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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, 2005). The
demand for auditing services arises because need to facilitate dealings between the internal
and external parties involved in business relationships such as shareholders, creditors, public
authorities, employees, customers and others (Chia, Lapsley and Lee, 2007). However, from
the management perspective, the values of the firms are related to report earnings figures,
therefore it will creates economic incentives for management to engage in earnings
management. Thus, fraud and mismanagement on financial reporting will occur due to
personal interest of managers or other related parties.

Accounting fraud and corporate collusion also become important issues in Malaysia. It seems
the credibility and quality of auditor becomes decreased. As a result, this matter will
contribute to the issue of fraud, collusion, bribes and manipulation of accounting numbers
among the companies in Malaysia. According to Securities Commission Malaysia 2010
(www.aob@sc.com.my), report that Transmile Group Berhad amount of deviation for year
2005 is RM 150 million and year 2006 is RM260 million. In case of Energro has manipulate
their export sales of RM 64 million in year 2003, and GP Ocean, has made the fictitious sales
about RM 25.7 million to four of their customers. Megan Media was submitting false revenue
of RM 1 billion in financial statement in 2006. Latest, the case of accounting fraud such in
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Port Klang Free Zone and corporate collusion in Malaysian Airlines, also proved that the case
of accounting scandal has spread out (Gomez, 2010). Currently, from January to April 2010,
Securities Commission has convicted some cases who are pleaded guilty on reporting
misleading statements such in cases of March 2010 PP v Tan Chin Han, Ang Sun Beng
and Ang Soon An (The Reporter, 2010). Thus, these cases are the example of accounting
manipulation which originated from earnings management.

There are many researches that have been conducted on the determinants of earnings
management, such as a firms financial characteristics and audit quality (Dechow et al. 1995).
Various definitions exist for earnings management. Schipper (1989) appears to have captured
the essence of earnings management by defining it as purposeful intervention in the
external financial reporting process with the intent of obtaining private gain Likewise,
Healy and Wahlen (1999) state that earnings management occurs when managers use
judgment in financial reporting and in structuring transactions to alter financial reports to
either mislead some stakeholders about the underlying economic performance of the
company or to influence contractual outcomes that depend on reported accounting numbers.
Regardless of its different definitions, earnings management is inherently unsolved problem.

1.2

Background of study

Malaysia is argued here to provide a setting less transparent with low levels of public
scrutiny compared to the West, in which to test the propensity of auditors to issue a qualified
audit opinion when earning management is not constrained due to many factors of earnings
management. Malaysia is a country where reporting and auditing practices are heavily
influenced by common-law sources given their historical influence in the setting of
International Financial Reporting Standards and International Standards on Auditing (ISAs),
facilitating comparison with research results in the Western World financial reporting and
auditing standards. However, although there has been much emphasis on strengthening the
accounting and disclosure standards in Malaysia, the same perhaps cannot be said with
respect to auditing practices (Thillainathan, 1999). Effort has been made by the International
Federation of Accountants (IFAC) to improve the uniformity of auditing practices and related
services throughout the world. This is evidenced by the formation of the IFAC FOF and the
Transnational Auditors Committee (TAC) in January 2001. The FOF is a voluntary body
made up of international audit firms performing audits across national borders. The FOF
agree to meet certain requirements and undergo a global independent quality review. TAC is
an executive committee of IFAC devoted to representing and meeting the needs of the
members of FOF. It plays a major role in encouraging member firms to meet high standards
in the international practice of auditing.

Therefore, Malaysia has also following the world development to comply with audit practices
and standards. On 10 April 2010, Malaysia had established Audit Oversight Board (AOB) to
ensure high quality and reliable financial reporting. The AOB is not a statutory body, but
since it was established under the auspices of the Securities Commission (SC), the SC would
remain accountable for all of the AOB's acts and omissions. The AOB would also work
closely with all regulatory agencies to ensure a holistic regulatory framework for auditors in
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Malaysia. The AOB has taken its first step, by registering individual auditors and audit firms
that audits the financial statements of a Public Interest Companies. After the registration
stage, the AOB would knock on the auditors doors to make inspections. This inspection
process allows AOB officers to have the power to access working papers, books and
accounts. Apart from inspections, AOB officers would also have the necessary powers to
conduct inquiries and impose proportionate sanctions against auditors. Other functions would
include the setting of auditing, quality control, ethics, independence and other standards
relating to the preparation of audited financial statements.

The AOB was established because to monitor and inspect the audit firms in Malaysia. The
one of the reason of earnings management happen because is due to agency problem. The
agency problem occurs because investors and other stakeholders may not be able to make
optimal decisions concerning a company when earnings management distorted economic
results and hinder the ability of all stakeholders to make financial decisions. Davidson III,
Jiraporn, Kim and Nemec (2004) extended the agency theory by showing that earnings
management in particular can be an agency problem. They also added that managers may
have personal goals that conflicted shareholders. Since managers have been empowered by
shareholders to make decisions, a conflict of interests has potential agency costs.Agency
problems occur when managers do not operate a company for the shareholders best interests.
When a firm manages the impression it presents to the marketplace through earnings
management, shareholders and other stakeholders must base financial decisions on numbers
that do not, perhaps, reflect the true economic conditions of the firm (Neu, 1991).
Pressure to manage earnings does not stem from a single force. Factors such as analysts
forecasts, access to debt markets, competition, contractual obligation, a roaring stock market,
new financial transactions, market disregard of big charges, merger attractiveness,

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


requests from superiors, periods of excessive profit followed by a fear of subsequent decline,
concealing unlawful transactions, personal bonuses, promotions, focus on team, and job
retention are among the reasons that are mentioned in the literature (Duncan, 2001). The
effects of these variables on earnings management in different countries may be different. For
example, the debt hypothesis suggests that the larger the firms debt-to-equity ratio the more
managers are expected to choose income increasing accruals. However, this hypothesis has
no effect in the Japanese business environment. It is known that managers of larger
companies in Japan are more likely to choose income-decreasing accruals (Kester, 1992;
Phan and Yoshikawa, 1996; Pourjalali and Hansen, 1996)

A study by Zunaidah and Fauzias (2008), suggested that dividends among Malaysian listed
firms can play an important monitoring role in reducing agency cost (i.e. earnings
management). It was agreed by Farinha and Moreira (2007) that dividends can act as a
credible signal of earnings quality, with companies unengaged in EM being more likely to
pay dividends. Sant and Cowant (1994) concluded that firms pay dividends to convey
information to investor that cannot be conveyed costless and credibly in other ways.
Therefore, dividend can be one of motive in earnings management.

Several researchers identify leverage as a motive in earning management. As Beatty and


Weber (2003) suggested, firms engaging in EM are more likely to avoid debt covenant
default from the leverage made. It is supported by Aini, Takiah, Pourjalali and Teruya (2006)
saying that the corporate sector in Malaysia became more leveraged and heavily dependent
on commercial bank financing after the 1997 economic crisis. They added that financial
difficulties faced by companies might transpire managers to improve upon their performance

through earnings management. So based on the findings, banks could impose more
monitoring mechanisms on firms with high leverage to avoid manipulation of earnings by the
managers (Aini, Takiah, Pourjalali and Teruya, 2006)

The opportunity for earnings management is higher among companies with high surplus free
cash flow. A study by Chung, Firth and Kim (2005) indicates that companies with high
surplus free cash flow face major agency problems. Agency problem occurred particularly
when the free cash flow is high but investment opportunities are low (Gul, 2001). Managers
of these companies act opportunistically for personal gain, and tend to get involved in
unprofitable projects, over investments and misuse the funds (Jensen, 1986). They tend to
carry out non-value maximizing activities amounting to agency problems (Jensen, 1986).
Their activities may bring benefits or rewards for themselves at the expense of the
shareholders. These companies are found to have engaged in expenditures that decrease
shareholders wealth (Chung et al., 2005).

Managers may employ accounting procedures that increase reported earnings to hide the
negative impact of projects (Chung, Firth and Kim, 2005). In order to conceal these activities,
managers are forced to manage earnings via accounting discretions. However, the managers
opportunistic behavior may be minimized if the company internal corporate governance
monitoring mechanism, such as independence of audit committee, is effective (Bedard,
Chtourou & Courteau, 2004)
It 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
exact amount but rather is an amount selected from a continuum of amounts derived from the
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application of different acceptable accounting accrual choices (Healy and Wahlen, 1999 and
Dechow and Skinner, 2000). Firms can choose between various allowable accounting
methods or can apply different assumptions or estimates within an accounting method.
Hence, the role of accrual accounting is believed to have caused some forms of earnings
management, such as income smoothing, which are hard to distinguish from appropriate
accrual accounting choices. The practice of earnings management has digressed from the
primary focus of financial reporting, which is to provide information on the companys
performance measured by earnings and its components (Dechow and Skinner, 2000).

1.3

Problem statement

The question of whether auditors adequately safeguarding accounting information by


ensuring credible reporting has recently received much attention. This attention has focused
on Asia and the 1997 Asian Crisis, and more recent (2001) very public collapses of two
corporations, Enron in the USA and HIH in Australia. Against this backdrop, this paper
investigates in the emerging market of Malaysia an aspect of audit quality (AQ) product
differentiation in association with financial reporting discretion on audit outcome (audit
opinion) and earnings management (Johl, Jubb and Houghton, 2007).

Enron case has brought more attention to the questions of how and why firms manage
earnings. Accounting numbers form a fundamental part of an organizations efficient
contracting technology. Since many of the terms, conditions, and covenants found in
contracts use accounting variables, contractual arrangements and the associated contracting
costs are major determinants of accounting method choices hence earnings management. It is
important to understand the processes that may drive the earnings management. As measuring
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and reporting performance has become increasingly important in our society, the study of
how statistics are produced and managed may need to be included in management thought
(Corvellec, 1997).

Thus, if markets were perfect, earnings volatility would not be costly to managers and their
firms and, therefore, managers would have no incentives to smooth earnings. However,
empirical and anecdotal evidence suggests that earnings management is pervasive. However,
a question remains largely unexplored by previous literature. If managers have incentives to
manage earnings, will they still elect to manage earnings through discretionary accounting
decisions when they can reduce earnings volatility by smoothing cash flows. This can lead
the investor to overvalue the current value of the company (Teoh et al., 1998).

Hence, this study will investigate whether certain motive and opportunities factors may
influence earnings management in establishment of Audit Oversight Board (AOB). The study
also identifies numerous monitoring mechanisms including the role of various types of
stakeholders such as shareholders, lenders, auditors and managers which concern about
dividend, leverage, audit quality and free cash flow respectively. The AOB is expected able to
oversight the auditors to be more quality and high quality of financial reporting can be
produced.

