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JAEE
10,1 Effect of audit committee
independence, board ethnicity and
family ownership on earnings
74 management in Malaysia
Received 1 January 2019
Revised 3 August 2019
Wan Masliza Wan Mohammad
11 November 2019 College of Business Administration, University of Bahrain, Sakheer, Bahrain, and
Accepted 12 November 2019
Shaista Wasiuzzaman
School of Business,
Universiti Teknologi Brunei, Brunei-Muara, Brunei Darussalam

Abstract
Purpose – The purpose of this paper is to investigate the effect of audit committee independence, board
ethnicity and family ownership on earnings management in Malaysia.
Design/methodology/approach – The effect of audit committee independence, board ethnicity and family
ownership on corporate governance is investigated via 1,206 firm-year observations between the fiscal years
of 2004 and 2009 of Bursa Malaysia listed firms. Panel data regression analysis is used to analyze the
relationship.
Findings – The findings of this study fail to associate the role of audit committee independence as proposed
under RMCCG (2007) in curtailing earnings management activities, thus supporting the findings on power
distance scores that power granted to the top management may result in less effective independent directors.
Nonetheless, in support of the alignment effect theory, family ownership is found to reduce earnings
management activities. The findings show that corporate governance is more effective in developing country
family firms due to their long history of family reputation and the importance of institutional culture factors.
Research limitations/implications – This study focuses on board ethnicity, family ownership and its
influence on earnings management.
Originality/value – This study offers insights into the importance of family institutional structures on
corporate governance reforms in Malaysia as Malaysian family firms are mostly traditional firms that have
built their reputation and strength in the industry for many generations.
Keywords Earnings management, Ethnicity, Corporate governance, Family ownership, Audit committee
Paper type Research paper

