Final Research Master (Write Up) Edited - Final Print

8/10/2019 Final Research Master (Write Up) Edited - Final Print

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CHAPTER ONE

INTRODUCTION

1.0 Introduction

Auditors play an important role in order to ensure the maintenance and issuance of high

quality financial reports. The function of auditing is to ensure the quality of corporate

earnings has come under considerable enquiry due to some high-profiled earnings

management cases such as WorldCom and the collapse of Enron (Li and Lin, !!"#. The

demand for auditing ser$ices arises because need to facilitate dealings bet%een the internal

and e&ternal parties in$ol$ed in business relationships such as shareholders, creditors, public

authorities, employees, customers and others (Chia, Lapsley and Lee, !!'#. o%e$er, from

the management perspecti$e, the $alues of the firms are related to report earnings figures,

therefore it %ill creates economic incenti$es for management to engage in earnings

management. Thus, fraud and mismanagement on financial reporting %ill occur due to

personal interest of managers or other related parties.

Accounting fraud and corporate collusion also become important issues in )alaysia. *t seems

the credibility and quality of auditor becomes decreased. As a result, this matter %ill

contribute to the issue of fraud, collusion, bribes and manipulation of accounting numbers

among the companies in )alaysia. According to +ecurities Commission )alaysia !!

(%%%.aobsc.com.my#, report that Transmile roup /erhad amount of de$iation for year

!!" is 0) "! million and year !!1 is 0)1! million. *n case of Energro has manipulate

their e&port sales of 0) 12 million in year !!3, and 4 5cean, has made the fictitious sales

about 0) ".' million to four of their customers. )egan )edia %as submitting false re$enue

of 0) billion in financial statement in !!1. Latest, the case of accounting fraud such in

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4ort 6lang 7ree 8one and corporate collusion in )alaysian Airlines, also pro$ed that the case

of accounting scandal has spread out (ome9, !!#. Currently, from :anuary to April !!,

+ecurities Commission has con$icted some cases %ho are pleaded guilty on reporting

misleading statements such in cases of ;)arch !! < PP v Tan Chin Han, Ang Sun Beng

and Ang Soon An; (The 0eporter, !!#. Thus, these cases are the e&ample of accounting

manipulation %hich originated from earnings management.

There are many researches that ha$e been conducted on the determinants of earnings

management, such as a firm=s financial characteristics and audit quality (>echo% et al. ??"#.

@arious definitions e&ist for earnings management. +chipper (??# appears to ha$e captured

the essence of earnings management by defining it as ;Bpurposeful inter$ention in the

e&ternal financial reporting process %ith the intent of obtaining pri$ate gainB LiDe%ise,

ealy and Wahlen (???# state that ;earnings management occurs %hen managers use

udgment in financial reporting and in structuring transactions to alter financial reports to

either mislead some staDeholders about the underlying economic performance of the

company or to influence contractual outcomes that depend on reported accounting numbers.

0egardless of its different definitions, earnings management is inherently unsol$ed problem.

1.2 Background of stud

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)alaysia is argued here to pro$ide a setting ;less transparent %ith lo% le$els of public

scrutiny compared to the West, in %hich to test the propensity of auditors to issue a qualified

audit opinion %hen earning management is not constrained due to many factors of earnings

management. )alaysia is a country %here reporting and auditing practices are hea$ily

influenced by common-la% sources gi$en their historical influence in the setting of

*nternational 7inancial 0eporting +tandards and *nternational +tandards on Auditing (*+As#,

facilitating comparison %ith research results in the Western World financial reporting and

auditing standards. o%e$er, although there has been much emphasis on strengthening the

accounting and disclosure standards in )alaysia, the same perhaps cannot be said %ith

respect to auditing practices (Thillainathan, ???#. Effort has been made by the *nternational

7ederation of Accountants (*7AC# to impro$e the uniformity of auditing practices and related

ser$ices throughout the %orld. This is e$idenced by the formation of the *7AC 757 and the

Transnational Auditors Committee (TAC# in :anuary !!. The 757 is a $oluntary body

made up of international audit firms performing audits across national borders. The 757

agree to meet certain requirements and undergo a global independent quality re$ie%. TAC is

an e&ecuti$e committee of *7AC de$oted to representing and meeting the needs of the

members of 757. *t plays a maor role in encouraging member firms to meet high standards

in the international practice of auditing.

Therefore, )alaysia has also follo%ing the %orld de$elopment to comply %ith audit practices

and standards. 5n ! April !!, )alaysia had established Audit 5$ersight /oard (A5/# to

ensure high quality and reliable financial reporting. The A5/ is not a statutory body, but

since it %as established under the auspices of the +ecurities Commission (+C#, the +C %ould

remain accountable for all of the A5/Fs acts and omissions. The A5/ %ould also %orD

closely %ith all regulatory agencies to ensure a holistic regulatory frame%orD for auditors in

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)alaysia. The A5/ has taDen its first step, by registering indi$idual auditors and audit firms

that audits the financial statements of a 4ublic *nterest Companies. After the registration

stage, the A5/ %ould DnocD on the auditors= doors to maDe inspections. This inspection

process allo%s A5/ officers to ha$e the po%er to access %orDing papers, booDs and

accounts. Apart from inspections, A5/ officers %ould also ha$e the necessary po%ers to

conduct inquiries and impose proportionate sanctions against auditors. 5ther functions %ould

include the setting of auditing, quality control, ethics, independence and other standards

relating to the preparation of audited financial statements.

The A5/ %as established because to monitor and inspect the audit firms in )alaysia. The

one of the reason of earnings management happen because is due to agency problem. The

agency problem occurs because in$estors and other staDeholders may not be able to maDe

optimal decisions concerning a company %hen earnings management distorted economic

results and hinder the ability of all staDeholders to maDe financial decisions. >a$idson ***,

:iraporn, 6im and Gemec (!!2# e&tended the agency theory by sho%ing that earnings

management in particular can be an agency problem. They also added that managers may

ha$e personal goals that conflicted shareholders. +ince managers ha$e been empo%ered by

shareholders to maDe decisions, a conflict of interests has potential agency costs.Agency

problems occur %hen managers do not operate a company for the shareholders= best interests.

When a firm manages the impression it presents to the marDetplace through earnings

management, shareholders and other staDeholders must base financial decisions on numbers

that do not, perhaps, reflect the true economic conditions of the firm (Geu, ??#.

4ressure to manage earnings does not stem from a single force. 7actors such as analysts=

forecasts, access to debt marDets, competition, contractual obligation, a roaring stocD marDet,

ne% financial transactions, marDet disregard of big charges, merger attracti$eness,

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management compensation, short-term focus, unrealistic plans and budgets, period-end

requests from superiors, periods of e&cessi$e profit follo%ed by a fear of subsequent decline,

concealing unla%ful transactions, personal bonuses, promotions, focus on team, and ob

retention are among the reasons that are mentioned in the literature (>uncan, !!#. The

effects of these $ariables on earnings management in different countries may be different. 7or

e&ample, the debt hypothesis suggests that the larger the firm=s debt-to-equity ratio the more

managers are e&pected to choose income increasing accruals. o%e$er, this hypothesis has

no effect in the :apanese business en$ironment. *t is Dno%n that managers of larger

companies in :apan are more liDely to choose income-decreasing accruals (6ester, ??H

4han and IoshiDa%a, ??1H 4ouralali and ansen, ??1#

A study by 8unaidah and 7au9ias (!!#, suggested that di$idends among )alaysian listed

firms can play an important monitoring role in reducing agency cost (i.e. earnings

management#. *t %as agreed by 7arinha and )oreira (!!'# that di$idends can act as a

credible signal of earnings quality, %ith companies unengaged in E) being more liDely to

pay di$idends. +ant and Co%ant (??2# concluded that firms pay di$idends to con$ey

information to in$estor that cannot be con$eyed costless and credibly in other %ays.

Therefore, di$idend can be one of moti$e in earnings management.

+e$eral researchers identify le$erage as a moti$e in earning management. As /eatty and

Weber (!!3# suggested, firms engaging in E) are more liDely to a$oid debt co$enant

default from the le$erage made. *t is supported by Aini, TaDiah, 4ouralali and Teruya (!!1#

saying that the corporate sector in )alaysia became more le$eraged and hea$ily dependent

on commercial banD financing after the ??' economic crisis. They added that financial

difficulties faced by companies might transpire managers to impro$e upon their performance

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through earnings management. +o based on the findings, banDs could impose more

monitoring mechanisms on firms %ith high le$erage to a$oid manipulation of earnings by the

managers (Aini, TaDiah, 4ouralali and Teruya, !!1#

The opportunity for earnings management is higher among companies %ith high surplus free

cash flo%. A study by Chung, 7irth and 6im (!!"# indicates that companies %ith high

surplus free cash flo% face maor agency problems. Agency problem occurred particularly

%hen the free cash flo% is high but in$estment opportunities are lo% (ul, !!#. )anagers

of these companies act opportunistically for personal gain, and tend to get in$ol$ed in

unprofitable proects, o$er in$estments and misuse the funds (:ensen, ?1#. They tend to

carry out non-$alue ma&imi9ing acti$ities amounting to agency problems (:ensen, ?1#.

