1489
94. Discuss the decision-maki ng of managers‘ not board pay? 1
95. Numbers of managers‘ not on board salaries disclosed? 1
96. Form of managers‘ not on board salaries disclosed? 1
97. Specifics disclosed on performance-related pay for managers? 1 98.
Details of the CEO‘s contract disclosed? 1
1490
RISK SIGNAL, FINANCIAL DERIVATIVES TRANSACTIONS AND THE INDONESIAN GAAP
HILDA ROSSIETA, PhD
The University of Indonesia
ACKNOWLEDGEMENT:
This research is funded by Competitive Research Grant from DRPM
– the University of Indonesia under contract No. 240AFDRPM-UINI.42008 Special thanks to Septian Haryo Seto, MSc for helping me out with the data, and also for
Desi Adhariani, MSi and Dyah Setyaningrum, SE, MSM for being my cheerful research assistant.
Abstract
εotivated by the accounting events of firm‘s default related to derivatives and other financial instruments transactions, this study is aimed to investigate the capability of
accounting information to signal the risks associated with the use of financial derivatives for hedging. Hypothesis are developed based on the theory and empirical evidences of
manager‘s motive to use derivatives for hedging Berkman and Bradbury, 1968; Dune et al., 2003 as well as signaling theory of accounting information Ball and Brown, 1968;
Beaver and Dukes, 1972; Jensen and Meckling, 1976; Megginson, 1997. The hypotheses are formulated in the Ordinary Least Square model. The study uses SPSS
version 14 as software to conduct the statistical tests. Non-bank and non-financial institutions firms with financial derivatives transactions listed in Indonesian Stock
Exchange during 2001 to 2006 are chosen as the sample. Determinations of the time frame has considered the timing of introduction of revisions of accounting standard on
derivatives and other financial instruments in Indonesia PSAK 50 ―Financial Instruments: Presentations and Disclosures‖ which was published in 15 July 1998, as well as PSAK
55 ―Financial Instruments: Recognition and εeasurements‖ which was published in 21 September 1998.
Based on the sample selections procedure and the completeness of the data required by the model, 24 firms listed during 2001
– 2006 or equal to 66 firm-years observations were identified as the data to be tested. Empirical evidences suggests that Indonesian
GAAP is capable of providing signal associated with: i fair value exposures related to manager‘s motive to reduce the cost of financial distress; ii cash flow exposures related
to manager‘s motive to practice tax arbitrage as well as to overcome underinvestment problems; iii interest rate risks related to manager‘s motive to avoid the risk default due
to limitations of debt covenants; iv forex risk related to manager‘s motive to control forex exposures caused by foreign operations as well as foreign sales.
n the future, to increase results generalizations, research should be conducted to be more inclusive, covering all the firms with and without financial derivatives. In addition,
more specific enquiries should be conducted to check the capability of PSAK 50 and PSAK 55 in providing the risk signals related to the use of derivatives and other financial
instruments.
1491
I. Introduction
The trace of derivatives in the context of corporate finance start in form of capital instruments, in particular are shares and debt securities. From the contractual perspectives,
shares and debt securities has clear distinction in terms of financial cost i.e., dividend for shares and interest for debt. In addition, from accounting earnings perspective, they have
diverse implications on tax and financial performance. However, the difference from economic terms most likely to be less clear Davies et al., 1994. This is due to
development and growing complexity of capital instruments that characterized both equity and debt, such as redeemable preference shares i.e., substantially it is resemble
more as debt than equity, convertible bonds i.e., closer to the nature of equity than debt, even before conversion occurred, or securities with its valued tied to debt value like
Market Based Securities MBS. Rapid development and growing complexity create challenges for accounting profession
to put balance judgment on competing considerations of substance over form when accounting for financial instruments. Previous studies i.e., Beaver and Dukes, 1972; Ball
and Brown, 1968 suggested that residual changes in stock prices were highly associated with residual changes in earnings. One interpretation is that accounting earnings are
perceived to be the best approximation of economic value of the firm, in term of stock price. This means that the economic substance matter the most on the reporting earnings.
However, the fact that fundamental distinction of capital instruments is rooted in legal form is more likely to cause fair judgment on economic substance more difficult for the
accounting profession. The issues regarding economic substance versus legal form generate problems for accounting profession as well as accounting information to
accommodate achievement of efficient contracting cost.
The expected role of accounting in the efficient agency contract seemed to be compromised when looking at inability of accounting information to immediately detect
the existence of derivatives related financial scandals in the past Winograd, et al, 1995. This relates to the potential use of financial derivatives to hedge the market risk, but at
1492 the same time, could also be used for ‗gambling‘ i.e., engage in trading derivatives
without any link to underlying assetsliabilities which expose the company to unlimited downside risk. Most importantly, unless manager provide sufficient disclosure regarding
their intention, the financial market allows manager to switch between hedging and trading purpose to go unnoticed in the financial statements. Hence, the
„off-balance- sheet‟ nature of financial derivatives instruments allow the financial risk to be concealed
until the uncontrollable problem suddenly appeared.
Some major issues surrounding accounting and reporting for financial derivatives and other financial isntruments, among others, are:
i. Financial derivatives could be used for trading i.e., profit seeking activities or for hedging i.e., to manage the financial risk exposure. The effect of hedging versus
trading derivatives transactions is contradictory. Derivatives hedging stabilize earnings, while derivatives trading increase earning volatility.
ii. Financial derivatives need only small upfront investment, while the down-side risk could be unlimited. The unlimited down-side risk especially happen when there are
no underlying assets associated with the financial derivatives transactions, as in the case of financial derivatives trading to gain profit. Therefore, disclosures regarding
managements‘ intention to use derivative i.e., for trading or hedging is critical to increase transparency of risk exposures associated with financial derivative
transactions. However, there is timing incompatibility between management intentions for using derivatives in on one hand, and financial reporting on the other
hand. Management intentions could change easily anytime dependent upon the opportunity of market movement, while, in contrast, accounting information is
reported periodically. Therefore, some argued that although management has good intention to report the transactions, yet, accounting information is naturally incapable
of reporting risk exposure associated with derivatives transactions.
1493 iii. Being a financial instruments, financial derivatives transaction involving fair value
measurements. The accuracy of fair value measurements depends on the availability of market value, as well as frequency of trading activities in the ‗arm‟s length
transactions ‘ i.e., investors‘ decisions to sell, buy or hold are purely based on
rational considerations, free from conflict of interest or forces of any kinds. Fair value measurements become problematic during the financial market crisis such as
occurred in the 2007. In such situation, most of the parties willing to sell and only a few willing to buy. This condition leads to unprecedented decreasing market value for
almost all the traded financial instruments. To contain further damage, some regulators suspended trading activities, hoping for the market to regain confidence.
Practicing fair value measurements in these circumstances needs benchmark other than the market,such as the quantitative models provided by management. However,
accuracy and reliability of the model is often difficult to be assessed objectively. In the case where the model is absence, financial instruments are valued by their
historical cost. This is problematic in the market that is severely distressed, in which historical cost is often higher than the distressed market value. To present historical
cost bigger than market value is inconsistent with conservatism principles, where the lowest value between market and historical cost should be choose for the purpose of
accounting report.
iv. Even in the normal market circumstances, where ‗arm‘s length transactions‘ could be
practiced, reporting unrealized gains and losses associated with fair value measurement of financial derivatives is also problematic. Although there is a clear
distinction between reporting gainslosses due to trading i.e., charged directly to current Profit and Loss Statements and hedging activities i.e., deferral accounting is
acceptable, yet the ways deferral accounting should be practiced are still in disputes, including: i what are the criteria that differentiate hedging from trading, so that one
is entitled to apply hedge accounting?; ii where should unrealized gains or loss be reported, in the balance sheet or in the comprehensive income? iii if they are to be
reported in the balance sheet, should they be reported as parts of underlying
1494 assetsliabilities, or should they be charged directly to the equity section? iv if they
are to be reported in the balance sheet, are netting-off presentation i.e., direct off-set between unrealized gains or loss originated from the hedge contract and underlying
assetsliabilities acceptable?; v how do de-recognized hedge positions? Investigation of the financial Accounting Standard in Indonesia context would be quite
interesting for the some reasons. Mainly, despite growing importance of derivatives and other financial instruments in the corporate finance practice in both global as well as
national level, yet, financial default related to the use of financial derivatives continue to be happened. This leads to the major doubt regarding the capability of financial
accounting information to provide signal regarding risks related to the use of financial derivatives.
Considering the contrasting effects of financial derivatives use for hedging and trading on one hand, and the role of accounting information u
sed by managers to signals firm‘s performance on the other hand, this research is aimed to investigate the capability of
accounting information to provide signal regarding risk associated with financial derivatives and other financial instruments in the context of Indonesian capital market.
More specifically, this research would investigate whether the market could appreciate the use of financial derivatives for hedging purpose using accounting information
prepared based on Indonesian GAAP.
II. Theoretical Framework and Hypotheses Development
II.1.
Manager’s Motives to Use Financial Derivatives for Hedging
Berkman and Bradbury 1996 argue that, risk management can add value to a firm when capital market is imperfect. This provides incentives for managers to practice risk
management by using financial derivatives, aimed at increasing firm‘s performance.
Accordingly, the managers‘ motives to use financial derivatives are to manage risk exposures, including interest rate risk, foreign exchange risk, credit risk, fair value risk
and cash flow exposure. More specifically, the corporate i.e., manager motive to use derivative hedging are as follows:
1. To reduce the expected cost of financial distress Mayer and Smith, 1982; Smith and Stulz, 1985 in which manager presumably use financial derivatives to manage fair
value exposure, cash flow exposure and interest rate risk.
1495 2. To practice tax arbitrage and reduce the expected tax charge Mayers and Smith,
1982; Smith and Stultz, 1985 in which manager most likely to use financial derivatives to manage cash flow exposure.
3. To reduce agency cost associated with underinvestment problem Mayers and Smith, 1987; Bessembinder, 1991 due to increased volatility of future cash flows or short-
term liquidity constraints Froot et al., 1993 in which manager presumably use financial derivatives to mitigate fair value exposure, cash flow exposure and interest
rate risk. 4. To accommodate managerial self interest i.e., to gain high and stable bonus and risk
aversion i.e., to avoid debt covenant violation as argued by Smith and Stultz 1985 as well as Dunne et al., 2003, in which manager most likel to use financial
derivatives to manage fair value exposure and credit risk. 5. To overcome the short term liquidity constraint Berkman and Bradbury, 1996, in
which manager presumably use financial derivatives to manage cash flow exposure. 6. To manage foreign currency exposure Berkman and Bradbury, 1996, in which
manager most likely to use financial derivatives to manage foreign exchange risk. The study of Berkman and Bradbury 1996 on all domestic and non financial services
firms in New Zealand which held derivative financial instruments at the 1994 balance sheet date find that none of the sample firms used derivatives for speculative purposes. In
addition, the study develops and test the hypotheses based on the theory of financial derivatives hedging explained above. Accordingly, the empirical evidence suggested that
firms with financial derivatives have specific characteristics, such as: i tend to be larger; ii have higher leverage; iii less liquid; iv have greater dividend pay out; v have
higher use of quasi-equity i.e., convertible debt in their capital structure; vi have
1496 bigger tax losses carried forward; vii have higher long term growth prospects; and viii
have higher involvement in overseas activities.
Other study done by Dunne et al. 2003 tested 210 listed firms in UK right after introduction of Financial Reporting Standard on Derivatives and Other Financial
Instruments No. 1γ FRS 1γ in 1λλ8. Some results of Dune et el.‘s study β00γ consistent with Berkman and Bradbury‘s 1λλ6 findings on firm‘s characteristics, where
firms which use financial derivatives for hedging are larger and have higher involvement in overseas activities. In addition, although supported by less strong predictors, the
empirical findings suggest that firms use financial derivatives to reduce risk of financial distress and overcome the underinvestment problems.
II.2. Signalling Theory
Signalling theory emanate from the context of agency theory, in which firm‘s ownership is separated from its management Jensen and Meckling, 1976. Further, manager
supposed to act as an agent for the benefit of owner who act as principals, by maximizing the firm‘s value. Such agency relationship incorporates several problems, among othersμ
i agency costs; ii information asymmetry; iii moral hazards; and iii adverse selection.
Agent and principals as individuals have their own self-interest, which might be conflicting with others. Contracts between agent and principals are set to protect and
bond interests of all the parties involved in the agency relationship. However, no one could make the perfect contract that could fully protect self-interest of the contracting
parties involved. This leads to the practice of manager‘s moral hazard, in which managers try to maximize their self-
interest i.e., utility value at the cost of firm‘s value i.e., adverse selection. εanager‘s moral hazard to a great extent is due to the condition
of information asymmetry favourable for manager who involve in daily operations of the firm. On the other hand, although principals own the firms, yet their access to
1497 information is limted to the information provided by monitoring systems only. Although
principals have set bonding contract and monitoring system to protect their self-interests, still, the probability of managers‘ adverse selection at the costs of principals‘ interests
could never been fully eliminated i.e., residual loss. For that reasons, agency costs are assumed to be consisted of three kinds of costs: i bonding cost; ii monitoring costs;
and iii residual loss.
Due to the assumed condition of information asymmetry, potential investor of public companies use information provided by the monitoring system to asses firm‘s value.
Accounting information provided in the financial statements is considered as one of the most prominent and reliable monitoring system. In the light of these circumstances,
managers try to provide signal of firm‘s performance via financial statements, both directly i.e., via narrative disclosures and indirectly i.e., via accounting numbers, so
that firm‘s value would be more consistent with its performance.
Scott 2006 provide some empirical evidence from public companies in US suggesting that to maintain high equity positions, some managers purposely hold bad news and tend
to disclose good news. In addition, high level of leverage often interpreted as signal for good performance, as only companies with good performance are capable of taking such
a high leverage risk. Therefore, high-leverage firms are valued higher by investor compared to low-leverage firms Megginson, 1997.
II.3. Hypothesis Development
Based on the theory of corporate motive of financial derivatives use as well as signaling theory of accounting information, this study argue that when firms used financial
derivatives in their business operations, the firms‘ performance is associated with factors that motivate managers to use financial derivatives. If financial derivatives are used for
hedging purpose, then, firm‘s value is expected to be more stable. This leads to the following propositions:
1498 Firm‘s performance is positively associated with manager‘s motive to use
financial derivatives to mitigate fair value risk, cash flow risk, interest rate risk, credit risk and foreign exchange risk.
Firm‘s performance is defined as volatility of firm‘s value, assuming that general aim of derivatives use for hedging purpose is to mitigate risks, which resulting in increased
stability of firm‘s value. εore specifically, managers‘ motive to use financial derivatives is hypothesized as follows.
II.3.1. Managers’ Motive to Reduce the Cost of Financial Distress.
Financially distressed firms have higher variance of firm‘s value hence tend to have higher cost of capital Mayer and Smith, 1982; Smith and Stulz, 1985. To reduce the
probability of financial distress i.e., mitigating the fair value exposure, cash flow exposure and interest rate risk firms use derivatives hedging aimed at lessening the
variance of firm‘s value and reducing the cost of capital. Based on that argument, the first hypothesis suggested is as follows:
H
1
:
Volatility of firm‘s value is positively associated with cost of capital
II.3.2. Manager’s Motive to Reduce Income Tax
Under progressive tax rate, firms with high income volatility are having average tax higher than firms with stable income. For example, in the two consecutive years, due to
different tax bracket, firms with loss of Rp. 1 billion,- in the first year and has a profit of Rp.1 billion,- in the second year would pay higher average tax compared to firms which
has a profit of Rp.0.5 billion each year. Although cumulative income for these two different firms are equal i.e., Rp. 1 billion in total, yet, the firm that having profit of Rp.