1.3

Objectives of study

The objectives of this study are:


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1.

To examine the relationship between motive (leverage and dividend) and


earnings management.

2.

To examine the relationship between opportunity (audit quality and free cash
flow) and earnings management.

3.

To investigate any differences between motive, opportunity and earnings


management before and after the establishment of Audit Oversight Board
(AOB).

1.4

Significance of study

Capital markets are backbone of the economic activity of a democratic country. Regulation is
created to reduce the effects of information asymmetry for investors and to provide
transparency in the operation of the market. According to Bather and Burnaby (2006),
expects that fully informed decisions to be made by providers of finance. The corporate
collapses at the beginning of the twenty-first century in the USA show that information
asymmetry is a problem for investors. Management of the collapsed companies had
knowledge that was not shared with their shareholders, but may have known to their financial
auditors. These watchdog of financial markets did not ensure that knowledge was passed
on to investors or red-flagged to authorities, contributing to losses suffered by investors
(Bather and Burnaby, 2006).

Previous studies in Malaysia have focused on board of directors, audit committee and
concentrated ownership in reducing EM over the period of 2002-2003 (Rashidah & Fairuzana
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Haneem, 2006). Rashidah and Wan Razazila (2005) also studied on why firms issuing equity
produced poor return on 187 IPO firms that go public over the period 1989-1998. On the
other hand, only a number of studies on audit quality and EM were done in Malaysia.
Previous study by Becker, Defond, Jiambalvo and Subramanyam (1998) have found evidence
that clients of non-big six auditors report higher discretionary accruals than clients of big six
auditors but this evidence is on U.S based. Similarly, Krishnan (2003) supported the
statement by stating that specialist auditors mitigate accruals based EM more than non
specialist auditors and therefore, influence the quality of earnings. This study contributes to
the current literature by examining audit quality in public firms in Malaysia, and by
questioning whether audit quality enhances financial reporting quality in public firms.

In order to integrate all these main issues, it is necessary to examine the underlying factors
simultaneously. The focus of the study is to acquire an understanding of whether the
dividend, leverage, and free cash flow could act as monitoring mechanisms and curb earnings
management practice in Malaysian public listed companies. Other characteristics that will be
examined are the audit qualities and to see whether all these variables have significant
relationship on managers to practice earnings management due to motive and opportunity of
earnings management.

1.5

Organization of chapters

This study is divided into five chapters. Chapter one provides an introductory background of
the research. It provides a brief introduction of EM and issues involving it. The objective,
significance and research statement of the study are also highlighted in this chapter. Chapter
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two reviews the agency theory that links to EM and studies of EM related to dividend,
leverage, free cash flow and audit quality. Chapter three provides the method of data
collection, hypothesis development and measurement used in this study. Analyses and
findings are presented and discussed in Chapter 4. Lastly, Chapter 5 draws up the conclusion
and limitation of the study. Recommendations for future research are also provided in this
chapter.

CHAPTER TWO
LITERATURE REVIEW

2.0

Introduction

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Literature review is a collection of review of published and unpublished work on the


secondary sources (Sekaran, 2000). This chapter provides the literature review that serve as a
basis of ideas in this study. Therefore, this section aimed to discuss the previous literature on
the research topic. Under Section 2.1 discusses on agency theory. Section 2.2 explains about
EM and its motives. Then, section 2.3 provides discussion on dividend followed by leverage
in section 2.4. Free cash flow will be discussed in section 2.5 and 2.6 will explain about audit
quality. In section 2.7 will be discussed on Audit Oversight Board (AOB) followed by 2.8
will be explains about conceptual framework. The last section, 2.9 will be mainly about the
summarization and conclusion of the chapter. Moreover, this part will discuss on earnings
management and audit quality which are competence and independence.

2.1

Agency Theory

Agency theory is commonly used to explain certain accounting issues such as conflicts of
interest, incentive problems, and mechanisms for controlling incentive problems (Lambert,
2001). The agency relationship occurs when one or more persons or the principles employ
another person or the agent to perform some services on their behalf (Jensen & Meckling,
1976). Conflicts of interest among principles (shareholders) and agents (managers) frequently
happen. The agency problem becomes more evident if both the managers and shareholders
are utility maximizers because the presumption is that the managers will not act in the best
interest of the shareholders (Jensen & Meckling, 1976). The agency theory provides logical
predictions about what rational individuals may do if placed in such a relationship.

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Managers may have self-interest that conflict with their shareholders. A conflict of interests
has potential agency cost such as management decisions that do not maximise shareholders
interests. Managers may manage reported earnings to obscure their actions. Earnings
management may lead to an agency cost when investors make non-optimal investment
decisions from reported earnings. In a situation where a company has high free cash flow, the
manager may be engaged in earnings management to show better performance of the
company. Then, this relation can be explained by using agency theory.
Agency theory proposes a series of mechanisms that seek 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 behaviour of agents (Coles, McWilliams & Sen,
2001). These mechanisms include external governance instruments such as takeovers
(Easterwood, 1997) and merger (Erickson & Wang, 1999). The potential for shareholder
manager conflict may also be reduced by the utilization of internal control mechanisms such
as monitoring by non-executive directors (Klein, 2002), monitoring by institutional
shareholders and auditors (Chung, Firth and Kim, 2005), and the incentive effects of
executive share ownership (Jensen & Meckling, 1976). An additional instrument of
shareholder monitoring is the statutory audit whereby independent auditors report annually to
shareholders on the appropriateness of the financial statements prepared by the management
(Watts & Zimmerman, 1983).
2.2

Earnings Management and Its Motives

The practice of earnings manipulation is very common among companies as a result of


serious agency problems (Healy & Whalen, 1999). The nature of earnings manipulation
ranges from earnings fraud to earnings management. Earnings fraud relates to fraudulent
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financial reporting which involves intentional misstatements or omission of amounts or


disclosures in the financial statements to deceive financial statements users (MIA, 2002).
Earnings management may involve 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., 2006). Earnings management occurs when managers use
judgment in financial reporting and in structuring transactions to alter financial reports to
either mislead some stakeholders about the underlying economic performance of the
company, or to influence contractual outcomes that depend on reported accounting numbers
(Healy & Wahlen, 1999).

The practice of earnings management occurs because of the availability of different


acceptable accounting accrual choices to be applied for the determination of reported income
(Healy & Wahlen, 1999; Dechow & Skinner, 2000). According to Teoh, Welch and Wong
(1998b), sources of earnings manipulations within generally accepted accounting principles
include the choice on the application of accounting methods, and the timing of asset
acquisitions and dispositions. The alternative representations of accounting events permitted
by generally accepted accounting principles through accrual accounting provides some
flexibility for managers in their discretions when deciding on actual earnings. The
management has the opportunity to manage the timing and recognition of actual expense
items such as advertising expenses or research and development expenditures, and the timing
of revenue recognition through an early recognition of credit sales revenue or deferral of
losses by establishing loss reserves (Teoh et al., 1998).

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In practice, managers are often motivated to gain personal benefits through direct reward
such as salary and bonus or indirect reward such as future promotions, prestige, and job
security. These rewards are given to managers based on the company earnings performance.
If the incentives are based on the company financial performance, managers may be tempted
to act in their self-interest and to impress the shareholders and other stakeholders of the
company good performance through earnings management. The management discretion over
reported earnings and its effect on the management compensation lead to a potential agency
problem. A compensation incentive is only one example of many other opportunities of
earnings management in free cash flow. However, this study does not intend to examine
directly the compensation incentives. 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. Investors use
financial information to make economic decisions which are reflected in share prices. The
market efficiency is based upon the information flow to capital markets. Securities may be
valued inappropriately because of the use of the managed information by the investors.
Managers behaviour of obscuring the real performance through earnings management may
create agency costs such as costs to undo the managed earnings, to resolve misallocations of
resources, or to seek for other information (Xie et al., 2003).
Past studies investigate the relationships between earnings management and certain corporate
events which resulted in the occurrence of agency conflicts. The studies found mixed results.
Wu (1997) finds supports for the assertion that managers are motivated to understate earnings
in an attempt to acquire a company at a lower price. In contrary, DeAngelo (1988) finds no
evidence of earnings management practices among managers. Generally, studies on earnings

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management are conducted in the context of capital markets where contractual incentives
may exist for companies to manage earnings such as lowering the price for an acquisition of
companies. Wu (1997) finds supports for the assertion that managers are motivated to
understate earnings in attempt to acquire a company at a lower price.

In contrary, Easterwood (1997) and Erickson and Wang (1999) find evidence of earnings
management in both hostile takeovers and in stock for stock mergers. Easterwood (1997)
finds that in hostile takeover attempts companies increase their earnings for the period prior
to the takeover in order to discourage shareholders from supporting the takeover. In the case
of mergers, Erickson and Wang (1999) find similar results where companies engaging in
stock for stock mergers increase their earnings prior to the merger in order to inflate their
stock price and thereby reduce the cost of the merger.

Other researchers investigate managers motivation to manipulate earnings in trying to


influence investors and other stakeholders. Teoh et al. (1998), Rangan (1998) and Dechow,
Sloan and Sweeney (1995) provide evidence that managers inflate earnings prior to seasoned
equity offerings. The studies show that managers seek to manage pre-issue earnings in order
to improve investors expectations of the company future performance. There is, however, a
cost associated with the earnings management. In study of Teoh et al. (1998) shows that,
companies which managed earnings prior to initial public equity offerings experience poor
stock return performance in the subsequent three years.

2.3

Dividend and Its Motives

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Dividend is a well-known cash disbursement strategy for public listed that seeks to return
cash or assets to their shareholders. The distribution of excess cash to shareholders constitutes
the most fundamental device that alleviates conflicts between corporate insiders and outside
shareholders (Jensen, 1986). However, firms can also return their cash to shareholders in the
form of share repurchases, where certain amount of cash is used to buy back outstanding
shares in the firm and reduce the number of shares outstanding.

Regular distributions of funds to shareholders force firms with value-enhancing investment


projects to raise capital externally (Easterbrook, 1984). Consequently, firms are regularly
forced to undergo the scrutiny of the market, that is, the providers of external funds. The
commitment to pay out excessive funds to shareholders reduces the amount of free cash flows
that managers could otherwise spend on value-reducing projects (Jensen, 1986).