Journal of Accounting in Emerging
Economies
Vol. 10 No. 1, 2020
pp. 74-99
© Emerald Publishing Limited
2042-1168
DOI 10.1108/JAEE-01-2019-0001
1. Introduction
Numerous prior studies have tackled the issue of audit committee and earnings
management in various types of corporate environment via various methodologies (Ghafran
and O’Sullivan, 2013). In most studies, it is widely acknowledged that experienced audit
committee members improve financial reporting (Davidson et al., 2005). However, little
attention has been given to some of the findings from previous studies on the ceremonial
role of audit committees and their ineffectiveness in executing their tasks (Spira, 1999;
Fearnley et al., 2011). For instance, Fearnley et al. (2011) found that 41 percent of financial
statement issues are discussed only with Chief Financial Officers and audit partners without
the involvement of audit committee members perhaps due to their lack of commitment and
authority to effectively execute their tasks. Additionally, in terms of audit committee
members’ credibility, KPMG (2013) reported that in Malaysia, the appointment of
independent directors in audit committees is actually based on their influence and network
rather than their technical expertise (KPMG, 2013). This is evidence that the corporate
The authors would like to thank the anonymous reviewers and the editor for their constructive
feedback which greatly benefited this paper.
community in Malaysia favors business and political connections to enable access to Effect of audit
business opportunities (Abdul Wahab et al., 2017; Faccio et al., 2006). It is also reported that, committee
in year 2009, most independent directors in the top 300 companies listed on Bursa Malaysia independence
were either retired civil servants or former politicians (KPMG, 2013). The appointment of
these “gray directors” who lack the skills and expertise raises serious doubts about their
ability to fulfill their task as effective audit committee members. This issue is further
exacerbated in the Malaysian corporate scenario where ethnicity and political influence play 75
important roles. Some studies suggest that ethnic (Malay Bumiputera) directors are usually
appointed due to their political influence rather than their technical expertise (Gomez and
Jomo, 1997; Johnson and Mitton ,2003). A recent study by Germain et al. (2014) on Malaysian
firms has found evidence of an increase in monitoring costs and private benefits available to
managers despite the increase in the number of independent directors.
A prominent feature in Asian corporations is the existence of family shareholders.
Compared to the diffused ownership structures of western firms, ownership in most Asian
firms is more concentrated and mostly in the hands of families. Despite the claim that family
firms have built their business reputation solidly throughout their existence, concentrated
family ownership structures are often saddled with the negative connotation that managers
restrain themselves from reporting fraudulent activities that may conflict with minority
interests (La Porta et al., 2000; Claessens et al., 2000). Several studies on Asian and western
firms show that family firms are associated with higher earnings quality, disclosure and
performance (Ali et al., 2007; Anderson and Reeb, 2004; Corbetta and Salvato, 2004; Hashim,
2009; Wan-Hussin, 2009; Wang, 2006; Yeh et al., 2001). Evidence found by Puchniak and Lan
(2015) on firms in Singapore and Siregar and Utama (2008) on firms in Indonesia supports the
notion that family firms are focused on gaining market recognition of the business operations
of a firm and avoiding being categorized as firms that practice earnings management.
In light of these issues, the purpose of this study is to investigate the effect of audit
committee independence, ethnic diversity of the board and family ownership on earnings
management. Although previous studies have investigated the role and effectiveness of
audit committees, very few have considered the combined effects of ethnic diversity and
concentrated family ownership on earnings management. There are limited findings on the
effectiveness of audit committees in an environment where there is ethnic diversity and
concentrated family ownership (Wan Mohammad et al., 2016). Essentially, in an
environment where the corporate community is a blend of a small circle of business
networks, political leaders and family members, there is the question of whether audit
committee members can effectively execute their duties in such an environment. The focus
of this study is, thus, to investigate the potential effect of audit committee independence,
board ethnicity and family ownership structures on earnings management. We also go one
step further by considering both direct and indirect family ownership. To achieve this, panel
regression analysis is carried out on a dataset of 1,206 firm-year observations of firms listed
on Bursa Malaysia between the fiscal years of 2004 and 2009. The findings suggest that the
appointment of independent directors in audit committees acts as a signal to the stock
market of the firm mere compliance with the code but fails to mitigate earnings management
occurrence. Furthermore, it is found that independent non-executive directors are less
effective in controlling earnings management in firms where there is stronger family
influence. There is no evidence, however, to infer that ethnic diversity of the board
influences earnings management in Malaysia.
This study contributes to the literature on earnings management in several ways.
First, the findings should be of interest to policymakers in Malaysia as well as to other
emerging markets with similar institutional and cultural environment and family structures
of firms (La Porta et al., 2000). Policymakers will have a clearer understanding of the
difference in ownership structures and the importance of director independence and, hence,
JAEE will understand that corporate governance in Asia needs to strive for a corporate culture in
10,1 which managers and boards understand the benefits of, and need for, effective disclosure
practices. Second, the findings of this study will also assist firms in understanding the cost-
benefit analysis of the appointment of firms of qualified audit members in the complex
structure of family and politically influenced firms. Based on a survey conducted by
McKinsey in year 2000, companies are willing to invest as much as 20–25 percent of the total
76 stock market value of a well-governed organization in Asia. Although the premiums paid
for independent directors provide assurance and encourage stock market commitment for
long-term investment in Asian countries, the appointment of these independent audit
committee members should be based on their experience, knowledge and expertise rather
than their political and business connections.
The paper is structured as follows: Section 2 presents the discussion on the ownership
structure, governance, diversity and financial reporting in Malaysia. Section 3 discusses the
theory used for this study. Section 4 provides the literature review and the hypotheses
development. Section 5 presents the research design and Section 6 is the empirical results
and discussion. Finally, Section 7 is the summary and conclusion.