Their acti$ities may bring benefits or re%ards for themsel$es at the e&pense of the

shareholders. These companies are found to ha$e engaged in e&penditures that decrease

shareholders= %ealth (Chung et al., !!"#.

)anagers may employ accounting procedures that increase reported earnings to hide the

negati$e impact of proects (Chung, 7irth and 6im, !!"#. *n order to conceal these acti$ities,

managers are forced to manage earnings $ia accounting discretions. o%e$er, the managers=

opportunistic beha$ior may be minimi9ed if the company internal corporate go$ernance

monitoring mechanism, such as independence of audit committee, is effecti$e (/edard,

Chtourou J Courteau, !!2#

*t is sometimes suggested that the practice of earnings management often results in inaccurate

and misleading financial reports. The income reported in the financial statements is not an

e&act amount but rather is an amount selected from a continuum of amounts deri$ed from the

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application of different acceptable accounting accrual choices (ealy and Wahlen, ??? and

>echo% and +Dinner, !!!#. 7irms can choose bet%een $arious allo%able accounting

methods or can apply different assumptions or estimates %ithin an accounting method.

ence, the role of accrual accounting is belie$ed to ha$e caused some forms of earnings

management, such as income smoothing, %hich are hard to distinguish from appropriate

accrual accounting choices. The practice of earnings management has digressed from the

primary focus of financial reporting, %hich is to pro$ide information on the company=s

performance measured by earnings and its components (>echo% and +Dinner, !!!#.

1.! Pro"#$% stat$%$nt

The question of %hether auditors adequately safeguarding accounting information by

ensuring credible reporting has recently recei$ed much attention. This attention has focused

on Asia and the ??' Asian Crisis, and more recent (!!# $ery public collapses of t%o

corporations, Enron in the K+A and * in Australia. Against this bacDdrop, this paper

in$estigates in the emerging marDet of )alaysia an aspect of audit quality (A# product

differentiation in association %ith financial reporting discretion on audit outcome (audit

opinion# and earnings management (:ohl, :ubb and oughton, !!'#.

Enron case has brought more attention to the questions of ho% and %hy firms manage

earnings. Accounting numbers form a fundamental part of an organi9ation=s efficient

contracting technology. +ince many of the terms, conditions, and co$enants found in

contracts use accounting $ariables, contractual arrangements and the associated contracting

costs are maor determinants of accounting method choices hence earnings management. *t is

important to understand the processes that may dri$e the earnings management. As measuring

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and reporting performance has become increasingly important in our society, the study of

ho% statistics are produced and managed may need to be included in management thought

(Cor$ellec, ??'#.

Thus, if marDets %ere perfect, earnings $olatility %ould not be costly to managers and their

firms and, therefore, managers %ould ha$e no incenti$es to smooth earnings. o%e$er,

empirical and anecdotal e$idence suggests that earnings management is per$asi$e. o%e$er,

a question remains largely une&plored by pre$ious literature. *f managers ha$e incenti$es to

manage earnings, %ill they still elect to manage earnings through discretionary accounting

decisions %hen they can reduce earnings $olatility by smoothing cash flo%s. This can lead

the in$estor to o$er$alue the current $alue of the company (Teoh et al., ??#.

ence, this study %ill in$estigate %hether certain moti$e and opportunities factors may

influence earnings management in establishment of Audit 5$ersight /oard (A5/#. The study

also identifies numerous monitoring mechanisms including the role of $arious types of

staDeholders such as shareholders, lenders, auditors and managers %hich concern about

di$idend, le$erage, audit quality and free cash flo% respecti$ely. The A5/ is e&pected able to

o$ersight the auditors to be more quality and high quality of financial reporting can be

produced.

1.! O"&$cti'$s of stud

The obecti$es of this study areM

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. To e&amine the relationship bet%een moti$e (le$erage and di$idend# and

earnings management.

. To e&amine the relationship bet%een opportunity (audit quality and free cash

flo%# and earnings management.

3. To in$estigate any differences bet%een moti$e, opportunity and earnings

management before and after the establishment of Audit 5$ersight /oard

(A5/#.

1.( )ignificanc$ of stud

Capital marDets are bacDbone of the economic acti$ity of a democratic country. 0egulation is

created to reduce the effects of information asymmetry for in$estors and to pro$ide

transparency in the operation of the marDet. According to /ather and /urnaby (!!1#,

e&pects that fully informed decisions to be made by pro$iders of finance. The corporate

collapses at the beginning of the t%enty-first century in the K+A sho% that information

asymmetry is a problem for in$estors. )anagement of the collapsed companies had

Dno%ledge that %as not shared %ith their shareholders, but may ha$e Dno%n to their financial

auditors. These ;%atchdog of financial marDets did not ensure that Dno%ledge %as passed

on to in$estors or ;red-flagged to authorities, contributing to losses suffered by in$estors

(/ather and /urnaby, !!1#.

4re$ious studies in )alaysia ha$e focused on board of directors, audit committee and

concentrated o%nership in reducing E) o$er the period of !!-!!3 (0ashidah J 7airu9ana

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aneem, !!1#. 0ashidah and Wan 0a9a9ila (!!"# also studied on %hy firms issuing equity

produced poor return on ' *45 firms that go public o$er the period ??-??. 5n the

other hand, only a number of studies on audit quality and E) %ere done in )alaysia.

4re$ious study by /ecDer, >efond, :iambal$o and +ubramanyam (??# ha$e found e$idence

that clients of non-big si& auditors report higher discretionary accruals than clients of big si&

auditors but this e$idence is on K.+ based. +imilarly, 6rishnan (!!3# supported the

statement by stating that specialist auditors mitigate accruals based E) more than non

specialist auditors and therefore, influence the quality of earnings. This study contributes to

the current literature by e&amining audit quality in public firms in )alaysia, and by

questioning %hether audit quality enhances financial reporting quality in public firms.

*n order to integrate all these main issues, it is necessary to e&amine the underlying factors

simultaneously. The focus of the study is to acquire an understanding of %hether the

di$idend, le$erage, and free cash flo% could act as monitoring mechanisms and curb earnings

management practice in )alaysian public listed companies. 5ther characteristics that %ill be

e&amined are the audit qualities and to see %hether all these $ariables ha$e significant

relationship on managers to practice earnings management due to moti$e and opportunity of

earnings management.

1.* Organi+ation of c,a-t$rs

This study is di$ided into fi$e chapters. Chapter one pro$ides an introductory bacDground of

the research. *t pro$ides a brief introduction of E) and issues in$ol$ing it. The obecti$e,

significance and research statement of the study are also highlighted in this chapter. Chapter

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t%o re$ie%s the agency theory that linDs to E) and studies of E) related to di$idend,

le$erage, free cash flo% and audit quality. Chapter three pro$ides the method of data

collection, hypothesis de$elopment and measurement used in this study. Analyses and

findings are presented and discussed in Chapter 2. Lastly, Chapter " dra%s up the conclusion

and limitation of the study. 0ecommendations for future research are also pro$ided in this

chapter.

CHAPTER TO

/ITERATURE REIE

2.0 Introduction

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Literature re$ie% is a collection of re$ie% of published and unpublished %orD on the

secondary sources (+eDaran, !!!#. This chapter pro$ides the literature re$ie% that ser$e as a

basis of ideas in this study. Therefore, this section aimed to discuss the pre$ious literature on

the research topic. Knder +ection . discusses on agency theory. +ection . e&plains about

E) and its moti$es. Then, section .3 pro$ides discussion on di$idend follo%ed by le$erage

in section .2. 7ree cash flo% %ill be discussed in section ." and .1 %ill e&plain about audit

quality. *n section .' %ill be discussed on Audit 5$ersight /oard (A5/# follo%ed by .

%ill be e&plains about conceptual frame%orD. The last section, .? %ill be mainly about the

summari9ation and conclusion of the chapter. )oreo$er, this part %ill discuss on earnings

management and audit quality %hich are competence and independence.

2.1 Ag$nc T,$or

Agency theory is commonly used to e&plain certain accounting issues such as conflicts of

interest, incenti$e problems, and mechanisms for controlling incenti$e problems (Lambert,

!!#. The agency relationship occurs %hen one or more persons or the principles employ

another person or the agent to perform some ser$ices on their behalf (:ensen J )ecDling,

?'1#. Conflicts of interest among principles (shareholders# and agents (managers# frequently

happen. The agency problem becomes more e$ident if both the managers and shareholders

are utility ma&imi9ers because the presumption is that the managers %ill not act in the best

interest of the shareholders (:ensen J )ecDling, ?'1#. The agency theory pro$ides logical

predictions about %hat rational indi$iduals may do if placed in such a relationship.

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)anagers may ha$e self-interest that conflict %ith their shareholders. A conflict of interests

has potential agency cost such as management decisions that do not ma&imise shareholders=

interests. )anagers may manage reported earnings to obscure their actions. Earnings

management may lead to an agency cost %hen in$estors maDe non-optimal in$estment

decisions from reported earnings. *n a situation %here a company has high free cash flo%, the

manager may be engaged in earnings management to sho% better performance of the

company. Then, this relation can be e&plained by using agency theory.