Jensen (1986) views dividends as a device to extract free cash flow (FCF) from the control of
managers that pursue non-value-maximizing objectives, for example, empire building. It also
can be argued in the context of agency costs of free cash flow argument that any form of
distribution of excess cash to shareholders would reduce the agency problem between
shareholders and managers. An important implication for this argument is that cash
distribution through dividends could have a positive impact on firm value because it reduces
the over-investment problem. La Porta et al. (1998) have argued that dividend policy is the
result of the pressure exercised by minority shareholders in order to force insiders to pay
cash. On the one hand, La Porta et al. (2002) state that firms located in countries with a
higher legal protection to minority shareholders pay higher dividends, as compared to
countries where legal protection is weak.

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2.4

Leverage and Its Motives

Companies that have high leverage may be at risk of bankruptcy if they are unable to make
payments on their external debt financing, they could also be unable to find new lenders in
the future. So, if a company wishes to take out a new loan, lenders will scrutinize several
measures of whether the company is borrowing too much and will demand that it keeps its
debt within reasonable boundaries.

Previous literature suggests that leveraged firms engage in EM to avoid debt covenant default
(Beatty and Weber 2003; Dichev and Skinner 2002; DeFond and Jiambalvo 1994). However,
these studies measure EM using accrual based measures. Jelinek (2007) studies the effect of
leverage increase on accrual EM. Jelinek suggests that leverage changes and leverage levels
have a different impact on EM and concludes that increased leverage is associated with
reduced accrual EM. Moreover results suggest that there is a beneficial consequence of debt
because the increased debt reduces managers discretionary spending, and in turn, reduces
accrual EM.

The conclusion has been drawn by Jelinek could be incorrect. As there could be another
explanation of why increased leverage is associated with reduced accrual EM. For example
companies with increasing debt could be involved in the Real Earning Management (REM).
However, increased leverage could give an incentive for managers to switch from accrual
earnings management to Real Earning Management. Moreover, reducing of discretionary
expenses is one of the Real Earning Management activities that could provide evidence that
the company engage in Real Earning Management.
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One relevant research on management of Cash Flow From Operation is performed by Zhang
(2006) and comes close to consider the effect of the level of leverage on REM; he
investigates the possibility that debt covenants, amongst others, could be a one of the
incentives for management to manipulate cash flow through real activities. The result of his
research suggests that coefficients on debt covenants are positive but not significant, because
the proxy to capture incentives is too crude. Unlike this paper, Zhang considers the incentives
to avoid default of debt covenants, amongst which debt-to-equity-ratio, rather than
researching whether changes in the level of leverage are positively correlated to Real Earning
Management.

2.5

Free Cash Flow and Its Opportunities

It has long been recognized in the finance literature that the allocation of free cash flow is an
important aspect of the basic conflict of interest between managers and owners (Jensen,
1986). Specifically, free cash flow tempts managers to expand the size of the firm, thereby
increasing managers' control and personal remuneration even though such an action may
decrease the overall value of the firm. The finance literature has long recognized the impact
of agency costs on the allocation of discretionary monies.
A large strand of research examines the relationship between agency costs and financial
structure. Jensen (1986) posits that leveraged buyout activities are one way of controlling free
cash flow because the debt incurred in such transactions forces managers to disgorge excess
cash rather than direct it to unprofitable opportunities. Evidence supporting the free cash flow

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motivation for financial restructuring has been provided by many authors (Gibbs 1993;
Griffin 1988; Gupta and Rosenthal 1991: Lehn and Poulsen 1989; Loh 1992: Moore,
Christensen and Roenfeldt 1989).

In the accounting literature, Gul and Tsui (1998) examine the relationship between the
amount of free cash flow and audit fees. They hypothesize that because managers will likely
engage in non-value-maximizing activities while allocating free cash flow, auditors'
assessment of the inherent risk and, in turn, the audit effort will increase with the amount of
free cash flow possessed by the firm. Gul and Tsui therefore postulate a positive relationship
between high levels of free cash flow and audit fees. As expected, they find this association in
their data set.

The free cash flow hypothesis has also been tested in the context of the issue of equity. Mann
and Sicherman (1991) hypothesized that shareholders will respond negatively to equity issue
announcements because they expect management to misuse such no bonded funds.
Furthermore, they also expect shareholder response to be moderated by the track record of
management with respect to previous equity issues. Finally, Wells, Cox, and Gaver (1995)
compare the level of cash flow for mutual insurers and stock insurers and find that the latter
possess greater levels of cash flow. Wells, Cox, and Gaver posit that management at these
firms is able to hoard cash because it is governed by fewer monitoring and control
mechanisms. This hoarding of cash, though non-value maximizing, provides management
with the important benefit of avoiding the scrutiny of the capital markets when the firm
requires additional capital.

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In summary, there is a vast body of research in accounting and finance that convincingly
demonstrates that agency costs play an important role in the allocation of discretionary
monies. As is evident from this brief review, researchers have examined the impact of agency
costs on various topics, such as financial structure, audit fees, response to equity
announcements, and the level of free cash flow. This stream of research enables us to
conceptualize the impact of agency costs on the allocation of discretionary monies.

2.6

Audit Quality and Its Opportunities

From an audit market perspective, there are two types of audit quality. First, audit quality
depends on the probability that material misstatements and signals of financial distress are
discovered. Second, the audit quality depends on the probability that the auditor will report
these misstatements and signals (DeAngelo, 1981). While the technical capability of auditors
or the probability that the auditor will discover 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
prevent auditors from compromising their independence and as such, provide incentives to
the auditor to constrain earnings management or issue a qualified opinion when necessary.
Apart from the sanctions themselves, litigious actions or disciplinary sanctions damage the
auditors reputation. In this respect, larger audit firms are expected to be less likely to
perform low quality audits because these firms have 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
auditors reputational capital (DeAngelo, 1981).

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However, this reputation rational is only expected to hold when the probability that an audit
failure is detected and the risk of litigation is high, hereby damaging the auditors reputation.
When the risk of audit failure detection and litigation is low, litigation and reputation costs of
providing a low quality audit are expected to be reduced, hereby lowering the incentives of
large audit firms to supply a high quality audit. As documented in different empirical studies
(e.g. Maijoor and Vanstraelen, 2006; Francis and Wang, 2008), Big 4 audit firms are less
inclined to supply public client firms with high quality audits in countries with weaker
investor protection, lower level of enforcement and lower risk of litigation.

2.7

Audit Oversight Board (AOB) and Regulation

The establishment of Public Companies Accounting Oversight Board (PCAOB) in USA 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 which carry the same
mission of establishment are Auditing and Assurance Standard Board and Financial
Reporting Council in Australia; Financial Reporting Council in UK and Public Accountant
Oversight Committee (PAOC) in Singapore. Malaysia has also established a similar regulated
body known as Accounting Oversight Board (AOB) in April 2010 (Securities Commission,
April, 2010). The idea to establish the AOB is mainly driving from the PCAOB in US.
AOB is proposed based on Malaysias requirement and environment which started on 2007.
After the announcement of AOB in Budget Speech 2008, the proposal of the establishment of
AOB which is Securities Commission Bill (Amendment) 2009 has passed by the Parliament.
Finally, AOB was formally established on 10 April 2010 (Gomes, 2010). Upon to this,
Securities Commission Act 1993 has been amended. The AOB implementation was divided

22

into process of registration, inspection, inquiry and sanctions, international affairs and annual
reporting (Yusoff, 2010). Upon to the establishment, seven members comprise of one
Executive Chairman and six non-executives have been appointed. AOB was lead by Nik
Mohd Hasyudeen Yusoff, as an Executive Chairman. Whereas the other members are
representing the various institution such as Financial Reporting Foundation, Companies
Commission Malaysia, Securities Commission Malaysia, Central Bank of Malaysia and
individual from the public companies (www.aob@sc.com.my). The objectives of AOB are (i)
to promote and develop effective and robust audit oversight framework; (ii) to strengthen the
investors confidence on the reliability and quality of audited financial statements and (iii) to
provide regulation of work to PLCs and PIEs auditor. The AOB will inspect auditors of
PLCs and public interest bodies like banks and financial institutions, whereas auditors of
private companies will be subjected to the MIA review committee, (Accountant Today,
2008).
The auditors of Public Listed Companies (PLCs) and Public Interest Companies (PIEs) must
register with Securities Commission. As Bursa Malaysia has issued the new listing
requirement, stated that all the public issuers should appoint the auditors who are registered
under Section 310 of Securities Commission Act 1993. This is to ensure only the proper and
fit auditors would conduct the auditing. Moreover, Section 31P of Securities Commission Act
1993, stated that to be auditors should fulfill the criteria such as must be approved as an
auditor under Section 8, Companies Act, 1965, not discharge bankrupts within or outside
Malaysia, not convicted any offences involving fraud or dishonesty and not engaged in any
practices which reflect discredit on his ability to meet professional auditing standards
(www.aob@sc.com.my). Once, fulfill these criteria, the auditors eligible to register with
AOB. To ensure the establishment of AOB is standardized and achieve the mission, the
auditors are recommended to comply with the International Standards on Quality Control

23

(ISQC 1) (Yusoff, 2010). MIA President Abdul Rahim Abdul Hamid really stressed on the
compliance of ISQC1 (Gomes, 2010) ISQC1 should be a benchmark against international
requirements. ISQC1 also believed could be a cornerstone to shift the audit firm in building
the independent and competent in deliver the high quality of audit reports. High audit quality
which consists of competence and independence will mitigate the earnings management
practices in the clients company (Becker et al, 1998; Krishnan et al 2003).
In the essence, the main effect on the establishment of AOB is on audit quality. Audit quality
is believed will boost the investor confidence level, hence; restore their confidence on the
credibility of auditors work. As said by Securities Commission Executive Director Goh
Ching Yin, While the AOB oversees auditors and protects the interests of investors, it also
benefits the auditing profession. Audit quality will be raised, which in turn will promote
confidence in the assurance work that is performed by the auditing profession (Gomes,
2010).
Perhaps, the audit oversight framework as stipulated in AOB will guide and monitor the
auditors in conducting audit consistent with the international and audit professional standard.
More topical, the establishment of AOB able to increase the audit quality, whereas, will
enhance public confidence on financial reporting (Accountants Today, June, 2009).
2.8
Conceptual Framework

Motive (IV)
Dividend (H1)
Earnings
Management

Leverage (H2)

(DV)

Opportunity (IV)
Audit Quality (H3):-

Audit Fees
Non Audit Fees

Free Cash Flow (H4)

24

Control Variables:-

Profitability
Firm size
Audit Oversight
Board (AOB)

Figure 2.1 Conceptual Framework

Where:
IV = independent variable;
DV = dependent variable.