2. Ownership structure, governance, diversity and financial reporting in

Malaysia
The main objective of this study is to investigate the moderating effect of family ownership
on the relationship between audit committee independence and board ethnicity on earnings
management. In this section, we discuss how family ownership and ethnic diversity
influence financial reporting in Malaysia. Malaysia offers an interesting avenue for research
on board diversity due to its high levels of ownership concentration and crossholdings, as
well as the dominance of owner-managed or family-owned firms (Claessens et al., 2000).
Differences abound on how concentrated ownership in family firms influences the decision
making of the directors. For instance, in firms with high ownership concentration, numerous
prior studies have postulated that type (II) agency problems will occur as family members
try to protect the interest of their family members at the expense of minority shareholders.
The World Bank (2005) reports that the largest shareholder groups in Malaysia include
nominee firms either owned by families or the government. As the proportion of family
ownership is large in Malaysia, it is imperative to investigate its influence over firm’s
financial reporting.
Furthermore, another unique difference between Malaysia and other developed countries
is its diverse multicultural ethnic groups. In this multicultural ethnic environment, one of the
main concerns is the existence of economic imbalances between ethnic Malays and minority
Chinese. Ethnic Malays represent the majority in the ruling government, whereas a
majority of the firms listed on the Bursa Malaysia are family firms, majority of which are
owned by the Chinese minority. On a positive note, ethnic diversity improves organizational
values and decision making via the exchange of ideas and knowledge (Carter et al., 2003). On
the contrary, although the pooling and exchange of ideas may improve board effectiveness,
cultural diversity may negatively influence board decision if the appointment of ethnic
Malays is solely due to their links to the government instead of their expertise and capacity
to fill in the role of effective decision makers.
The relationship-based system practiced by most Malaysian companies with close
connections among banks, politicians, the government and other stakeholders such as
auditors in Malaysia may also influence audit committee independence (Abdul Wahab et al.,
2015). The relationship-based system is rather alarming based on the recent 1MDB
misappropriation fund scandal where a majority of 1MDB’s independent directors were
elected and appointed by the government. Jaffar and Abdul-Shukor (2016) argued that
politically connected firms with board members who are political figures or government
representatives are linked to lower performance in comparison to firms without the influence Effect of audit
of political or government figures. Besides, board diversity may influence the tendency for committee
firms to manage their earnings to meet the expectations of other stakeholders and this is more independence
evident in countries that rely on connections among bankers, politicians and government
entities to gain access to major projects (Abdul Wahab et al., 2017; Faccio et al., 2006).
The economic policy of Malaysia has been argued to be the main reason for the
introduction and growth of cronyism in the business community due to the appointment of 77
ethnic Malays in major government-linked companies (GLCs) (Gomez and Jomo, 1997;
Johnson and Mitton, 2003). Even though Malaysian economic policy aims to improve
economic imbalances amongst the different ethnic groups[1], the act of appointing ethnic
Malay directors, particularly in major GLCs, is argued to be a tool exploited by politicians to
serve their own political interest (Gomez, 2018). Based on these arguments, this paper aims
to investigate how ownership and board diversity can influence the financial reporting of a
Malaysian firm as well as its tendency to manage earnings.

3. Managerial hegemony, alignment and entrenchment effect theory

From a behavioral perspective, prior studies indicate that board ethnicity influences
financial reporting disclosure practices (Abdul Wahab et al., 2017; Faccio et al., 2006) and
differences exist in the ownership structures of family and non-family firms (Claessens et al.,
2000). Empirically, most prior studies focus on the influence of board diversity, religion and
morality on earnings management activities (Elghuweel et al., 2017). In Malaysia, the issue
lies in the appointment of politically affiliated directors or “gray directors” who may
influence earnings management activities in a firm as the morale and ethical values of the
independent directors may be affected by their close relationship and affiliation with the
family members. As postulated by the managerial hegemony theory, the appointment of
affiliated independent directors or their cronies to fulfill regulatory requirements serves as
an illusion of active board monitoring to the shareholders (Cohen et al., 2008; Wan-Hussin,
2009). The theory further argues that appointed independent directors in audit committees
will not protect the interests of minority shareholders in a culture of “high-power
distancing” where independent directors avoid obstructive scrutiny that will negatively
affect their managers’ reputation (Zinkin, 2011). In a culture of high-power distance, less
powerful members of the board accept inequality in the board structure and follow the
autocractic directives of the leader. Similarly, in family firms, founding family members who
have strong influence over board decision making may influence audit committee
independence and create a culture of “high-power distancing.”
Furthermore, in Malaysia, there is a strong emphasis on the culture of preserving family
firms and its close business ties. Independent directors in family firms form a close
relationship with family owners to serve as effective mediators who resolve disputes
between family members and minority shareholders. In addition, they act as trusted
advisors to the firm while engaging in activities to attract foreign capital and to signal their
compliance with international corporate governance standards (Puchniak and Lan, 2015).
Accordingly, Jaggi et al. (2009) found that, after controlling for family ownership,
independent directors are more effective in controlling earnings management. Similarly,
Chau and Gray (2010) found a positive association between family ownership and voluntary
disclosure, suggesting that family firms have greater disclosure and independent directors
in family firms facilitate these accordingly.
We use two main theories to explain the relationship between family ownership and
earnings management. First, the alignment effect theory suggests positive effects of
disclosure practices on earnings management activities. The theory suggests that due to the
long-term growth and reputation of firms, family firms will attempt to align the interests of
family members with those of the other stakeholders. Most family firms that have existed
JAEE for decades will attempt to safeguard their family heritage (Morck and Yeung, 2004). Recent
10,1 studies in Malaysia and other developed countries associate family firms with higher
disclosures and earnings quality (Ali et al., 2007; Wan-Hussin, 2009; Wang, 2006). Within the
context of the alignment effect theory, the convergence of interest between shareholders and
managers reduces agency costs as the owner–manager’s ownership interest increases (Chau
and Leung, 2006; Feldmann and Schwarzkopf, 2003; Menon and Williams, 2004).
78 In contrast to the alignment effect theory, the entrenchment effect theory suggests that
high levels of family ownership result in lower disclosure of corporate governance practices
(Ali et al., 2007) and lower earnings quality (Wang, 2006) as founding family owners have
the capacity and influence over the operations of their firm. Hence, they have the incentive to
engage in negative activities such as the deployment of corporate assets for personal use
and engagement in perquisite consumption that is detrimental to firm performance
(Setia-Atmaja et al., 2011). The severe effects of rent extraction in family firms (Setia-Atmaja
et al., 2011) imply that family members, as the controlling party, engage in activities to
maximize their own self-interests rather than their stakeholders which may result in
earnings management activities ( Jung and Kwon, 2002; Morck et al., 1988; Wang, 2006).
Hutchinson and Leung’s (2007) study on the relationship between management
ownership and earnings management over a six-year period with 15,945 firm-year
observations finds a non-monotonic relationship between ownership by top management
and earnings management. Their findings suggest that increasing ownership at low levels
decreases earnings management, whereas ownership at high levels increases earnings
management activities. This is further supported by Chau and Leung (2006) who find that
low levels of family ownership (between 5 and 25 percent) can be beneficial as family
owners align their interests with those of outside shareholders (alignment effect) but at high
levels of family ownership, the entrenchment effect dominates over the alignment effect.
Hence, high levels of ownership may entrench insiders, causing moral hazard and
information asymmetry problems between the owners and outside investors, resulting in
higher earnings management (Chau and Leung, 2006).