Agency theory proposes a series of mechanisms that seeD to reconcile the interests of

shareholders and managers. Companies can choose certain mechanisms to align the interests

of agents and principles and to monitor the beha$iour of agents (Coles, )cWilliams J +en,

!!#. These mechanisms include e&ternal go$ernance instruments such as taDeo$ers

(Easter%ood, ??'# and merger (EricDson J Wang, ???#. The potential for shareholder


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financial reporting %hich in$ol$es intentional misstatements or omission of amounts or

disclosures in the financial statements to decei$e financial statements users ()*A, !!#.

Earnings management may in$ol$e manipulation of accounting records, intentional omission

or intentional misapplication of accounting principles. Earnings management, on the other

hand, is a practice by the management that often results in inaccurate and misleading

financial reports (Aini et al., !!1#. ;Earnings management occurs %hen managers use

udgment in financial reporting and in structuring transactions to alter financial reports to

either mislead some staDeholders about the underlying economic performance of the

company, or to influence contractual outcomes that depend on reported accounting numbers

(ealy J Wahlen, ???#.

The practice of earnings management occurs because of the a$ailability of different

acceptable accounting accrual choices to be applied for the determination of reported income

(ealy J Wahlen, ???H >echo% J +Dinner, !!!#. According to Teoh, Welch and Wong

(??b#, sources of earnings manipulations %ithin generally accepted accounting principles

include the choice on the application of accounting methods, and the timing of asset

acquisitions and dispositions. The alternati$e representations of accounting e$ents permitted

by generally accepted accounting principles through accrual accounting pro$ides some

fle&ibility for managers in their discretions %hen deciding on actual earnings. The

management has the opportunity to manage the timing and recognition of actual e&pense

items such as ad$ertising e&penses or research and de$elopment e&penditures, and the timing

of re$enue recognition through an early recognition of credit sales re$enue or deferral of

losses by establishing loss reser$es (Teoh et al., ??#.

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*n practice, managers are often moti$ated to gain personal benefits through direct re%ard

such as salary and bonus or indirect re%ard such as future promotions, prestige, and ob

security. These re%ards are gi$en to managers based on the company earnings performance.

*f the incenti$es are based on the company financial performance, managers may be tempted

to act in their self-interest and to impress the shareholders and other staDeholders of the

company good performance through earnings management. The management discretion o$er

reported earnings and its effect on the management compensation lead to a potential agency

problem. A compensation incenti$e is only one e&ample of many other opportunities of

earnings management in free cash flo%. o%e$er, this study does not intend to e&amine

directly the compensation incenti$es. The study focuses on earnings management based on

discretionary accounting accruals.

As a result of earnings management, the reported accounting numbers do not reflect the

economic conditions of the company resulting in non-optimal decisions. *n$estors use

financial information to maDe economic decisions %hich are reflected in share prices. The

marDet efficiency is based upon the information flo% to capital marDets. +ecurities may be

$alued inappropriately because of the use of the Nmanaged= information by the in$estors.

)anagers= beha$iour of obscuring the real performance through earnings management may

create agency costs such as costs to undo the managed earnings, to resol$e misallocations of

resources, or to seeD for other information (Oie et al., !!3#.

4ast studies in$estigate the relationships bet%een earnings management and certain corporate

e$ents %hich resulted in the occurrence of agency conflicts. The studies found mi&ed results.

Wu (??'# finds supports for the assertion that managers are moti$ated to understate earnings

in an attempt to acquire a company at a lo%er price. *n contrary, >eAngelo (?# finds no

e$idence of earnings management practices among managers. enerally, studies on earnings

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management are conducted in the conte&t of capital marDets %here contractual incenti$es

may e&ist for companies to manage earnings such as lo%ering the price for an acquisition of

companies. Wu (??'# finds supports for the assertion that managers are moti$ated to

understate earnings in attempt to acquire a company at a lo%er price.

*n contrary, Easter%ood (??'# and EricDson and Wang (???# find e$idence of earnings

management in both hostile taDeo$ers and in stocD for stocD mergers. Easter%ood (??'#

finds that in hostile taDeo$er attempts companies increase their earnings for the period prior

to the taDeo$er in order to discourage shareholders from supporting the taDeo$er. *n the case

of mergers, EricDson and Wang (???# find similar results %here companies engaging in

stocD for stocD mergers increase their earnings prior to the merger in order to inflate their

stocD price and thereby reduce the cost of the merger.

5ther researchers in$estigate managers= moti$ation to manipulate earnings in trying to

influence in$estors and other staDeholders. Teoh et al. (??#, 0angan (??# and >echo%,

+loan and +%eeney (??"# pro$ide e$idence that managers inflate earnings prior to seasoned

equity offerings. The studies sho% that managers seeD to manage pre-issue earnings in order

to impro$e in$estors= e&pectations of the company future performance. There is, ho%e$er, a

cost associated %ith the earnings management. *n study of Teoh et al. (??# sho%s that,

companies %hich managed earnings prior to initial public equity offerings e&perience poor

stocD return performance in the subsequent three years.

2.! Di'id$nd and Its oti'$s

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>i$idend is a %ell-Dno%n cash disbursement strategy for public listed that seeDs to return

cash or assets to their shareholders. The distribution of e&cess cash to shareholders constitutes

the most fundamental de$ice that alle$iates conflicts bet%een corporate insiders and outside

shareholders (:ensen, ?1#. o%e$er, firms can also return their cash to shareholders in the

form of share repurchases, %here certain amount of cash is used to buy bacD outstanding

shares in the firm and reduce the number of shares outstanding.

0egular distributions of funds to shareholders force firms %ith $alue-enhancing in$estment

proects to raise capital e&ternally (EasterbrooD, ?2#. Consequently, firms are regularly

forced to undergo the scrutiny of the marDet, that is, the pro$iders of e&ternal funds. The

commitment to pay out e&cessi$e funds to shareholders reduces the amount of free cash flo%s

that managers could other%ise spend on $alue-reducing proects (:ensen, ?1#.

:ensen (?1# $ie%s di$idends as a de$ice to e&tract free cash flo% (7C7# from the control of

managers that pursue non-$alue-ma&imi9ing obecti$es, for e&ample, empire building. *t also

can be argued in the conte&t of agency costs of free cash flo% argument that any form of

distribution of e&cess cash to shareholders %ould reduce the agency problem bet%een

shareholders and managers. An important implication for this argument is that cash

distribution through di$idends could ha$e a positi$e impact on firm $alue because it reduces

the o$er-in$estment problem. La 4orta et al.(??# ha$e argued that di$idend policy is the

result of the pressure e&ercised by minority shareholders in order to force insiders to pay

cash. 5n the one hand, La 4orta et al. (!!# state that firms located in countries %ith a

higher legal protection to minority shareholders pay higher di$idends, as compared to

countries %here legal protection is %eaD.

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2.( /$'$rag$ and Its oti'$s

Companies that ha$e high le$erage may be at risD of banDruptcy if they are unable to maDe

payments on their e&ternal debt financing, they could also be unable to find ne% lenders in

the future. +o, if a company %ishes to taDe out a ne% loan, lenders %ill scrutini9e se$eral

measures of %hether the company is borro%ing too much and %ill demand that it Deeps its

debt %ithin reasonable boundaries.

4re$ious literature suggests that le$eraged firms engage in E) to a$oid debt co$enant default

(/eatty and Weber !!3H >iche$ and +Dinner !!H >e7ond and :iambal$o ??2#. o%e$er,

these studies measure E) using accrual based measures. :elineD (!!'# studies the effect of

le$erage increase on accrual E). :elineD suggests that le$erage changes and le$erage le$els

ha$e a different impact on E) and concludes that increased le$erage is associated %ith

reduced accrual E). )oreo$er results suggest that there is a beneficial consequence of debt

because the increased debt reduces manager=s discretionary spending, and in turn, reduces

accrual E).

The conclusion has been dra%n by :elineD could be incorrect. As there could be another

e&planation of %hy increased le$erage is associated %ith reduced accrual E). 7or e&ample

companies %ith increasing debt could be in$ol$ed in the 0eal Earning )anagement (0E)#.

o%e$er, increased le$erage could gi$e an incenti$e for managers to s%itch from accrual

earnings management to 0eal Earning )anagement. )oreo$er, reducing of discretionary

e&penses is one of the 0eal Earning )anagement acti$ities that could pro$ide e$idence that

the company engage in 0eal Earning )anagement.

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5ne rele$ant research on management of Cash 7lo% 7rom 5peration is performed by 8hang

(!!1# and comes close to consider the effect of the le$el of le$erage on 0E)H he

in$estigates the possibility that debt co$enants, amongst others, could be a one of the

incenti$es for management to manipulate cash flo% through real acti$ities. The result of his

research suggests that coefficients on debt co$enants are positi$e but not significant, because

the pro&y to capture incenti$es is too crude. KnliDe this paper, 8hang considers the incenti$es

to a$oid default of debt co$enants, amongst %hich debt-to-equity-ratio, rather than

researching %hether changes in the le$el of le$erage are positi$ely correlated to 0eal Earning

)anagement.

2.* r$$ Cas, #o3 and Its O--ortuniti$s

*t has long been recogni9ed in the finance literature that the allocation of free cash flo% is an

important aspect of the basic conflict of interest bet%een managers and o%ners (:ensen,

?1#. +pecifically, free cash flo% tempts managers to e&pand the si9e of the firm, thereby

increasing managersF control and personal remuneration e$en though such an action may

decrease the o$erall $alue of the firm. The finance literature has long recogni9ed the impact

of agency costs on the allocation of discretionary monies.