Figure 2.1 generally covers the whole picture of the current study. The main objective of this
study is to examine the effect of dividend, leverage, free cash flow and audit quality on EM.
First, this study covers on the issue of dividend as a symbol of good performance of a
company. It is expected dividend as a monitoring mechanism that would reduce the
probability of managers to involve in EM. For the second relationship, leverage is expected to
reduce managers from involving in EM. Next is to examine whether audit quality will reduce
EM. Lastly, this study examine whether high free cash flow would have higher earnings
management. All of the independent variables discussed are monitoring mechanisms.

2.9

Summary and conclusion

25

There are various factors relating to EM in Malaysia 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, 1998b), . This chapter summarises the
work done by previous researchers in the area of agency theory, earnings management,
dividend, leverage and audit quality. It will look on whether all factors (dividend, leverage,
audit quality and free cash flow) have positive or negative significant relationship to the
earnings management. It will also look on whether EM is prevented or increases in the
presence of the factors mentioned above. Hence, this study will investigate the motive and
opportunity in engagement of earnings management before and after the establishment of
AOB. Here, this study will examine any differences between motive (leverage and dividend),
opportunity (audit quality and free cash flow) and earnings management before and after the
establishment of Audit Oversight Board (AOB).

CHAPTER THREE
RESEARCH DESIGN AND METHODOLOGY
3.0

Introduction

This chapter elaborates on the process of data selection, sampling and data analysis that were
undertaken during this study. This chapter is organized as follows; section 3.1 discusses the
sampling design and section 3.2 will be explained about hypothesis development to be tested.
26

Section 3.3 provides details on the measurement of all variables in this study. This is
followed by Section 3.4 explained details on the research method to be used in analyzing the
sample data. Finally, Section 3.5 concludes and discusses the pertinent points of this chapter.

3.1

Sampling design

3.1.1

Sample selection

In this study, the samples were chosen from the public listed companies in Bursa Malaysia.
There are six industrial sectors in Bursa Malaysia as sample in this study. The sectors are
Industrial Product, Consumer Product, Trading and Services, Plantation, Properties and
Construction. These sector are included as sample because the some homogeneous
characteristic between these sectors which will contribute to the accurate in comparison as
well as it results. This study will exclude the finance industry (bank, insurance, unit trusts and
finance firms) because of the different regulatory requirement on finance industry. Hence, it
would affect the abnormal accrual and audit fees paid to the auditors (Srinidhi, 2007). The
remaining industry sectors as listed in KLSE also eliminated because of data availability and
size of industry which are not relatively to compare with the top six industrial sectors in
Bursa Malaysia.
Bursa Malaysia has issued the new listing requirement, stated that all the public company
listed in Bursa Malaysia should appoint the auditors who registered under Section 310 of
Securities Commissions Act 1993. Therefore, this study matched the sample whether the
auditors of the sample companies has yet registered with AOB or not. After sifting out
companies with incomplete data, 115 companies were identified for the analysis in 2009 and
115 companies also were identified for analysis in 2010. Therefore, the final sample of this
27

study is 230 firms - year companies covered a period of 2009 and 2010. These samples were
chosen based on before and after the establishment of AOB on 10 April 2010. According
Roscoe (1975) and by Sekaran (1992) suggested that the most appropriate sample size for the
most research are range between not larger than 30 and less than 500.

3.1.2

Data collection

The data related to all selected companies were collected from the Thomson DataStream and
Thompson One Banker Database in Perpustakaan Abdul Razak 1 in UiTM Shah Alam. While
some other data like auditors fees and auditors name were collected from Bursa Malaysia
website and downloaded from companies annual report.

3.1.3

Research design

There are lot of EM detection models used in previous studies. Dechow, Sloan and Sweeney
(1995) had studied past models such as the Healey Model (1985), the DeAngelo Model
(1986), the Jones Model (1991), the Modified Jones Model (1995), and the Industry Model
(1991). Dechow, Sloan and Sweeney (1995) claimed that the modification of Jones Model
(Modified Jones Model) is the most powerful in detecting earnings management. But later on,
Kothari, Leone and Wasley (2005) tried to test whether a performance-matched discretionaryaccrual approach (a type of control sample approach) is both well specified and powerful at
estimating discretionary accruals. They found that performance-matched discretionary
accrual measures are well specified and powerful in various circumstances. Among the
28

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


multi-year horizons and their sensitivity to sample size.

Kothari, Leone and Wasley (2005) and Dechow, Sloan and Sweeney (1995)

used the

parameters from the Jones model estimated in the pre-event period for each firm in their
sample, and applied them to a modified sales change variable defined as (SALES it - ARit)
to estimate discretionary accruals in the event period. This approach is likely to generate a
large estimated discretionary accrual whenever a firm experiences extreme growth in the test
period as compared to the estimation period. In order to mitigate this problem and due to the
non-existence of the pre-event period where they can assume that changes in accounts
receivable are unmanaged, Kothari et al. estimated the model as if all changes in accounts
receivable arouse from earnings management.

a)

Performance-matched Discretionary-accrual Approach proposed by Kothari

The third model proposed by Kothari, Leone and Wasley (2005) has been augmented from
the two models above and known as Performance-matched discretionary-accrual approach.

First, Kothari et al. estimated the total accruals as below:

TAit = [( non-cash current asset it ) - ( current liabilitiesit excluding the


current portion of long term debt) - (Depreciation and amortization it)]
/ total assets it-1.

29

Then discretionary accruals, a proxy for earnings management, are estimated by subtracting
nondiscretionary accruals from total accruals, where all accrual variables are scaled by lagged
total assets to control for potential scale bias.

Kothari, Leone and Wasley (2005) have augmented to include the ROA it or ROAit

. They

claimed that this approach is designed to provide a comparison of the effectiveness of


performance matching including a performance measure in the accruals regression to
generate the normal or non-discretionary proxy with the following equation:

TAit

= 0 + 1 (1 / ASSETS it 1) + 2(SALESit ) + 3 PPE it


+ 4ROA it (or it 1) + it ;

Where:

ROA it (or it 1)

= Net income in current year (or previous year) divided by


total assets in the current year; and all other variables are as
previously defined.

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

30

The study incorporates absolute value of DAC consistent as used by Rashidah and Fairuzana
Haneem (2006) and Becker, Defond, Jiambalvo and Subramanyam (1998), and Frankel et al.
(2002). This study restates the absolute discretionary accruals as ABSDAC.

Hence, the current study will use the model suggested by Kothari, Leone and Wasley (2005)
to detect EM as a dependent variable. Cooper and Schindler (2008) defined EM as an
independent variable value which is manipulated by dependent variable that has been
measured, predicted or monitored by researcher. The reason behind using Kothari et al. model
is that the model is improvised in terms of performance measures in the accruals regression
(Kothari, Leone and Wasley, 2005).

3.2

Hypothesis development

This study has primarily focused on discretionary-accrual type EM by examining the


importance of multiple roles of external agency monitoring mechanisms, i.e. from the
perspective of multiple stakeholders such as shareholders, lenders, and auditors. This study is
to investigate whether certain motive and opportunities factors may influence earning
management before and after establishment of Audit Oversight Board (AOB) also. Five
hypothesis were developed to be tested and to support the research objectives.
31

3.2.1

Development of Hypothesis 1 (Dividend and EM)

Dividend and firm value have been researched extensively, at least since Modigliani and
Millers (M & M) seminal work (see, Modigliani and Miller, 1958; Miller and Modigliani,
1961). The implicit assumption from those prior studies has been that dividend
announcements and dividend yield measure are relevant aspects of a firms dividend policy
(Stevens and Jose, 1992; Frankfurter and Wood Jr., 2002; Docking and Koch, 2005).

Apart from that, La Porta et al. (2000a) documented evidence that dividends were paid
because minority shareholders pressured corporate insiders to disgorge cash. Their findings
are consistent with the agency theory that unless profits are paid out to shareholders, they
may be diverted by the insiders for personal use or committed to unprofitable projects that
provide private benefits for the insiders. As a consequence, outside shareholders have a
preference for dividends over retained earnings (La Porta et al. 2000a). Therefore, it can be
argued that dividends can play an important role to address the agency problems between
corporate insiders and outside shareholders.
According to Rozeff (1982), dividends is generally viewed as a control device that helps
reduce managerial discretion and such action is part of the firms optimal monitoring bonding
package. Easterbrook (1984) and (Rozeff 1982) suggested that higher dividends reduced
agency costs by forcing management to seek external financing, resulting in closer market
scrutiny and lead to higher firm value. In the same vein, Jensen (1986) argued that dividend
reduced free cash flow that managers may otherwise divert for personal use or to fund
unprofitable projects. This evidence is consistent with the notion that dividends are paid when
firms have excess cash flows in order to reduce potential over investment by management.

32

Therefore, there is a need to further test this theory in one of the developing markets such as
Malaysia, particularly with the implementation of recent reform on corporate governance.

The Malaysian corporate governance reform agenda has focused on two main areas. There
areas are, to those enhance transparency and increase accountability of directors and to those
aimed specifically at minority shareholders (Liew, 2007). According to Liew (2007), the
success of the new corporate governance rules and regulations with the aim of improving
corporate governance practices in the country is ultimately dependent on the prospect of
limiting the powers of Malaysian controlling owner managers and bureaucrats influence on
businesses.

The above arguments suggest the following hypothesis in an alternative form:


Hypothesis 1:
Firms with higher level of dividend payment would have lower earnings management.

3.2.2

Development of Hypothesis 2 (Leverage and EM)

Leverage is also suggested as having a positive incentive effect on firm management resulting
from the adverse consequences associated with defaulting on debt obligations. The use of
external debt finance will also result in the firm likely being subjected to additional outside
monitoring by debt providers, which have similar incentives to major institutional investors
or external stockholders in relation to protecting their investment interests. As such,

33

increasing leverage use should reduce the extent of agency costs inherent in a firms
operating structure.

According to Agrawal and Knoeber (1996), debt financing is often used either as an
alternative or complementary control mechanism for reducing agency costs of a firm.
Fleming, Heaney and McCosker (2005) outline a number of benefits associated with the use
of debt financing in controlling agency costs. Grossman and Hart (1982) suggest that short
term debt can align managerial incentive with that of shareholders since bankruptcy is costly
for management. They also support the agency theory and argue that financial leverage can
reduce agency costs by increasing the possibility of bankruptcy. Grossman and Hart (1982)
and Williams (1987), however, advanced the argument that greater financial leverage may
affect managers and reduce agency costs through the threat of liquidation, which causes
personal losses to managers of salaries, reputation, perquisites, and, according to Jensen
(1986), through pressure to generate cash flow to pay interest expenses.

