Hypothesis Development Executive Compensation and Evaluation EXE_EVAL

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. REFERENCES 1. Davies, Mike, Ron Paterson and Allister Wilson 1994, UK GAAP, MacMillan Press Ltd, Basingstoke, England, Fourth Edition. 2. Beaver, W.H. and R.E. Dukes 1972. Interperiod Tax Allocation, Earnings Expectations, and the Behaviour of Security Prices. Accounting Review 48 April: 170-187. 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. Journal of Financial and Quantitative Analysis, December: 391-405 7. Mayers, D. and C. Smith 1987. Corporate Insurance and the Underinvestmetn Problems . Journal of Risk and Insurance, 54:45-54. 8. Bessembinder, H. 1991. Forward Contracts and Firm Value: Investment Incentives and Contracting Effects. Journal of Financial and Quantitative Analysis, December: 519-532 9. Froot, K.A., G.S. Hyatt, R.C. Marston, and C.W. Smithson 1995. Risk Management : Coordinating Corporate Investment and Financing Policies . Journal of Finance, December: 1629-1659 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 13. Megginson, L. William 1997. Corporate Finance Theory. Addison – Wesley 14. 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