A large strand of research e&amines the relationship bet%een agency costs and financial

structure. :ensen (?1# posits that le$eraged buyout acti$ities are one %ay of controlling free

cash flo% because the debt incurred in such transactions forces managers to disgorge e&cess

cash rather than direct it to unprofitable opportunities. E$idence supporting the free cash flo%

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moti$ation for financial restructuring has been pro$ided by many authors (ibbs ??3H

riffin ?H upta and 0osenthal ??M Lehn and 4oulsen ??H Loh ??M )oore,

Christensen and 0oenfeldt ??#.

*n the accounting literature, ul and Tsui (??# e&amine the relationship bet%een the

amount of free cash flo% and audit fees. They hypothesi9e that because managers %ill liDely

engage in non-$alue-ma&imi9ing acti$ities %hile allocating free cash flo%, auditorsF

assessment of the inherent risD and, in turn, the audit effort %ill increase %ith the amount of

free cash flo% possessed by the firm. ul and Tsui therefore postulate a positi$e relationship

bet%een high le$els of free cash flo% and audit fees. As e&pected, they find this association in

their data set.

The free cash flo% hypothesis has also been tested in the conte&t of the issue of equity. )ann

and +icherman (??# hypothesi9ed that shareholders %ill respond negati$ely to equity issue

announcements because they e&pect management to misuse such no bonded funds.

7urthermore, they also e&pect shareholder response to be moderated by the tracD record of

management %ith respect to pre$ious equity issues. 7inally, Wells, Co&, and a$er (??"#

compare the le$el of cash flo% for mutual insurers and stocD insurers and find that the latter

possess greater le$els of cash flo%. Wells, Co&, and a$er posit that management at these

firms is able to hoard cash because it is go$erned by fe%er monitoring and control

mechanisms. This hoarding of cash, though non-$alue ma&imi9ing, pro$ides management

%ith the important benefit of a$oiding the scrutiny of the capital marDets %hen the firm

requires additional capital.

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*n summary, there is a $ast body of research in accounting and finance that con$incingly

demonstrates that agency costs play an important role in the allocation of discretionary

monies. As is e$ident from this brief re$ie%, researchers ha$e e&amined the impact of agency

costs on $arious topics, such as financial structure, audit fees, response to equity

announcements, and the le$el of free cash flo%. This stream of research enables us to

conceptuali9e the impact of agency costs on the allocation of discretionary monies.

2.4 Audit 5ua#it and Its O--ortuniti$s

7rom an audit marDet perspecti$e, there are t%o types of audit quality. 7irst, audit quality

depends on the probability that material misstatements and signals of financial distress are

disco$ered. +econd, the audit quality depends on the probability that the auditor %ill report

these misstatements and signals (>eAngelo, ?#. While the technical capability of auditors

or the probability that the auditor %ill disco$er material misstatements and going concern

breaches is often assumed to be constant across different auditors, audit quality is assumed to

be a function of auditor independence. Litigation and disciplinary sanctions are supposed to

pre$ent auditors from compromising their independence and as such, pro$ide incenti$es to

the auditor to constrain earnings management or issue a qualified opinion %hen necessary.

Apart from the sanctions themsel$es, litigious actions or disciplinary sanctions damage the

auditor=s reputation. *n this respect, larger audit firms are e&pected to be less liDely to

perform lo% quality audits because these firms ha$e more to lose in terms of clients and audit

fees in case of an audit failure. Auditor independence is thus considered to relate to the

auditor=s reputational capital (>eAngelo, ?#.

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o%e$er, this reputation rational is only e&pected to hold %hen the probability that an audit

failure is detected and the risD of litigation is high, hereby damaging the auditor=s reputation.

When the risD of audit failure detection and litigation is lo%, litigation and reputation costs of

pro$iding a lo% quality audit are e&pected to be reduced, hereby lo%ering the incenti$es of

large audit firms to supply a high quality audit. As documented in different empirical studies

(e.g. )aioor and @anstraelen, !!1H 7rancis and Wang, !!#, /ig 2 audit firms are less

inclined to supply public client firms %ith high quality audits in countries %ith %eaDer

in$estor protection, lo%er le$el of enforcement and lo%er risD of litigation.

2.6 Audit O'$rsig,t Board 7AOB8 and R$gu#ation

The establishment of 4ublic Companies Accounting 5$ersight /oard (4CA5/# in K+A is a

strong effort by the regulators to restore the public confidence on the audit profession and the

reliability of the audited financial reporting. The other global trend %hich carry the same

mission of establishment are Auditing and Assurance +tandard /oard and 7inancial

0eporting Council in AustraliaH 7inancial 0eporting Council in K6 and 4ublic Accountant

5$ersight Committee (4A5C# in +ingapore. )alaysia has also established a similar regulated

body Dno%n as Accounting 5$ersight /oard (A5/# in April !! (+ecurities Commission,

April, !!#. The idea to establish the A5/ is mainly dri$ing from the 4CA5/ in K+.

A5/ is proposed based on )alaysia=s requirement and en$ironment %hich started on !!'.

After the announcement of A5/ in /udget +peech !!, the proposal of the establishment of

A5/ %hich is +ecurities Commission /ill (Amendment# !!? has passed by the 4arliament.

7inally, A5/ %as formally established on ! April !! (omes, !!#. Kpon to this,

+ecurities Commission Act ??3 has been amended. The A5/ implementation %as di$ided

22


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into process of registration, inspection, inquiry and sanctions, international affairs and annual

reporting (Iusoff, !!#. Kpon to the establishment, se$en members comprise of one

E&ecuti$e Chairman and si& non-e&ecuti$es ha$e been appointed. A5/ %as lead by GiD

)ohd asyudeen Iusoff, as an E&ecuti$e Chairman. Whereas the other members are

representing the $arious institution such as 7inancial 0eporting 7oundation, Companies

Commission )alaysia, +ecurities Commission )alaysia, Central /anD of )alaysia and

indi$idual from the public companies (%%%.aobsc.com.my#. The obecti$es of A5/ are (i#

to promote and de$elop effecti$e and robust audit o$ersight frame%orDH (ii# to strengthen the

in$estor=s confidence on the reliability and quality of audited financial statements and (iii# to

pro$ide regulation of %orD to 4LC=s and 4*E=s auditor. ;The A5/ %ill inspect auditors of

4LCs and public interest bodies liDe banDs and financial institutions, %hereas auditors of

pri$ate companies %ill be subected to the )*A re$ie% committee, (Accountant Today,

!!#.

The auditors of 4ublic Listed Companies (4LC=s# and 4ublic *nterest Companies (4*E=s# must

register %ith +ecurities Commission. As /ursa )alaysia has issued the ne% listing

requirement, stated that all the public issuers should appoint the auditors %ho are registered

under +ection 3! of +ecurities Commission Act ??3. This is to ensure only the proper and

fit auditors %ould conduct the auditing. )oreo$er, +ection 34 of +ecurities Commission Act

??3, stated that to be auditors should fulfill the criteria such as must be appro$ed as an

auditor under +ection , Companies Act, ?1", not discharge banDrupts %ithin or outside

)alaysia, not con$icted any offences in$ol$ing fraud or dishonesty and not engaged in any

practices %hich reflect discredit on his ability to meet professional auditing standards

(%%%.aobsc.com.my#. 5nce, fulfill these criteria, the auditors eligible to register %ith

A5/. To ensure the establishment of A5/ is standardi9ed and achie$e the mission, the

auditors are recommended to comply %ith the *nternational +tandards on uality Control

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(*+C # (Iusoff, !!#. )*A 4resident Abdul 0ahim Abdul amid really stressed on the

compliance of *+C (omes, !!# *+C should be a benchmarD against international

requirements. *+C also belie$ed could be a cornerstone to shift the audit firm in building

the independent and competent in deli$er the high quality of audit reports. igh audit quality

%hich consists of competence and independence %ill mitigate the earnings management

practices in the client=s company (/ecDer et al, ??H 6rishnan et al !!3#.

*n the essence, the main effect on the establishment of A5/ is on audit quality. Audit quality

is belie$ed %ill boost the in$estor confidence le$el, henceH restore their confidence on the

credibility of auditors= %orD. As said by +ecurities Commission E&ecuti$e >irector oh

Ching Iin, ;While the A5/ o$ersees auditors and protects the interests of in$estors, it also

benefits the auditing profession. Audit quality %ill be raised, %hich in turn %ill promote

confidence in the assurance %orD that is performed by the auditing profession (omes,

!!#.

4erhaps, the audit o$ersight frame%orD as stipulated in A5/ %ill guide and monitor the

auditors in conducting audit consistent %ith the international and audit professional standard.

)ore topical, the establishment of A5/ able to increase the audit quality, %hereas, %ill

enhance public confidence on financial reporting (Accountants Today, :une, !!?#.

2.9 Conc$-tua# ra%$3ork

24

Earnings

)anagement

(>@#

5pportunity (*@#

Audit uality (3#M-

- Audit 7ees

- Gon Audit 7ees

7ree Cash 7lo% (2#

)oti$e (*@#

>i$idend (#

Le$erage (#


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igur$ 2.1 Conc$-tua# ra%$3ork

WhereM

*@ P independent $ariableH

>@ P dependent $ariable.