Myers (1977) explains that higher leverage can mitigate conflicts between shareholders and
managers concerning the choice of investment. Since debt has to be paid back in cash, the
amount of free cash flow that could be diverted by the manager is reduced by debt
repayment. Debt thus serves as a mechanism to discipline corporate managers and prevent
them from maximizing their private gains by lavish perquisites, plush offices, and empire
building through sub-optimal investment decisions (Jensen and Meckling, 1986). Companies
that have high leverage may face the risk of bankruptcy if they are unable to make payments
on their external debt financing.

Hence, based on the above arguments, the hypothesis is developed as follows:

34

Hypothesis 2:
Firms with higher level of leverage would have higher earnings management.

3.2.3 Development of Hypothesis 3 (Audit Fees and Non-Audit Fees and EM)
3.2.3.1 Development of Hypothesis 3a (Audit Fees and EM)

Auditors facilitate contracting between investors and management by attesting to the


reliability of the financial statements. However, the auditors monitoring is valuable to
investors only if the auditor is independent (Watts and Zimmerman 1990). DeAngelo (1981)
defines independence within a broader framework of audit quality. Audit quality is the joint
probability that the auditor discovers and reports a misstatement, and independence is
considered compromised when auditors fail to report misstatements they have discovered.

According to Simunic (1984), the provision of non-audit services can impair independence
by creating an economic bond between auditor and client. Simunic (1984) models the joint
demand for audit and non-audit services. He defines a decrease in auditor independence as
any situation which alters incentives such that a self-interested auditor is more likely to
ignore, conceal, or misrepresent his findings. He shows that when the same auditor provides
both services and the auditor retains a portion of the cost savings from knowledge
spillovers, the auditor will be economically bonded to the client. Parkash and Venable
(1993) and Firth (1997) present empirical evidence using U.S. and U.K. data, respectively,
that firms act as if the purchase of non-audit services jeopardizes independence. Both studies
find that firms requiring high quality audits because of high agency costs will be less likely to
purchases non-audit services from their auditor. Gore et al. (2001) present evidence also
using U.K. data of a positive association between the provision of non-audit services and

35

earnings management. They also documented that Non-Big Five auditors allow more
earnings management than Big Five auditors.

Hoitash et al (2007) found the effects of audit fees on audit quality. High audit fees paid to
the auditors may affect the increase of effort to conduct extensive audit. As a result, this will
increase the audit quality, Therefore, Hoitash et al (2007) support that when the audit quality
increased, it may provide a low opportunity for earnings management.

A study found that non-audit fees increase auditor-client economic bonds, leading to a decline
in accrual quality, while high audit efforts as reflected in high audit fees improve accrual
quality (Srinidhi and Gul, 2007). However, since audit fees produce more stable yearly
revenue than the non-audit fees, auditor might perceive greater fee pressure from client who
pays high audit fees than non-audit fees (Reynolds, Deis and Francis, 2004). This study will
use the total audit fees divided by total assets of the firms. If the amount of the audit fees is
too high compared to the size of the firm audited, it means that there is probability that the
audit firm might impair its judgment during auditing process. When this thing happens, there
might be high EM by the managers.

Hence, based on the above arguments, the hypothesis is developed as follows:


Hypothesis 3(a):
Firms with higher audit fees have lower effect to earning management.

3.2.3.2 Development of Hypothesis 3b (Non-Audit Fees and EM)

36

Frankel et al (2002) find that, when the audit firm receives higher revenue from non-audit
services, thus, this will provide more opportunity for the management to manage earnings.
High non-audit fees lead to the impairment of auditors independence. As study of Lee et al.
(2003) found that audit firm who received higher non-audit fees more likely to involve in
earnings management practices. Therefore, the public might suspicious on the auditors
independence. Thus, it was supported by Gore et al. (2001) who has found the positive
relationship between the provision of non-audit services and earnings management. The other
related arguments is stated that, the auditors independence will compromised and the
earnings quality will diminished if the accountants are allowed to consult their clients, at the
same time (Romano, 2004 and Weil, 2004).
Additionally, Lee et al. (2003) found that non-audit fees is associated with the lower
independence of auditors, therefore, they found that auditors who provide more non-audit
services 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, while
high audit efforts as reflected in high audit fees improve accrual quality (Srinidhi and Gul,
2007). The previous studies are support that non-audit services will impair the auditors
independence. Thus, when there is lack of independence, the probability for earnings
management will increase.
Hence, based on the above arguments, the hypothesis is developed as follows:
Hypothesis 3(b):
Firm with higher non-audit fees have higher effect towards earning management.

3.2.4

Development of Hypothesis 4 (Free cash Flow and EM)

37

Jensen (1986) stated that if free cash flow in a company is not used or invested to maximize
or to balance the best interest of shareholders, then it raises agency problems. The manager
may choose to invest in an unprofitable project due to his or her self-interest. As a result, the
company may be in the position of low growth. In the absence of effective monitoring or
disciplinary actions by other independent stakeholders, the manager can conceal information
on the activities by providing minimal disclosure or manipulating accounting number.
Investors as a group of stakeholders do not have access to inside information. Managers may
not provide adequate discloses to investors on the investment cash flows or the underlying
assumptions of the project. Based on this minimal information, investors may not be able to
know the prospect and the advantages or disadvantages of the project for their wealth
(Chung, Firth and Kim, 2005).

Managers may not provide the internally projected cash flows for some investments. As a
result of personal interests, managers overlook the need for preparing projected cash flow and
profit forecast. The choice for making poor investments may reduce future earnings and lead
to a move to remove directors or senior executives (Rina and Takiah, 2009). In order to avoid
the risk of facing the management turmoil, managers may employ accounting numbers to
increase reported earnings. It is assumed that investors are completely unravelled of earnings
numbers. Hence, managers are motivated to manage earning in order to fulfil their needs
(Rina and Takiah, 2009).

The fourth hypothesis is:


Hypothesis 4:
Firm with higher free cash flow would have higher earning management

38

3.3

Measurement of variables

3.3.1

Independent variables

Cooper & Schindler (2008) defined the independent variables as the variable manipulated by
the researcher, thereby causing an effect or change on the dependent variable. There are three
main independent variables that influence EM in this study which are:

a)

Dividend

Dividend was primarily measured by dividend yield (dividend-to-price ratio). Formally, the
dividend yield is the dividend per share (DPS) divided by closing market price per share
(MPS), that is, DYLD = DPS / MPS. The dividend yield was used rather than the payout ratio
(dividends to earnings) for two reasons. Firstly, the denominator in dividend yield is a market
measure (share price) compared to an accounting measure (net income). Secondly, to avoid
problems of negative payout ratios are resulting from negative earnings or excessively high
payout ratios resulting from income being close to zero (Schooley and Barney, 1994). Several
other studies also employed dividend yield as a measure of dividend policy (e.g:, Chang and
Rhee, 1990; Han et al. 1999; Ho, 2003).

b) Leverage

There are different opinions on whether leverage increases or decreases the potential for EM
to happen. Some literature such as Jensen (1986), Stulz (1990), and Hart and Moore (1995)
suggested that debt discourages free cash flows over-investment by self-serving managers
39

and it can be monitored by lenders. Hence it will reduce the tendency for EM to happen.
Others somehow, argued that leverage increases the potential for EM (Dichev and Skinner,
2002), (Beatty and Weber, 2003), (Sweeney, 1994), (Watts and Zimmerman, 1990),
(DeFond and Jiambalvo, 1994). The current study is keener to the second opinion in
the sense that managers tend to implement EM to avoid debt covenant violation. The
measurement of leverage (LEVERAGE) in this study will adapt measurement as used by
Kim and Yoon (2008) and Rashidah and Fairuzana (2006) who measured leverage as total
debts divided by total assets.

c)

Audit Fees

Audit fees are used as a measurement because high price of audit fees reflect the high
competencies of the auditor (Choi, Kim and Zang, 2010). In the study of relationship between
earnings management, log audit fees is used to measure specialization (Choi, Kim and Zang ,
2010, ; Hay, Knechel and Wong, 2006; and Lowensohn et al. 2007). Similarly, the study of Li
and Lin (2005), they include the log total audit fees to obtain empirical result on the
relationship between audit fees and earnings management. The above previous study provides
a motivation for this study to use audit fees as a measurement for audit competence. This
study also used the specification disaggregate audit fees because this will provide the separate
incentive effect for each audit fees and non-audit fees (Frankel et al., 2002).
d) Non-Audit Fees
Some previous study used non-audit fees ratio (Chung and Kallapur, 2003; Li and Lin, 2005).
However, there is some problem when the non-audit fees ratio used as measurement. The
problem is such the numerator (NAF) and denominator (AF) both will affect the accrual
quality, hence the effect cannot be identified separately. Audit fees and non-audit fees will

40

result in different way and provide the different effect, (Srinidhi, 2007). In the fee models,
how much of the dollar value of non-audit fees paid to the auditors has been used as proxy for
the level of non-audit services (Whisenant et al, 2003). 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., 2003; and Defond et al., 2002). A study by Frankel et al
(2002), suggested log non-audit fees to measure the audit independence since log audit fees is
a proxy for audit quality.
In conclude this study used the log audit fees and log-non audit fee separately as to examine
the different effect of incentive between these variable. Furthermore, this study would like
mitigate the bias between two variable because these variable are highly correlated (Frankel
et al, 2002; Duh et al, 2009).

e)

Free Cash Flow

The free cash flow is the flow from the companys operations, disregarding financial
expenses and adding expenses that do not mean outflow of cash, such as amortization and
depreciation, and subtracting investments in working capital and permanent assets. The free
cash flow is the flow directly available to the companys security holders such as common
and preferred shareholders and debt holders. This study identifies the existence of surplus
free cash flow agency problem by calculated from operating income, including taxes, before
any return to the mentioned security holders. Free cash flow is measured by operating income
before depreciation minus expenses such as tax expense, interest expense, and dividend
(Lehn & Poulsen, 1989). Companies are categorized as having potential free cash flow
agency problems when free cash flow is high (Aulia and Norman, 2008).
41

3.3.2

Control Variables

This section will present the measurement for each control variables used in the current study.
At the end of sample period, all control variables will be regressed and measured for
examining the relationship between EM (Earnings Management).

a)

Profitability

Two commonly used measures of profitability are return on assets and return on equity. The
study of Wasimullah et al (2010), ROE variable is used in order to measure the profitability.
The listed firm which is incurred lower profitability more likely to involve in earnings
management.
b) Firm Size
This study included a measure of firm size because it is possible that larger firms are
perceived differently by shareholders. Further, larger firms may pay higher dividend levels
and may have larger boards. On the other hand, Bhabra (2007) demonstrates that firm value is
inversely related to firm size. This could be the result of a number of factors such as lack of
focus or a lesser degree of transparency in managerial actions. However, Short and Keasey
(1999) report that firm size has a significantly positive effect on performance, since larger
firms have the potential to access funds with greater ease, both internally and externally.
Larger companies may also have better growth opportunities and access to financing
opportunities. Larger companies may have greater analyst following and thus have more
information available to reduce information asymmetry and a wider share spread and
ownership profile. Accordingly, many past studies have used total assets as a proxy for firm
size. SIZE is measured as the logarithm of total assets.