1 billion would pay higher tax due to the higher rate applied for higher level of income. Accordingly, firms are using financial derivatives hedging to smooth earnings and reduce
average tax charge i.e., mitigating cash flow risk exposure. Hence, progressive income
1499 tax provides incentives for manager to practice tax arbitrage by using financial
derivatives for hedging. Therefore, the second hypothesis is as follows:
H
2
:
Volatility of firm‘s value is negatively associated with tax arbitrage
II.3.3. Managers’ Motive to Overcome Underinvestment Problems
As agent to shareholders, managers might forgo positive Net Present Value project if the gains accrue primarily to debt-holders i.e., underinvestment problems. This
circumstance provide incentives for managers to use derivatives to hedge cash flow exposures, so that the underinvestment problems could be overcome, but at the same time,
could also increase the residual claim for shareholders in the future. Accordingly, the third hypothesis is as follows:
H
3
:
Volatility of firm‘s value is positively associated with the volatility of future cash flow
II.3.4. Manager’s Motive to Mitigate Default-risk as well as Accommodate their
Self-interest
If hedging could increase firm‘s value by reducing its variability, and managers‘ wealth is dependent on firm‘s value, then, managers have incentives to use financial derivatives
hedging for default-risk aversion as well as to accommodate their economic self-interest. One of risk associated with firm‘s default is restriction in debt covenants. Accordingly,
when firms violate the restriction, then most probably that firm‘s value would be
deteriorated. In addition, as bonus level is often tied to earnings level, manager use financial derivatives to maintain high level of earning. Therefore, the fifth and seventh
hypotheses are as follows:
H
41
:
Volatility of firm‘s value is positively associated with level of leverage
1500 H
42
:
Volatility of firm‘s value is positively associated with earnings level
II.3.5. Manager’s Motive to Overcome Short-term Liquidity Constraint
Manager could resolve conflict of interest between shareholders and debt-holders by implementing low dividend pay-out policy, so that plenty of funds available to pay the
fixed claimholders, and the same time, maintaining sufficient liquidity as a means of financial buffers. Accordingly, firms have incentive to use financial derivatives to hedge
cash flow risk exposure, maintain stable cash flow and overcome short term liquidity constraint. Based on this argument, the fourth hypothesis is as follows:
H
5
:
Volatility of firm‘s value is positively associated with short-term liquidity constraint
II.3.4. Manager’s Motive to Hedge Foreign Exchange Exposure
Compared to others, firms with overseas operations have higher proportion of forex assets and liabilities relative to its equity, and also, they tend to have higher forex sales
proportion. Therefore, they presumably have higher exposures to foreign exchange risk. Accordingly, these kinds of firms tend to use financial derivatives to hedge foreign
exchange exposure. Therefore, hypothesis six is as follows:
H
61
: Volati
lity of firm‘s value is negatively associated with the net open position between foreign assets and foreign liabilities.
H
62
:
Volatility of firm‘s value is positively associated with proportion of foreign sales
III. Research Methods and Methodology
III.1. Hypotheses Testing
1501 The hypotheses would be tested using the Ordinary Least Square OLS regression
method based on the following model: Y
1
= a + b
1
X
1
+ b
2
X
2
+ b
3
X
3
+ b
41
X
41
+ b
42
X
42
+ b
5
X
5
+ b
61
X
61
+ b
62
X
62
+ , εost of the variables used in the model are adopted from Berkman and Bradbury‘s study
1996, as defined as follows:
Y
1:
Firms performance VOL, defined as annualized 30 day volatility of stock return
X
1:
Cost of capital STRESS, defined as interest expense to total debt ratio
X
2:
Tax arbitrage TARBIT, defined as ratio of earnings growthtax growth
X
3:
Volatility of future cash flow UNINV defined as ratio of working capital of year n to year n-1
X
41:
Restriction of debt covenant DER defined as debt to equity
ratio
X
42:
εanager‘s self-interest MSINT defined as Ln Earnings Before Interest and Tax EBIT
X
5:
Short term liquidity constraint DIVPR defined as dividend pay out ratio
X
61:
Net open position between foreign assets and foreign
liabilities NFNOPEN defined as ratio of net open position in foreign currency to total equity
X
62:
Proportion of forex sales FNSALES defined as ratio of forex
sales to total sales
ε:
error term Statistical software SPSS version 14 is used to test the model. General hypothesis of the
data is defined as H μ b ≠ 0 and H
A
= 0.
The use of OLS method in hypotheses testing requires several assumptions to satisfy First, OLS assumes the data to be normally distributed. Second, there is no association among
independent variables i.e., no multicollinearity. Finally, the effect of variability of individual company has been addressed i.e., random effect and fixed effect
1502
III.2. Sample Selection and Data Description
Non-probability sampling method i.e., purposive sampling method is applied to choose non-bank and non-financial institutions companies listed in Jakarta Stock Exchange
predicted to be significantly involved in financial derivatives transactions. The observation covers 5 years period when the PSAK 50 i.e., accounting standar ―Financial
Instrumentsμ Presentations and Diclosures‖ published on 15 July 1λλ8 and PSAK 55 i.e., accounting standard ―Financial Instrumentsμ Recognition and εeaserements‖ published
on 21 September 1998 have been effective, which is from 2001 to 2006.
Examination of notes to financial statements on particular account predicted to be associated with risk exposures i.e., financial assets, financial liabilities and sales was
conducted to identify firms predicted to be significantly involved in financial derivatives transactions. Further, the study assumes that risk exposures are sustained as the risks are
associated with firms‘ business process. Hence, when the examination showed that firms disclose the use of financial derivatives on year 2006, it was assumed that the firms had
been using the financial derivatives since year 2001. Based on the sample selection procedure, 73 seventy three companies listed during 2001 to 2006 were identified,
resulting 438 firms-years pooled data available for observations before data cleaning. The research used Bloomberg database as data source. Descriptive statistic for the variables
identified by the SPSS software is shown in the following table.
1503
Table 1 Statistic Descriptive
Dependent and Independent Variable of the Identified Sample
DEPN.VAR INDEPENDENT VARIABLES
VOL30 STRESS
TABIT UNINV
DER MSINT
DIVPR NFNOPEN FNSALES
N - Valid 369
385 344
350 415
356 416
146 113
N - Missing
69 53
94 88
23 82
22 292
325
Mean 57.14
9.26 2.25
0.66 395.49
10.89 26.44
70.70 42.9573
Median 45.74
7.31 0.63
-0.01 72.47
11.71 10.40
-11.87 29.3283
Std. Deviation
34.38 13.64
27.76 18.30
4,492.08 3.46
50.61 913.75
37.96924
Variance 1,182.11
186.08 770.45
334.79 20,178,799.34 11.96
2,561.58 834,930.86
1441.663
Skewness 1.92
12.47 16.35
7.08 19.93
-1.38 5.13
10.83 0.6
Minimum 4.96
0.00 -55.53
-151.05 0.00
0.78 0.00
-1,089.75
Maximum
219.74 236.53
493.91 214.49
90,991.82 16.89
473.35 10,631.15
163.67
The table above shows that dependent variable VOL30 is highly dispersed, range from the minimum 4.96 to the maximum 219.74. Notably, the variance is quite high, which is
1,182.11, far above standard deviations of 34.38 and mean of 57.14. Most of the independent variable are highly skewed, except for MSINT and FNSALES, which are -
1.38 and 0.6 consecutively. Correlations among variables in the model are presented in Table 2 below.
1504
Table 2 Correlations among Variables in the Model
Pearson Correlations, 1 Tailed-test
STRESS1 FNSALES NFNOPEN VOL30 TABIT
UNINV MSINT1 DIVPR DER
STRESS1 1
-0.078 -0.056
0.057 -0.015
0.01 0.076 .109
0.038 0.209
0.251 0.15
0.394 0.427
0.088 0.018
0.234 N
110 144
331 304
320 320
367 366
FNSALES 1 .269
.234 0.12
-0.005 -0.025
- .207
0.056 0.004
0.008 0.112
0.48 0.406
0.015 0.281
N 94
106 105
110 93
110 109
NFNOPEN 1
0.036 -0.039
0.003 0.003
-0.009 .178 0.336
0.328 0.485
0.488 0.459
0.018 139
131 137
126 142
140 VOL30
1 .152 -0.008 -.129
- .114
-0.014 0.004
0.443 0.012
0.016 0.398
N 300
302 302
355 354
TABIT 1
-0.043 -0.011
-0.007 0.026
0.216 0.424
0.448 0.317
333 285
338 330
UNINV 1
-0.004 -0.002
-0.01 0.474
0.485 0.424
N 293
344 336
MSINT1 1
- .093
0.005 0.041
0.465 N
346 348
DIVPR 1
-0.035 0.239
N 404
DER 1
N 415
One tailed-test - significant at 5 level One tailed test - significant at 1 level
The results of Pearson correlations statistical test above shows some significant correlations between dependent variable VOL30 with independent variables as follows:
i positively correlated with tax arbitrage TABIT at 1 level, cosistent with H
2; ii
negatively correlated with earnings level MSINT at 5 level, consistent with H
42; iii
positively correlated with short term liquidity constraint DIVPR at 5 level, consistent
1505 with H
5
; and iv positively correlated with the proportion of foreign sales FNSALES at 1 level, consistent with H
62
.
SPSS check the completeness of the variables included in the model, resulting 24 firms left or equal to 66 firm-years data to be tested in the model. Descriptive statistic for the
data included in the model after cleaning the outlier data i.e., 3 standard devitation is presented in the table below.
Table 3 Statistic Descriptive
Dependent and Independent Variable of the Data Tested N=66
N=66 DEPN.VAR
INDEPENDENT VARIABLE VOL30
STRESS TABIT
UNINV DER
MSINT DIVPR
NFNOPEN FNSALES Mean
52.70 7.49
0.73 3.56
196.45 10.94
16.71 -31.50
43.39
Std. Dev.
28.62 6.94
3.52 26.43
722.93 3.25
16.58 183.85
34.60
Notably, Table 3 shows some differences of the central tendency statistics i.e., the value of means and standard deviations of the data included in the model compared to the
original data previously presented in Table 1, most particularly for the data with high skewness level. Presumably, this relates to the data distribution included in the model,
which is better normally distributed compared to the original data.
1506
IV. Empirical Results, Analysis and Interpretation
The results of OLS regression is presented in the Table 4 below
Table 4 The Results of OLS Regression
Dependent Var.: VOL30
Independent Variables
Standardized Coefficients
t Sig.
Collinearity Statistics
Beta Tolerance
VIF
Constant 2.433
0.02 STRESS
0.492 5.085
0.00 0.959 1.043
TABIT -0.407
-2.874 0.01
0.447 2.238 UNINV
-0.112 -1.161
0.25 0.971 1.029
DER 0.661
3.512 0.00
0.253 3.947 MSINT
-0.04 -0.412
0.68 0.953 1.049
DIVPR -0.116
-1.071 0.29
0.759 1.317 NFNOPEN
-0.375 -2.111
0.04 0.285 3.512
FNSALES 0.343
3.425 0.00
0.897 1.115
Significant at 5 level Significnat at 1 level
o The variables included in the model are defined as follows: i VOL30:
firms performance, defined as `annualized volatility of stock return; ii STRESS: expected cost of financial distress, defined as cost of
debt; iii TABIT: tax arbitrage, defined as of growth in net income to growth in inome tax; iv UNINV: volatility of future cash flow, defined
as of working capital of year n to year n-1; v DER: restriction of debt covenant, defined as of debt to equity; vi manager self interest,
defined as Ln earnings before interest and tax; vii DIVPR: short term liquidity constraint, defined as dividend pay out ratio ; viii
NFNOPEN: proportion of forex assets and liabilities, defined as of net open position in foreign currency to total equity; ix proportion of forex
sales, defined as of forex sales to total sales.
o The model is statistically significant at less than 1 level, with R-square
is 48.83 and adjusted R-square is 41.65 o
The results of Durbin-Watson test is 1.98 at less than 1 level, suggesting that no autocorrelation of the residuals. Hence, no indication
of underestimation on the level of statistical significance. o
The result of collinearity test suggests that no multicollinearity problems found in the model, in which Tolerance value is close to 1 and VIP value
is less than 10
1507 Empirical results presented in Table 4 suggest that for firms using financial derivatives
instruments in Indonesian context, their volatility of market return is: i positively influenced by the cost of capital as stated in H
1
; ii negatively influenced by tax arbitrage as stated in H
2
; iii positively influenced by restriction of debt covenant as stated in H
41
; iv negatively influenced by the net open position of forex v positively influenced by the proportion of foreign sales, as stated in H
62
. Hence, test results of the data suggest that H
3
, H
42
and H
5
are rejected. Apparently, volatility of future cash-flow, earnings level and short-term liquidity constraint do not influence volatility of firm value.
As hypothesized, the empirical findings indicate that in Indonesia, firms i.e., managers use financial derivatives for the following purposes: i to reduce the probability of
financial distress aimed at lessening variance of firm‘s value and reducing the cost of capital; ii to smooth earnings and reduce average tax charge; iii to reduce default-risk
related to restriction of debt covenants; iv to reduce forex risks exposure associated with foreign operations and foreign sales. This means that under the current GAAP,
accounting information has a capability to signal risk associated with: i fair value exposure related to the cost of capital; ii cash flow exposure related to tax arbitrage as
well as underinvestment problems; iii interest rate risk related to limitations of debt covenants; iv forex risk related to foreign operations and foreign sales.
V. Research Limitations and Suggestions for Future Research
The purposive sampling method in this study excludes firms without financial derivatives from the investigations. This relates to the assumptions of managers‘ motive which use
financial derivatives to hedge certain types of risks. However, hedging could also be done naturally without using financial derivatives. Therefore, future research should
investigate whether Indonesian GAAP could also capable of signal the risk for the firms that use natural hedging to mitigate the risks. This would involve inclusion of all non
bank and non financial institutions listed firms as the sample. If financial derivatives are
1508 preferred to natural hedging, then, it is expected that certain accounting measures used in
this model for firms with financial derivatives would be significantly different to firms without financial derivatives.
In addition, future research should also investigate the capability of accounting standard that specifically addressed financial derivatives and other financial instruments i.e.,
PSAK 50 ―Financial Instrumentsμ Presentation and Disclosures‖ and PSAK 55 ―Financial Instrumentsμ Recognition and εeasurements‖ to signal the associated risks. This is
important, considering the big effort conducted to improve accounting standard on derivatives and other financial instruments in the national as well as international level,
besides the continuing failure of accounting information to signal firm‘s default associated with derivatives and other financial instruments. Currently, PSAK 50 and
PSAK 55 have undergone some major revisions aimed to be more aligned with IAS 32 and IAS 39 of International Financial Reporting Standards. The revised versions were
planned to be effective by the beginning of year 2009. However, due to recent global financial crisis, in which most of the capital markets were highly distressed, then,
implementation of the revised version of PSAK 50 and PSAK 55 were delayed until the early 2010.
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3. Ball, R.J. and P. Brown 1968. An Empirical Evaluation of Accounting
Income Numbers. Journal of Accounting Research, 6 Autumn: 300- 323.
4. Berkman, H. and M.E. Bradbury. 1996. Empirical Evidence on the
Corporate Use of Derivatives. Financial Management, 25 2- Summer:1-11.
1509 5.
Mayers, D. and C. Smith 1982. On the Corporate Demand for Insurance. Journal of Business, 55:281-90.
6. Smith, C.W. and R.M. Stulz 1985. The Determinants of Hedging Policies.
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7. Mayers, D. and C. Smith 1987. Corporate Insurance and the Underinvestmetn
Problems
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8. Bessembinder, H. 1991. Forward Contracts and Firm Value: Investment
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9. Froot, K.A., G.S. Hyatt, R.C. Marston, and C.W. Smithson 1995. Risk
Management : Coordinating Corporate Investment and Financing Policies .
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10. Dunne, T., C. Helliar, C. Mallin, L. Moir, K. Ow-Yong, D. Power 2003.
The Financial Reporting of Derivatives and Other Financial Instruments: a Study of the Implementation and Disclosures of FRS 13. Centre for
Business Performance, The ICAEW , Chartered Accountants‘ Hall,
Moorgate Place, London EC2P 2BJ 11.
Jensen, M.C. and W.H Meckling 1976. Theory of the Firm: Managerial Behaviour, Agency Costs, and Ownership Structure. Journal of Financial
Economics, 3: 305-360
12. Citron, David. B.1995. The Incidence of Accounting-based Covenants in
UK Public Debt Contracts: An Empirical Analysis. Accounting and Business Research 25 99:139-150
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Megginson, L. William 1997. Corporate Finance Theory. Addison
– Wesley
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Scott, William R 2004. Financial Accounting Theory. Prentice Hall
1510
AUDIT COMMITTEE ATTRIBUTES, FINANCIAL DISTRESS AND THE QUALITY OF FINANCIAL REPORTING IN MALAYSIA
Wan Nordin Wan-Hussin Noor Marini Haji-Abdullah Universiti Utara Malaysia
November 2009
ABSTRACT
Audit committee effectiveness remains one of the significant themes in corporate governance debates. We examine the association between audit committee characteristics,
financial distress and the quality of financial reporting. This study is one of the few studies that overcome the imprecision inherent in the abnormal accrualsearnings
management models as a proxy of the financial reporting quality, by using a more direct measure of financial reporting quality. The evidence suggests that the desirable
characteristics which the policy makers believe would enhance the effectiveness of the audit committee in carrying out its financial oversight responsibilities do not seem to
yield the intended consequence. The significant finding on the association between financial distress and financial reporting quality reinforces the importance of including
distress variable in future corporate transparency study.
JEL code: G32 Keywords: Audit committee, financial reporting quality, Malaysia
1511
INTRODUCTION
In the wake of a series of highly publicized accounting scandals around the world see, for example, Enron and Worldcom in the US, Parmalat, Ahold, Gescartera and BBVA in
Europe and Transmile in Malaysia, the effectiveness of audit committee in monitoring the financial reporting process is one of the significant themes in corporate governance
debates Gendron Bedard, 2006. These high profile governance failures have led to the introduction of significant corporate governance regulatory reforms, which focused
on the structures of audit committee, to improve the quality of governance over financial reporting. For example, the Blue Ribbon Committee 1999 in the US recommends a
minimum size of three audit committee members, the independence of the board members who serve on the audit committee, and financial expertise of the audit
committee members
266
. The Sarbanes Oxley Act 2002 or SOX brings further improvements in the corporate governance environment with audit committees that are
substantially more active and diligent and possessing greater expertise and power to fulfill its expanded responsibilities Cohen, Krishnamoorthy, Wright, 2009. SOX
requires that all audit committee members be independent and that the company‘s annual report disclose whether a member of the audit committee is a financial expert Engel,
Hayes, Wang, 2009. SOX also stipulates that audit committees appoint, compensate, and oversee the external auditor Section 301.