4. Empirical literature review and hypotheses development

Ghafran and O’Sullivan (2013) discussed the two phases in research on audit committees.
The first phase, which is from the 1980s to the early 2000s, focuses on issues surrounding
the formation and composition of audit committees and its implication on studies in the
areas of corporate governance. The second phase of research focuses more on the audit
committee characteristics and its effect on financial reporting, quality of financial
statements and internal audit process. In the second phase, there are more studies
conducted to understand the implications of audit committee characteristics on various
issues such as firm performance, disclosure and earnings management. Studies on
developed countries in this phase have concluded that corporate governance effectively
reduces earnings management occurrence (Abbott et al., 2004; Baxter and Cotter, 2009;
Beasley et al., 2009; Bedard et al., 2004; Caramanis and Lennox, 2008; Peasnell et al., 2005;
Jaggi and Leung, 2007). The appointment of audit committee members will deter possible
fraud cases if the committee members objectively and diligently execute their tasks. One
of the earliest studies by Beasley (1996) shows that the incidence of financial statement
fraud is negatively related to the proportion of outside directors. In fact, Abbott (2000)
found that audit committees fully comprising of independent directors who convene at
least biannually are less likely to be associated with fraudulent or misleading reporting.
In another study on audit committee characteristics, Bedard et al. (2004) suggested that
earnings management is negatively associated with the financial and governance
expertise of audit committee members; hence, strong emphasis is made on the quality of
the audit committee members.
 However, the quality of the audit committee members differs across cultures and Effect of audit
institutional environments. The formation and mere the presence of an audit committee in a committee
firm does not ensure that the company has complied with the prescribed regulation as some independence
independent directors in Asian countries lack the skills and expertise needed and/or are
politically connected (KPMG, 2013; Barton et al., 2004; Tsui and Gul, 2003). As there are only
limited numbers of qualified independent directors, there are two issues of concern for the
audit committees in executing their tasks. First, there is the issue of time allocated to 79
examine the financial report’s accuracy when there are inexperienced and ill-informed
independent directors. Second, audit committees lack the power to question the senior
executives’ decisions regarding the operation of a firm (George, 2003).
Some studies in developed countries observe that audit committee independence is
unable to constrain earnings management activities. For instance, Klein (2006) found no
association between discretionary accruals (DAC) and a fully independent audit committee
when investigating a sample of 687 observations from the S&P 500 Index in the USA
(henceforth USA) using several measurements for director independence such as
independent board of directors greater than 50 percent, percentage of outsiders on the
board and percentage of outsiders in audit committees. Similarly, Ghosh et al. (2010)
investigated a comprehensive sample of 9,290 observations from firms publicly traded in
the USA between 1998 and 2005 and found no evidence to suggest that audit committee
independence is associated with earnings management pre- and post-Sarbanes-Oxley.
Proponents of audit committees in Malaysia suggest that audit committees reduce
earnings management activities (Mohd-Saleh et al., 2005, 2007). However, both studies were
carried out in year 2001, which was the first year of compulsory corporate governance
implementation. During the early phase of corporate governance implementation, most
companies complied on a voluntary basis. It was only in 2007 that the code recommended
the appointment of independent directors in audit committees. These studies only focused
on the characteristics of audit committee without exploring the possibility of how ethnicity
may affect earnings management. It is important to note that the effectiveness of corporate
governance lies in its ability to assimilate regulation with the local institutional
environment. In Malaysia, the institutional structure comprises of various ethnicities, with
Bumiputera directors who may be politically connected and may be involved in rent-seeking
activities (Gomez, 2007). Although there are studies conducted on board ethnicity in
Malaysia, the findings fail to find any significant relationship between board ethnicity and
earnings management.
In another stream of the literature, Malaysian firms are found to be substituting
non-independent directors for more independent directors on the board. Germain et al. (2014)
reported an upward trend in board independence of Malaysian firms, resulting in a
significant increase in the mean number of independent directors from 3.02 in 2002 to 3.16 in
2007 and a downward trend in non-independent directors ( from 4.8 in 2002 to 4.4 in 2007).
This signifies the commitment made by most companies in recapturing shareholders’
confidence in the market by appointing more independent directors on the board. For
instance, it is found by Puchniak and Lan (2015) that in order to reclaim market interest
after the 1997 Asian Financial crisis, an overwhelming 98 percent of the listed companies in
Singapore reported full compliance in year 2001. An immediate response of firm full
compliance despite reports that Asian countries lack qualified independent directors,
therefore, raises concerns about the appointment of independent directors merely to signal
the firm compliance to the stock market in the form but not the substance of the code.

