for the year; Ait-1 = Total asset for the previousyear, i.e. time

t-1; ∆REVit = Difference of revenue in the current period and the previous period;

∆ARit = Difference of accounts receivable in the current period and the previous

period; PPEit = Non-current asset for the period; NAit = Non-discretionary accruals

for the current period; DAit = Discretionary accruals for the current period


A high value of discretionary accruals (DA) indicates a high level of

earnings management. Earnings quality is negatively translated from the absolute

DA. In other words, a higher value of absolute discretionary indicates a higher effort

of earning management, thus implying a lower earnings quality (Hashim & Devi,

2015; Mojtahedi, 2013).


2.5 Earlier Research

Table 2.1 Earlier Research

2.5

E

arli

er R

ese

arc

h













2.6 Research Hypotheses

2.6.1 Board of Directors and Earnings Quality

Corporate governance holds a crucial role to ensure the quality of financial

reporting process as financial reporting is a means for preventing and detecting any

possible agency problem that may arise (Hashim & Devi, 2015). In other words, a

robust corporate governance implementation in a company should be able to

increase the quality of earnings reported to the shareholders. Majority of investors

agreed that corporate governance is a source of concern and should prioritize to

strengthen the quality of accounting disclosure. Moreover, a good corporate

governance can also increase the willingness of investors to pay a premium price

for the company’s shares. In fact, majority agrees that accounting disclosure is the

most important consideration for their investment decision (McKinsey & Company,

2002). One of the most important mechanism in corporate governance is its board

of directors.

There has been extensive researches conducted on the correlation between

board of director and earnings quality or earnings management. Each of these

studies uses various combination of the components of board of directors available

and uses the subject of firms across the globe. Most of these studies use the indicator

of discretionary accrual to measure earnings quality (Swastika, 2013; Yang, Lai, &

Tan, 2008; Saleem & Alzoubi, 2016; Peni & Vahamaa, 2010; Hashim & Devi, 2015;

Gavious, Segev, & Yosef, 2012; Abdullah & Ismail, 2016).

The board of directors represents one of the most prominent mechanism of

corporate governance as they hold the highest control over the company’s

management team. They have the right to monitor the decisions made by the

management as well as to approve new or changes in company policies (Fama &

Jensen, 1983). Some indicators used for corporate governance include composition

of independent director on board, board size, gender diversity, ownership structure,

and audit quality. Each of this mechanism have different results in terms of their

impact to earnings quality. This might also be different for each country under

observation. Unlike Malaysia, Indonesia adopts the two-tier board structure.

Therefore, the term “board” in each of the indicators will be separated to board of


directors and board of commissioners to accommodate for this characteristic. In

accordance to previous studies, the hypothesis formed is as follows:

H1: Board of director has an impact to earning quality

The following sub chapters will explain the impact of each of board of

director indicators to company’s earnings quality.

Board Size and Earnings Quality

Board size has been a subject of various studies regarding its impact towards

earnings management. Some studies have stated that the large number of people

sitting on board can make coordination and communication difficult thus making

consensus of decisions difficult to reach as well (Jensen, 1993; Bushman, Chen,

Engel, & Smith, 2004). As a result, with the larger number of board size, earnings

management practices is more prominent in a firm indicating a lower earning

quality. A study by Swastika (2013) over companies listed in Indonesia stock

exchange showed that the number of director sitting on the board is positively

associated with earnings management. Other studies, namely Hashim & Devi

(2015); Buniamin, et. Al (2012) also support this notion.

However, there are some inconsistencies as well where a study found there

is no association between board size and earnings management (Taktak & Mbarki,

2014), or where is there is a significant negative correlation between board size and

earnings management (Obigbemi, Omolehinwa, Mukoro, Ben-Caleb, & Olusanmi,

2016). The negative correlation can be explained by the fact that a large board size

can pool different expertise, knowledge and experiences thus reducing the

occurrence of earnings management and thus increasing earnings quality (Jian &

Ken, 2014; Xie, et.al, 2003 as mentioned in Taktak & Mbarki, 2014).