266
The Blue Ribbon Committee BRC was established by the National Association of Securities Dealers and New York Stock Exchange at the behest of Arthur Levitt, the then Chairman of the Securities and
Exchange Commission SEC. SEC subsequently adopted certain recommendations by the BRC with effect from Dec 15, 2000.
1512 The situation in Malaysia with regards to audit committee is not much difference
from the US. Since 1994, the Bursa Malaysia Listing Requirements have required a listed company to appoint an audit committee which meets the following requirements; 1
must be composed of not fewer than three members; 2 a majority of the audit committee must be independent directors; and 3 at least one member of the audit
committee must be a member of the Malaysian Institute of Accountants MIA or possesses sufficient accounting experience and qualification, or deemed ―financially
literate ‖ by the stock exchange.
267
In the 2007 enhancements to the voluntary Malaysian Code on Corporate Governance 2001, it is stipulated that all audit committee members
to be non-executives and financially literate with at least one of them is a member of an accounting association or body.
Beasley, Carcello, Hermanson, Neal 2009 note that the bulk of past studies which examine the efficacy of the audit committee attributes as proposed by the
regulators mainly focused on the association between certain audit committee inputs e.g. audit committee member independence, expertise and diligence and financial reporting
outputs. They conclude that these quantitative studies generally find that a more independent, expert and diligent audit committee is associated with higher quality
financial reporting and auditing. However, the recent corporate governance disaster at Hollinger International Inc. despite having audit committee members who possess all the
desirable attributes financially literate, independence and meet frequently and Enron
267
The Bursa Malaysia Corporate Governance Guide 2009 defines a member of audit committee as financially literate if heshe has the ability to read and understand financial
statements, ability to analyze financial statements and ask pertinent questions about the company‘s operations against internal controls and risk factors, and ability to understand and
interpret the application of approved accounting standards p. 56.
1513 where ―The audit committee followed all the rules – but it let the shareholders down‖
Business Week, 2002, p. 28, triggers them to probe deeper into ―Do audit committee
appear to provide substantive oversight of financial reporting, or do they appear to be primarily ceremonial bodies designed to create legitimacy?‖ Through in-depth interviews
with audit committee members, they reveal that audit committee practices contain a mixture of substantive monitoring of financial reporting and ceremonial practices,
consistent with Cohen, Krishnamoorthy, Wright 2002 who document that audit partners generally perceive ―audit committees are ineffective and are not powerful
enough to resolve contentious matters with management‖ p. 586.
Another stream of emerging research focused on whether audit committee members who are independent in form are also independent in substance
Gendron Bedard, 2006; Cohen et al., 2009. These studies reveal that senior management has significant role in board and audit committee appointment, and
it is possible that management appoints passive, compliant audit committee members who satisfy regulatory requirements but provide minimal oversight over
management‘s actions. This suggests that at least some changes in governance may have been more form than substance. We continue with this line of
investigation and examine whether firms imbued with the prime features needed by audit committee members are associated with reliable financial reporting in
Malaysia. Previous Malaysian studies provide mixed results on the desirability of the
audit committee attributes, as proposed by the regulators. For example,
1514 Bradbury, Mak, Tan 2006 and Mohd-Saleh, Mohd-Iskandar, Rahmat 2007
document that independent audit committee enhances financial reporting quality, whereas Abdullah Mohd-Nasir 2004 and Abdul-Rahman Mohamed-Ali
2006 show otherwise. Ismail, Mohd-Iskandar, Rahmat 2008 and Abdul- Rahman Mohamed-Ali 2006 do not find any evidence to indicate that audit
committee activeness and financial literacy significantly impact financial reporting quality. However, Ismail, Mohd-Iskandar, Rahmat 2008 find that audit
committee multiple directorship impacts corporate reporting quality. Thus, to help inform policy makers on the efficacy of their regulatory reforms,
this study investigates whether audit committee characteristics such as the size of audit committee, independence of audit committee, audit committee meeting frequency and
attendance, financial literacy of audit committee and multiple directorships held by audit committee members in other public listed companies would affect the quality of financial
reporting. Malaysia provides another suitable setting to evaluate the efficacy of prescribing
certain ―best practices‖ for audit committee since all listed companies in εalaysia are required to include in their annual reports, a report on the profile, composition, frequency
and attendance of meeting, terms of reference and summary of activities carried out by the audit committee and summary of internal audit activities. We indicate the quality of
financial reporting as high when the company won the prestigious annual award given by the stock exchange, and low when the company was publicly reprimanded by the stock
exchange for violating the Listing Requirements pertaining to mandatory corporate disclosures, or the company received disclaimer audit opinion because the auditors were
1515 not able to ascertain the accuracy of the financial statements. In overseeing the financial
reporting, the audit committee is responsible, among others, in assessing the appropriateness of management‘s selection of accounting policies and disclosures in
compliance with approved accounting standards, ensuring timely submission of financial statements by management, reviewing significant or unusual transactions and accounting
estimates and assessing whether the financial report presents a true and fair view of the company‘s financial position and performance and complies with regulatory
requirements Bursa Malaysia Corporate Governance Guide, 2009, para 2.2.2. Thus, our study is one of the few studies that overcome the imprecision in using
the earnings management models as a proxy of the financial reporting quality by using a more direct measure of financial reporting quality to provide further evidence on the
effectiveness of audit committee. The main problem with the abnormal accrual models is the presence of measurement error in detecting whether earning management has or has
not taken place Dechow, Sloan, Sweeney, 1995; Guay, Kothari, Watts, 1996; McNicholls Wilson, 1998; Dechow Dichev, 2002.
In addition, following Rosner 2003 and Garcia-Lara, Garcia-Osma, Neophytou 2009, we incorporate financial distress indicator in the financial reporting
quality model. Most earnings management studies in the past may suffer from omitted variable bias by not including the distress variable. And given that the role of the audit
committee chairperson is highlighted in the Malaysian Code on Corporate Governance 2007
268
, Bursa Malaysia Corporate Governance Guide 2009
269
and the Malaysian
268
Under the Code, the best practices in corporate governance include: The chairman of the audit committee should engage on a continuous basis with senior
management, such as the chairman, the chief executive officer, the finance director, the head of
1516 Corporate Governance Index 2009 endorsed by Minority Shareholder Watchdog Group,
we also include the background of the audit committee chairperson in terms of degree of independence, accounting financial expertise and multiple directorships in the robustness
tests. An empirical study by Engel et al. 2009 shows that the quality of audit committee, proxied by the accounting financial expertise of the chairperson, is positively related to
the level of audit committee compensation. The findings show that audit committee size and financial distress influence the
quality of financial reporting. The other audit committee attributes such as independence, board seats in other companies, frequency of and level of attendance at audit committee
meeting and financial literacy are not significantly related to the quality of financial reporting. There is also no association between financial reporting quality and the audit
committee chairman independence, financial literacy and multiple directorships. All in all, the evidence suggests that the desirable characteristics which the policy makers believe
would enhance the effectiveness of the audit committee in carrying out its financial oversight responsibilities do not seem to yield the intended consequence.
The rest of the paper is organized as follows. The next section reviews the relevant studies and presents the research hypotheses. Then we describe the research
method and discuss the results. The concluding section is devoted to the implication of
internal audit and the external auditors in order to be kept informed of matter affecting the company. Through the engagements, relevant issues affecting the company can be brought to
the attention of the audit committee in a timely manner.
269
The Guide emphasizes that a key element for a successful audit committee is a strong chair demonstrating depth of skills and capabilities. The audit committee chairman should assume,
among others, the following responsibilities: planning and conducting meetings, overseeing reporting to the board, encouraging open discussion during meetings and developing and
maintaining an active ongoing dialogue with senior management and both the internal and external auditors. The chair is also accountable for the agenda of the audit committee meeting
and should not delegate it to management.
1517 our study for investors, regulators and academics who are examining the audit committee
oversight process.
PRIOR STUDIES AND HYPOTHESIS DEVELOPMENT
Agency theory suggests that shareholders require protection because management agents may not always act in the interests of the absentee owners principals Jensen
Meckling, 1976; Fama Jensen, 1983. To deal with this agency problem, the board assumes an oversight role that typically involves monitoring the Chief Executive Officer
CEO and other top executives, approving the company‘s strategy, and monitoring the internal control over financial reporting. Given board diverse responsibilities, the board
of directors delegates some of its oversight to the audit committee and other committees of the board.
The issue of audit committee ‘s effectiveness in monitoring the financial reporting
process was examined by, among others, Klein 2002, Felo, Krishnamurthy, Solieri β00γ, Xie, Davidson, DaDalt β00γ, Abbott et al. β004, Bédard, Chtourou,
Courteau 2004, Persons 2005, Lin, Li, Yang 2006, Qin 2007 and Archambeault, DeZoort, Hermanson 2008. They examine the association between audit committee
characteristics and incidence of fraud or restatements or extent of earnings management
or disclosure quality. We summarize below the arguments that link audit committee
characteristics and financial reporting quality and provide the empirical evidence on the relationship. In addition, we also discuss the financial reporting behavior among
financially distressed firms to illustrate the need to include distress variable in study on financial reporting quality.
1518 Size of Audit Committee
As mentioned earlier, the Bursa Malaysia Listing Requirements require a listed company to appoint audit committee from amongst its directors which must be composed of not
fewer than three members. A larger audit committee may make it more likely that potential problems in the financial reporting process will be uncovered and resolved. This
could arise if a larger committee size increases the resources available to the audit committee and improves the quality of oversight. Felo et al. 2003 document a positive
relationship between financial reporting quality and audit committee size in a univariate analysis but this relationship does not hold in the multivariate analysis. In Malaysia,
Ahmad-Zaluki Wan-Hussin 2009 provide evidence that audit committee size is positively associated with the quality of financial information disclosure, proxied by the
accuracy of IPO management earnings forecast. Based on the above, the following hypothesis is proposed:
H1: Larger audit committee size is associated with higher quality of financial
reporting. Independence of Audit Committee
The role of audit committee is to safeguard an organization by its authority to question top management regarding the way financial reporting responsibilities are handled, as
well as to make sure that corrective actions are taken. In a famous speech by Arthur δevitt entitled ―The Numbers Game‖, the former Chairman of the Securities and
1519 Exchange Commission remarked that ―qualified, committed, independent and tough
minded audit committees represent the most reliable guardians of the public interest‖.
The Listing Requirements of Bursa Malaysia stipulates that all listed companies to have audit committees comprising three members whom a majority
shall be independent. The term independent in the Malaysian context refers to two crucial aspects, independence from management and independence from
significant shareholder. The Revised Malaysian Code on Corporate Governance 2007 reinforces the desirability of audit committee independence by excluding
executive directors from membership. Meanwhile, SOX requires firms to have audit committees comprised solely of independent directors, i.e. those not an
affiliate of the firm and not accepting any compensation from the firm other than directors‘ fees.
Many studies have uncovered empirical regularities that audit committee independence enhances the quality of financial reporting. Klein 2002, Abbott et al.
β004, Bédard et al. β004, Persons 2005 and Archambeault et al. 2008 show that audit committee independence reduce earnings management, or the likelihood of
financial reporting restatement and financial reporting fraud. Krishnan 2005 finds that independent audit committees are significantly less likely to be associated with the
incidence of internal control problems over financial reporting. These studies support the view that independent audit committees contribute positively to the financial reporting
process, which motivate the following hypothesis:
1520 H2: Higher percentage of independent directors in audit committee is associated
with higher quality of financial reporting.
Audit Committee Meeting Frequency and Attendance The National Committee on Fraudulent Financial Reporting, also known as
Treadway Commission 1987, states that an audit committee, which intends to play a major role in oversight, would need to maintain a high level of activity. The
audit committee should meet regularly, with due notice of issues to be discussed and should record its conclusions in discharging its duties and responsibilities. In
the same vein, The Malaysian Code on Corporate Governance 2001 posits that audit committee which does not meet or meets only once is unlikely to be an
effective financial monitor. The Revised Code 2007 advocates an increase in the frequency of meetings between the audit committee and the external auditor
without the executive board members present to at least twice a year. This encourages a greater exchange of free and honest views and opinions between
both parties. The Guidelines for Audit Committees in the UK are particularly useful on
the issue of timing of audit committee meetings. The number of meetings required in a year depends on the company‘s terms of reference and the extent
of the complexity of the company‘s financial operations. The Guidelines state that the main meetings are often planned between the end of one year‘s audit and the
1521
beginning of the next, before the issue of the Interim Statements, after the Interim Results and after the year end, but before the accounts are finalized.
Menon Williams 1994 contend that the more often an audit committee meets, the more active it is being perceived, which leads to fewer financial reporting problems.
Xie et al. 2003 and Vafeas 2005 document that when audit committee meets more frequently, discretionary accruals are lower and there is lower likelihood of firm
reporting a small earnings increase, which indicates better financial reporting quality. Abbott et al. 2004 document that higher levels of committee activity measured by
holding a minimum of four meetings are significantly related to a lower incidence of financial restatement. These studies provide evidence in support of the view that audit
committees which meet more often are more effective in monitoring management and can potentially enhance the quality of financial reporting.
There are several dimensions that can be used to indicate audit committee activity such as meeting frequency, meeting duration and time allocation among different
functions, meeting regularity, information exchange at the meetings, and whether executive directors are present at meetings and level of attendance of audit committee
members. Due to archival data constraint, the two dimensions of activity that are examined in this study are frequency of audit committee meeting and the level of
attendance of audit committee members. Based on the above discussion, two sub- hypotheses are formulated:
H3a: Higher frequency of audit committee meeting is associated with higher quality of financial reporting.
1522 Besides regular meetings, the level of attendance of audit committee
members can also be used to measure the activeness of audit committee members. Even though the frequency of meeting is high but if the attendance
levels are poor this may impair the effectiveness of audit committee. It is posited that the higher the level of attendance of audit committee members, the more
active and participative the audit committee is, therefore the better is the quality of financial reporting.
H3b: Higher level of attendance of audit committee members is associated with higher quality of financial reporting.
Financial Expertise of Audit Committee Audit committees are responsible for numerous duties that require a high degree
of accounting sophistication such as understanding auditing issues and risks as well as the audit procedures proposed to address them, comprehending audit
judgments and understand the substance of disagreement between management and external auditor, and evaluate judgmental accounting areas. DeZoort
Salterio 2001 show that audit committee members with previous experience and knowledge in financial reporting and audit are more likely to make expert
judgments than those without. Xie et al. β00γ, Abbott et al. β004 and Bédard
et al. 2004 document that audit committee financial expertise reduces financial
restatements or constrain the propensity of managers to engage in earnings management. DeFond, Hann, Hu 2005 document that appointment of
1523 accounting financial experts generates positive stock market reaction, in line with
market expectation that the audit committee members‘ financial sophistication are useful in executing their role as financial monitors. Krishnan 2005 and
Zhang, Zhou, Zhou 2007 find that firms are more likely to be identified with deficiencies in internal control over financial reporting, if their audit committees
have less financial expertise. All in all, these studies suggest that financially knowledgeable audit committee members that possess accounting qualifications
are more likely to prevent and detect material misstatements. Thus, the following
hypothesis is proffered:
H4: Higher percentage of audit committee members who are financial experts
is associated with higher quality of financial reporting.
Audit Committee Members with Board Seats in Other Companies
Morck, Shleifer, Vishny 1988 state that monitoring of top officers requires time and effort. As the additional directorships on other firms‘ board increase,
demands on the individual board member‘s time decrease the amount available for the director to effectively fulfill monitoring responsibilities at a single firm.
Shivdasani 1993 contends that multiple directorships hold by board members is a double edged sword. On one hand, it is important in terms of adding to the
experience, but on the other hand, it can cause limitation of time and
1524 commitment for board members to perform effectively. Persons 2005 finds that
the likelihood of financial statements fraud is lower when audit committee members hold fewer directorships with other firms. Meanwhile, Song Windram
2004 and Vafeas 2005 find that multiple outside directorships may not undermine audit committee effectiveness. One possible interpretation of this
result is that under a certain limit, outside directorships enable directors to acquire specific experience from other companies. Given the inconclusive
finding, the following hypothesis non-directional is proposed: H5: The number of outside directorships per audit committee member
affects the quality of financial reporting. Financial Distress
For an entity experiencing financial distress, the quality of financial reporting is often
proxied by the tenor of the relevant financial statement notes and of the liquidity section of the Management Discussions Analysis MDA. Carcelo and Neal 2003 find that
there is a significant positive relation between the percentage of affiliated directors on the audit committee and the optimism of both the financial statements notes and MDA
discussions for financially distressed entities. This evidence corroborates the finding by Jones 1996 that managers in financially distressed firms would prefer no disclosure or
optimistic disclosure because they believed that disclosure of the going concern problems may adversely affect the en
tity‘s stock price. Similarly, Koch 2002 contends that management earnings forecast issued by distressed firms exhibit greater upward bias and
1525 are viewed as less credible than similar forecasts made by non-distressed firms.