4.1 Audit committee independence, family ownership and earnings management

Research interest in earnings management in Malaysia has grown largely due to competing
views that exist regarding the relationship between audit committee independence and
JAEE earnings management. Although agency theorists suggest that independent directors can
10,1 improve the stewardship of firms due to the separation of control between managers and
shareholders, there are still mixed findings from both developed and developing countries
(Abbott, 2000; Beasley, 1996; Beasley et al., 2000; Mohd-Saleh et al., 2005, 2007). The
institutional environment in developing countries with diverse ethnic groups, concentrated
family ownership and close ties amongst its business community raises concerns regarding
80 the extent to which alarming issues are raised by members of the audit committees.
Studies have shown that power distance scores of Asian countries are far higher in
comparison to those of most developed countries (Guan and Pourjalali, 2010). A higher score
indicates society acceptance of an autocratic corporate environment and the hierarchical
order, which reflect inequalities. Although it has been pointed out in the previous literature
that audit committee independence improves corporate governance and acts as a strong
monitoring mechanism due to its ability to question management on their audit reports, it is
arguable whether such compliance may result in better governance if the independent
directors are affiliated and operating within a culture of “high-power distancing.”
In addition to that one of the salient issues of RMCCG (2007) requirement is the shortage of
qualified independent directors due to the increasing trend of independent directors’
appointment in audit committees (Tsui and Gul, 2003). Although independent directors are
believed to enforce better stewardship of their respective firms, in the context of Malaysia,
evidence has shown that increasing the number of independent directors fails to improve board
monitoring (Germain et al., 2014). Many independent directors sit on the board of several other
companies and devote limited time to strenuous audit tasks unless the directorship is within
the same industry (Clements et al., 2015). Also, despite the strong and well-documented
requirements of the RMCCG (2007) for audit committees to be fully comprised of independent
directors, several studies suggest that audit committee independence is unlikely to result in
audit committee effectiveness unless the committee is supported by the presence of active audit
committee members or an industry specialist auditor (Menon and Williams, 2004; Abbott,
2000). In order to avoid the ineffectiveness of independent directors, countries like Singapore
have imposed stricter regulations on the nomination of independent directors in a newly
revised code in 2012 and have called for the appointment of qualified and experienced
independent directors. Proponents of signaling theory claim that companies send signals to the
market to avoid asymmetric information and any adverse effects of shareholders’ negative
reactions (Leland and Pyle, 1977). Therefore, in the context of corporate governance disclosure,
an increase in the number of independent directors in audit committees can be part of the
positive signal that firms try to send to the stock market, particularly after the 1997 Asian
Financial Crisis. Merely signaling firm compliance to the code without having the capacity to
fully enforce the code requirements for more transparent and ethical financial reporting has
resulted in negative implications on the effectiveness of audit committees.
In an environment where family ownership is highly concentrated and there are diverse
ethnic groups on the board, the role of audit committees in executing their task is subject to
some debate. Therefore, as a result of these conflicting factors from previous studies in
Malaysia as well as other developed countries, the study posits the following hypothesis:
H1. A higher number of independent directors in audit committees significantly affects
earnings management.
Prior research yield mixed findings on the effectiveness of audit committees in reducing
earnings management activities in family firms. Based on the entrenchment effect theory,
conflicts between family members may lead to fewer disclosures and an increase in earnings
management due to different business objectives, unfair treatment by related family members
or, to some extent, unhealthy competition among family members themselves (Gomez, 2007;
Setia-Atmaja et al., 2011). To resolve such conflicts, some studies suggest the appointment of
independent directors as both mediators and trusted advisors to family firms in order to Effect of audit
improve governance practice (Puchniak and Lan, 2015). On the contrary, within the context of committee
the alignment effect theory, the extent to which family ownership curtails earnings management independence
depends on the level of family ownership. The convergence-of-interest hypothesis argues that at
low levels of family ownership, agency conflicts are reduced as family members increase their
ownership. At higher levels of ownership, greater agency conflicts are observed when the family
increases its ownership of the firm (Chau and Leung, 2006; Feldmann and Schwarzkopf, 2003; 81
Menon and Williams, 2004). It is, therefore, expected that family control through family
ownership concentration is likely to moderate the monitoring effectiveness of independent
directors in an audit committee. In Malaysia, Abdullah and Pok (2015) found no evidence of
minority interest expropriation in family-owned firms. This may be due to strong shareholder
protection laws compared to other emerging markets such as Indonesia, Thailand and
Philippines (Abdullah and Pok, 2015). Therefore, we hypothesize that:
H1a. Audit committee independence moderated by family ownership is likely to have a
significant effect on earnings management.