Board Independence and Earnings Quality

Fama (1980), as cited in Haji & Ghazali (2013), stated that independent

directors have a major role in ensuring that the rights of the shareholders are

protected. Independent directors, or sometimes also referred to as outside directors,

have the task of monitoring opportunistic behaviors associated with insiders (Haji

& Ghazali, 2013). In another case, the presence of independent director can pressure

companies to take a more proactive approach in disclosure. This is also supported


by the knowledge and expertise owned by the independent directors to detect

discretionary accrual practices (Hashim & Rahman, n.d). Independent directors also

are more likely to suppress discretionary practices in companies as they exercise

control and discipline more effectively than the non-independent ones (Taktak &

Mbarki, 2014). Studies in Jordan and Nigeria showed a negative correlation

between proportion of independent director and discretionary accruals (Saleem &

Alzoubi, 2016; Obigbemi, Omolehinwa, Mukoro, Ben-Caleb, & Olusanmi, 2016).

This means, the higher the proportion of independent director on board, the higher

earnings quality that the company reports.

Despite that, there are also several studies that show that board

independence has no correlation with earnings quality. In the study on Malaysian

and Indonesian companies, board independence has no correlation with earnings

management (Swastika, 2013; Hashim & Devi, 2015; Buniamin, Johari, Rahman,

& Rauf, 2012). The reason behind this is, according to Hashim & Devi (2015), they

might not have much influence on the process or not have enough qualification to

be able to influence earnings quality in the company.

Managerial Ownership and Earnings Quality

Executives or members of board of directors may own a part of the

company’s shares as an attempt to overcome agency problems. The rationale behind

this incentive is that the interests of managers and external shareholders can be

aligned when managers own a stake at the company’s shareholding (Yang, Lai, &

Tan, 2008). Therefore, it is implied that higher managerial ownership can lower

agency-principal conflict as managers would have more incentive to maximize job

performance. When job performance translates to a maximized company

performance, the executives will benefit as well through the ownership of shares

(Haji & Ghazali, 2013). In other words, ownership of share can improve the quality

of earning of the company (Saleem & Alzoubi, 2016).

Despite that, managerial ownership should be done in moderation. An

excessive managerial ownership can have an adverse impact on the firm. As they

have more stake in the company, managers may take on aggressive decisions in

order to maximize personal benefit, for instance adopting accounting policies to


window-dress financial performance (Jung & Kwon, 2002). This is also known as

the entrenchment effect. Through the high ownership of shares, managers can

guarantee their own future employment benefits thus can deviate from an effective

alignment of interest between the shareholders and the executives (Hashim & Devi,

2015). On the contrary, a study by Yang (2008) discovered that the relationship

between executive ownership and discretionary accrual follows an inverted U shape

which indicated that the higher stake of ownership, the higher earnings quality due

to lower discretionary accruals. This means that the amount of ownership can both

decrease or increase earnings management.

An inconsistency is found, however, in a study by Hashim & Devi (2015)

where it showed no relationship between managerial ownership and earnings

quality. It instead found a positive significant correlation between outside director

ownership, family ownership, institutional ownership and earnings quality.

Board Gender Diversity and Earnings Quality

In terms of earnings management, it is found that the presence of female

executive on board has a significant positive influence on earnings management,

but income decreasing earnings management practices (Buniamin, Johari, Rahman,

& Rauf, 2012; Peni & Vahamaa, 2010). This translates as the presence of women

can decrease the earnings quality due to the earnings management practices, despite

it being an income-decreasing accruals. However, another study stated there is a

significant negative correlation between board gender diversity and earnings

management practices (Obigbemi, Omolehinwa, Mukoro, Ben-Caleb, & Olusanmi,

2016; Gavious, Segev, & Yosef, 2012). In other words, the higher proportion of

women present on board, the higher earning quality the company has. This might

be caused by women’s conservative nature which suppress the practice of earnings

management.

A contradiction is found on the study over Malaysia listed company which

showed that there is no correlation between female directors and earnings

management, possibly due to the little influence they have over the decision itself

(Abdullah & Ismail, 2016).