Meanwhile, Holder-Webb Cohen 2007 in their study of firms entering financial distress, find that the firms increase the disclosure quality of MDA in the year of initial
distress. However, sustained increases in the disclosure quality are limited to firms that subsequently recover from distress.
Apart from examining the MDA, very limited studies have compared the accruals quality between financially distressed firms and non-distressed firms. Rosner
2003 shows that financially distressed firms are more likely to exhibit signs of material income increasing earnings manipulation than those of non-distressed firms. Likewise,
Garcia-Lara et al. 2009 show that managers resort to both accrual manipulation and real activity manipulation in the years leading up to bankruptcy. Based on the above
discussion that points to the low reliability of financial report emanates from financially distressed firm with propensity to camouflage its real performance, the following
hypothesis is derived: H6: Firm experiencing financial distress is associated with low financial
reporting quality.
METHODOLOGY
According to Cohen, Krishnamoorthy, Wright 2004 and Pomeroy Thornton 2008, there is a lack of consensus on how to operationalize financial reporting quality.
Dimensions of financial reporting quality that have been used by previous researchers include incidence of financial restatements and fraudulent financial reporting, weaknesses
1526 in internal controls, and earnings quality using constructs such as earnings response
coefficient and discretionary or abnormal accruals. Given that the public disclosure of financial restatements due to misrepresentation, fraudulent financial reporting and
weaknesses in internal controls are rare in Malaysia, this study proxies the quality of financial reporting according to whether the company is a winner of the Stock Exchange
Corporate Award KLSE Award or is meted disciplinary action by the KLSE for deficient corporate reporting, or is a recipient of disclaimer audit opinion.
270
The KLSE Corporate Awards recognize listed companies which have shown exemplary corporate conduct in complying with the Listing Requirements. In addition,
the Award recognizes public listed companies which have demonstrated high standards of corporate governance, disclosure and transparency coupled with proactive investor
relations efforts. Importantly, these Awards also seek to promote international best practices by public listed companies. In February 2004 it was announced that 40
companies won the 2003 KLSE Corporate Awards, the last year the Awards were given since they were started in 1999, including four financial institutions. In this study, the
winners of KLSE Awards, excluding financial institutions, are deemed to have good quality financial reporting see Appendix 1.
On the other hand, companies which were fined andor publicly reprimanded by the Stock Exchange for failure to comply with certain provisions in the Listing
Requirements are considered to have poor financial reporting quality. In 2003, disciplinary actions were taken against 21 companies, and the natures of the offences of
270
KLSE is the abbreviation for Kuala Lumpur Stock Exchange, which is now known as Bursa Malaysia.
1527 each company are described in Appendix 2. These companies are considered to have low
quality of financial reporting because they failed to comply with some of the qualitative characteristics of financial information such as timeliness and relevance. Another
dimension of poor financial reporting quality used in this study is when the auditors are not able to express an opinion on whether the financial statements give a true and fair
view. For financial year ended 2003, we identify 11 such companies see Appendix 3. Thus, unlike previous studies, our research design which focuses on companies with
extremely high and low financial reporting quality provides us with a more competent and powerful test to identify characteristics of audit committee that matters in enhancing
financial reporting quality. The study uses logistic regression analysis to test the hypotheses. Maddala 1991
states that logistic regression is appropriate where disproportionate sampling from two populations occurs. Studies on the effectiveness of audit committee that have used
logistic regression include and Felo et al. 2003, Abbott et al. 2004, Song Windram 2004, Lin et al. 2006, Pucheta-Martinez De Fuentez 2007 and Archambeault et al.
2008. The regression is specified as follows:
Dependent Variable = α + ∑βAudit Committee Attributes + πDistress
+ ∑µControls + ε
1
If a non-finance company has been awarded the KLSE Awards, the dependent variable = 1. If a company has received a public reprimand with
1528
or without fines imposed by the Stock Exchange or disclaimer audit opinion, the dependent variable = 0. The variables associated with audit
committee attributes are defined as follows: ACSIZE denotes audit committee size, ACIND denotes the proportion of audit committee
members who are independent directors, ACLIT denotes the proportion of audit committee members who are financial experts i.e. members of
professional accounting bodies, ACFREQ denotes the number of audit committee meetings held during the year, ACATT denotes the percentage
of members who attended the audit committee meetings during the year, ACMULT denotes the percentage of audit committee members with board
seats in other listed companies, ACCHINDLIT is a dummy variable which takes the value of 1 if audit committee chairperson is both independent and
a financial expert and 0 otherwise, ACCHMULT is a dummy variable which takes the value of 1 if audit committee chairperson has directorship in
other listed companies and 0 otherwise, and DISTRESS is a dummy variable which takes the value of 1 if the Z-score is below 2.07 based on the
widely used Altman 1993 distress model
271
and 0 otherwise. The control variables are BIG-3, which takes a value of 1 if the company is audited by
Ernst and Young, KPMG or PricewaterhouseCoopers and 0 otherwise, ROA
271
The Altman distress model is computed as follows: Z = 1.2working capitaltotal assets + 1.4retained earningstotal assets + 3.3EBITtotal assets +
0.6market value of equitytotal liabilities + 1.0net salestotal assets. It is used in Malaysian studies by Nor and Chin 2002, Gul 2006 and Hasnan et al. 2009.
1529
which is net income divided by total assets, and FIRMSIZE which is the natural log of total assets.
Our data sources are Bursa Malaysia website, and the annual reports of the respective companies for financial years ended 2002 and 2003. We used the annual
reports ended 2002 for companies that won the 2003 KLSE Corporate Excellence Awards having financial year ending in October, November and December. We used the
annual reports ended 2003 for all the remaining companies.
FINDINGS
Table 1 shows the sample partitioned by quality of financial reporting, type of auditor, distress indicator and the background of the audit committee chairperson. Out of 36 non-
financial firms that won the KLSE Awards, 26 or 73 percent were audited by the Big-3 firms of Ernst and Young, KPMG or PricewaterhouseCoopers. On the other hand, out of
the 32 firms that were reprimanded for violating the Listing Requirements or issued disclaimer audit opinion, 17 or 53 percent were audited by non Big-3. Almost two third
of companies with good financial reporting quality do not have distress indicator, whereas 88 percent of companies with poor financial reporting quality have distress
indicator. About two-thirds of the sample firms have audit committee chairperson who is
also directors in other listed companies. The instances of audit committee chairperson who is both independent and a financial expert are lower among the high quality financial
reporting firms than the low financial reporting firms 22 percent vs. 34 percent. The
1530 chi-square tests not shown in Table 1 indicate there are associations between the quality
of financial reporting and type of auditor and between the quality of financial reporting and distress indicator.
Insert Table 1 here
Table 2 shows the descriptive statistics of the sample partitioned by quality of financial reporting, either good or poor. Univariate analyses t-test showing comparison
between poor financial reporting companies and good financial reporting companies are also shown for each of the variables of interest, and control variables. The average audit
committee size for the full sample is 3.8. The average audit committee size for the good quality companies is slightly higher than the poor quality companies 4.1 vs. 3.5. All the
companies in the sample have an audit committee with at least 3 members, which is in accordance with the Listing Requirements. On average, 73 percent of audit committee
members are independent. All companies in the sample have audit committee where the majority is independent directors. The difference in means on audit committee
independence between poor and good quality companies 0.69 vs. 0.76 is statistically significant. With regards to financial expertise of audit committee members, on average,
one third of audit committee members is considered expert. The average audit committee meeting frequency is the same for good and poor
financial reporting companies at 4.75 times. Another way to measure the activeness of audit committee is to look at the audit committee meeting attendance. The level of
1531 attendance is higher although insignificant for good quality companies than poor quality
companies whereby on average 94 percent of members attended the audit committee meetings of high financial reporting quality companies, as compared to 91 percent for
poor financial reporting quality companies. On average, nearly 60 percent of audit committee members are also directors in
other listed companies, with good financial reporting quality companies have higher multiple directorships among its audit committee members than their counterparts 64
percent vs. 56 percent, although the difference is not significant. High financial reporting quality companies also have higher Z-score, albeit insignificant, than low financial
reporting quality companies. In terms of firm‘s performance, high financial reporting
firms perform significantly better than low financial reporting firms, with their average ROAs
at 5.3 percent and -40 percent respectively. To summarize, the evidence from Tables 1 and 2 shows that firstly, the incidence
of engaging Big-3 audit firm is significantly higher for good financial reporting companies than poor financial reporting companies, and secondly the audit committee
size and audit committee independence for good financial reporting companies are significantly higher than poor financial reporting companies. More companies in the
poor financial reporting quality category have distress indicator than their counterparts in the good financial reporting quality category, although the difference in the Z-score
means between the two categories is not statistically significant. Poor financial reporting firms are also smaller and have lower return on assets than their counterparts.
Insert Table 2 here
1532 Table 3 shows the correlation analysis among the independent and control
variables. Based on the correlation matrix, the correlation coefficients among the variables are all less than 0.6 except for the Spearman correlation between DISTRESS and
ROA which is -0.62, which indicates that multicollinearity problem is not a cause for
concern. This is further supported by the variance inflation factors of less than 2, when ordinary least square regressions are run for all the various models
Insert Table 3 here
Table 4 presents the regression results. In all the models the common variables are audit committee size, financial distress and the
control variables. In Model 1, the additional audit committee attributes tested are the degree of independence and accounting financial expertise
of audit committee members, In Model 2, we include the diligence of audit committee in terms of frequency of meeting and level of attendance at
meetings, alongside with audit committee member with multiple directorships. In Model 3, we focus on the background of the audit
committee chairperson. Based on the results, none of the audit committee attributes influence the quality of financial reporting, except for audit
committee size in Model 2. Good financial reporting companies are more likely to have larger audit committee size than poor financial reporting
companies. This is consistent with the evidence by Lin et al. 2006 who
1533
show that a larger audit committee provides more oversight over the financial reporting process and reduces the probability of restating
financial statements after their original filings with the SEC, but contrasts with the evidence from Felo et al. 2003, Abbot
t et al. 2004 and Bédard et al. 2004.
Our finding that independent audit committee is not associated with the quality of financial reporting is in contrast with previous Malaysian
studies such as Abdullah and Mohd-Nasir 2004 and Abdul-Rahman and Mohamed-Ali 2006 that uses abnormal accruals as proxy for financial
reporting quality. However, it is in tandem with Bradbury, Mak, Tan 2006 and Mohd-Saleh, Mohd-Iskandar, Rahmat 2007. Similar to previous
Malaysian studies such as Ismail, Mohd-Iskandar, Rahmat 2008 and Abdul-Rahman and Mohamed-Ali 2006, we do not find any evidence to
indicate that audit committee activeness and financial literacy significantly impact financial reporting quality. We also find no association between
audit committee multiple directorship and corporate reporting quality, which challenges previous finding by Ismail, Mohd-Iskandar, Rahmat
2008. Poor financial reporting companies are also more likely to have
distress indicator consistent with the univarite results presented in Table 1 earlier. Consistent with Table 2, the results in Table 4 also indicate that
larger and better performing firms are more likely to exhibit higher financial
1534
reporting quality. Overall, there is very little support for hypotheses 1 to 6. Although the variables associated with the hypotheses are not statistically
significant, the signs of the coefficients are in the predicted directions.
The accuracy of the model indicates that the percentage of correct classification is very high at above 85 percent. The Nagelkerke R squared also indicates that about 75
percent of all variation in the quality of financial reporting is explained by the models. Although not tabulated in Table 4, when we include all the hypothesized variables and
the control variables, the results are qualitatively similar. The significant variables are DISTRESS
, ROA and FIRMSIZE, whilst all of the audit committee attributes are insignificant.
Insert Table 4 here
CONCLUSION
Audit committee effectiveness remains one of the significant themes in corporate governance debates Gendron and Bédard, β006. The main objective of the study is to
examine the relationships between audit committee characteristics and the quality of financial reporting. The characteristics of audit committee that are examined are size,
independence, literacy, multiple directorships, level of activities which is proxied by meeting frequency and attendance, and background of the audit committee chairperson.
The evidence that firms with more members in the audit committee are more likely to have good quality financial reporting is in contrast with the evidence from
1535 previous studies such as Felo et al. β00γ, Abbott et al. β004 and Bédard et al. β004,
but consistent with Lin et al. 2006. This suggests that larger audit committee makes it more likely that it can devote adequate time and effort to ensure that the information
disclosed in the financial statements is accurate and timely and hence increase the quality of financial reporting.
This study also documents that financial distress is associated with the quality of financial reporting. This implies that previous studies that exclude financial distress in the
financial reporting quality model may be misspecified,
Overall the findings can provide guidance to users of accounting information such
as investors and regulators. For users, our findings serve as a reminder that audit committees may appear to comply with regulatory requirements on independence,
financial expertise and minimum number of meetings, yet in actuality they serve only a ritualistic role with no substantive monitoring in the financial reporting process, in
tandem with institutional theory Cohen, Krishnamoorthy, Wright, 2008. To help users make an informed decision on the quality of audit committee and to facilitate a
sound assessment of ―independence in substance‖, more qualitative disclosure is required on the activities of audit committee. For the regulators, the efficacy of prescribing certain
―best practices‖ for audit committee remains an open question. It is also fruitful for future research to consider moderating factors that may blunt
the ability of audit committee members in promoting corporate transparency. An independent audit committee member‘s lack of seniority on the board may adversely
affect hisher ability to scrutinize top management and raise concern over questionable accounting practices. Audit committee member who is appointed by the incumbent CEO
1536 may face obstacles in becoming an effective financial monitor. One of the limitations of
this study is the possibility of error in the archival measure of audit committee diligence. Audit committee compensation may be a better proxy for diligence than number of
meetings and level of attendance at such meetings. We also ignore non accounting financial expertise when measuring the level of audit committee financial literacy.
1537
APPENDIX 1 The recipients of KLSE Corporate Awards 2003
NO. COMPANY NAME - MAIN
BOARD AWARDS’ CATEGORY
SECTOR
1. AIC Corporation Berhad
KLSE Corporate Excellence Awards 2003
2. British American Tobacco
Malaysia Berhad KLSE Corporate Sectoral
Awards 2003 Consumer Products
3. Petronas Gas Berhad
KLSE Corporate Sectoral Awards 2003
Industrial Products 4.
Road BuilderM Holdings Berhad
KLSE Corporate Sectoral Awards 2003
Construction 5.
Telekom Malaysia Berhad KLSE Corporate Sectoral
Awards 2003 TradingServices
6. Island Peninsular Berhad
KLSE Corporate Sectoral Awards 2003
Property 7.
Golden Hope Plantations Berhad KLSE Corporate Sectoral Awards 2003
Plantation 8.
Puncak Niaga Holdings Berhad KLSE Corporate Sectoral
Awards 2003 Infrastructure
Project Companies 9.
Computer Systems Advisers M Berhad
KLSE Corporate Sectoral Awards 2003
Technology 10.
Shangri-La Hotels Malaysia Berhad
KLSE Corporate Sectoral Awards 2003
Hotels 11.
Malaysia Mining Corporation Berhad
KLSE Corporate Sectoral Awards 2003
Mining 12.
UMW Holdings Berhad KLSE Merit Awards 2003
Consumer Products 13.
Carlsberg Brewery Malaysia Berhad
KLSE Merit Awards 2003 Consumer Products
14. Top Glove Corporation Berhad
KLSE Merit Awards 2003 Industrial Products
15. Tractors Malaysia Holdings
Berhad KLSE Merit Awards 2003
Industrial Products 16.
IJM Corporation Berhad KLSE Merit Awards 2003
Construction 17.
Gamuda Berhad KLSE Merit Awards 2003
Construction 18.
Genting Berhad KLSE Merit Awards 2003
TradingServices 19.
Malaysia International Shipping Corporation Berhad
KLSE Merit Awards 2003 TradingServices
20. Sunrise Berhad
KLSE Merit Awards 2003 Property
21. S P Setia Berhad
KLSE Merit Awards 2003 Property
22. Kumpulan Guthrie Berhad
KLSE Merit Awards 2003 Plantation
23. Guthrie Ropel Berhad
KLSE Merit Awards 2003 Plantation
24. Unisem M Berhad
KLSE Merit Awards 2003 Technology
1538
NO. COMPANY NAME - SECOND BOARD
AWARDS’ CATEGORY SECTOR
1. Pharmaniaga Berhad
KLSE Corporate Excellence Awards 2003 2.