4.2 Board ethnicity, family ownership and earnings management

Generally, there is inconclusive evidence to indicate that board ethnicity is associated with
earnings management in Malaysia. A possible explanation for this may be associated with the
new economic policy (NEP) practiced by the previous ruling government. Under the New
Economic Model (NEM), Malaysia has moved to a more liberalized economy with less
government intervention (Wan Jan, 2011) compared to the previous NEP that implemented
preferential treatment of Bumiputera directors (Abdul Wahab et al., 2007). One of the
preferential treatments afforded to the Malays is the requirement that 30 percent of the board
should be composed of Bumiputeras (Security Industry Act 280). This requirement has
induced firms to employ Malays for political networking rather than their skills and expertise
in managing firm affairs. The appointment of Bumiputera directors in firms may, therefore,
have been an effort to gain access to major projects rather than their credibility in the
management of firm affairs (Yoshihara, 1988; Wan Jan, 2011). Preferential treatment toward
the Malays may lead to riskier and inefficient firms (Abdul Wahab et al., 2014) as firms engage
in corporate decisions for political reasons with an increase in the possibility of government
bailouts (Faccio et al., 2006) and earnings management activities (Chen et al., 2011).
However, Abdul Rahman and Mohamed Ali (2006) found no evidence to associate board
ethnicity with earnings management. A plausible explanation may be due to significant changes
after the establishment of NEM that minimized government intervention in the economy leading
to the appointment of more competitive and well-experienced Malay independent directors.
In support of this, the appointment of independent directors from various ethnic backgrounds
comprising of ethnic Malays, Chinese and Indians on the board may also improve firm
performance due to their expertise and diverse networking (Carter et al., 2010; Westphal and
Milton, 2000). Yatim et al. (2006) also found that Malay firms have more favorable corporate
governance practices compared to non-ethnic firms. The Malays’ adherence to favorable
corporate governance practices is possibly due to the level of expertise and networking they
possess. Therefore, the role of the Malays as providers of expertise and networking to firm
operations may improve management of organizations and reduce earnings management
activities (Pfeffer and Salancik, 1978). Therefore, the present study hypothesizes that:
H2. Board ethnicity is likely to have a significant effect on earnings management.
Based on the arguments earlier, the alignment effect theory postulates that family firms will
attenuate earnings management activities to uphold their reputation and align the interests
of shareholders and family members. Ethnic Malays appointed on the board improve the
JAEE board’s expertise and mediate conflicts between family board members. According to
10,1 Puchniak and Lan (2015), appointed directors on the board may resolve family conflicts and
act as firm trustees, resulting in less earnings management practices when family
ownership moderates the effect of board ethnicity on earnings management. In contrast,
under the entrenchment effect theory, the appointment of Malays in highly concentrated
family firms may not mitigate earnings management activities as they are merely part of the
82 regulatory compliance under the Security Industry Act 280. Furthermore, Malays’ political
connections may induce rent-seeking activities and reduce their ability to monitor firm
operations ( Johl et al., 2012) and, hence, increase earnings management activities. Based on
the mixed arguments and findings, we posit that:
H2a. Board ethnicity moderated by family ownership is likely to have significant effect
on earnings management.