42

c)

Audit Oversight Board (AOB)

The usefulness of accounting information depends on its timeliness and this will portray the
quality of audit. This study will use partial measurement by Karim, Ahmed and Islam (2006),
which measures the timeliness and audit delay. In this study dummy variable for Audit
Oversight Board is including in order to examine whether this variable would affect earnings
management or not. To differentiate between the year 2009 and year 2010, the dummy
variable of AOB is used. AOB is coded as 0 if the firm is audited before establishment of
AOB in year 2009 and 0 if the firm is audited after establishment of AOB on 10 April 2010.

3.4

Research Method

The current study uses the descriptive statistics and standard regression analysis. SPSS
statistical package is used for all analysis. To test the research hypotheses, a multivariate
model was developed

a)

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

First, Kothari, Leone and Wasley (2005) estimated the total accruals as below:

TAit = [( non-cash current asset it ) - ( current liabilitiesit excluding the


current portion of long term debt) - (Depreciation and amortization it)]
/ total assets it-1.

43

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

TA it = + (1 / ASSETS it 1 ) + SALES it + PPE it +


ROA it (or it -1) + it

Where:
TA it
ASSETS it 1
SALES it

the total accruals of firm i in year t


the total assets of firm i at the end of year t -1
sales change in net of the change of account receivable of firm

PPE it

i between years t and t 1


the level of gross property, plant, and equipment of firm i in

ROA it (or it -1)

year t
ROA of firm i at the end of year t
(ROA of firm i at the end of year t 1)

The components of non-discretionary accrual from this model which are change in sales and
property, plant and equipment is scaled by lagged total assets. In calculating the discretionary
accrual which is earnings management, the Kotharis Model includes the current or lagged
years of ROA.

ROA i t =

Net Income i t

ROA it -1 =

Net Income it 1

Total Assets i t
or
Total Assets it
This model will include the ROA it or ROA it - 1, which stand for ROA current year and last
year as to control the firms performance. The reason why this model has included ROA in
their model is to compare the effectiveness of performance matching versus regression based
approach by Kothari, Leone and Wasley (2005).
b) In order to examine the impact of AOB, Dummy AOB is used to identify the event
before and after the AOB establishment. In order to examine the relationship between
earnings management and the variable, regression model was employed as follows:
44

DA t = + ( LEV) it + (LogNAFEE) + (LogAFEE) it + 5 (LogFCF) it +


6 (DYLD) it + 7 (ROE) it + 8 (LogTA) it + 9 (DummyAOB) it + it

Where:

c)

DA

absolute performance adjusted discretionary accrual

LEV
LogAFEE
LogNAFEE
Log FCF
DYLD
ROE
LogTA
DummyAOB

(earnings management)
leverage; debt to total assets
audit fees
non-audit fees
free cash flow
dividend yield
return on equity
total assets
0 = before AOB and 1 = after AOB

For the companys security holders such as common shareholders, preferred shareholders
and debt holders, the free cash flow is the flow directly available in company. It is
calculated from operating income, including taxes, before any return to the mentioned
security holders. Free cash flow is measured by operating income before depreciation
minus expenses such as tax expense, interest expense, and dividend (Lehn & Poulsen,
1989).

The FCF model is defined as:

Ct = Free cash flow expected date t


In turn where,
Ct = EBIT taxes + dep. amort + (fixed assets + inc.def) working capital investment
Where:
EBIT

earnings before interest and taxes


45

Taxes
Dep. amort
fixed assets
inc. def

taxes on operating income (EBIT x

depreciation and amortization


variation of fixed assets (purchase of fixed assets)
increase of deferred charges (if any)

Working capital investments = variation of working capital;


Working capital = (inventories + accounts receivable from customers accounts
payable to suppliers) x (sales/365).

3.5

Summary of the chapter

This chapter discusses on the methodology of the study on agency monitoring and earnings
management. The final sample used in this study taken from the main board of Bursa
Malaysia. There are five hypotheses developed and each of them being tested using
regression model with expected results that will be presented in Chapter 4.

46

CHAPTER FOUR

DATA ANALYSIS

4.0

Introduction

This chapter discusses on the result and findings of this study. The previous chapter discussed
in detail the sample selection, data collection procedure, hypotheses development and
regression models of the current study. This chapter presents the data analysis and discusses
the findings of the study. There are two types of statistical analysis used in this study, namely
descriptive analysis and regression analysis. This chapter is organized into four sections.
Section 4.1 discusses on the descriptive data for all dependent and independent variable used
in this study. Subsequently, section 4.2 discusses on the correlation analysis, then in section
4.3, discusses on regression analysis. Section 4.4 discusses on additional regression analysis,
in order to examine the relationship between dependent variable and independent variable

47

using separate data of year 2009 and 2010. Next, discusses the robust regression analysis
exclude firm with no non-audit fees to test hypothesis for all years, 2009 and 2010 before and
after implementation Audit Oversight Board (AOB). Lastly, section 4.5 provides a summary
for data analysis.

4.1

Descriptive statistic
Table 4.1: Descriptive statistic for full sample
Mean

Minimum

Maximum

Standard
Deviation

Skewness

Kurtosis

Dependent Variable
Discretionary Accrual

.0652

.00

.41

.06712

2.119

6.185

Leverage

0.2080

.00

.77

.173

.735

.288

LogAuditFee

11.754

9.87

15.23

0.882

0.838

1.306

LogNonAuditFee

7.497

.00

15.06

4.510

-.866

-.771

LogFreeCashFlow

8.686

.00

16.26

4.085

-1.200

.532

DYLD

2.832

.00

19.35

3.285

1.597

3.888

12.715

10.37

18.12

1.514

1.000

.823

1.024

-188.56

36.74

26.785

-4.755

28.740

Independent Variables

Control Variables
LogTotalAsset
ROE

Table 4.1 presents the descriptive statistic for the dependent variable, independent variable
and control variable used in this study. The descriptive analysis statistically explain the
variables used in the study.
Dependent variable, Discretionary accrual (DA) obtains using the model of earnings
management via total discretionary accrual. Discretionary accrual is a proxy to measure the
earnings management. Discretionary accrual is between positive values of 0.00 to 0.41. The
mean value is report at 0.0652.
48

The independent variables consist of leverage, log audit fees, log non audit fees, log free cash
flow, dividend yield (DYLD), and some of the control variables consist of log total asset and
return in equity (ROE). Overall, most of the variables have positive skewness and kurtosis,
indicating that most of the data are distributed at positive values and clustered in the center.
Based 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 violation of assumption of
normality.

The first, second, third and fourth columns in Table 4.1 present the minimum, maximum
mean and standard deviation value for each variable. The maximum value for leverage is 0.77
and minimum value of leverage is 0.00. Meanwhile, the audit fee value, the maximum value
of audit fees paid to the auditors is 15.23 and the minimum value of audit fees is 9.87.
Therefore, it is indicate the amount of the clients willing to pay in substitute of the expertise,
knowledge and hours in conducting audit. For non-audit fees paid to auditors, the maximum
value of non-audit fees paid to the auditors is 15.06 and minimum value for non-audit fees is
0.00. The amount of non-audit fees is obtained from the other services rendered to the clients.
However, there are some companies appoint other auditors to conduct other than audit
service. Therefore, the value of non-audit services is considered as zero for those companies.
Next, the minimum value for free cash flow is 16.26 and minimum value is 0.00. Lastly, the
dividend yield range is between 0.00 to 19.35.

Control variable used in this study as shows in the table 4.1 under column control variable.
Overall, the sample has a total asset (log total asset) at range between 10.37 to 18.12. As for
measurement of performance, overall the highest ratio of net income to total equity (ROE) of
the sample company is 36.74 and the lowest is report at 188.56.
49

Skewness used to measure the distribution of variable. Moreover, Kurtosis is used to measure
data is peak or flat relative to normal distribution. Skewness is value near to zero and for
kurtosis is value in range within 3 and + 3. Overall, the entire variable used in this study is
normally distribution except for discretionary accrual. After checking the outliers and
transform the data using natural log, the entire variable used in this study is normally
distributed, except for dependent variable. However, this study assumed all data is normally
distributed. When the samples are large which above 30, sampling distribution is assumed
normal (Vaus, 2002). According to Vaus (2002) violating the normality assumption does not
have large effect on the statistical result. It also follows the central limit theorem which states
that large sample size of 100 or more will approximately distribute to the normal value (Vaus,
2002)
Overall, most of the variables have positive skewness and kurtosis, indicating that most of the
data are distributed at positive values and clustered in the center. Based 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 violation of assumption of normality.
4.2

Correlation analysis

The purpose of correlation analysis is to explain the strength and direction of the relationship
between two variable among the groups used in the model of the study. Therefore, this study
used Pearson correlation matrix to test the correlation of the variable in this study. Table 4.2
shows the summary of result when the bivariate analysis is done to test the correlation
between one variable to another.
Table 4.2: Pearson correlation matrix of variable used in the study
DA
DA
Leverage

Leverage
1

Log
AudFee

Log
NonAudFee

.123

-.110

-.005

Log
FreeCash
Flow
-.154*

.033

-.228**

.025

50

DYLD
-.117

Log
Tot
Asset
-.131

-.185**

-.022

ROE

AOB
INSPEC

-.062

.040

-.288**

-.037

LogAudFee

.294**

.166*

-.036

.765**

-.007

.019

.079

.030

.312**

.159*

.026

.073

.134

.034

.091

.052

.138*

-.130*

-.016

.006

.043

LogNonAudFee
LogFreeCash Flow
DYLD
Log TotAsset
ROE
AOB INSPEC

*Correlation is significant at 0.005 levels (2- tailed)


**Correlation is significant at 0.01 levels (2 tailed)

From the table, there are some variable are correlated. For discretionary accruals, only the
variable of free cash flow is significantly related, at r = 0.154, p < 0.05 with negative
relationship. Other variable is not correlated with DA. For AOB inspection, only the variable
of dividend yield (DYLD) is significantly related, at r = 0.130, p < 0.05 with negative
relationship. However, other variables are not correlated with AOB inspection.