SEG International Berhad KLSE Corporate Excellence Awards 2003
3. Khind Holdings Berhad
KLSE Corporate Sectoral Awards 2003 Consumer Products
4. Tien Wah Press Holdings Berhad
KLSE Corporate Sectoral Awards 2003 Industrial Products
5. Kumpulan Jetson Berhad
KLSE Corporate Sectoral Awards 2003 Construction
PropertyPlantation 6.
PJI Holdings Berhad KLSE Corporate Sectoral Awards 2003
TradingServices 7.
Industronics Berhad KLSE Corporate Sectoral Awards 2003
Technology 8.
Hunza Consolidation Berhad KLSE Merit Awards 2003
Consumer Products 9.
Malaysian AE Models Holdings Berhad
KLSE Merit Awards 2003 Industrial Products
10. Wong Engineering Corporation
Berhad KLSE Merit Awards 2003
Industrial Products 11.
Ahmad Zaki Resources Berhad KLSE Merit Awards 2003
ConstructionProperty Plantation
12. Nationwide Express Courier
Services Berhad KLSE Merit Awards 2003
TradingServices
1539
APPENDIX 2
Companies that were reprimandedfined by the KLSE
COMPANYS NAME DATE
NATURE YEAR ENDED
AMT OF FINE SINDORA
23-Aug-03 LS OF AAA
30 APRIL 2003 RM2,000
SELOGA 23-Oct-03
LS OF AAA 30 APRIL 2003
RM16,000 SOUTHERN PLASTIC
9-Jan-04 LS OF QR
31 MAY 2003 RM22,000
DATUK KERAMAT 9-Jul-04
LATE ANNOUNCEMENT OF WINDING UP AMTEK
7-May-04 FAIL TO ANNOUNCE TRANSACTION
DISCCOMP 20-Aug-04
LATE ANNOUNCEMENT OF RELATED PARTY TRANSACTION
PILECON 20-Feb-04
LATE ANNOUNCEMENT OF WINDING UP TANAH EMAS
19-Mar-04 OTHER
RM200,000 TIMBERWELL
5-Nov-04 LS OF AR
31 DEC 2003 RM72,000
TIMBERWELL 5-Nov-04
LS OF AAA 31 DEC 2003
RM126,000 CHUAN HUAT
26-Nov-04 INFORMATION NOT FACTUAL, CLEAR
RM50,000 SITT TATT
9-Jul-04 INFORMATION NOT FACTUAL, CLEAR
KSU 25-Jun-04
LS OF AAA 31 JULY 2003
RM200,000 KSU
9-Jul-04 LS OF AR
31 MARCH 2003 RM200,000
KSU 20-Aug-04
LS OF QR 30 SEP 2003
RM200,000 KSU
20-Aug-04 LS OF QR
31 DEC 2003 RM200,000
ANTAH 2-Mar-04
LS OF AAA 30 JUNE 2003
RM14,000 JIN LIN WOOD
24-Sep-04 LS OF QR
30 SEP 2003 RM100,000
JIN LIN WOOD 24-Sep-04
LS OF QR 31 DEC 2003
RM47,500 JIN LIN WOOD
24-Sep-04 LS OF AAA
30 JUNE 2003 RM100,000
JIN LIN WOOD 24-Sep-04
LS OF AR 30 JUNE 2003
RM125,000 SETEGAP
17-Sep-04 LS OF AAA
31 DEC 2003 RM5,000
LIEN HOE CORP. 20-Aug-04
LS OF QR 31 DEC 2003
RM3,000 GLOBETRONICS
03-Oct-03 OTHER
GENERAL SOIL 9-Feb-04
LATE ANNOUNMENT OF WINDING UP CONSOL. FARM
5-Nov-04 OTHER
AVANGARDE 3-Jan-05
LS OF AR 31 DEC 2003
2002 RM165,000
AVANGARDE 3-Jan-05
LS OF AAA 31 DEC 2003
2002 RM160,000
BUKIT KATIL 11-Mar-05
LS OF AR AR 30 JUNE 2003
RM200,000 BUKIT KATIL
11-Mar-05 LS OF AAA
AAA 30 JUNE 2003 RM200,000
INDICATOR LS OF QR = LATE SUBMISSION OF QUARTERLY REPORT
LS OF AAA = LATE SUBMISSION OF ANNUAL AUDITED ACCOUNT LS OF AR = LATE SUBMISSION OF ANNUAL REPORT
1540
APPENDIX 3 The recipients of Qualified Audit Report for the year 2003
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1545
Table 1- Sample Characteristics
Type of auditor Distress
indicator AC chairperson
is directors in other listed
companies AC chairperson
is both independent and financial expert
Non- Big-3
Big-3 No
Yes No
Yes No
Yes Good
quality financial
reporting n
10 26
24 12
10 26
28 8
percent 27
73 67
33 28
72 78
22 Poor
quality financial
reporting n
17 15
4 28
11 21
21 11
percent 53
47 12
88 36
66 66
34 Total
n 27
41 28
40 21
47 49
19 percent
40 60
41 59
31 69
72 28
Companies with good quality financial reporting are winners of 2003 KLSE Awards, whilst companies with poor quality financial reporting are violators of the Stock Exchange Listing Requirements or recipients of disclaimer audit
opinion, Big-3 consists of Ernst and Young, KPMG or PricewaterhouseCoopers.
Distress companies have Altman Z-score below 2.07 see footnote 6.
1546
Table 2 - Descriptive Statistics
The top figure is for equal variances assumed and the bottom figure is for equal variances not assumed. p .05 2-tailed.
The independent variables are defined as follows: ACSIZE denotes audit committee size, ACIND denotes the proportion of audit committee members who are independent directors, ACLIT denotes the proportion of audit committee members
who are financial experts i.e. members of professional accounting bodies, ACFREQ denotes the number of audit committee meetings held during the year, ACATT denotes the percentage of members who attended the audit
committee meetings during the year, ACMULT denotes the percentage of audit committee members who are also directors in other listed companies, Z-SCORE is based on Altman model see footnote 6, ROA is net income divided
by total assets, and FIRMSIZE is the natural log of total assets. ACSIZE
ACIND ACLIT
ACFREQ ACATT
ACMULT Z-SCORE
ROA FIRMSIZE
Good N =
36 Mean
4.08 0.76
0.31 4.75
0.94 0.63
3.86 0.053
13.74
Minimum 3.00
0.50 0.17
4.00 0.80
0.00 0.67
-0.07 11.00
Maximum 6.00
1.00 0.67
8.00 1.00
1.00 14.24
0.38 17.14
Poor N =
32 Mean
3.47 0.69
0.33 4.75
0.91 0.56
-13.11 -0.40
11.81
Minimum 3
0.5 0.00
2.00 0.40
0.00 -345.00
-4.15 7.22
Maximum 5
1.0 0.67
11.00 1.00
1.00 9.69
1.05 14.47
Good vs.
Poor t-test
difference in means
3.59 3.64
2.49 2.54
-0.70 -0.69
0.00 0.00
1.43 1.37
0.90 0.89
1.67 1.57
2.94 2.77
4.97 4.99
Total N =
68 Mean
3.79 0.73
0.32 4.75
0.93 0.60
-4.12 -0.16
12.83 Minimum
3.00 0.50
0.00 2.00
0.40 0.00
-345 -4.15
7.22 Maximum
6.00 1.00
0.67 11.00
1.00 1.00
14.24 1.05
17.14
1547
Table 3 - Correlations
1 2
3 4
5 6
7 8
9 10
11 12
1. ACSIZE
-0.04 -0.10
0.01 -0.30
0.20 -0.18
0.03 -0.15
0.22 0.19
0.46
2. ACIND 0.22
-0.18 0.05
0.05 0.25
-0.05 0.12
-0.25 0.11
0.20 0.19
3. ACLIT
-0.32 -0.28
0.10 0.09
-0.05 0.25
0.04 0.05
0.18 -0.12
-0.23
4. ACFREQ
0.00 0.08
0.07 0.05
-0.03 0.23
-0.01 0.05
-0.09 0.06
-0.02
5. ACATT
-0.30 -0.16
0.18 -0.14
-0.05 0.12
0.11 -0.15
-0.12 0.04
0.02
6. ACMULT
0.24 0.28
-0.13 0.02
-0.08 -0.04
0.57
-0.10 0.02
0.05
0.28
7. ACCHINDLIT
-0.16 -0.02
0.27 0.30
0.06 -0.05
0.13 0.12
-0.10 -0.12
-0.15
8. ACCHMULT
0.02 0.20
-0.02 0.06
0.00
0.54
0.13 -0.11
-0.02 -0.14
-0.01
9. DISTRESS
-0.14 -0.24
0.11 -0.08
-0.12 -0.09
0.12 -0.11
-0.13 -0.26
-0.20
10. BIG-3
0.24
0.13 0.07
-0.04 -0.06
0.03 -0.10
-0.02 -0.13
0.29 0.28
11. ROA
0.29 0.27
-0.24 -0.06
0.21 0.11
-0.25 0.04
-0.62 0.35
0.31
12. FIRMSIZE
0.43
0.22
-0.37
-0.02 -0.04
0.26
-0.15 -0.01
-0.20
0.27 0.47
Pearson diagonal up and Spearman diagonal down. Correlation in boldfaced indicatessignificant at the 0.05 level 2-tailed.
The independent variables are defined as follows: ACSIZE denotes audit committee size, ACIND denotes the proportion of audit committee members who are independent directors, ACLIT denotes the proportion of audit committee members who are financial experts i.e. members of professional accounting bodies, ACFREQ denotes the number of
audit committee meetings held during the year, ACATT denotes the percentage of members who attended the audit committee meetings during the year, ACMULT denotes the percentage of audit committee members who are also directors in other listed companies, ACCHINDLIT takes a value of 1 if audit committee chairman is both independent and a
financial expert and 0 otherwise, ACCHMULT takes a value of 1 if audit committee chairman is also directors in other listed companies and 0 otherwise, DISTRESS takes the value of 1 if the Z-score is below 2.07 based on the widely used Altman 1993 distress model see footnote 6, BIG-3 takes a value of 1 if the company is audited by Ernst and
Young, KPMG or PricewaterhouseCoopers and 0 otherwise, ROA is net income divided by total assets, and FIRMSIZE is the natural log of total assets.
1548
Table 4 - Logistic Regression
Dependent Variable = α + ∑βAudit Committee Attributes + πDistress +
∑µControls + ε
Model 1 Model 2
Model 3 Hypotheses
and Expected sign
Coefficient estimate
Coefficient estimate
Coefficient estimate
ACSIZE H1 +
1.35 2.06
1.25 ACIND
H2 + 6.80
ACFREQ H3a +
0.21 ACATT
H3b + 10.44
ACLIT H4 +
3.81 ACMULT
H5 ? -1.40
DISTRESS H6 -
-2.68 -2.86
-2.76 ACCHINDLIT
0.44 ACCHMULT
-0.11 BIG-3
-0.07 -0.08
0.11 ROA
6.41 6.10
5.96 FIRMSIZE
1.07 1.14
0.99 Constant
Nagelkerke R squared Hosmer-Lemeshow chi-square
Percentage correct -22.75
0.76 9.35
88.2 -29.70
0.77 7.95
86.8 -15.25
0.74 2.74
86.8
p .05.
The dependent variable = 1, if the company has been awarded the KLSE Awards, and 0 if the company has received a public reprimand with or without fines imposed by the Stock Exchange or disclaimer audit opinion.
The independent variables are defined as follows: ACSIZE denotes audit committee size, ACIND denotes the proportion of audit committee members who are independent directors, ACLIT denotes the proportion of audit
committee members who are financial experts i.e. members of professional accounting bodies, ACFREQ denotes the number of audit committee meetings held during the year, ACATT denotes the percentage of members who
attended the audit committee meetings during the year, ACMULT denotes the percentage of audit committee members who are also directors in other listed companies, ACCHINDLIT takes a value of 1 if audit committee
1549
chairman is both independent and a financial expert and 0 otherwise, ACCHMULT takes a value of 1 if audit committee chairman is also directors in other listed companies and 0 otherwise, DISTRESS takes the value of 1 if the Z-score is below
2.07 based on the widely used Altman 1993 distress model see footnote 6, BIG-3 takes a value of 1 if the company is audited by Ernst and Young, KPMG or PricewaterhouseCoopers and 0 otherwise, ROA is net income divided by total assets,
and FIRMSIZE is the natural log of total assets.
1550
5.2 Islamic Accounting, Banking and Finance
THE IMPACT OF RUHIYAH ASPECTS ON THE ASSESSMENT OF FINANCIAL PERFORMANCE HEALTH ON BMTS IN RESIDENCY
OF BANYUMAS, CENTRAL JAVA, INDONESIA
Muhammad Akhyar Adnan , International Islamic University Malaysia
Permata Ulfah, Sudirman State University Indonesia
Abstract The aim of the research is to analyze the impact of ruhiyah aspects on financial performance
in the health assessment of Baitul Maal [wa at]Tamweels BMT – the shariah micro
financing units – in Residency of Banyumas, Central Java, Indonesia. Four ruhiyah aspects
were examined in the study, which include: vision-mission, social sensibility, sense of belonging, and application of Shariah principles.
All 43 BMTs in Residency of Banyumas were initially targeted as respondents. However, after applying some criteria set up, only 27 units of them were selected to be samples of
research. The primary data were collected by distributing the questionnaires; the secondary data were based on their annual reports.
The study found that four above mentioned aspects have simultaneously significant impacts on the financial performance. Each variable has also been found to have a significant effect
individually. In spite of the results above, the other finding that needs to be emphasized here is that the
Shariah principles are rarely applied by the management of the BMTs. Simplicity, easiness, and risk minimizing, are the reasons often held by the management. It is obvious that the main
principles on which BMTs were initially based are ignored. Keywords: BMT, shariah micro financing unit, ruhiyah aspects, financial performance, health
levels, Indonesia. BACKGROUNDS
The World Conference of Islamic Countries, 21-27 April 1969, had a positive impact in fostering Islamic banks in many countries. After establishment of Islamic Development Bank
1551 in 1975, more than 200 Islamic financial institutions have also been established and recorded
about fifteen years after. They are speared not only in the countries where Muslims constitute the majority, but also in some countries where Muslims are minority [Adnan, 1996; Muallim,
2007] In Indonesia, on the initiatives of the Majlis Ulama Indonesia MUI and some Muslim
entrepreneurs, the first Islamic bank, Bank Muamalat Indonesia, was founded with reference to the Undang-undang RI No. 7 Tahun 1992 Banking Act No.7, 1992. In 1998, a revision of
the Act was passed to be Undang-undang RI No. 10 Banking Act No. 10 on Revision of Banking Act No. 7. On this basis, the Shariah banking has been admitted legally to be a sub-
system of the national banking system. According to Banking Act No. 10, 1998 the bank industry in Indonesia is classified into
two types. One is a general bank, and the other is a rural bank Bank Perkreditan Rakyat, abbreviated as BPR. The same classification is also applied for the Shariah bank industry,
with additional shariah terms added to the name of bank, such as Bank Shariah Mandiri BSM established in Jakarta and has many branches located throughout many other cities in
the country, and BPR Shariah Dana Hidayatullah in Yogyakarta. Beyond above classification, the unique micro Islamic financial institutions also exist in
the country. They are called as the Baitul Maal [wa at] Tamwils [commonly abbreviated as BMT. Legally, most of them apply the cooperative entity forms, but operationally, they look
like more [Shariah] banks in general. Ideally, the BMTs were founded mainly to serve social and local interests who have no access to the formal banking industry, and not merely aimed
at profit generating entities like many other micro financial institutions [See: Adnan, 2003]. The term ―Baitul εal‖ or ―a pool of third party‘s funds‖ means a place for everyone who
cares of social surroundings to save his or her money.
According to Pusat Inkubasi Bisnis dan Usaha Kecil Center for Incubation of Small- business and Enterprises
– abbreviated as PINBUK, although there are more than 3000 BMTs at the end of 2005, a far more higher number than that of 1997 1501 BMTs, owned
only below Rp. 1 trillion of assets [Pinbuk, undated]. The growth of BMTs is not always encouraging. Some of them were collapsed. The failure is caused by, first, unskilled
management [Adnan, 2003] which could be indicated by the high non-performing loan. Second is poor management supervision, in particular the fund management supervision. The
situation is worsened by the lack of management‘s sense of belonging. However, some exceptions also exist. For example is the BMT Ben Taqwa in Central Java. It has been
growing remarkably and controlling the assets of around thirty trillions rupiahs Agustianto, 2008.
1552 In the middle of flourishing conventional institutions, the trust is a crucial issue directly
connected to BMTs. Indonesian Minister of Cooperation and Small and Medium Enterprises, Surya Dharma Ali, urges that the performance of BMTs needs to be improved, especially in
term of Shariah concept application. Collateral should not be an absolute requirement in credit or financing proposal, but in reality, it is strictly required.
PINBUK defines that the health level of BMT is its performance and quality which are seen from important factors that directly impact on the development of BMT, both in a short
term and long term. There are two main aspects of the level, jasadiyah physical and ruhiyah spiritual PINBUK, undated.