5. Research design
5.1 Sample of the study and variable measurements
Sample for this study is drawn from non-financial companies listed on Bursa Malaysia. Data
are collected based on the industry of a particular firm to control for firm effects. All sectors in
the Bursa Malaysia are selected except for the financial sector. The data are first stratified
based on the list available in the Emerging Market Information System (EMIS) database. The
highest percentage of firms is from the consumer products sector (43.70 percent), whereas the
lowest is from the trading and services sector (10.56 percent). Initially, the population
consisted of 772 firms as of 31 December 2009. However, due to missing data from EMIS and
the exclusion of companies that were not allowed to continue trading due to financial distress
under Practice Note 4 and Practice Note 17, the final sample is finally 201 companies.
The three years pre- and post-RMCCG (2007) is selected to adequately measure the effect
of audit committees on earnings management activities across various industries. Since
MCCG (2012) was announced in 2012, a three-year range is chosen to avoid any bias in
investigating the effect of audit committee independence. We control for the effect of MCCG
(2012) in this way as the MCCG (2012) has extended the roles of chairman independence but
no changes were made to audit committee requirements. Therefore, a total of 1,206 firm-year
observations from the fiscal years of 2004–2009 are collected. Furthermore, only companies
that have complete data over these years are included to ensure a balanced panel dataset.
This is to avoid uncontrollable error component that will have a significant effect on the
panel regression when the data are unbalanced (Baltagi, 2005). Table I provides a
breakdown of the sampling across the industry sectors.
The variables chosen for this study and their measurements are summarized in Table II.
Audit committee independence, ethnicity and family ownership are the independent
variables. Family ownership is measured in three different ways based on total, direct and
indirect family ownership. A high value of family ownership (total, direct and/or indirect)

No. Industry Samples Total no. of firms Percentage of samples

1 Consumer products 59 135 43.70

2 Industrial products 72 251 28.69
3 Construction 17 45 37.78
4 Trading/services 19 180 10.56
5 Technology 10 28 35.71
6 Property 12 90 13.33
Table I. 7 Plantation 12 43 27.91
Data sampling Total 201 772 100.00
Variables Sign Definition References
Effect of audit
committee
Dependent variable independence
DAMODIFIED Absolute discretionary accruals
( Jones Model 1991)
Experimental variables
ACINDEP ± Percentage of independent non-executive Abdul Rahman and Mohamed Ali 83
directors in the audit committees (2006), Mohd-Saleh et al. (2007),
Wan Ismail et al. (2010)
ETHNICITY – Ratio of Bumiputera directors (ethnic Abdul Rahman and Mohamed Ali
Malay directors) to the total number of (2006), Haniffa and Cooke (2005),
directors on the board Marimuthu (2008)
FAMILYOWNERSHIP – TOWN-Percentage of total family Jaggi et al. (2009), Chen and Hsu
managerial ownership (2009), Mustapha and Che Ahmad
DFOWN-Percentage of direct family (2011)
managerial ownership
IDFOWN-Percentage of indirect family
managerial ownership
Control variables
FAMPERCENT – No. of family members on the board/total Wan-Hussin (2009)
no. of directors on the board
ACMEMBER – Log number of audit committees’ Ghafran and O’Sullivan (2013)
members
ACMEET ± Log number of audit committees’ Davidson et al. (2005)
meetings
QUALI – Indicator variable with the value of “1” if Chan and Li (2008)
at least one of the independent directors
in the audit committees has a degree in
accounting and finance “0“indicate
otherwise
ROA – Return on Assets Prencipe and Bar-Yosef (2011),
Jaggi et al. (2009), Wang (2006)
MBRATIO – Market value of equity/book value Park and Shin (2004)
of equity
LOGBSIZE – Log 10 of the number of directors in Abdul Rahman and Mohamed Ali,
the board (2006), Sáenz González and
García-Meca (2013)
LOGTENURE – Log 10 of total number of years of service Ali and Zhang (2015)
of the CEO
LOGASSET – Log 10 of total assets (MYR’000) Park and Shin (2004)
CHAIRINDEP – Indicator variable with the value of “1” if Chau and Gray (2010)
Chairman is independent non-executive
director and “0” otherwise
BIG4 – Indicator variable with the value of “1” if Gul and Leung (2004), Jaggi et al. Table II.
audited by Big 4 and “0”indicates (2009) List and definition of
otherwise variables

will reflect greater family-concentrated ownership and monitoring by family members.