2.6.2 Board of Director and Intellectual Capital

Intellectual capital (IC) has gained an increased recognition in its part as a

strategic asset for organizations in a knowledge-based economy (Appuhami &

Bhuyan, Examining the influence of corporate governance on intellectual capital

efficiency Evidence from top service firms in Australia, 2015; Iazzolino & Laise,

2013; Bohdanowicz, 2014). Despite its contribution to enhancing performance and

creation of value, there are still issues in managing and controlling IC in

organizations. IC can only maximize firms’ performance when it is managed

properly (Appuhami & Bhuyan, Examining the influence of corporate governance

on intellectual capital efficiency Evidence from top service firms in Australia,

2015).

Corporate governance mechanism, such as the board of director, holds

power to monitor and control company. Therefore, an increasing number of studies

have attempted to understand the role of corporate governance in an effective

management of IC on the basis of agency theory (Appuhami & Bhuyan, 2015;

Swartz & Firer, 2005; Ho & Williams, 2003; Bohdanowicz, 2014; Saleh, Rahman,

& Hassan, 2009; Abdoli, Panahi, & Rahimiyan, 2013; Altuner, Çelik, & Güleç,

2015; Abidin, Kamal, & Jusoff, 2009). It is argued that corporate governance helps

to ensure that managerial decisions are maximizing shareholders’ wealth by the

optimal use of IC (Appuhami & Bhuyan, Examining the influence of corporate


Australia, 2015).

The mechanism of board of director observed in the studies of their

correlation with intellectual capital efficiency varies greatly and each of the

mechanism is found to have different correlations to Value Added Intellectual

Coefficient (VAIC). Therefore, the second hypothesis is:

H2: Board of director has an impact on intellectual capital

The following sub-chapters will discuss how the components of board of

director can influence intellectual capital.


Board Size and Intellectual Capital

The size of the board can influence how effective it is in running their roles

to ensure a good corporate governance implementation. According to the agency

theory, a larger board size can lead to more agency problem due to the lack of

coordination and communication. It is also ineffective in monitoring the

management. In the context of IC management, larger board size is ineffective in

monitoring decisions and investments regarding an optimal use of intellectual

capital.

On the contrary, large board size can pool different expertise, knowledge

and experiences which the organization can benefit from (Jian & Ken, 2014). This

means, they are more capable to making sure of a more optimal intellectual capital.

Board size is found to be positively correlated to intellectual capital, i.e. higher

VAIC (Abidin, Kamal, & Jusoff, 2009). Despite that, a study by Appuhami &

Bhuyan (2015) found no correlation between board size and VAIC.

Board Independence and Intellectual Capital

Board composition (of independent directors) have a positive significant

correlation with VAIC (Appuhami & Bhuyan, Examining the influence of corporate


Australia, 2015; Ho & Williams, 2003; Abidin, Kamal, & Jusoff, 2009). Board

independence can influence intellectual capital positively by providing organization

with expertise, contacts and prestige needed to make decisions about resources such

as IC itself (Appuhami & Bhuyan, Examining the influence of corporate


Australia, 2015; Haniffa & Cooke, 2002). The increased proportion of independent

director can also minimize management’s exploitation of company’s resources and

better manage and monitor CEO’s actions which enhance IC (Ho & Williams, 2003;

Abidin, Kamal, & Jusoff, 2009). However, another study showed a different result

showing no correlation between non-executive director on board VAIC although it

is unclear why the relationship prevailed (Abdoli, Panahi, & Rahimiyan, 2013).


Managerial Ownership and Intellectual Capital

Based on the agency theory, managerial ownership can be a tool in order to

align shareholder’s and the management’s interest, that is to maximize firm’s value.

One way to do it through the use of intellectual capital efficiently. A study by Ho

& Williams (2003) showed that the higher percentage of insider ownership can

increase intellectual capital using VAIC as proxy. The more management owns a

stake in the company’s equity, the more incentive they have to create more value

through effective IC management which can result in higher IC performance.

However, another study by Saleh, et.al (2009) found a negative correlation

between management ownership and VAIC value. This means that the higher

management ownership a firm has, the lower intellectual capital it has. On the other

hand, another study also found that there is no relationship between managerial

ownership and the VAIC value of firms in Malaysia (Abidin, Kamal, & Jusoff,

2009). The argument regarding these matters lies in the questionable management’s

capability in creating value through maximizing the use of company’s resources.