4.3

Regression analysis

This section reports the testing of the (5) five hypotheses developed in Chapter 3. The
objective of this analysis is to examine the relationship between DA (discretionary accruals)
and each independent variable for entire period covering 2009 to 2010 (pooled data) and for
each individual year as well in the additional analysis. The regression results are presented in
Table 4.3 for the pooled data to test the hypothesis respectively. Next, the additional analysis
is shown in Table 4.4(a) and 4.4(b). This study mainly regress the variables using regression
model as presented in section 3.4 which is absolute performance adjusted discretionary
accruals.

Table 4.3: Results of regression analysis on EM for the year of 2009 and 2010
(pooled data)
51

Unstandardized
Coefficients
(Constant)
Leverage
LogAud Fee
LogNonAudFee
Log FreeCashFlow
DYLD
Log TotAsset
ROE
AOB INSPEC
R2
Adjusted R2
F-Statistic

B
.142
.023
.003
.001
-.002
-.001
-.008
.000
.007
.056
.018
2.994

Standardized
Coefficients
Std.
Error
.065
.030
.008
.001
.001
.001
.005
.000
.009

Sig.

2.181
.764
.342
.698
-1.798
-.755
-1.689
-.818
.755

.030
.446
.733
.486
.074**
.451
.093**
.414
.451

Beta
.058
.037
.053
-.127
-.054
-.182
-.060
.053

***Significant at the 0.001 level (Sig 2-tailed)


**Significant at the 0.05 level (Sig 2 tailed)
*Significant at the 0.1 level (Sig 2 tailed)

Based on Table 4.3 analysis (pooled data for the year 2009 and 2010) indicates that two
variables which are significant are log free cash flow and log total asset. It shows that only
variables log free cash flow and log total asset have an influence on EM. As a result,
hypothesis 4 which predicts that the surplus free cash flow, the more likely the manager is
expected to manage earnings is accepted.

Other independent variables did not show significant result. In hypothesis 1, predict that
firms with higher level of dividend would have lower earnings management. As s result, this
hypothesis has been rejected. The dividends could act as a credible signal of earnings quality,
with companies unengaged with EM being more likely to pay dividends, to have higher
dividend yields amongst dividend payers and to increase dividends per share (Farinha and
Moreira, 2007).

52

Here, in hypothesis 2 predict that firms with higher level of leverage would have higher
earnings management. Therefore, base on regression result this hypothesis has been rejected.
According to study by Aini et al. (2006) proposed that the corporate sector in Malaysia
became more leveraged and heavily dependent on commercial bank financing after the 1997
economic crisis. They added that financial difficulties faced by companies might transpire
managers to improve upon their performance through earnings management. Although Aini et
al. (2006) resulted that leverage does not affecting EM; this study of year of 2007 and 2008
might change based on current situation.

For hypothesis 3(a) (Audit fees and EM) and hypothesis 3(b) (Non-audit fees and EM) are
rejected. According to Hoitash et al (2007), support that when the audit quality increased, it
may provide a low opportunity for earnings management. Since in this study includes the
data for audit fees and non-audit fees for 2 years only, further studies might be able to answer
the question.

As for the control variables, the log total asset is shows significant results to EM. This result
consistent with Short and Keasey (1999) report that firm size has positively significant effect
on performance. Since larger firms have the potential to access funds with greater ease, both
internally and externally.

The adjusted R2 for the absolute discretionary accruals for the data is 1.8 percent. The
adjusted R2 is acceptable since it is quite consistent with the previous study such as revealed
by Aini et al. (2006) which range between 1 to 6 percent while Becker, Defond, Jiambalvo

53

and Subramanyam (1998) show only 1 percent of adjusted R2. The situation of small R2 also
occurs to Chang and Sun (2009) which range between 0.7 to 7.4 percent.

4.4

Additional regression analysis


Table 4.4 (a): Results of regression analysis on EM for the year 2009 and 2010
Model 1 (2009)
Standardized
Coefficients

(Constant)

Model 2 (2010)
Sig.

.300

.765

Standardized
Coefficients

Sig.

2.499

.014

Leverage

.140

1.342

.183**

-.030

-.269

.788

LogAud Fee

.191

1.215

.227

-.032

-.210

.834

LogNonAudFee

.086

.811

.419

.075

.693

.490

-.222

-2.084

.040*

-.114

-1.159

.250

.137

1.318

.191**

-.256

-2.573

.012*

Log TotAsset

-.237

-1.522

.131**

-.196

-1.296

.198**

ROE

-.034

-.320

.750

-.089

-.798

.427

Log FreeCashFlow
DYLD

R2

.095

.117

Adjusted R2

.028

.052

1.422

1.793

F-Statistic

***Significant at the 0.001 level (Sig 2 - tailed)


**Significant at the 0.01 (Sig 2 tailed)
*Significant at 0.05 level (Sig 2 tailed)

54

Additional analysis examines the hypotheses using separate data by separate years (2009 and
2010) and whether these two years might have different result. Table 4.4(a) presents the
results of the estimating equation before and after implementation of Audit Sight Board
(AOB). The result has revealed as follows; during 2010 the model has a better R square
compared to the year 2009. Therefore, it would enhance the explanation of dependent
variable of earning management by the independent variable. Meaning to say, when the
interaction effect is including in the model, after controlling the original independent
variable, the model has explained for 11.7 percent of the variance of discretionary accrual
which proxy for earnings management as compare to 2009 is only 9.5 percent. In the year
2010, F value of 1.793 is reported significant at level of p= 0.097, p < 0.10; indicate the
model is fit than model in year 2009.

In year 2010, the dividend has positive significant relationship at 0.012, p < 0.05 with
discretionary accrual. The result indicates that DYLD has influence the impact of increasing
EM. As conclusion, dividend has significantly affect EM in 2010. This relationships for year
2010, thus accept hypothesis 1. The result indicates that DYLD may influence in reducing
EM.

For log free cash flow, the result in 2009 report as significant at 0.040, p < 0.05. This makes
the contribution to support hypothesis 4. This study provides the evidence that the firm with
higher free cash flow would have higher earning management. This research consistent with
study by Jensen (1986) found that the allocation of free cash flow is an important aspect of
the basic conflict of interest between managers and owners. However in the year 2010, log
free cash flow has negative relationship with earning management. Therefore, this

55

relationship for year 2010, thus reject hypothesis 4. The result indicates that free cash flow
may not influence higher earning management.

Therefore, in hypothesis 2 predict that firms with higher level of leverage would have higher
earnings management. Hence, the result shows that in 2009, leverage has positive significant
relationship at 0.183, p < 0.10 with discretionary accrual. But in year 2010, this hypothesis
has been rejected. According to the studies by Beatty and Weber (2003), Dichev and Skinner
(2002), Defond and Jiambalvo (1994) and Sweeney (1994) found that firms with high
leverage engaged in EM to avoid debt covenant by the financial institutions, therefore it is not
consistent with the finding in this research. The previous study by Aini et al. (2006) resulted
that leverage does not affecting EM because it is might change based on current situation.

In hypothesis 3(a) (Audit fees and EM) and hypothesis 3(b) (Non-audit fees and EM) are
rejected. According to Hoitash et al (2007), support that when the audit quality increased, it
may provide a low opportunity for earnings management. Further studies might be able to
answer the question in engagement of earnings management. Due to time constraint, the
study includes the data for audit fees and non-audit fees for 2 years only.

56

Table 4.4 (b): Results of regression analysis on EM for the year 2009 and 2010
(Exclude firms without non-audit fees)
All
Standardized
Coefficients
(Constant)

2009
t

Sig.

2.146

.034

.101

1.198

.233

-.041

-.341

.144

Log
FreeCashFlow

Standardized
Coefficients

2010
t

Sig.

.849

.399

.169

1.382

.172**

.734

.093

.505

1.541

.126**

-.056

-.182

-2.278

.024*

DYLD

-.061

-.729

Log TotAsset

-.177

ROE

-.081

Leverage
LogAud Fee
LogNonAudFee

Standardized
Coefficients

Sig.

1.867

.066

.022

.190

.850

.615

-.084

-.509

.612

-.385

.701

.290

2.324

.023*

-.231

-1.841

.070**

-.177

-1.643

.105**

.467

.071

.576

.567

-.167

-1.398

.167**

-1.475

.142**

-.151

-.825

.412

-.239

-1.461

.148**

-.963

.337

-.107

-.799

.427

-.132

-1.056

.294

R2

.101

.106

.215

Adjusted R2

.058

.016

.136

2.365

1.171

2.735

F-Statistic

***Significant at the 0.001 level (Sig 2 - tailed)


**Significant at the 0.01 (Sig 2 tailed)
*Significant at 0.05 level (Sig 2 tailed)

Additional analysis try to analyses the firm with no non-audit fees using separate data by
separate years (2009 and 2010) and all data to look into whether these two years might have
different result with all data. Table 4.4(b) presents the results of the estimating equation
before and after implementation of Audit Sight Board (AOB) with no non-audit fees. The
result has revealed as follows; during 2010 the model has a better R square compared to the
57

year 2009 and all year. Therefore, it would enhance the explanation of dependent variable of
earning management by the independent variable. Hence, when the interaction effect is
including in the model, after controlling the original independent variable, the model has
explained for 21.5 percent of the variance of discretionary accrual which proxy for earnings
management as compare to 2009 is only 10.6 percent. Meanwhile, all year data show 10.1
percent of variance of discretionary accrual. In the year 2010, F value of 2.735 is reported
significant at level of p= 0.014, p < 0.05; indicate the model is fit than model in year 2009
and all years.