7igure . generally co$ers the %hole picture of the current study. The main obecti$e of this

study is to e&amine the effect of di$idend, le$erage, free cash flo% and audit quality on E).

7irst, this study co$ers on the issue of di$idend as a symbol of good performance of a

company. *t is e&pected di$idend as a monitoring mechanism that %ould reduce the

probability of managers to in$ol$e in E). 7or the second relationship, le$erage is e&pected to

reduce managers from in$ol$ing in E). Ge&t is to e&amine %hether audit quality %ill reduce

E). Lastly, this study e&amine %hether high free cash flo% %ould ha$e higher earnings

management. All of the independent $ariables discussed are monitoring mechanisms.

2.: )u%%ar and conc#usion

25

Control @ariablesM-

- 4rofitability

- 7irm si9e

- Audit 5$ersight

/oard (A5/#


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There are $arious factors relating to E) in )alaysia due to generally accepted accounting

principles include the choice on the application of accounting methods, the timing of asset

acquisitions and dispositions (Teoh, Welch and Wong, ??b#, . This chapter summarises the

%orD done by pre$ious researchers in the area of agency theory, earnings management,

di$idend, le$erage and audit quality. *t %ill looD on %hether all factors (di$idend, le$erage,

audit quality and free cash flo%# ha$e positi$e or negati$e significant relationship to the

earnings management. *t %ill also looD on %hether E) is pre$ented or increases in the

presence of the factors mentioned abo$e. ence, this study %ill in$estigate the moti$e and

opportunity in engagement of earnings management before and after the establishment of

A5/. ere, this study %ill e&amine any differences bet%een moti$e (le$erage and di$idend#,

opportunity (audit quality and free cash flo%# and earnings management before and after the

establishment of Audit 5$ersight /oard (A5/#.

CHAPTER THREE

RE)EARCH DE)I;N AND ETHODO/O;echo%, +loan and +%eeney (??"# claimed that the modification of :ones )odel

()odified :ones )odel# is the most po%erful in detecting earnings management. /ut later on,

6othari, Leone and Wasley (!!"# tried to test %hether a performance-matched discretionary-

accrual approach (a type of control sample approach# is both %ell specified and po%erful at

estimating discretionary accruals. They found that performance-matched discretionary

accrual measures are %ell specified and po%erful in $arious circumstances. Among the

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circumstances are the measurements of E) based on random and stratified-random samples,

multi-year hori9ons and their sensiti$ity to sample si9e.

6othari, Leone and Wasley (!!"# and >echo%, +loan and +%eeney (??"# used the

parameters from the :ones model estimated in the pre-e$ent period for each firm in their

sample, and applied them to a modified sales change $ariable defined as (Q+ALE+ it- QA0it#

to estimate discretionary accruals in the e$ent period. This approach is liDely to generate a

large estimated discretionary accrual %hene$er a firm e&periences e&treme gro%th in the test

period as compared to the estimation period. *n order to mitigate this problem and due to the

non-e&istence of the NNpre-e$ent== period %here they can assume that changes in accounts

recei$able are unmanaged, 6othari et al. estimated the model as if all changes in accounts

recei$able arouse from earnings management.

a8 P$rfor%anc$=%atc,$d Discr$tionar=accrua# A--roac, -ro-os$d " >ot,ari

The third model proposed by 6othari, Leone and Wasley (!!"# has been augmented from

the t%o models abo$e and Dno%n as ;4erformance-matched discretionary-accrual approach.

7irst, 6othari et al. estimated the total accruals as belo%M

TAit P R(Q non-cash current assetit # - (Q current liabilitiesit e&cluding the

current portion of long term debt# - (>epreciation and amorti9ationit#S

? total assets it-.

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Then discretionary accruals, a pro&y for earnings management, are estimated by subtracting

nondiscretionary accruals from total accruals, %here all accrual $ariables are scaled by lagged

total assets to control for potential scale bias.

6othari, Leone and Wasley (!!"# ha$e augmented to include the 05A it or 05Ait< . They

claimed that this approach is designed to pro$ide a comparison of the effecti$eness of

performance matching including a performance measure in the accruals regression to

generate the normal or non-discretionary pro&y %ith the follo%ing equationM

TAit P !U ( V A++ET+it < # U (Q+ALE+it#U 3 44E it

U 205Ait (or it < # U it H

WhereM

05A it (or it < # PGet income in current year (or pre$ious year# di$ided by

total assets in the current yearH and all other $ariables are as

pre$iously defined.

Finally, the residual (it)from the regression is the discretionary accruals

(!"#$

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The study incorporates absolute $alue of >AC consistent as used by 0ashidah and 7airu9ana

aneem (!!1# and /ecDer, >efond, :iambal$o and +ubramanyam (??#, and 7ranDel et al.

(!!#. This study restates the absolute discretionary accruals as A/+>AC.

ence, the current study %ill use the model suggested by 6othari, Leone and Wasley (!!"#

to detect E) as a dependent $ariable. Cooper and +chindler (!!# defined E) as an

independent $ariable $alue %hich is manipulated by dependent $ariable that has been

measured, predicted or monitored by researcher. The reason behind using 6othari et al. model

is that the model is impro$ised in terms of performance measures in the accruals regression

(6othari, Leone and Wasley, !!"#.

!.2 H-ot,$sis d$'$#o-%$nt

This study has primarily focused on discretionary-accrual type E) by e&amining the

importance of multiple roles of e&ternal agency monitoring mechanisms, i.e. from the

perspecti$e of multiple staDeholders such as shareholders, lenders, and auditors. This study is

to in$estigate %hether certain moti$e and opportunities factors may influence earning

management before and after establishment of Audit 5$ersight /oard (A5/# also. 7i$e

hypothesis %ere de$eloped to be tested and to support the research obecti$es.

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!.2.1 D$'$#o-%$nt of H-ot,$sis 1 7Di'id$nd and E8

>i$idend and firm $alue ha$e been researched e&tensi$ely, at least since )odigliani and

)iller=s () J )# seminal %orD (see, )odigliani and )iller, ?"H )iller and )odigliani,

?1#. The implicit assumption from those prior studies has been that di$idend

announcements and di$idend yield measure are rele$ant aspects of a firm=s di$idend policy

(+te$ens and :ose, ??H 7ranDfurter and Wood :r., !!H >ocDing and 6och, !!"#.

Apart from that, La 4orta et al. (!!!a# documented e$idence that di$idends %ere paid

because minority shareholders pressured corporate insiders to disgorge cash. Their findings

are consistent %ith the agency theory that unless profits are paid out to shareholders, they

may be di$erted by the insiders for personal use or committed to unprofitable proects that

pro$ide pri$ate benefits for the insiders. As a consequence, outside shareholders ha$e a

preference for di$idends o$er retained earnings (La 4orta et al.!!!a#. Therefore, it can be

argued that di$idends can play an important role to address the agency problems bet%een

corporate insiders and outside shareholders.

According to 0o9eff (?#, di$idends is generally $ie%ed as a control de$ice that helps

reduce managerial discretion and such action is part of the firm=s optimal monitoring bonding

pacDage. EasterbrooD (?2# and (0o9eff ?# suggested that higher di$idends reduced

agency costs by forcing management to seeD e&ternal financing, resulting in closer marDet

scrutiny and lead to higher firm $alue. *n the same $ein, :ensen (?1# argued that di$idend

reduced free cash flo% that managers may other%ise di$ert for personal use or to fund

unprofitable proects. This e$idence is consistent %ith the notion that di$idends are paid %hen

firms ha$e e&cess cash flo%s in order to reduce potential o$er in$estment by management.

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Therefore, there is a need to further test this theory in one of the de$eloping marDets such as

)alaysia, particularly %ith the implementation of recent reform on corporate go$ernance.

The )alaysian corporate go$ernance reform agenda has focused on t%o main areas. There

areas are, to those enhance transparency and increase accountability of directors and to those

aimed specifically at minority shareholders (Lie%, !!'#. According to Lie% (!!'#, the

success of the ne% corporate go$ernance rules and regulations %ith the aim of impro$ing

corporate go$ernance practices in the country is ultimately dependent on the prospect of

limiting the po%ers of )alaysian controlling o%ner managers and bureaucrats= influence on

businesses.

The abo$e arguments suggest the follo%ing hypothesis in an alternati$e formM

ypothesis M

7irms %ith higher le$el of di$idend payment %ould ha$e lo%er earnings management.

!.2.2 D$'$#o-%$nt of H-ot,$sis 2 7/$'$rag$ and E8

Le$erage is also suggested as ha$ing a positi$e incenti$e effect on firm management resulting

from the ad$erse consequences associated %ith defaulting on debt obligations. The use of

e&ternal debt finance %ill also result in the firm liDely being subected to additional outside

monitoring by debt pro$iders, %hich ha$e similar incenti$es to maor institutional in$estors

or e&ternal stocDholders in relation to protecting their in$estment interests. As such,

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increasing le$erage use should reduce the e&tent of agency costs inherent in a firm=s

operating structure.

According to Agra%al and 6noeber (??1#, debt financing is often used either as an

alternati$e or complementary control mechanism for reducing agency costs of a firm.

