Board Composition BACKGROUND OF THE STUDY AND LITERATURE REVIEW 1 Malaysian Code on Corporate Governance

393 The board of directors‘ role as a monitoring tool is viewed as the most crucial element for effective corporate governance mechanisms to enhance the quality and integrity of accounting information see e.g. Cadbury Report, 1992; Malaysian Code on Corporate Governance, 2000; Singapore Code on Corporate Governance, 2001; Higgs Report, 2003. Fama and Jensen 1983 theorize that the board of directors is the most important internal control mechanism that is responsible to monitor the actions of top management. They represent the interests of the firm‘s shareholders by setting st rategies, policies and goals that maximize shareholders‘ wealth Fama and Jensen, 1983. From an agency theory perspective, the board of directors is used for monitoring executive opportunistic behaviour. The theory emphasises the need for greater proportion independent directors to monitor any self-interested actions by managers Nicholson and Kiel, 2007. Independent directors have more incentive to effectively monitor management because of a strong need to develop their reputations as expert decision makers Fama and Jensen, 1983. With their independence and objectivity, independent directors have the ability to resist pressure from the firm to manipulate earnings and are better able to monitor the earnings process Machuga and Teitel, 2009. Nevertheless, empirical evidence on the association between independent directors and financial reporting quality is mixed. Some studies, especially from countries with a diffused ownership structure such as US and UK, have found that having greater proportion of independent directors on the board improves financial reporting quality Beasley, 1996; Peasnell et al., 2000; 2005; Klein, 2002; Davidson et al., 2005. Other studies from countries where the ownership structure is highly concentrated, either do not have found a link between independent directors and improved firms‘ financial reporting quality Abdullah and Mohd Nasir, 2004; Park and Shin, 2004; Abdul Rahman and Mohamed Ali, 2006; Hashim and Susela, 2008a; Siregar and Utama, 2008; Machuga and Teitel, 2009 or document contrary findings with agency theory predictions Norman et al., 2005; Klein et al., 2005; Hashim and Susela, 2008b. This raises doubt as to whether the requirement for a majority of independent directors is appropriate in countries with a concentrated ownership structure, which have lack of qualified independent directors and are controlled by a single majority owner Barton et al., 2004. 394 The MCCG 2000 views that good governance rests firmly with the board of directors. The Code requires one third of the board to comprise of independent non-executive directors. The Listing Requirements stipulate that at least two directors or one third of the board, whichever is higher, must be independent. Despite the conflicting results from prior studies, it is hypothesized that: H 1 : Firms with an independent board of directors are likely to have greater earnings quality.

2.3 Board Expertise

Daily et al. β00γ suggest that over emphasis on directors‘ oversight role to the exclusion of alternative roles such as resource, service and strategy roles is one potential explanation for limited evidence from board oversight functions. To perform specified duties and responsibilities, the board members must consist of a diverse collection of skills and competencies Reilly, 2003. Having board members who lack knowledge and experience actually threatens the firm‘s overall performance due to the inability to deal with issues affecting the firm‘s business CFA Institute, β005. Three aspects of board expertise, i.e. financial, governance and firm-specific expertise as discussed by Bedard et al. 2004 are examined in this study. 2.3.1 Financial Expertise Peasnell et al. 2000 believe that the ability of non-executive directors to perform a monitoring role, in reducing earnings management activity, is only pertinent when they are capable of identifying cases of earnings management that falls within the scope of the board of directors‘ expertise. George β00γ argues that poor financial reporting quality may result from a board member who has no technical expertise. To be effective in addressing issues relating to the financial information of the company, the directors should have a sound financial background and must at least be able to read and understand the balance sheet Renton, 2003. The study by Xie et al. 2003 finds that boards of directors composed of corporate or investment-banking backgrounds are negatively related to the level of earnings management and suggests that independent directors with corporate and financial backgrounds are an important determinant of board monitoring effectiveness as they have a better understanding of how earnings are being 395 managed. Bedard et al., 2004 observe that the presence of a financial expert on the audit committee is negatively related with the likelihood of aggressive earnings management. Although Park and Shin 2004 fail to find significant evidence between board independence and accrual management, they do find evidence that the presence of officers from financial intermediaries on the board are helpful in limiting abnormal accruals when the unmanaged earnings are below the target. They suggest that experienced outside board members actually helps them understand the firms and its people better and thus enhances their governance competencies. The Blue Ribbon Panel addresses the issue of the financial sophistication of audit committee members in preventing earnings management behaviour. In Malaysia, the revised MCCG Code 2007 requires all members of audit committees to be financially literate. This is so they are able to understand and interpret financial statements to effectively fulfil their role in monitoring the company‟s system of internal control and financial reporting. Additionally, the Code also requires at least one audit committee member to be a member of an accounting association or body. It is hypothesized that: H 2 : Firms with financial expert board committee members are likely to have greater earnings quality.

2.3.2 Governance Expertise

‗Economic theory suggests that one of the main factors motivating directors to act in shareholders‘ interests is their desire to establish a reputation in the labour market for directorships, thereby increasing the value of their human capital‘ Peasnell et al. 1999, p.106. Additional directorships signal the competence of directors in the managerial labour market and provide a platform for directors to gain governance expertise Bedard et al., 2004. Governance expertise refers to the ability of the director to appreciate the differences between management and direction and to have a good understanding of the board‘s operations, including the legal framework within which they operate Renton, 2003. Additional directorships help the directors to be more transparent as well as more sensitive to protect their reputations, thus, creating an incentive for them to perform