The Jasadiyah aspects include the financial performance, institutional structure and management. The Ruhiyah aspects include the vision-mission, social sensibility, sense of
belonging, and application of Shariah principles which must be complying with the shar‟iah
rules, based on the Holy Quran and Tradition or ahadith. Some studies might have been focused to the jasadiyah issues. However, very little studies if any have been conducted to
look at the ruhiyah issues, particularly in the case of the BMT, or micro Islamic financial institutions. This is among the reasons why this research was done.
Research Problems Three important questions are set to study this issue. They are as follows: First, are the
ruhiyah aspects affect simultaneously on the BMTs financial performance the jasadiyah
aspect? Second: are the ruhiyah aspects impacts partially the financial performance? And finally: Which is ruhiyah aspect among the four that we have identified that has the most
significant impact on the financial performance? Objectives
The objectives of this study are: 1. To know how significant the ruhiyah aspects impact simultaneously on the jasadiyah
aspect financial performance. 2. To know how significant the ruhiyah aspects impact partially on the jasadiyah aspect
financial performance. 3. To know which ruhiyah variable that has the most significant impact on the jasadiyah
aspect financial performance. Contribution of the Research
Upon the completion of the research, it is expected that it would be contributing the following:
1553 1.
To provide the BεT‘s management a general overview of factors influencing the financial performance. The research findings can be expected as a supporting
consideration in the effort of sustaining or even improving the BεT‘s performance.
2. To provide the management of BMTs the reliable information of variables in the research those are closely related to the financial performance.
3. To provide the management of BMT an alternative resource to which the management might refer in determining the most important variable influencing the performance.
Theoretical Framework and Hypothesis Shariah banking is a banking system that promotes morality and ethics. Values adopted
in its operation are based on the basic characteristic of Prophet Muhammad pbuh, which includes the siddiq honesty, istiqomah consistent, fathonah smartness, amanah
trustworthiness, and tabligh ability to deliver principles See also: Adnan 2006 in
Sulaiman, M. and Nik Nazli Nik Ahmad, 2008. In addition, the cooperation ta‟awun,
profesionalism ri‟ayah, and responsibility mas‟o-liyah, are other values that must be
observed, as also guided in both the Quran‘s verses and Ahadith. There are five interconnected factors that should be concerned in building a healthy
BMT; these include the owner and management, customers and local community, competitors, regulators and supervisions, and infrastructures Sudarsono, 2007.
The roles of BMTs as supporting agents for small enterprises are influenced by their health levels. A healthy BMT is a trusted, safe, and beneficial one. A BMT with an unhealthy
predicate indicates that there is something wrong, not only in term of management and institutionalism, but also in that of Shariah aspect.
A research conducted by team Kofesmeid 2000 discovers that financial performance of BMTs is strictly connected to human resources they employ. The human resource is the
main crucial issue faced by most of BMTs researched. The same finding was resulted by the team BεT Center Dompet Dhuafa Republika‘s research. The later shows that bad financial
condition is caused by poor management of BMTs.
There are two main aspects of health assessed, jasadiyah and ruhiyah. The first includes financial performance or the capability of BMTs in managing funds accurately and smartly to
ensure sustaining operation and profit generating, both in a short term and long term. The second covers institutionalism, or, the readiness of BMTs to perform their operations from the
perspective of the availability and quality of rules and mechanism in planning, implementation, advancement, supervision, human development, and so on, and management,
or, the readiness of BMTs to perform day-to-day operations.
1554 Ruhiyah
value is everyone‘s awareness of his or her existence as a creation of Allah makhluq, by which he or she must always be conscious of the presence of Allah in every
breath by consistently obeying what He wants. The ruhiyah aspects includes, fisrt: vision-mission; second: social sensibility; third:
sense of belonging; fourth: application of Shariah principles. Vision, according to David β00β, is a long term wish and desire, ―What do we want to
become”. Vision-mission has important roles in achieving defined objectives. Mission is the objectives or reasons why an organization lives. It is statements on what and how to achieve
the objectives Hunger et al, 2002. Social sensibility is how responsive founders, management, and all members of a BMT
are in caring of the surroundings, especially, local Muslim community. It is a fundamental basis for sustaining growth of the BMT as it is directly related to reputation and trust
Pambudi, 2007. Sense of belonging, according to Robbins 1988, is a condition where personnel take
the side of his organization with all its objectives. In line with Robbins, Gibson and Ivancevich 1λλ6 define the sense of belonging as one‘s commitment, partiality, and loyalty,
to certain organizations.
The research analyzes financial performance of BMTs in Residency of Banyumas from the point of view of the ruhiyah aspects. Two points are emphasized here, first, is to describe
the measurement of the performance in the health assessment of BMTs used PINBUK standard that is slightly different from Bank Indonesia Central Bank standard. Second, is to
scrutinize the relation between the ruhiyah aspects of management and the financial performance of BMTs in Residency of Banyumas that consists of four districts.
Hypotheses Three hypotheses are developed to be examined in the study. They are:
1. The ruhiyah aspects have a simultaneous impact on the jasadiyah aspect i.e. financial performance
2. The ruhiyah aspects have a partial impacts on the jasadiyah aspect i.e. financial performance
3. The variable of Vision-Mission have the most significant impact on the jasadiyah aspect i.e. financial performance
1555 RESEARCH METHOD
Population and Samples The population of the research is all BMTs located in the Residency of Banyumas,
Central Java, Indonesia. The samples were determined by non-probabilistic purposive sampling
or judgment sampling with the criterion of minimum 3 years of operation. There are 27 of 43 MBTs in Residency of Banyumas that comply with the criterion.
Data Type The primary data are obtained from questionnaires distributed to respondents, which
include the founders, management, and local leaders of where the BMT is located. The questionnaires were designed using the Likert scale with 5 alternative answers. The secondary
data are financial statements of 2005-2006 and other related information obtained from the BMT management.
Variables The independent variables are:
1. The vision-mission of the BMT with the proxy questions on what opinion the founders, management, and all staff members who have the important positions and roles of
BMTs. 2. The social sensibility which is measured by the proxy questions on percentage of
funds allocated for qard al-hasan as compared to total financing provided, distribution of below-1-million financing to members, how active the management and members
are in contributing to BMTs, and frequency of social-religious activities held by BMTs. 3. The sense of belonging which is measured by the proxy questions on the readiness of
the founders and management to provide their additional contribution if the rush happens, degree of presence of the members in activities held, and how they pay
obligatory contribution timely. 4. The application of shariah principles with the proxy questions on how BMTs collect
and channel money from and to peoples, how to determine profit-sharing ratios, when revenue-sharing can be taking place, and who bears responsibility when loss happens
in mudarabah agreement. The independent variables measurement is conducted by providing five alternative
answers for each proposed question, ranging from: strongly agree score: 5, somewhat agree score: 4, neither agree nor disagree score: 3, somewhat disagree score: 2, and strongly
1556 disagre
e score:1. The scores are then multiplied by the weight of each question. The health level of BMTs is the results of the multiplication. See Table 1. Health Level of BMTs below:
Table 1: Health Level of BMTs No.
Scores Predicates
1 3.50-4.00
healthy 2
2.50-3.49 moderately healthy
3 1.50-2.49
slightly unhealthy 4
1.5 unhealthy
Dependent Variables Dependent variables are the BεTs‘ financial performances reflected in obtained scores
for each component of capitalization, productive assets, liquidity, efficiency, and rentability. The scores are then multiplied by the weight of each score resulting in the health level as
above. See table below for further details.
Table 2: The Assessment of jasadiyah Aspects
Financial Performance of BMTs Components
Ratios Scores
Weights Capitalization
Saving s
Party Third
Capital Total
5 5 - 15.9
16 - 25 25
1 2
3 4
20 Productive Assets
Financing Total
Financing g
min Perfor
Non Total
a.
10 6 - 10
3 - 5.9 3
1 2
3 4
25
Financing Performing
Non Financing
Off Written
Reserved b.
0 - 25 26 - 50
51 - 75 76 - 100
1 2
3 4
5
1557 Liquidity
Fund s
Party Third
Total Financing
Total
71 and 94.9 71 - 74.9 and 91 - 94.9
75 - 80.9 and 86 - 90.9 81 85.9
1 2
3 4
20 Efficiency
Revenue l
Operationa Cost
l Operationa
a. 90
76 - 90 60 - 75.9
60 1
2 3
4 5
Capital Total
Asset Total
b. 50
41 - 50 31 - 40.9
31 1
2 3
4 5
Rentability
Asset Total
Profit a.
1 1 - 1.9
2 - 3 3
1 2
3 4
13
Capital Total
Profit b.
5 5 - 15.9
16 - 25 25
1 2
3 4
7
Analysis Validity and Reliability Tests
An instrument is said to have a high validity level if its components do not deviate from the instrument function. In this research, the validity test is conducted with the product
moment correlation method. According to Iqbal 2002, the minimum requirement for a
component to be regarded as valid if r
count
is grater than r
table
. The validity test of 19 statements used in the research shows the r
count
of 0.679-0.91, is greater than r
table
0.367. The statements are, thus, regarded as valid. The reliability test to measure the reliability of the questionnaires is conducted with the alpha cronbach r-alpha
correlation method. A statement is regarded reliable if the resulted r-alpha coefficient is greater than 0.5.
The reliability test of the 19 statements results in 0.742-0.93 of r-alpha, which is greater than 0.5. The statements are, thus, regarded reliable and can be used as measurement tools.
Hypothesis Test In the research, the hypotheses are tested with Path Analysis. The analysis is used as
there are both direct and indirect causal relation trends in the models.
1558 The simultaneous impact of the ruhiyah aspects on the jasadiyah aspects financial
performance is tested with F-test. The impact is regarded as significant if F
count
is greater than F
table
. The partial impact of the ruhiyah aspects on the jasadiyah aspects is tested with t-test. If a resulted t
count
of an aspect is greater than the corresponding t
table
, the impact is regarded to be partially significant. Further, which aspect of the ruhiyah aspects that has the most significant
impact on the jasadiyah aspect is determined by observing the Path Analysis co-efficient. The aspect with the greatest coefficient has the greatest impact.
RESULTS Descriptive Statistic
The number of respondents of each BMT is five people, these include one of founders, one of management staff members, one of local leaders, and two of customers. The totals of
135 respondents were successfully contacted. They are distributed as follows: Table 3: Descriptive Statistic of Respondents
No. Characteristic
Respondents Founders
Manage- ment
Local Leaders
Members Customers
1 Sex
a. Male b. Female
27 16
11 27
36 18
Sum 27
27 27
54 2
Education a. Senior High School
b. Under Graduate c. Graduate
3 12
12 10
9 8
6 10
11 34
9 11
Sum 27
27 27
54 3
Age a. 25 years
b. 25 -35 years c. 36 -50 years
d. 50 years 10
9 6
2 6
15 5
1 8
12 7
20 21
5 8
Sum 27
27 27
54 4
Salary a. Rp 1 million
b. Rp 1 -3 millions c. Rp 3 millions
na na
na 24
3 na
na na
na na
na
Sum 27
5 Years of work in BMT
a. 1 year na
2 na
na
1559 b. 1
– 3 years c. 3
– 5 years d. 5 years
na na
na 14
4 7
na na
na na
na na
Sum 27
Ruhiyah Aspects of BMTs
The health of BMTs in the Residency of Banyumas, viewed from the ruhiyah aspects, is presented in the table below.
Table 4: The Health Level of BMTs Viewed from Ruhiyah Aspects
No. BMTs
Ruhiyah Aspects
Vision- Mission
Social Sensibility
Sense of Belonging
Application of Shariah Principles
1 A
3.540 3.307
3.747 3.480
2 B
3.568 3.216
3.104 3.248
3 C
3.640 3.590
3.460 3.320
4 D
3.840 3.520
3.700 3.800
5 E
3.920 3.600
3.920 3.800
6 F
3.888 3.992
3.648 3.376
7 G
3.847 3.953
3.747 3.587
8 H
2.937 2.990
3.493 2.789
9 I
3.710 3.670
3.240 3.500
10 J
3.690 3.393
2.880 3.333
11 K
3.644 3.512
3.488 3.424
12 L
3.393 3.447
3.347 3.240
13 M
3.566 3.806
3.726 3.371
14 N
3.660 3.330
3.240 3.500
15 O
3.150 2.540
2.600 3.200
16 P
3.880 3.247
3.427 3.293
17 Q
3.840 3.120
3.840 3.760
18 R
3.472 2.496
3.184 2.704
19 S
3.250 3.050
3.440 3.300
20 T
3.560 3.624
3.728 3.072
21 U
3.667 2.920
3.147 2.947
22 V
3.048 3.120
2.592 2.944
23 W
2.920 3.040
2.720 2.912
24 X
3.155 2.965
2.990 2.950
25 Y
3.263 3.223
3.246 3.154
26 Z
3.153 3.007
3.067 2.960
27 AA
3.116 3.129
2.933 3.129
1560 Maximum
3.920 3.992
3.920 3.800
Minimum 2.920
2.496 2.592
2.704 Average
3.493 3.289
3.320 3.263
The table above shows that the health level of Vision-Mission aspect of BMTs in Residency of Banyumas on average is moderately healthy with the point of 3.493. There is no
BMT with less than 2.49. Since the minimum point is 2.920, this means that none of BMTs in Banyumas can be classified as slightly unhealthy or unhealthy. The table also shows that
seventeen of them have a healthy category. The Social Sensibility variable shows the same results with the average point of 3.289
moderately healthy. No BMT with the level of slightly unhealthy or unhealthy is found. The healthy
category is achieved by nine BMTs with the points greater than 3.5. In regards to the third variable, that is the sense of belonging, there is again none of
BMT is found to be classified as slightly unhealthy or unhealthy. As indicated by the figures in the table, eight of them can be categorized as healthy.
The application of Shariah Principles is the most important aspect as it is the spirit of BMTs that makes them different from other small or micro sized financial institutions. How
to determine profit sharing ratios, who bears responsibility when loss happens, and what rules to obey in running the operation, are all based on the said principles. The results show that
there is no BMT in the Residency of Banyumas that does not respect the principles. In terms of the application, average point of 3.263 moderately healthy is achieved by the BMTs. It
means that they have great concerns to apply the Shariah laws. Six of them have, in fact, respected the laws very much as indicated by the points recorded that are greater than 3.5
healthy.
Jasadiyah Aspects Financial Performance of BMTs
1561 Based on the method described in Table 5, the assessment of
jasadiyah aspects financial performance of BMTs, the health levels of the BMTs
’
financial performances are presented in the following table. The levels are obtained by adding up all the components
’ health levels.
Table 5: The health levels of The BMTs
’s Financial Performances
No. BMTs Components
Health Levels
Capitali- zation
Productive Assets
Liquidity Efficiency Renta-
bility Sum
1 A
0.80 0.85
0.60 0.20
0.80 3.25
MH 2
B 0.80
0.80 0.60
0.25 0.53
2.98 MH
3 C
0.80 0.90
0.20 0.25
0.20 2.35
SUH 4
D 0.80
0.30 0.80
0.20 0.73
2.83 MH
5 E
0.60 0.65
0.80 0.25
0.40 2.70
MH 6
F 0.40
0.55 0.20
0.10 0.20
1.45 UH
7 G
0.40 0.80
0.80 0.15
0.67 2.82
MH 8
H 0.40
0.70 0.20
0.25 0.80
2.35 SUH
9 I
0.20 0.60
0.20 0.10
0.41 1.51
SUH 10
J 0.60
0.55 0.80
0.25 0.80
3.00 MH
11 K
0.60 0.65
0.80 0.20
0.46 2.71
MH 12
L 0.40
0.55 0.60
0.15 0.20
1.90 SUH
13 M
0.40 0.55
0.80 0.20
0.47 2.42
SUH 14
N 0.40
0.60 0.40
0.25 0.27
1.92 SUH
15 O
0.60 0.45
0.80 0.30
0.20 2.35
SUH 16
P 0.40
0.55 0.80
0.25 0.47
2.47 SUH
17 Q
0.80 0.65
0.80 0.40
0.80 3.45
MH 18
R 0.40
0.85 0.60
0.25 0.67
2.77 MH
19 S
0.80 0.65
0.80 0.20
0.40 2.85
MH 20
T 0.40
0.80 0.60
0.15 0.80
2.75 MH
21 U
0.60 0.80
0.60 0.30
0.60 2.90
MH 22
V 0.60
0.95 0.60
0.40 0.27
2.82 MH
23 W
0.60 0.85
0.20 0.25
0.20 2.10
SUH 24
X 0.80
0.80 0.80
0.25 0.66
3.31 MH
25 Y
0.60 0.80
0.80 0.30
0.27 2.77
MH 26
Z 0.80
0.80 0.80
0.15 0.20
2.75 MH
27 AA
0.60 0.95
0.80 0.25
0.40 3.00
MH
Notes: H=Healthy; MH=Moderately Healthy; SUH=Slightly Unhealthy; UH=Unhealthy
1562 The table above clearly indicates that, there are only 17 of BMTs in Residency of
Banyumas achieving moderately healthy levels, and none of them is categorized as healthy.