7leming, eaney and )cCosDer (!!"# outline a number of benefits associated %ith the use

of debt financing in controlling agency costs. rossman and art (?# suggest that short

term debt can align managerial incenti$e %ith that of shareholders since banDruptcy is costly

for management. They also support the agency theory and argue that financial le$erage can

reduce agency costs by increasing the possibility of banDruptcy. rossman and art (?#

and Williams (?'#, ho%e$er, ad$anced the argument that greater financial le$erage may

affect managers and reduce agency costs through the threat of liquidation, %hich causes

personal losses to managers of salaries, reputation, perquisites, and, according to :ensen

(?1#, through pressure to generate cash flo% to pay interest e&penses.

)yers (?''# e&plains that higher le$erage can mitigate conflicts bet%een shareholders and

managers concerning the choice of in$estment. +ince debt has to be paid bacD in cash, the

amount of free cash flo% that could be di$erted by the manager is reduced by debt

repayment. >ebt thus ser$es as a mechanism to discipline corporate managers and pre$ent

them from ma&imi9ing their pri$ate gains by la$ish perquisites, plush offices, and Nempire

building= through sub-optimal in$estment decisions (:ensen and )ecDling, ?1#. Companies

that ha$e high le$erage may face the risD of banDruptcy if they are unable to maDe payments

on their e&ternal debt financing.

ence, based on the abo$e arguments, the hypothesis is de$eloped as follo%sM

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ypothesis M

7irms %ith higher le$el of le$erage %ould ha$e higher earnings management.

!.2.! D$'$#o-%$nt of H-ot,$sis ! 7Audit $$s and Non=Audit $$s and E8

!.2.!.1 D$'$#o-%$nt of H-ot,$sis !a 7Audit $$s and E8

Auditors facilitate contracting bet%een in$estors and management by attesting to the

reliability of the financial statements. o%e$er, the auditor=s monitoring is $aluable to

in$estors only if the auditor is independent (Watts and 8immerman ??!#. >eAngelo (?#

defines independence %ithin a broader frame%orD of audit quality. Audit quality is the oint

probability that the auditor disco$ers and reports a misstatement, and independence is

considered compromised %hen auditors fail to report misstatements they ha$e disco$ered.

According to +imunic (?2#, the pro$ision of non-audit ser$ices can impair independence

by creating an economic bond bet%een auditor and client. +imunic (?2# models the oint

demand for audit and non-audit ser$ices. e defines a decrease in auditor independence as

;any situation %hich alters incenti$es such that a self-interested auditor is more liDely to

ignore, conceal, or misrepresent his findings. e sho%s that %hen the same auditor pro$ides

both ser$ices and the auditor retains a portion of the cost sa$ings from ;Dno%ledge

spillo$ers, the auditor %ill be economically bonded to the client. 4arDash and @enable

(??3# and 7irth (??'# present empirical e$idence using K.+. and K.6. data, respecti$ely,

that firms act as if the purchase of non-audit ser$ices eopardi9es independence. /oth studies

find that firms requiring high quality audits because of high agency costs %ill be less liDely to

purchases non-audit ser$ices from their auditor. ore et al. (!!# present e$idence also

using K.6. data of a positi$e association bet%een the pro$ision of non-audit ser$ices and

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earnings management. They also documented that Gon-/ig 7i$e auditors allo% more

earnings management than /ig 7i$e auditors.

oitash et al (!!'# found the effects of audit fees on audit quality. igh audit fees paid to

the auditors may affect the increase of effort to conduct e&tensi$e audit. As a result, this %ill

increase the audit quality, Therefore, oitash et al (!!'# support that %hen the audit quality

increased, it may pro$ide a lo% opportunity for earnings management.

A study found that non-audit fees increase auditor-client economic bonds, leading to a decline

in accrual quality, %hile high audit efforts as reflected in high audit fees impro$e accrual

quality (+rinidhi and ul, !!'#. o%e$er, since audit fees produce more stable yearly

re$enue than the non-audit fees, auditor might percei$e greater fee pressure from client %ho

pays high audit fees than non-audit fees (0eynolds, >eis and 7rancis, !!2#. This study %ill

use the total audit fees di$ided by total assets of the firms. *f the amount of the audit fees is

too high compared to the si9e of the firm audited, it means that there is probability that the

audit firm might impair its udgment during auditing process. When this thing happens, there

might be high E) by the managers.


ypothesis 3(a#M

7irms %ith higher audit fees ha$e lo%er effect to earning management.

!.2.!.2 D$'$#o-%$nt of H-ot,$sis !" 7Non=Audit $$s and E8

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7ranDel et al (!!# find that, %hen the audit firm recei$es higher re$enue from non-audit

ser$ices, thus, this %ill pro$ide more opportunity for the management to manage earnings.

igh non-audit fees lead to the impairment of auditor=s independence. As study of Lee et al.

(!!3# found that audit firm %ho recei$ed higher non-audit fees more liDely to in$ol$e in

earnings management practices. Therefore, the public might suspicious on the auditor=s

independence. Thus, it %as supported by ore et al. (!!# %ho has found the positi$e

relationship bet%een the pro$ision of non-audit ser$ices and earnings management. The other

related arguments is stated that, the auditor=s independence %ill compromised and the

earnings quality %ill diminished if the accountants are allo%ed to consult their clients, at the

same time (0omano, !!2 and Weil, !!2#.

Additionally, Lee et al. (!!3# found that non-audit fees is associated %ith the lo%er

independence of auditors, therefore, they found that auditors %ho pro$ide more non-audit

ser$ices to the clients lead to higher income increasing accrual. A study found that non-audit

fees increase auditor-client economic bonds, leading to a decline in accrual quality, %hile

high audit efforts as reflected in high audit fees impro$e accrual quality (+rinidhi and ul,

!!'#. The pre$ious studies are support that non-audit ser$ices %ill impair the auditor=s

independence. Thus, %hen there is lacD of independence, the probability for earnings

management %ill increase.


ypothesis 3(b#M

7irm %ith higher non-audit fees ha$e higher effect to%ards earning management.

!.2.( D$'$#o-%$nt of H-ot,$sis ( 7r$$ cas, #o3 and E8

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:ensen (?1# stated that if free cash flo% in a company is not used or in$ested to ma&imi9e

or to balance the best interest of shareholders, then it raises agency problems. The manager

may choose to in$est in an unprofitable proect due to his or her self-interest. As a result, the

company may be in the position of lo% gro%th. *n the absence of effecti$e monitoring or

disciplinary actions by other independent staDeholders, the manager can conceal information

on the acti$ities by pro$iding minimal disclosure or manipulating accounting number.

*n$estors as a group of staDeholders do not ha$e access to inside information. )anagers may

not pro$ide adequate discloses to in$estors on the in$estment cash flo%s or the underlying

assumptions of the proect. /ased on this minimal information, in$estors may not be able to

Dno% the prospect and the ad$antages or disad$antages of the proect for their %ealth

(Chung, 7irth and 6im, !!"#.

)anagers may not pro$ide the internally proected cash flo%s for some in$estments. As a

result of personal interests, managers o$erlooD the need for preparing proected cash flo% and

profit forecast. The choice for maDing poor in$estments may reduce future earnings and lead

to a mo$e to remo$e directors or senior e&ecuti$es (0ina and TaDiah, !!?#. *n order to a$oid

the risD of facing the management turmoil, managers may employ accounting numbers to

increase reported earnings. *t is assumed that in$estors are completely unra$elled of earnings

numbers. ence, managers are moti$ated to manage earning in order to fulfil their needs

(0ina and TaDiah, !!?#.

The fourth hypothesis isM

ypothesis 2M

7irm %ith higher free cash flo% %ould ha$e higher earning management

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!.! $asur$%$nt of 'aria"#$s

!.!.1 Ind$-$nd$nt 'aria"#$s

Cooper J +chindler (!!# defined the independent $ariables as the $ariable manipulated by

the researcher, thereby causing an effect or change on the dependent $ariable. There are three

main independent $ariables that influence E) in this study %hich areM

a# >i$idend

>i$idend %as primarily measured by di$idend yield (di$idend-to-price ratio#. 7ormally, the

di$idend yield is the di$idend per share (>4+# di$ided by closing marDet price per share

()4+#, that is,DYLD PDPS / MPS. The di$idend yield %as used rather than the payout ratio

(di$idends to earnings# for t%o reasons. 7irstly, the denominator in di$idend yield is a marDet

measure (share price# compared to an accounting measure (net income#. +econdly, to a$oid

problems of negati$e payout ratios are resulting from negati$e earnings or e&cessi$ely high

payout ratios resulting from income being close to 9ero (+chooley and /arney, ??2#. +e$eral

other studies also employed di$idend yield as a measure of di$idend policy (e.gM, Chang and

0hee, ??!H an et al. ???H o, !!3#.

b# Le$erage

There are different opinions on %hether le$erage increases or decreases the potential for E)

to happen. +ome literature such as :ensen (?1#, +tul9 (??!#, and art and )oore (??"#

suggested that debt discourages free cash flo%s o$er-in$estment by self-ser$ing managers

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and it can be monitored by lenders. ence it %ill reduce the tendency for E) to happen.