Board Gender Diversity and Intellectual Capital

Mattis (1993) believes that female directors can give unique contributions

to the company which can improve approaches to intellectual capital related

decisions and other decision making. In addition to that, a greater diversity has a

greater ability to acquire resources which support intellectual capital performance.

Thus, a greater gender diversity can lead to a higher VAIC.

Despite this, Swarts & Firer (2005) found no relationship between board

gender diversity and VAIC in the context of South African companies. This study

argued that the absence of relationship is due to the low number of women actually

sitting on the board. Only 46% of companies listed in the South African Stock

Exchange had female directors on board as opposed to the average of 75% in more

developed nations such as United States of America.

2.6.3 Intellectual Capital and Earnings Quality

In the knowledge-based business setting, knowledge holds an important role

on business growth and success. This knowledge needed for the running of the

business is part of intellectual capital. On the other hand, earnings quality is said to


hold an important role in reflecting firm’s performance. A high earning quality

reflects the true condition of a firm (Mojtahedi, 2013). There has been not many

study that observes the direct correlation between intellectual capital and earnings

quality. However, two studies in Malaysia and Tehran has found that there is a

positive correlation between IC, with VAIC as the measurement model used, and

earnings quality, measured using discretionary accrual (Darabi, Rad, & Ghadiri,

2012; Mojtahedi, 2013).

Intellectual capital can be divided into human capital, structural capital

efficiency and capital employed efficiency. Mojtahedi (2013) explained that the

higher knowledge and experience that the management has, i.e. higher HCE, the

better they are in managing accruals thus improving earning quality. The advanced

technology leading to a higher structural capital efficiency also is able to make

information readily and quickly available to users, thus management rely less on

earning management techniques which can improve earnings quality.

H3: Intellectual capital has a positive impact to earnings quality

2.6.4 Firm Characteristics as Concomitant Variables

Firm Size

Firm size is indicated by the natural log of total asset, as also used in studies

by Abdullah & Ismail, 2016; Yang, Lai, & Tan, 2008; Saleem & Alzoubi, 2016;

Hashim & Devi, 2015; Gavious, Segev, & Yosef, 2012; Peni & Vahamaa, 2010.

Larger companies tend to receive more scrutiny from financial analysts and

investors. Therefore, they are less likely to engage in behaviors of earnings

management (Yang, Lai, & Tan, 2008). In addition to that, larger firms tend to have

a stronger governance structure and lower information asymmetries which hinders

earnings management better, indicating a positive correlation with earnings quality

(Gavious, Segev, & Yosef, 2012; Mojtahedi, 2013; Darabi, Rad, & Ghadiri, 2012).

A study in Poland found that firm size is positively correlated to intellectual

capital efficiency but negatively correlated to capital employed efficiency

(Bohdanowicz, 2014). However, a study in Malaysia by Abidin, et.al. (2009)

showed there is a positive correlation to VAIC.


Leverage

Leverage is used as a proxy for the financial condition the company is in.

Studies by Abdullah & Ismail, 2016; Yang, Lai, & Tan, 2008; Saleem & Alzoubi,

2016; Gavious, Segev, & Yosef, 2012; Peni & Vahamaa, 2010 incorporate leverage

as one of the control variables in their study. Gavious, Segev & Yosef (2012) stated

that companies with financial distress are more likely to engange in earnings

management. It can also be used to window-dress company performance that is not

doing as well as expected. Some studies reveal that there is a negative association

between leverage and discretionary accrual (Gavious, Segev, & Yosef, 2012). It is

found there is a negative correlation between leverage and earnings quality

indicating the higher leverage it has, the higher earnings management thus lower

earnings quality (Darabi, Rad, & Ghadiri, 2012; Abdullah & Ismail, 2016).

Appunhami & Bhuyan (2015) found there is significant relationship

between leverage and VAIC. Bohdanowic (2014) found a negative correlation

between leverage and VAIC indicating a lower leverage indicates a better

intellectual capital. Abidin, et.al. (2009) showed an opposite result in which

leverage is positively correlated with VAIC.

Documents

2 LITERATURE REVIEW 2.1 Hofstede Cultural Dimension