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

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 396 well Haniffa and Cooke, 2005; Vafeas, 2005. However, this is dependent upon the time and effort they spend, as a large number of outside directors may limit the time they can devote to a particular firm, which in turn may decrease their governing effectiveness Bedard et al., 2004. In US study, Bedard et al., 2004 find that the average number of cross-directorships of independent audit committee members is significantly related to both income-increasing and income-decreasing earnings management. They find that the greater the additional number of other directorships held by board members, the lower the likelihood of earnings management activity of the firm. Similarly, a study by Norman et al. 2005 for Malaysian study reports a significant and negative association between multiple directorships and earnings management in firms with negative unmanaged earnings. They suggest that multiple directorships serve as important governance mechanisms in mitigating earnings management activity and any attempt of earnings management would jeopardize directors‘ future in the managerial labour market. For Malaysian cases, the Bursa Malaysia adopts restriction in the number of directorship per director in its listing requirement in 2002. The maximum number of directorship is ten in public companies and fifteen in private listed companies to ensure the directors to perform their duties effectively with less commitment, resources and time available Zulkafli et al., 2005. It is hypothesized that: H 3 : Firms with governance expert board committee members are likely to have greater earnings quality.

2.3.3 Firm-specific Expertise

Other important characteristics to determine the expertise of the board come from studying the impact of board tenure on financial reporting quality. Firm specific expertise is acquired through experience as a member of the board by developing more knowledge of a company‘s operations and its executive directors Bedard et al., 2004. Beasley 1996 finds negative and significant association between the number of years of board service for outside directors and the likelihood of financial statement fraud. He believes that the ability of boards to monitor management effectively is consistent with the increased number of years they serve. 397 Nevertheless, Vafeas 2005 identifies conflicting theoretical views on the impact of independent director tenure length and board effectiveness. While longer average tenure is associated with greater experience and knowledge about the firm‘s operation, she argues that too long a board service in the same company will compromise their independence as they are more likely to befriend management and be less critical about the quality of financial reporting. A survey by Peasnell et al. 1999 finds that on average the length of tenure for non-executive directors in the UK is five years with twenty five percent of the sample having served the company more than six and a half years. Their findings cast doubts about the independence of the board who serve on boards too long. Xie et al. 2003 find that the longer the tenure of directors, the less effective they became as they may co-opt with management. They find a positive instead of negative relationship between board tenure and the level of discretionary accruals. Despite the conflicting results from prior studies, it is hypothesized that: H 4 : Firms with firm-specific expert board committee members are likely to have greater earnings quality.

3. METHODOLOGY

3.1 Sample Selection The initial sample of the study consists of all companies that were listed on the Main Board of Bursa Malaysia for the period 1998 to 2006. At the end of the year 2006, there were 649 financial and non-financial companies listed on the Main Board. Due to different statutory requirements, all banks, insurance and unit trusts companies as well as utility companies were excluded from the population of interest, reducing the sample size to 592 non-financial companies. For a sample of three years period, nine years complete accounting data, t = 1998- 2006 is required to estimate accrual quality. For that reason, the number of data observations is further reduced to 424 non-financial companies with complete data for current assets, current liabilities, cash, change in debt in current liabilities, cash flow from operations, revenues and property, plant and equipment. A firm is included in the year t sample if data is available for year‘s t-4 to t. Any firms that were de-listed within 398 years 1998 to 2005 were also excluded from the population of interest due to incomplete data. As consistent with prior research Davidson et al., 2005; Abdul Rahman and Mohamed Ali, 2006 industries with less than 8 firms were also eliminated from the analysis. Further, 139 companies were excluded as the required financial and corporate governance data was not available, resulting in a final sample of 277 companies from 2003 to 2005, giving a total of 831 firm-year observations with complete data for earnings quality and board of directors‘ characteristics. 3.2 Regression Model This study uses a linear multiple regression analysis to test the association between the dependent variable of earnings quality and the independent variable of board independence, board financial expertise, board governance expertise and board firm- specific expertise. EQ =  +  1 BIND +  2 BDFINEXP +  3 BDCROSS +  4 BDTENURE +  5 BDSIZE +  6 LNSALES +  7 LEV +  8 ROA +  9 BIG4 +  10 DUM_YR04 +  11 DUM_YR05 + … 1 Where: EQ = measured by accrual quality based on Dechow and Dichev 2002 model BIND = proportion of independent non-executive directors to the total number of directors on the board of the company BDFINEXP = proportion of directors on the board with financial expertise to the total number of directors BDCROSS = proportion of directors on the board, with directorships in other companies, to the total number of directors. BDTENURE = average number of years of board service of independent non- executive Directors BDSIZE = total number of directors on the board of company LNSALES = natural log of total sales LEV = ratio of total liabilities to total assets ROA = ratio of net income to total assets BIG4 = dummy variable, 1 if audited by Big 4 audit firms, 0 if otherwise As prior studies, this study includes board size, firm size, leverage, firm growth and audit quality as control variables in the regression model as these variables have been shown to have impact on earnings quality Wang, 2006; Jaggi et al., 2007.