Post on 14-Feb-2022
transcript
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
10 Petra Christian University
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
11 Petra Christian University
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
12 Petra Christian University
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
13 Petra Christian University
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
14 Petra Christian University
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
15 Petra Christian University
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.
16 Petra Christian University
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.
17 Petra Christian University
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
18 Petra Christian University
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
19 Petra Christian University
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,
20 Petra Christian University
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):
21 Petra Christian University
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
22 Petra Christian University
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.
23 Petra Christian University
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.
24 Petra Christian University
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
25 Petra Christian University
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
26 Petra Christian University
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
27 Petra Christian University
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).
28 Petra Christian University
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
29 Petra Christian University
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
30 Petra Christian University
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:
31 Petra Christian University
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)
32 Petra Christian University
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
33 Petra Christian University
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.
34 Petra Christian University
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
35 Petra Christian University
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”
36 Petra Christian University
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
37 Petra Christian University
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).
38 Petra Christian University
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
39 Petra Christian University
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).
40 Petra Christian University
2.5 Earlier Research
Table 2.1 Earlier Research
2.5
E
arli
er R
ese
arc
h
41 Petra Christian University
42 Petra Christian University
43 Petra Christian University
44 Petra Christian University
45 Petra Christian University
46 Petra Christian University
47 Petra Christian University
48 Petra Christian University
49 Petra Christian University
50 Petra Christian University
51 Petra Christian University
52 Petra Christian University
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
53 Petra Christian University
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
54 Petra Christian University
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
55 Petra Christian University
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).
56 Petra Christian University
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
governance on intellectual capital efficiency Evidence from top service firms in
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.
57 Petra Christian University
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
governance on intellectual capital efficiency Evidence from top service firms in
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
governance on intellectual capital efficiency Evidence from top service firms in
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).
58 Petra Christian University
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
59 Petra Christian University
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.
60 Petra Christian University
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.