Path Analysis The aim of this analysis is to understand the impacts of the ruhiyah
aspects‘s health levels on the jasadiyah
aspect financial performance‘s health levels. The variables to be analyzed are pictured in the table below.
Table 6: The Variables Used in Path Analysis
No. BMTs Health levels of ruhiyah aspects
Financial performance
Vision- Mission
Social Sensibility
Sense of Belonging
Application of Shariah
Principles 1
A 3.54
3.31 3.75
3.48 3.25
2 B
3.57 3.22
3.10 3.25
2.98 3
C 3.64
3.59 3.46
3.32 2.35
4 D
3.84 3.52
3.70 3.80
2.83 5
E 3.92
3.60 3.92
3.80 2.70
6 F
3.89 3.99
3.65 3.38
1.45 7
G 3.85
3.95 3.75
3.59 2.82
8 H
2.94 2.99
3.49 2.79
2.35 9
I 3.71
3.67 3.24
3.50 1.51
10 J
3.69 3.39
2.88 3.33
3.00 11
K 3.64
3.51 3.49
3.42 2.71
12 L
3.39 3.45
3.35 3.24
1.90 13
M 3.57
3.81 3.73
3.37 2.42
14 N
3.66 3.33
3.24 3.50
1.92 15
O 3.15
2.54 2.60
3.20 2.35
16 P
3.88 3.25
3.43 3.29
2.47 17
Q 3.84
3.12 3.84
3.76 3.45
18 R
3.47 2.50
3.18 2.70
2.77 19
S 3.25
3.05 3.44
3.30 2.85
20 T
3.56 3.62
3.73 3.07
2.75 21
U 3.67
2.92 3.15
2.95 2.90
22 V
3.05 3.12
2.59 2.94
2.82 23
W 2.92
3.04 2.72
2.91 2.10
24 X
3.16 2.97
2.99 2.95
3.31 25
Y 3.26
3.22 3.25
3.15 2.77
26 Z
3.15 3.01
3.07 2.96
2.75 27
AA 3.12
3.13 2.93
3.13 3.00
1563 The social research has always a degree of aptness in explaining a relationship between
variables. The relationship will not be able to be regarded as absolute causality due to unexplained variables and uncertainties. How apt the ruhiyah aspects influence on the
jasadiyah aspect is determined by R
2
. The greater R
2
, the more correct the relations. The table below shows the degree of aptness of the ruhiyah aspects have an influence over the
jasadiyah aspect.
Table 7: The Matrix of The X ruhiyah aspects
’s Impacts on The Y jasadiyah
Aspect
Impacts Aspects
Vision - Mission
Social Sensibility
Sense of Belonging
Shariah Principles
Direct 95.08
47.75 4.28
8.11 Indirect
Vision-Mission -40.87
-8.80 -19.42
Social Sensibility -40.87
8.02 10.22
Sense of Belonging -8.80
8.02 2.58
Shariah Principles -19.42
10.22 2.58
Sum of Impacts 25.99
25.12 6.08
1.49 The total sum of X‘s impacts on Y isμ β5.λ8+β5.1β+6.08+1.4λ or 58.68 percent R
2
. As it has been explained before, this indicates that from all variables that impact Y, X
represent 58.68 of them. The remaining other variables hold 41.36. The remaining are unexplained variables and uncertainties.
Hypothesis Tests Simultaneous impact of the ruhiyah aspects on the jasadiyah aspect financial
performance is tested with F-test with significance of λ5 α = 0.05. The result shows that
F
count
is 5.3183, greater than F
table
2.73. It means all the ruhiyah aspects do simultaneously have a significant impact on the jasadiyah aspect.
Partial test of each ruhiyah aspect is conducted by t- test with significance of λ5 α =
0.05, resulting in the outcome below. Table 8: The Result of Partial t-test on each The
ruhiyah Aspect Variables
p YX
i
t
count
Vision-Mission X
1
-0,9751 -6,6632
Social Sensibility X
2
0,6910 5,19495
Sense of Belonging X
3
0,2069 1,74743
1564 Shariah Principles X
4
0.2848 2,06929
Based on the table above, Vision- εission‘s t
count
is less than t
abel
. Each of the other three variables has t
count
greater than t
table
. It means all the four variables have significant impacts respectively on the financial performance. By comparing each path coefficient of the variables,
it is obvious that pYX
2
, pYX
3
, pYX
4
pYX
1
, meaning that Vision-Mission is the variable with the most significant impact on the financial performance.
The table also shows that Application of Shariah Principles is the variable with the smallest coefficient. It is in line with the evident that some or many BMTs used to operate the
entity closer to the conventional principles than complying with the Shariah rules purely. This include the treatment of money as a traded commodity, rather than means of payment,
treating the mudarabah savings and deposits accounts with monthly fixed interests that are relatively equal to that of conventional banks, whether consumers agree or do not agree with.
These have been regarded as the simplest and easiest way as the customers do not fully understand yet the Shariah techniques the BMTs try to apply.
In term of credit channeling, the BMTs often face a dilemma. In one hand customers needs the mudarabah and musharakah financing with an agreement of both profit and loss
sharing as emphasized by the Shariah rules, on the other hand the management has to carefully place client‘s funds in safe instruments with zero losses. The management merely
offers the profit sharing schemas, and avoids the loss sharing schemes. This is among the
reasons why most BMTs tend not to offer the mudarabah and musharakah products. As a result, they devote their efforts mainly to seek profit, and set aside social and
religious missions at which their institutions are initially aimed. The reasons are: a. The Shariah principles are still relatively difficult to be applied in the operations when,
at the same time, consumers need easy, express, simple, and satisfying services. b. Consumers have not yet fully understand the sharing systems, while the management
reluctantly socializes the matter due to their limited knowledge. CONCLUSIONS
Based on previous data analysis, the following findings are offered: 1. All the ruhiyah aspects have moderately healthy levels with the points of 3.493, 3.289,
3.320, and 3.263, for Vision-Mission, Social Sensibility, Sense of Belonging, and Application of Shariah principles indicators respectively.
2. In term of financial performance, from all the selected BMTs, 17 of them 63 have moderately healthy predicates with the average point of 2.921, 33 bear slightly
unhealthy with the point of 2.152, and 1 BMT 4 is classified as unhealthy.
1565 3. All the ruhiyah aspects have a simultaneous impact on the financial performance with
F
count
of 5.3183 greater than F
table
2.73. 4. Each of the ruhiyah aspects has a significant impact on the financial performance.
This is concluded from the resulted Vision- εission‘s t
count
-6.6632 which is less than –t
table
- 1.7, and the other three‘s those are greater than t
table
1.7. 5. Vision-Mission is the ruhiyah aspect that has the most significant impact on the
financial performance with its path coefficient β5.λ8 greater than the other three‘s coefficient Social Sensibility: 25.12; Sense of Belonging: 6.07; Application of
Shariah Principles: 1.48 IMPLICATION
In our view, the above findings might have some implications. Among other is that the imperative of ruhiyah aspects to be well understood, planned and implemented by those
BεTs‘ management and staffs. The research has proven convincingly the strong relationship between the jasadiyah and ruhiyah aspects. The reality in many cases had shown that little, if
any, of ruhiyah aspects have been into account. A failure of taking care of these aspects, undoubtedly shall affect the life of entities.
As discussed previously, the implementation of shariah principles is having the lowest score. It indicates the likelihood of disregarding the shariah principles on the operation of BMTs.
Regardless the reasons held by BMTs management, this practice can no longer be tolerated. Failure to implement the shariah principles properly might affect the fundamental well-being
of the BMT. In the medium or long run, the existence of BMT can be fading. The BMTs would be seen as indifferent to any conventional riba based micro credit entities. The basic
objectives of the establishment BMT will never be able to be reached. LIMITATIONS AND FURTHER RESEARCH SUGGESTIONS
Although we believe that the findings are important, yet we have to recognize the inherent limitations of this study. These include, first: the study area coverage. The research was
conducted in Residency of Banyumas that consists of four districts. As we have informed previously, we cover only 27 BMTs out of three more thousand BMTs scattered in the
country. Different results might be possibly obtained if the observations are expanded to other or larger areas. The validity of the conclusions is, thus, restricted merely to Residency of
Banyumas.
1566 Second, the financial ratios used in the research to measure the health level of BMTs are
based on the standards issued by PINBUK that are slightly different from that of Bank Indonesia the latter is designed to measure the health level of conventional banks. Thus,
there are possibly variables other than used in the research that impact, too, on the financial performance of the BMTs. These variables have not been regarded yet in the study. Moreover,
the financial statements periods only cover two consecutive years 2005 – 2006.
Due to these constraints, we strongly suggest that more rigorous study can be conducted to overcome the above limitations of the current study.
References
Adnan, Muhammad Akhyar, Agus Widarjono and M. Bekti Hendri Anto β00γ, ―Study on Factors Influencing Performance of The
Best Baitul Maal Wat Tamwils Bmts in Indonesia ‖, Iqtisad,
Vol. IV, No. 1, March 2003, Pp13-35. Adnan, εuhammad Akhyar 1996 ―An Investigation of Accounting
Concepts and Practice s of Islamic Banks‖. Un-published
PhD Thesis, University of Wollongong, Australia. Agustianto 2008 in agustianto.niriah.com20080430bmt-dan-
pengentasan-kemiskinan - 28k - David, Fred R., 2002, Manajemen Strategis, PT Prenhallindo, Edisi
Ketujuh, Jakarta. Gibson, James L., John M Ivanecevic and James H Donnely Jr, 1996,
Organisasi, Perilaku-Struktur-Proses, Terjemahan, Edisi ke delapan, Binarupa Aksara, Jakarta.
http:www.kompas.comkompas-cetak050910utama2038383.htm, accessed 1 Agustus 2007.
http:www.media-indonesia.comberita.asp?id=76237 accessed 1 Maret 2007
http:www.msi-uii.net accessed 13 Agustus 2007 http:www.pinbukbmt.netindex.phppinbuklsm accessed 1 Maret
2007 http:www.republika.co.idkoran_detail.asp?id=225415kat_id=269,
accessed 1 Maret 2007
1567 http:www.stie-stikubank.ac.idwebjurnaledisi_agusgus_2003
accessed 1 Maret 2007 Hunger, J. David dan Thomas L Wheleen, 2002, Manajemen Strategis
terjemahan, Andi Offset, Yogyakarta Malhotra, N. K., 1996, Marketing Research: An Applied Orientation, 2
nd
edition, Englewood Cliffs, New Jersey: Prentice Hall Inc. εu‘allim, Amir β007 ―Persepsi εasyarakat Terhadap δembaga Keuangan
Shariah‖, quoted from http:www.msi-uii.net
accessed 13 August 2007.
Muhammad, 2002, Manajemen Bank Shariah, Yogyakarta : UPP AMP YKPN
Pambudi, Sri Teguh, 2007, ―Tanggung Jawab Sosial Harus Dilakukan –
δandasan Pertumbuhan Berkelanjutan‖ http:www.kompas.comkompas-cetak060313jogja,
accessed 1 Agustus 2007
Pusat Inkubasi Bisnis Usaha Kecil, t.t, Pedoman Penilaian Kesehatan BMT: Baitul Maal wat Tamwil Balai Usaha Mandiri Terpadu,
Jakarta: PINBUK Stephen, Robbin P., 1988, Organizational Behaviour, New Prentice
Hall Inc, New Jersey Sudarsono, Heri., 2003, Bank dan Lembaga Keuangan Shariah :
Deskripsi dan Ilustrasi, Yogyakarta : Penerbit ekonisia. Sulaiman, M. and Nik Nazli Nik Ahmad, 2008, Management Accounting
Fundamentals, International Islamic University, Malaysia. Weston J. Fred and Eugene F. Brigham, 1994, Dasar-dasar Manajemen Keuangan,
Edisi ke-9, diterjemahkan oleh Alfonsus Sirait, , Jakarta : Erlangga
1568
CONVERTING A CONVENTIONAL BROKERAGE HOUSE INTO AN ISLAMIC ONE
AN APPLICATION TO THE TURKISH MARKET Sinan OkumuΒ, εarmara University
Abstract
Islamic Finance is gaining momentum worldwide not only with the wealth accumulation in Islamic societies along with the higher oil prices but also with its
asset backed structure casting out excessive uncertainty. Islamic Banking activities has been carried out by Participation Banks for the last 25 years in Turkey, however
other Islamic Finance institutions like Islamic brokerage and Islamic Insurance Takaful are quite new to Turkish market with the former introduced in 2007 and the
latter is yet to be launched. This paper lays out the ground for the conversion principles of a conventional brokerage house into an Islam compliant brokerage
house by benefiting from the experience of Inter Invest, the first Islamic brokerage house in Turkey.
I. INTRODUCTION
Islamic Finance has been recently attracting interest from both the researchers and the practitioners. Many researchers analyse Islamic Finance whether its principles
can be an alternative to crises worn global finance system. And as for the practitioners, Islamic Finance is a rapidly growing finance field with the oil driven
1569 wealth accumulation and high population growth among Muslim communities. The
industry‘s assets have grown β8 percent globally in β008 after observing an annual growth rate of 20 to 30 percent over the last ten years. However the industry growth
is expected to slow down in 2009 due to severe global crises
272
. Basically, Islamic finance relies upon trade and bans interest. Any transaction should
be based on assets like real estate and commodities. Excessive uncertainty and leverage is not allowed thus avoids speculation. Both the assets and the transaction
structure should comply with the Islamic principles. The financial structures and operations should be approved by the Shariah board religious board which is
consisted of at least three Islamic scholars
273
. There are however shortcomings of Islamic finance like the lack of uniform
interpretation and application of the Islamic principles and the shortage of the Islamic financial products. The industry is working on generally accepted Islamic principals
through associations. As for the shortage of the Islamic financial products, the number of the Islamic finance institutions is growing along with the volume of the
financial products. Also the governments across the world are tapping the Islamic finance market with asset based debt products.
272
Islamic Finance Industry Growth May Falter in 2009, Bloomberg May 7,2009
273
The Economics of Islamic Finance and Securitization, Andreas A. Jobst, February 2007
1570 Islamic Finance was first introduced in 1985 to Turkish finance market through
Islamic banks called as Participation Banks in Turkey
274
.Islamic banks has reached to 3.7 of the all banking assets, 4.7 of deposits
275
, 4.9 of credits and 4.2 of capital within 24 years of operations
276
.Participation banks channelled most of the collected deposits into credits more than the conventional banks due to the fact that
there were no available asset based government debt complying the Islamic investment principles until 2009
277
. Islamic financial system is not only limited to banks, other conventional finance
operations like brokerage, funds, insurance and the like can be carried out on Islamic principles. Yet these Islamic institutions are quite new but they have been growing
with solid steps. The following section of this paper explains the Islamic brokerage and the differing
functions between the conventional and Islamic brokerage house both on the
274
Albaraka Turk was the first Islamic bank to operate in Turkey.Currently there are 4 participation banks active.
275
Islamic Banking has serious disadvantage over the conventional banking on the deposit side.The earliest deposit maturity is one month due to the Islamic operating nature of the Participation banks,
while the conventional banks accepts overnight deposits and repurchase agreement.
276
May,2009 Bulletin, Banking Regulation and Supervision Agency BRSA
277
Turkish Treasury launched new bonds linked to income of several state agencies in January and April 2009. The participation banks showed large demand for their proprietary portfolios as well as
their clients.
1571 operational and business lines. The paper also aims to lay out the equity selection
and investments criteria for mutual funds to operate in line with the Islamic principles.
II. ISLAMIC BROKERAGE
Brokerage houses act as intermediaries between the investors and the capital markets. Islamic brokerage houses are means for Islamic investors to invest their
wealth ethically into assets complying with Islamic principles avoiding interest, manipulation speculation, excessive uncertainty, leverage and detriment to third
parties. Mostly an investor is not in a position to know whether an investment is Islam-
compliant or not. Islamic brokerage house provides information on the Islam compliancy of the investment in addition to financial advising and intermediary
services. Brokerage houses are extensively regulated and scrutinized by state or vocational
organizations
278
.Islam applies additional responsibilities on the brokerage houses in order to ensure ethical financial system. These additional responsibilities are like
freedom from interest, excessive uncertainty, gambling, unearned income, price
278
A Model of an Islamic Stockbrokerage Firm, Thomas D. Telner, www.djindexes.commdsidxdownloadstellner.pdf
1572 control and manipulation, detriment to third parties and entitlement to transact at fair
prices and equal, adequate and accurate information.
279
Islamic brokerage house carries out most of the functions of the conventional brokerage houses. It provides investors advise on investments, brokerage on
securities and commodities, manages mutual funds, real estate funds, private equity funds and discretionary portfolios. Additionally it provides corporate finance services
like IPO‘s and debt securitization. Islamic brokerage house differs from the conventional brokerages in areas like margin trading, transaction of interest bearing
bonds, transaction of equities which are not fulfilling the Islamic investment criteria. Islamic brokerage activities have gained momentum within the last ten years. Some
brokerage houses are solely offering Islamic brokerage while some of them offering both conventional and Islamic brokerage services. The banking clients of the Islamic
banks constitute solid base for the Islamic brokerage houses to offer their services. Potentially, the network among the Islamic brokerage houses around the world will
strengthen the growth of the industry to ensure the continuation of the success.