5thers someho%, argued that le$erage increases the potential for E) (>iche$ and +Dinner,

!!#, (/eatty and Weber, !!3#, (+%eeney, ??2#, (%atts and &immerman, 1990#,

(eFond and 'iamal)o, 1994#. The current study is Deener to the second opinion in

the sense that managers tend to implement E) to a$oid debt co$enant $iolation. The

measurement of le$erage (LE@E0AE# in this study %ill adapt measurement as used by

6im and Ioon (!!# and 0ashidah and 7airu9ana (!!1# %ho measured le$erage as total

debts di$ided by total assets.

c# Audit 7ees

Audit fees are used as a measurement because high price of audit fees reflect the high

competencies of the auditor (Choi, 6im and 8ang, !!#. *n the study of relationship bet%een

earnings management, log audit fees is used to measure speciali9ation (Choi, 6im and 8ang ,

!!, H ay, 6nechel and Wong, !!1H and Lo%ensohn et al. !!'#. +imilarly, the study of Li

and Lin (!!"#, they include the log total audit fees to obtain empirical result on the

relationship bet%een audit fees and earnings management. The abo$e pre$ious study pro$ides

a moti$ation for this study to use audit fees as a measurement for audit competence. This

study also used the specification disaggregate audit fees because this %ill pro$ide the separate

incenti$e effect for each audit fees and non-audit fees (7ranDel et al., !!#.

d# Gon-Audit 7ees

+ome pre$ious study used non-audit fees ratio (Chung and 6allapur, !!3H Li and Lin, !!"#.

o%e$er, there is some problem %hen the non-audit fees ratio used as measurement. The

problem is such the numerator (GA7# and denominator (A7# both %ill affect the accrual

quality, hence the effect cannot be identified separately. Audit fees and non-audit fees %ill

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result in different %ay and pro$ide the different effect, (+rinidhi, !!'#. *n the fee models,

ho% much of the dollar $alue of non-audit fees paid to the auditors has been used as pro&y for

the le$el of non-audit ser$ices (Whisenant et al, !!3#. Log non-audit fees is used to measure

the audit independence because, higher the non-audit fee, might impair the audit

independence (Whisenant et al., !!3H and >efond et al., !!#. A study by 7ranDel et al

(!!#, suggested log non-audit fees to measure the audit independence since log audit fees is

a pro&y for audit quality.

*n conclude this study used the log audit fees and log-non audit fee separately as to e&amine

the different effect of incenti$e bet%een these $ariable. 7urthermore, this study %ould liDe

mitigate the bias bet%een t%o $ariable because these $ariable are highly correlated (7ranDel

et al, !!H >uh et al, !!?#.

e# 7ree Cash 7lo%

The free cash flo% is the flo% from the company=s operations, disregarding financial

e&penses and adding e&penses that do not mean outflo% of cash, such as amorti9ation and

depreciation, and subtracting in$estments in %orDing capital and permanent assets. The free

cash flo% is the flo% directly a$ailable to the company=s security holders such as common

and preferred shareholders and debt holders. This study identifies the e&istence of surplus

free cash flo% agency problem by calculated from operating income, including ta&es, before

any return to the mentioned security holders. 7ree cash flo% is measured by operating income

before depreciation minus e&penses such as ta& e&pense, interest e&pense, and di$idend

(Lehn J 4oulsen, ??#. Companies are categori9ed as ha$ing potential free cash flo%

agency problems %hen free cash flo% is high (Aulia and Gorman, !!#.

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!.!.2 Contro# aria"#$s

This section %ill present the measurement for each control $ariables used in the current study.

At the end of sample period, all control $ariables %ill be regressed and measured for

e&amining the relationship bet%een E) (Earnings )anagement#.

a# 4rofitability

T%o commonly used measures of profitability are return on assets and return on equity. The

study of Wasimullah et al (!!#, 05E $ariable is used in order to measure the profitability.

The listed firm %hich is incurred lo%er profitability more liDely to in$ol$e in earnings

management.

b# 7irm +i9e

This study included a measure of firm si9e because it is possible that larger firms are

percei$ed differently by shareholders. 7urther, larger firms may pay higher di$idend le$els

and may ha$e larger boards. 5n the other hand, /habra (!!'# demonstrates that firm $alue is

in$ersely related to firm si9e. This could be the result of a number of factors such as lacD of

focus or a lesser degree of transparency in managerial actions. o%e$er, +hort and 6easey

(???# report that firm si9e has a significantly positi$e effect on performance, since larger

firms ha$e the potential to access funds %ith greater ease, both internally and e&ternally.

Larger companies may also ha$e better gro%th opportunities and access to financing

opportunities. Larger companies may ha$e greater analyst follo%ing and thus ha$e more

information a$ailable to reduce information asymmetry and a %ider share spread and

o%nership profile. Accordingly, many past studies ha$e used total assets as a pro&y for firm

si9e. +*8E is measured as the logarithm of total assets.

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c# Audit 5$ersight /oard (A5/#

The usefulness of accounting information depends on its timeliness and this %ill portray the

quality of audit. This study %ill use partial measurement by 6arim, Ahmed and *slam (!!1#,

%hich measures the timeliness and audit delay. *n this study dummy $ariable for Audit

5$ersight /oard is including in order to e&amine %hether this $ariable %ould affect earnings

management or not. To differentiate bet%een the year !!? and year !!, the dummy

$ariable of A5/ is used. A5/ is coded as ! if the firm is audited before establishment of

A5/ in year !!? and ! if the firm is audited after establishment of A5/ on ! April !!.

!.( R$s$arc, $t,od

The current study uses the descripti$e statistics and standard regression analysis. +4++

statistical pacDage is used for all analysis. To test the research hypotheses, a multi$ariate

model %as de$eloped

a# Total accrual (TA# is estimated in order to obtain the amount of discretionary accrual.

7irst, 6othari, Leone and Wasley (!!"# estimated the total accruals as belo%M

TAit P R(Q non-cash current assetit # - (Q current liabilitiesit e&cluding the

current portion of long term debt# - (>epreciation and amorti9ationit#S

? total assets it-.

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The model in the table captures the components of total accrual and non-discretionary

accruals.

WhereM

TA it the total accruals of firmiin year t

A++ET+ it 1 the total assets of firm iat the end of year t -1

Q +ALE+ it sales change in net of the change of account recei$able of firm

ibet%een yearst andt 1

44E it the le$el of gross property, plant, and equipment of firm i in

yeart

05A it(or it -1# 05A of firm i at the end of year t

(05A of firm i at the end of year t 1#

The components of non-discretionary accrual from this model %hich are change in sales and

property, plant and equipment is scaled by lagged total assets. *n calculating the discretionary

accrual %hich is earnings management, the 6othari=s )odel includes the current or lagged

years of 05A.

This model %ill include the 05A it or 05A it - , %hich stand for 05A current year and last

year as to control the firm=s performance. The reason %hy this model has included 05A in

their model is to compare the effecti$eness of performance matching $ersus regression based

approach by 6othari, Leone and Wasley (!!"#.

b# *n order to e&amine the impact of A5/, >ummy A5/ is used to identify the e$ent

before and after the A5/ establishment. *n order to e&amine the relationship bet%een

earnings management and the $ariable, regression model %as employed as follo%sM

44

05A i tP Get *ncome i t 05A it -1P Get *ncome it 1

Total Assets i t or Total Assets it

TA it P XU X*( V A++ET+ it 1# U X+Q +ALE+ itU X44E itU

X-05A it(or it -1# U Y it


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WhereM

>A absolute performance adusted discretionary accrual

(earnings management#

LE@ le$erageH debt to total assets

LogA7EE audit fees

LogGA7EE non-audit fees

Log 7C7 free cash flo%

>IL> di$idend yield

05E return on equity

LogTA total assets>ummyA5/ ! P before A5/ and P after A5/

c# 7or the company=s security holders such as common shareholders, preferred shareholders

and debt holders, the free cash flo% is the flo% directly a$ailable in company. *t is

calculated from operating income, including ta&es, before any return to the mentioned

security holders. 7ree cash flo% is measured by operating income before depreciation

minus e&penses such as ta& e&pense, interest e&pense, and di$idend (Lehn J 4oulsen,

??#.

The 7C7 model is defined asM

Ct 7ree cash flo% e&pected datet

*n turn %here,

CtP E/*T < ta&es U dep. amort U (Qfi&ed assets U inc.def# < %orDing capital in$estment

WhereM

E/*T earnings before interest and ta&es

45

>A Zt P [*U [+( LE@# it U [(LogGA7EE# U [-(LogA7EE# it U ["(Log7C7# it U

[1(>IL># it U ['(05E# it U [(LogTA# it U [?(>ummyA5/# it U it


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Ta&es ta&es on operating income (E/*T & #

>ep. amort depreciation and amorti9ation

Qfi&ed assets $ariation of fi&ed assets (purchase of fi&ed assets#

inc. def increase of deferred charges (if any#

WorDing capital in$estments P $ariation of %orDing capitalH

WorDing capital P (in$entories U accounts recei$able from customers < accounts

payable to suppliers# & (salesV31"#.

!.* )u%%ar of t,$ c,a-t$r

This chapter discusses on the methodology of the study on agency monitoring and earnings

management. The final sample used in this study taDen from the main board of /ursa

)alaysia. There are fi$e hypotheses de$eloped and each of them being tested using

regression model %ith e&pected results that %ill be presented in Chapter 2.