As reported in the table, in year 2010 non-audit fees are significantly related to the earnings
management at 0.023, p < 0.05 percent significant level. The result also report the direction
of the relationship is positive relationship. Therefore the hypothesis 3 (b) is supported. This
result is consistent with the study of Gore et al (2009) which found that audit independence
has a positive relationship with the level of earnings management. Lee et al (2003) support
that widely provides non-audit services to client would impair auditors independence hence
will develop relationship with clients. Therefore, the auditors are less likely to report any
wrongdoing that might lead to earnings management or corporate fraud.
For log free cash flow, the result in 2009 report as significant at 0.070, p < 0.05 and it support
hypothesis 4. Meanwhile in 2010, log free cash flow report significant at 0.105, p < 0.10 and
it support hypothesis 4 also. This study provides the evidence that the firm with higher free
cash flow would have higher earning management. This research consistent with study by
Jensen (1986) found that the allocation of free cash flow is an important aspect of the basic
conflict of interest between managers and owners.

58

As reported in the table, dividend are significantly related to the earnings management at
0.167, p < 0.10 percent significant level in year 2010. The result also report the direction of
the relationship is positive relationship. Therefore the hypothesis 1 is supported. According to
Syed Zulfikar et al. (2010), dividends can be used as a predictor of earnings whereas another
view is that earnings can also be used as a predictor of dividends. They added that dividends
are considered as a way to mitigate agency problem (i.e earnings management) by giving
shareholder their share.

In hypothesis 3(a) assume that firms with high audit fees have lower effect to EM. As
reported in the table, audit fees insignificantly related to earnings management. Thus it is
reject hypothesis 3(a). The study by Hoitash et al (2007) found the effects of audit fees on
audit quality. High audit fees paid to the auditors may affect the increase of effort to conduct
extensive audit. As a result, this will increase the audit quality, Therefore, Hoitash et al (2007)
support that when the audit quality increased, it may provide a low opportunity for earnings
management.

Indeed, the study also found that, the other independent variables negatively show significant
relationship with earning management. Here, the expectation of hypothesis 2 shows that firms
with higher level of leverage would have higher earnings management. As reported in the
table, leverage insignificantly related to the earnings management. Based on current situation
leverage does not affecting EM because it is might change (Aini et al., 2006). Myers (1977)
explains that higher leverage can mitigate conflicts between shareholders and managers
concerning the choice of investment.

59

4.5

Summary of findings

The main objective of this current study is to examine the effect of five main variables which
are dividend, leverage, audit fees and non-audit fees and free cash flow on EM. First, is to
examine whether firms with higher level of dividend payment would have lower earnings
management. Second, is to examine whether firms with higher level of leverage would have
higher earnings management. Third is to examine whether firms with higher audit fees have
lower earnings management. Fourth is to examine whether firms higher audit non-audit fees
would have higher earnings management. And lastly to examine whether firm with higher
free cash flow would have higher earnings management.

By using pooled data (2009 and 2010), the result obviously shows that hypothesis 1,
hypothesis 3(b) and hypothesis 4 are accepted. As reported in table of pooled data (2009 and
2010) hypothesis 2 and hypothesis 3(a) are rejected. However, by separating the year of 2009
and 2010, the analysis shows mixed results as explained in 4.4, 4.4 (a) and 4.4(b).

60

CHAPTER FIVE
CONCLUSIONS

5.0

Introduction

This chapter mainly aims to discuss the research findings and offer recommendation for
further study. The main topics of the chapter include discussion of the study conducted, study
implications, limitation of the study and suggestions for future research.

5.1

Discussion

An attempt was made in the present study to investigate whether certain motive and
opportunities factors may influence earning management in the establishment of Audit
Oversight Board (AOB). Specifically, the study has three main objectives. Firstly, the study is
to examine the relationship between motives in both dividend and leverage towards earning
management. Second, is to examine the relationship between opportunities in audit quality
and free cash flow towards earning management. Lastly, is to examine the effect of AOB
inspection and earnings management.

61

As mentioned in last chapter, the first hypothesis predicted that firms with higher level of
dividend payment would have lower earnings management. Therefore the first hypothesis
regarding dividend yield and EM has been accepted. The dividends could act as a credible
signal of earnings quality, with companies unengaged with EM being more likely to pay
dividends, to have higher dividend yields amongst dividend payers and to increase dividends
per share (Farinha and Moreira, 2007). As a result, the study found a significant association
between dividend yield and EM. The research found that dividend yield does significantly
affect EM in Malaysian companies for the year 2010 in the sample period.

The expectation of the second hypothesis shows that firms with higher level of leverage
would have higher earnings management. In this study showed significant negative result of
firm with a higher level of leverage is able to increase the tendency for managers to engage in
EM. The previous studies by Beatty and Weber (2003), Dichev and Skinner (2002), Defond
and Jiambalvo (1994) and Sweeney (1994) found that firms with high leverage engaged in
EM to avoid debt covenant by the financial institutions, therefore it is not consistent with the
finding in this research.

Under third hypothesis assume the effect of audit quality towards EM. In hypothesis 3(a)
predicted that firms with high audit fees have significant effect to EM. The research found
that, there is no statistically significant of audit fees with the earnings management. The
result is insignificant because the amount of audit fees is mainly related to audit
independence. Sometime the higher amount of audit fees paid to the auditors reflects to the
operating expenditure or the total assets. So, this will bias in reflecting the independence of

62

the auditors because auditor might perceive greater fees from client who pay high audit fees
(Reynold, Deis and Francis, 2004)

Meanwhile, in hypothesis 3(b) predicted that non-audit fees have significant effect to EM.
There is significant positive relationship between non-audit fees and earnings management in
this study. This means that when the non-audit fees increase, the independence of the
auditors is impaired. As a result, this will provide more opportunity for the management to
manage earnings. This result of the study is consistent with the previous studies such as
Becker et al, 1998; Frankel et al, 2002; Duh et al; 2007. This also reflects the realistic
condition. In Malaysia, there is no regulatory requirement stringent on the provision of nonaudit services. There is lack of regulation on the full disclosure of non-audit fees to the
public. This might impair the independence of the auditors because when the auditors receive
higher non audit fees, this might create the economic bond between auditors and the clients.
This study concludes that the non-audit services have an explanatory power to determine
whether the auditors are independence or not. Lee et al. (2003) found that non-audit fees is
associated with the lower independence of auditors, therefore, they found that auditors who
provide more non-audit services to the clients lead to higher income increasing accrual.

The fourth hypothesis predicts that surplus free cash flow and is positively related to EM. In
this study found that, there is partially significant relationship between surplus free cash flow
toward EM. Due to agency problem, manager may choose to invest in an unprofitable project
because his or self-interest. This result is consistent with previous study by Chung, Firth and
Kim (2005) found that, based on minimal information investors may not able to know the
prospect and advantages or disadvantages of the project for their wealth.

63

Since, Malaysia has also following the world development to comply with audit practices and
standards. On 10 April 2010, Malaysia had established Audit Oversight Board (AOB) to
ensure high quality financial reporting. Therefore, this study investigates the effect of AOB
inspection before and after establishment of AOB. From all hypothesis tested, the study
concluded that the firms inspected had generally put in place systems and processes in line
with global best practices. The users have increased the confidence level in audited financial
statement and it will mitigate the risk of earnings management. Furthermore, with the
establishment of AOB, the auditors can produce the high quality and reliable audited financial
statement of the firms. Thus, the auditors are resourceful and follow the audit practices and
standards to ensure the high quality of audited financial statement. Hence, the auditors are
more competence and independence in preparing financial statement in order to avoid
earnings management.

5.2

Implication of the study

This research contributes to the current literature by examining characteristics in this study
which are dividend and leverage and seek whether these variables have significant
relationship to the managers in engagement of earnings management.

The study also

examines the audit quality in public firms in Malaysia, and by questioning whether audit fees
and non-audit fees enhances financial reporting quality in public firms. The study also
investigates whether surplus free cash flow is one of the factors to manager practice earning
management. However, the impact of the establishment of AOB cannot be generalized. This
is due to the data limitation and time period. However, since this is an exploration study on

64

the AOB establishment, the findings from this study would be a basis for further studies in
future.

The outcomes from the current study are hopefully will shed more light on the limiting factor
for EM in the Malaysian context. From the five hypothesis, one is accepted and another four
are rejected. Dividend yield that is predicted to reduce EM shows a significant relationship
with EM in year 2010. Thus, the first hypothesis is rejected.

For second hypothesis, LEVERAGE, show a significant negative towards EM in year 2009
and 2010. Therefore, it indicates that high debt firms could increase the opportunities for
managers to involve in EM. This findings is inconsistent with Beatty and Weber (2003),
Dichev and Skinner (2002), Defond and Jiambalvo (1994) and Sweeney (1994) studies that
found that firms with high leverage engage in EM to avoid debt covenant by financial
institutions.

The audit quality measurements which are audit fees and non-audit fees in the hypothesis 3(a)
and 3(b) show insignificant results with EM for hypothesis 3(a) but positive significant for
hypothesis 3(b). For fourth hypothesis, surplus fee cash flow shows significant results for
pooled data indicating that managers in the trading and services industries might manage the
earnings for their own benefits.

65

5.3

Limitations of the study

There are some limitations listed in this section which could have been the underlying factors
for the rejection of most hypothesis. First, this study used a sample of two years period with
final sampling of 230 firms, which is considered too short as compared to the other studies.

Second, this study only used one type of accruals models which is Performance-matched
discretionary-accrual approach by Kothari et al. (2005). By using more accruals models, the
possibility for the findings to be significant could be higher. This is because Jaggi and Lee
(2002) research argued that the use of different accruals models will reduce errors in
calculating discretionary accruals.

Since this study includes the data for first and second year of AOB establishment, this will
not provide a better reflect on the effect of AOB establishment. The additional impact of
AOB can be determined if the study considered the data from the later years before and after
implementation of AOB. Additionally, due to the limitation of data, this study only focuses on
the sample company in general. This study also, not focuses on the specific industry or
specific firm size.
There are many opportunities for future research. The alternative research approach for this
study is by having survey, questionnaire or interview. The future research may consider the

66

issues in this study by the perception of regulator and external auditors and internal auditors.
Broader scope and constraint on the issues could be analyzed more extensively.

5.4

Future Study

By extending the sample size, this study suggests that there is possibility for future studies to
find a significant relationship. For future study, it is strongly encouraged to use larger sample
size because it might be able to find more significant results. The time frame could also be
extended to 5 or more, compared to just 2 years as done in this study. Use the latest studies or
new models to detect the discretionary accruals (EM) could also be apply in comparing
which model gives the best possible result in detecting EM. This study can also be extended
to include detailed information for other relevant factors such as audit tenure, qualified
opinion and auditor changes. Future research also needs to be done to examine to which
extent EM is harmful or useful to shareholders.

67

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