III. THE POTENTIAL OF ISLAMIC BROKERAGE IN TURKEY
A. Brokerage Business in Turkey
279
Islamic Financial Services, Mohammed Obaidullah, Islamic Economics Research Center, March 2005
1573 The number of the active brokerage houses is 88 as of March 2009 down from 99 in
2007. In the last four years the sector has gone through consolidation. International banks and investment banks acquired local firms in order to take place in developing
Turkish capital markets
280
. A typical brokerage house in Turkey provides brokerage in equity, fixed income,
derivatives and foreign securities to earn commission income. Net commission revenues constituted 55 of the brokerage firms‘ revenue which was 561 million
USD in 2008. 74 of the commission income is derived from equities, 23 from derivatives with the remaining derived from fixed income and foreign securities.
In addition to brokerage services, the firms also provide corporate finance, asset management and other services to constitute 28 of the revenue. The rest of the
income comes from the proprietary trading and interest income received from the clients.
281
Exhibit 1
Exhibit 1: Breakdown of brokerage firms‟ revenues 200812
280
The Capital Market Board of Turkey has not been issuing new licenses such that the only entrance to Turkish brokerage industry is to acquire a brokerage firm.
281
The Association of Capital Markets Intermediary Institutions of Turkey
1574
Source: The Association of Capital Markets Intermediary Institutions of Turkey
When we evaluate the breakdown of the stock trading volumes Exhibit 2 28,4 of trading is realised by domestic sales department, 25,1 by international sales
department, 14,9 by branches total 185 branches, 13,1 by bank branches 5.664 bank branches, 9,3 through internet, 5,5 by proprietary trading and the
remaining 3,6 by the other departments.
Exhibit 2: Breakdown of stock trading volumes by departments 200812
1575
Source: The Association of Capital Markets Intermediary Institutions of Turkey
Turkish brokerage industry is intensively dominated by the bank owned brokerage companies and the international investment banks.The former have the advantage of
the broader distribution network through their branches, call center and internet banking and the latter have their own international network of investors and
funds.However specialised islamic brokerage companies with islamic banking backing can built solid business in Turkey.
B. Islamic Banking in Turkey
Four Islamic banks called as Participation Banks are operative as of May 2009, constituting 3,7
282
of the all banking assets. The annualised average growth of the sector has become 30,7 within the last seven years while it has been 19,3 for the
282
May,2009 Bulletin, Banking Regulation and Supervision Agency BRSA
1576 whole banking industry. There are 682.000 deposit accounts participation accounts,
176,000 credit accounts and 758.000 credit cards with the Islamic banks.
283
Islamic banks totally have 540 branches and 11.074 employees as of first quarter of 2009.
284
Islamic banks are important pillars of the Turkish banking system with their non interest and profit loss sharing structures.
Islamic banks have long ignored the other Islamic finance institutions like brokerage and insurance. Since these banks already have client base and solid reputation of
ethical and Islamic operations, any attempt to get in to the brokerage and insurance business has a high chance welcome by the Islamic investors.
Islamic banks are warming up with the equity markets with Asya Bank and Albaraka Turk shares started trading at Istanbul Stock Exchange in recent years. Saying that
there might be more interest in providing brokerage services to their clients in the near future through either their brokerage house or some other independent Islamic
brokerage firm.
IV. CONVERSION OF A CONVENTIONAL BROKERAGE HOUSE INTO ISLAMIC ONE
283
Participation Banks within the Turkish Finance System, Osman Akyüz, β0 εarch β009, The Participation Banks Association of Turkey
284
The Participation Banks Association of Turkey
1577 The Islamic board of the Unicorn Investment Bank Bahrain based Islamic Investment
Bank requested the management of Inter Invest Turkish Brokerage House and its subsidiary Inter Asset Management in 2007 to convert the company activities to
comply with the Islamic rules within a three year period, under the condition of substantial progress in each year.
Brokerage house functions can be divided as business units and operation units.
A. Conversion of Operation Units
Operation units of a typical brokerage company are order processing, cashiering, clearing, transfer, financeaccounting, administration, internal audit, compliance, risk
management and IT. As for the conversion of operation activities, two major areas were needed for change.
1. Proprietary Accounts: All proprietary accounts in bonds and money market instruments are liquidated and deposited into participation
accounts held with Islamic Banks. Also the equities in the proprietary accounts are liquidated to invest into Islam compliant equities.
2. Collaterals Held with Istanbul Stock Exchange ISE Settlement and Custody Bank: The company had treasury bonds with Settlement and
1578 Custody Bank as collateral. The bonds were replaced by letter of
guaranty of Islamic banks.
B. Conversion of Business Units
Business units of a brokerage house are treasury cash management and proprietary trading, sales marketing domestic and international, corporate finance, asset
management and research. I. Treasury: Treasury department of a brokerage firm mainly functions in
cash management of the firm, lend or borrow money in the money markets and trade treasury bonds on behalf of the firm. Therefore,
treasury department is not allowed to lend or borrow money in the money markets and trade treasury bonds. Instead, the department uses deposit
accounts held with Islamic banks and trade income indexed government bonds when it is possible.
II. Sales Marketing: Margin trading accounts of clients were cancelled since it does not comply with Islamic principles. Derivatives and fixed
income instruments trading of clients is also not permissible in a Islamic brokerage house.
1579 The clients were able to trade in equities which fulfil the following Islamic
principles
285
.
Equity Selection Criteria-Business Lines
Companies dealing in alcohol, tobacco, pork-related products, conventional financial services, defenceweapons and entertainment
businesses are excluded from the Islamicaly investable equity list.
Equity Selection Criteria-Financial Ratios
Companies whose; -Total debt divided by trailing 12-month average market capitalization is
33 or more, -Cash plus interest-bearing securities divide by trailing 12- month
average market capitalization is 33 or more, -accounts receivables divided by 12-month average market capitalization
is 33 or more, are also excluded from the investable equity list.
The list of Islam compliant stocks in Istanbul Stock Exchange ISE will be revised after each quarter financial results for amendments. Research
285
According to the Islamic Board of Unicorn Investment Bank.
1580 department is responsible for the update of the stocks in line with the
Islamic board. There were 81 stocks approved by Islamic guidelines with total market
capitalization at 32.5 billion USD which was 31 of the ISE total.The floating market capitalization of these stocks was at 9.7 billion USD as of
November 2008. III. Corporate Finance: Corporate finance activities should also align with the
Islamic guidelines as outlined above for equities. Securitization should be based on asset and the total structure should be approved by the Islamic
board.
IV. Mutual Funds: There are basically two ways of transition of the existing mutual funds into Islamic funds.
1- Amendment of the equity funds‘ bylaws to comply with Islamic
guidelines and the closure of the money market funds and fixed income funds since they do not comply with the Islamic principles due to the lack
of asset backed, revenue sharing or profitloss sharing securities available in the Turkish market.
286
286
Turkish Treasury recently launched new bonds indexed to income of several state agencies which
1581 2- Merger of the existing funds to create an Islamic equity fund.
There are challenges to managing Islamic funds in Turkish capital markets. The fund should invest fully in equities all the time regardless of
the market condition due to the lack of Islamic debt and money market products. Also the Turkish Capital Market Board Code CMB is
restricting funds to deposit money into conventional or participation bank accounts. Investing fully in equities creates pressure on the fund returns
thus limiting the success of the fund. Investing into commodities like gold also is not a solution to the problem due to commodity price fluctuations.
Islamic funds in Turkey will be successful in Turkish market when there will be more of government and private sector Islamic debt available with
liquidity in the secondary market.
V. CONCLUSION
In this paper, we tried to explain the application process of the first of a kind conversion of a conventional brokerage house into an Islamic brokerage house in
Turkey. Islamic brokerage has not kept up pace along with the Islamic banking
comply with the Islamic investment criteria however the secondary market of the issues is not liquid. Mutual funds can not invest into illiquid securities due to uncertain redemption dates.
1582 up until recently however, today it is generally accepted as complementary to the
Islamic banking business. Brokerage business has been going through consolidation in Turkey. In order to
be successful in these growing market institutions has been looking for ways of specialization. Islamic brokerage offers high potential in parallel with rapidly
growing Islamic banking both in Turkey and worldwide. The introduction of the Islamic insurance takaful in the near future will boost the Islamic asset
management business. However, there are challenges ahead for the Islamic brokerage in Turkey. Firstly,
the lack of I slamic debt is a major obstacle for the industry‘s growth. We believe
there will be more Islamic debt issues coming to the market in the near future in order to attract more of Islamic capital in to Turkey. Secondly, an independent
Islamic brokerage house would be highly dependent to the distribution network of the existing Islamic banks in Turkey. Such a company should target to be active
in international sales and corporate finance in case it will have distribution problems for brokerage and fund management businesses. Lastly, Islamic
brokerage is not well known to investors. The industry should accelerate its efforts to promote Islamic brokerage.
1583
VI. REFERENCES
Akyüz, Osman β009 , ―Participation Banks within the Turkish Finance System‖, The Participation Banks Association of Turkey
Bader Al-Refai,Majid Al- Sayed β005, ―Challenges Facing the Islamic Financial Institutions‖,
2nd Annual Asian Islamic Banking Finance Summit Bernard, Jacques β005, ―Value Beyond Real Estate‖ ,Presentation at International Islamic
Finance Forum, Singapore Buyukdeniz, Adnan β006, ― Participation Banks in Turkey: An Economic and Social
Reality‖, Albaraka Turk Participation Bank Inc. El-
Gamal, εahmoud A.β00β, ―The Need for Adaptable Shari‘a Screening of Stocks: A case study
of equity REITs‖, Rice University Telner, Thomas D. A Model of an Islamic Stockbrokerage Firm,
www.djindexes.commdsidxdownloadstellner.pdf Jobst, Andreas A. 2007, The Economics of Islamic Finance and Securitization, Working
Paper, Journal of Structured Finance, Vol.13 No.1 Obaidullah, Mohammed 2005, Islamic Financial Services, Islamic Economics Research
Center, King Abdulaziz University Jeddah, Saudi Arabia
1584
WAQF ACCOUNTING AND THE CONSTRUCTION OF ACCOUNTABILITY
Hidayatul Ihsan
287
,Padang State Polytechnic, Indonesia Abstract
This paper aims to explore the major themes that constitute the basis of the discussion on accountability in awqaf institutions. In doing this, the theoretical underpinnings and the existing
empirical investigations relating to waqf accounting and accountability are examined. Review on waqf studies indicates the common phenomenon i.e. the absence of accounting standards for waqf.
Nevertheless, this phenomenon could be due to there is no clear consensus about accountability. Due to previous waqf studies did not capture the dynamic aspect of stakeholders, this study suggest
Mitchell, Agle and Wood MAW model to explain the nature of waqf stakeholders. By combining MAW model with Hayes accountability, this paper comes up with the proposal regarding what kind
information should be provided by mutawalli to various waqf stakeholders. Keywords: waqf accounting, accountability, MAW model, Hayes accountability
1. Introduction
Perhaps, prior to the last decade there were not many academicians realized that waqf accounting deserved to be researched. Waqf plural awqaf subject was marginal and only
attracted small number of students and researchers to investigate Hoexter, 1998; hence it is not surprising why waqf literature, including waqf accounting was hardly found. The absent
of waqf accounting might be due to some reasons, but among other things is probably because many academicians thought that there was nothing to do with accounting for waqf.
287
Hidayatul Ihsan is a lecturer at accounting department, Padang State Polytechnic, Indonesia. He is currently pursuing his study at Ph.D program in the International Islamic University Malaysia IIUM. He can be contacted through e-mail address :
hidayatul_im2yahoo.com
1585
The way of waqf is simple Rashid, 2008 hence accounting for waqf is regarded very basic besides it is not as complicated as accounting for Islamic banking and other Islamic financial
institutions Muhammad 2008. Clearly, the development of waqf institutions in the last decade is not as rapid as the development of Islamic banking. While Islamic banking has
attracted many researchers and scholars to investigate, waqf issue was left behind Ihsan and Shahul, 2007, Adnan, Maliah and Putri Nor Suad, 2007.
It has been witnessed in the last few years that the revitalization of waqf institution has been on agenda of Muslim communities around the world. Plenty international waqf
conferences
288
which were held by Islamic Development Bank IDB through its subsidiary organ the Islamic Research and Training Institute IRTI indicates a growing interest and
awareness in waqf institutions as one of the tools for community development Cajee, 2008. Along with the revival of this historic institution, the attention to the call for waqf accounting
had been emerged. The new and modern waqf management has put greater emphasize on the principles of accountability and transparency Cajee, 2008. Thus, as part of good
governance and best practices of awqaf institutions, accounting is believed can improve the accountability and transparency of the mutawalli
289
Adnan et al., 2007. Besides, accounting
288
Recently, there were a number of waqf conferences held by IRTI i.e. in Singapore 2007, Bangladesh 2007, South Africa 2007, Dubai 2008, Iran 2008 and some other countries.
289
Mutawalli is waqf manager, sometimes also called nazeer
1586
is a tool for mutawalli to discharge his accountability to many parties such as wāqif
290
, waqf board, government and community in large Ihsan and Shahul, 2007.
Studies on accounting practices in waqf institutions indicate there is diversity with regard to accounting and reporting of waqf see Abdul Rahim et al., 1999; Siti Rokyah, 2005;
Hisham, 2006 and Ihsan, 2007. Ihsan 2007 believes that the phenomenon of dissimilarity of accounting practices among awqaf institutions is due to the absence of accounting
standards for waqf. In addition, Ihsan found that the perception of mutawalli regarding responsibility and accountability influence the way of awqaf institutions produce and
disseminate accounting information. This is an interesting finding when Cordery and Morley 2005 also assert that the uncertainty over accounting practices in charitable sectors and
other not-for profit organizations is not only due to the absence of accounting standards but also because the failure to establish a widely agreed definition of accountability for that
sector. In the awqaf
context, although Hisham β006 and Ihsan β007 agree that Shahul‘s proposal of dual accountability is more appropriate for waqf, it requires further explanation as
to whether it can be implemented and measured. Indeed, defining accountability is essential as it is deemed critical to regulatory functioning Cordery and Morley, 2005. While Cutt and
290
Wāqif is waqf founder
1587
Murray 2000 state that accountability is a foundation of performance measurement, evaluation and reporting. Further, Lewis 2006 believes that accountability is a central theme
in Islam since the accountability to Allāh and the community is paramount to a εuslim‘s faith.
As asserted by Askary and Clarke 1997, the word hisab which is interrelated with account and accountable is repeated more then eight times in different verses in the Qur‘an.
Therefore this paper aims to explore the major themes that constitute the basis of the discussion on accountability in awqaf institutions. In doing this, the theoretical underpinnings
and the existing empirical investigations relating to waqf accounting and accountability are examined. To begin the discussion, the development of waqf studies in general will be
highlighted. It will be followed by the review of studies on waqf accounting in the recent years. The discourse about accountability construction in awqaf is presented before the conclusion.
2. Waqf studies as the key driver towards awqaf revitalization
In Islam, waqf is one of the principle means to alleviate the poverty problem in the society besides zakat compulsory charity and sadaqah optional charity. Kahf 2003 defines waqf
as ―…holding certain property and preserving it for the confined benefit of philanthropy and prohibiting any use or disposition of it outside its specific objective‖. Waqf can be an
effective system for poverty alleviation by improving non-income aspect such as health,
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education etc as well as increasing access to physical facilities, resources and employment Sadeq, 2002. Therefore, waqf
activities became part of εuslim‘s life in the past. Ironically, in the last one or two decades the non-Muslim scholars had paid more
attention to waqf study than Muslim scholars. It is evidenced by the inclusion of waqf subject into the M.A and B.A curricula in some universities which have specialization in Islamic
history and culture Hoexter, 1998. Some masters and PhD research on waqf were undertaken in western universities see for example Deguilhem-Schoem, 1986;
Christoffersen, 1997. Even the first international seminar on waqf which was held in Jerusalem in 1979 was organized by non-Muslim scholars.
At the mean time, waqf study in Muslim countries or majority Muslim population was not progressing very well. This is indicated by Rashid 2008 when he traced waqf literatures
which had been produced during the last 30 years from 1977 to 2007 in five countries i.e. India, Pakistan, Bangladesh, Malaysia, and Indonesia. The type of waqf materials being
reviewed were
books, published
papers, PhD
thesis, masters
dissertations, newspapersmagazines, seminar proceedings, book reviews, reports and on-line materials.
From his research Rashid found only 306 waqf materials had been produced during that time in the above-mentioned countries. Although this finding did not represent all Muslim countries,
to some extent it implies that waqf literatures are still limited and hardly found. As a matter of