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CHAPTER OUR

DATA ANA/


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using separate data of year !!? and !!. Ge&t, discusses the robust regression analysis

e&clude firm %ith no non-audit fees to test hypothesis for all years, !!? and !! before and

after implementation Audit 5$ersight /oard (A5/#. Lastly, section 2." pro$ides a summary

for data analysis.

(.1 D$scri-ti'$ statistic

Ta"#$ (.1@ D$scri-ti'$ statistic for fu## sa%-#$

)ean )inimum )a&imum +tandard

>e$iation

+De%ness 6urtosis

Dependent Variable

>iscretionary Accrual .!1" .!! .2 .!1' .? 1."

Independent Variables

Le$erage !.!! .!! .'' .'3 .'3" .

LogAudit7ee .'"2 ?.' ".3 !. !.3 .3!1

LogGonAudit7ee '.2?' .!! ".!1 2."! -.11 -.''

Log7reeCash7lo% .11 .!! 1.1 2.!" -.!! ."3

>IL> .3 .!! ?.3" 3." ."?' 3.

Control Variables

LogTotalAsset .'" !.3' . ."2 .!!! .3

05E .!2 -."1 31.'2 1.'" -2.'"" .'2!

Table 2. presents the descripti$e statistic for the dependent $ariable, independent $ariable

and control $ariable used in this study. The descripti$e analysis statistically e&plain the

$ariables used in the study.

>ependent $ariable, >iscretionary accrual (>A# obtains using the model of earnings

management $ia total discretionary accrual. >iscretionary accrual is a pro&y to measure the

earnings management. >iscretionary accrual is bet%een positi$e $alues of !.!! to !.2. The

mean $alue is report at !.!1".

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The independent $ariables consist of le$erage, log audit fees, log non audit fees, log free cash

flo%, di$idend yield (>IL>#, and some of the control $ariables consist of log total asset and

return in equity (05E#. 5$erall, most of the $ariables ha$e positi$e sDe%ness and Durtosis,

indicating that most of the data are distributed at positi$e $alues and clustered in the center.

/ased on the information and the shape of distribution on the histogram, it is indicated that

the data is close to normal distribution and suggests that there is no $iolation of assumption of

normality.

The first, second, third and fourth columns in Table 2. present the minimum, ma&imum

mean and standard de$iation $alue for each $ariable. The ma&imum $alue for le$erage is !.''

and minimum $alue of le$erage is !.!!. )ean%hile, the audit fee $alue, the ma&imum $alue

of audit fees paid to the auditors is ".3 and the minimum $alue of audit fees is ?.'.

Therefore, it is indicate the amount of the clients %illing to pay in substitute of the e&pertise,

Dno%ledge and hours in conducting audit. 7or non-audit fees paid to auditors, the ma&imum

$alue of non-audit fees paid to the auditors is ".!1 and minimum $alue for non-audit fees is

!.!!. The amount of non-audit fees is obtained from the other ser$ices rendered to the clients.

o%e$er, there are some companies appoint other auditors to conduct other than audit

ser$ice. Therefore, the $alue of non-audit ser$ices is considered as 9ero for those companies.

Ge&t, the minimum $alue for free cash flo% is 1.1 and minimum $alue is !.!!. Lastly, the

di$idend yield range is bet%een !.!! to ?.3".

Control $ariable used in this study as sho%s in the table 2. under column control $ariable.

5$erall, the sample has a total asset (log total asset# at range bet%een !.3' to .. As for

measurement of performance, o$erall the highest ratio of net income to total equity (05E# of

the sample company is 31.'2 and the lo%est is report at < ."1.

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+De%ness used to measure the distribution of $ariable. )oreo$er, 6urtosis is used to measure

data is peaD or flat relati$e to normal distribution. +De%ness is $alue near to 9ero and for

Durtosis is $alue in range %ithin < 3 and U 3. 5$erall, the entire $ariable used in this study is

normally distribution e&cept for discretionary accrual. After checDing the outliers and

transform the data using natural log, the entire $ariable used in this study is normally

distributed, e&cept for dependent $ariable. o%e$er, this study assumed all data is normally

distributed. When the samples are large %hich abo$e 3!, sampling distribution is assumed

normal (@aus, !!#. According to @aus (!!# $iolating the normality assumption does not

ha$e large effect on the statistical result. *t also follo%s the central limit theorem %hich states

that large sample si9e of !! or more %ill appro&imately distribute to the normal $alue (@aus,

!!#

5$erall, most of the $ariables ha$e positi$e sDe%ness and Durtosis, indicating that most of the

data are distributed at positi$e $alues and clustered in the center. /ased on the information

and the shape of distribution on the histogram, it is indicated that the data is close to normal

distribution and suggests that there is no $iolation of assumption of normality.

(.2 Corr$#ation ana#sis

The purpose of correlation analysis is to e&plain the strength and direction of the relationship

bet%een t%o $ariable among the groups used in the model of the study. Therefore, this study

used 4earson correlation matri& to test the correlation of the $ariable in this study. Table 2.

sho%s the summary of result %hen the bi$ariate analysis is done to test the correlation

bet%een one $ariable to another.

Ta"#$ (.2@ P$arson corr$#ation %atri of 'aria"#$ us$d in t,$ stud

>A Le$erage Log

Aud7ee

Log

GonAud7ee

Log

7reeCash7lo%

>IL> Log

TotAsset

05E A5/

*G+4EC

>A .3 -.! -.!!" -."2\ -.' -.3 -.!1 .!2!

Le$erage .!33 -.\\ .!" -."\\ -.! -.\\ -.!3'

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LogAud7ee .?2\\ .11\ -.!31 .'1"\\ -.!!' .!?

LogGonAud7ee .!'? .!3! .3\\ ."?\ .!1

Log7reeCash 7lo% .!'3 .32 .!32 .!?

>IL> .!" .3\ -.3!\

Log TotAsset -.!1 .!!1

05E .!23

A5/ *G+4EC

!Co""elation i# #igni$i%ant at &.&&' level# (- tailed)

!!Co""elation i# #igni$i%ant at &.&1 level# ( tailed)

7rom the table, there are some $ariable are correlated. 7or discretionary accruals, only the

$ariable of free cash flo% is significantly related, at r P !."2, p ] !.!" %ith negati$e

relationship. 5ther $ariable is not correlated %ith >A. 7or A5/ inspection, only the $ariable

of di$idend yield (>IL># is significantly related, at r P !.3!, p ] !.!" %ith negati$e

relationship. o%e$er, other $ariables are not correlated %ith A5/ inspection.

(.! R$gr$ssion ana#sis

This section reports the testing of the ("# fi$e hypotheses de$eloped in Chapter 3. The

obecti$e of this analysis is to e&amine the relationship bet%een >A (discretionary accruals#

and each independent $ariable for entire period co$ering !!? to !! (pooled data# and for

each indi$idual year as %ell in the additional analysis. The regression results are presented in

Table 2.3 for the pooled data to test the hypothesis respecti$ely. Ge&t, the additional analysis

is sho%n in Table 2.2(a# and 2.2(b#. This study mainly regress the $ariables using regression

model as presented in section 3.2 %hich is absolute performance adusted discretionary

accruals.

Ta"#$ (.!@ R$su#ts of r$gr$ssion ana#sis on E for t,$ $ar of 200: and 20107-oo#$d data8

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Knstandardi9ed

Coefficients+tandardi9edCoefficients T +ig.

/

+td.

Error /eta

(Constant# .2 .!1" . .!3!

Le$erage .!3 .!3! .!" .'12 .221

LogAud 7ee .!!3 .!! .!3' .32 .'33

LogGonAud7ee .!! .!! .!"3 .1? .21

Log 7reeCash7lo% -.!! .!! -.' -.'? .!'2\\

>IL> -.!! .!! -.!"2 -.'"" .2"

Log TotAsset -.!! .!!" -. -.1? .!?3\\

05E .!!! .!!! -.!1! -. .22

A5/ *G+4EC .!!' .!!? .!"3 .'"" .2"

0 .!"1

Adusted 0 .!

7-+tatistic .??2

!!!Signi$i%ant at the &.&&1 level (Sig -tailed)!!Signi$i%ant at the &.&' level (Sig tailed)

!Signi$i%ant at the &.1 level (Sig tailed)

/ased on Table 2.3 analysis (pooled data for the year !!? and !!# indicates that t%o

$ariables %hich are significant are log free cash flo% and log total asset. *t sho%s that only

$ariables log free cash flo% and log total asset ha$e an influence on E). As a result,

hypothesis 2 %hich predicts that the surplus free cash flo%, the more liDely the manager is

e&pected to manage earnings is accepted.

5ther independent $ariables did not sho% significant result. *n hypothesis , predict that

firms %ith higher le$el of di$idend %ould ha$e lo%er earnings management. As s result, this

hypothesis has been reected. The di$idends could act as a credible signal of earnings quality,

%ith companies unengaged %ith E) being more liDely to pay di$idends, to ha$e higher

di$idend yields amongst di$idend payers and to increase di$idends per share (7arinha and

)oreira, !!'#.

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ere, in hypothesis predict that firms %ith higher le$el of le$erage %ould ha$e higher

earnings management. Therefore, base on regression result this hypothesis has been reected.

According to study by Aini et al. (!!1# proposed that the corpor

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