Similar to Madah Marzuki and Abdul Wahab (2016), three different measurements are used
to adequately incorporate the complex pyramidal ownership structure for Malaysian firms
wherein the majority is owned via indirect ownership. As firms in Malaysia report
ownership structure based on two categories, either direct or indirect ownership, selecting
only one measure may be biased toward the overall analysis of family ownership structures.
The 11 control variables are as follows: family members’ ratio on the board
(FAMPERCENT), log number of audit committees’ members (ACMEMBER), log number of
JAEE audit committees’ meetings (ACMEET), QUALI is an indicator variable with the value of “1”
10,1 if at least one of the independent directors in the audit committee has a degree in accounting
and finance and “0” otherwise, return on asset (ROA), chairman independence
(CHAIRINDEP), market-to-book ratio (MBRATIO), Big 4 auditor (BIG4), board size
(LOGBSIZE), CEO tenure (LOGTENURE) and total assets (LOGASSET). Following
previous studies, we have selected only 11 control variables due to the restriction of
84 overfitting the regression models (Babyak, 2004).

5.2 Model specification: audit committee independence, board ethnicity and earnings
management (with family ownership as a moderating variable)
In measuring earnings management, DAC (unexpected portion) is separated from non-DAC
(expected portion). The expected portion is a result of changes in the economic environment
of a firm and is not particularly influenced by management discretion. The unexpected
portion is the outcome of discretionary manipulation by the management. The Jones Model
(1991) model suggests that high-level DAC indicates that the firm is engaging in earnings
management activities. Consistent with Klein (2006) and Jaggi et al. (2009), a minimum
requirement of ten observations in each industry every year is needed to estimate the
coefficients for the DAC. The first step is to conduct a regression analysis between TAt as
the dependent variable and REVit and PPEit as the independent variables. This is to find the
OLS estimates of α1, β1 and β2. After obtaining the OLS estimates, NDAit will be calculated
and deducted from TAt to calculate DAit, which is a measure of DAC:




TAt =Ait
1 ¼ a1 1=Ait
1 þb1 DREV it =Ait
1 þ b2 PPE it =Ait
1 þe; (1)

 
N DAit ¼ a1 1=Ait
1 þb1 ðDREV it
DREC it Þ=Ait
1 þb2 ðPPE it =Ait
1 Þ; (2)

DAit ¼ TAit =Ait
NDAit ; (3)

where TAt is the change in non-cash current assets minus the change in current liabilities;
Ait−1 total asset for firm i at the end of year t‒1; ΔREVit revenue for firm i in year t less
revenues year t‒1; PPEit gross property, plant and equipment for firm i at the end of year t;
α1, β1, β2 the OLS estimates of α1, β1, β2; and e the residuals.
Following Jaggi et al. (2009) and Prencipe and Bar-Yosef (2011), this study tests the effect
of family firms based on the moderating effects of the direct, indirect and total ownership
variables. Family ownership is used as a moderating variable as previous studies have
shown that it moderates the effect of corporate governance variables and earnings
management ( Jaggi et al., 2009; Madah Marzuki and Abdul Wahab, 2016). Consistent with
studies by Madah Marzuki and Abdul Wahab (2016) as well as Mustapha and Che Ahmad
(2011), total ownership is subdivided between direct and indirect ownership because certain
families own an indirect percentage of shares in the firms. This model also enhances the
findings of this study by examining more specific types of firm ownership:

DAMODIFIED ¼ a0 INTERCEPT þa1 ACINDEP þa2 ETHNICITY

þa3 FAMILYOWNERSHIP þa4 FAMILYOWNERSHIP  ACINDEP
þa5 FAMILYOWNERSHIP  ETHNICITYþa6 FAMPERCENT
þa7 ACMEMBER þa8 ACMEET þa9 QUALI þa10 ROA
þa11 CHAIRINDEP þa12 MBRATIOþa13 BIG4 þa14 LOGBSIZE
þa15 LOGTENUREþa16 LOGASSET þe:
6. Empirical results and discussion Effect of audit
6.1 Descriptive statistics and univariate analysis committee
The mean, median, maximum, minimum and standard deviation values of the variables are independence
provided in Table III.
In Malaysia, annual reports disclose both the direct and indirect family ownerships of the
family members. The disclosures allow further analysis to be conducted on the effect of family
ownership as a moderating variable influencing earnings management. In this study, average 85
direct family ownership is 7.8218 percent, with the highest being 60.76 percent, whereas the
mean of indirect family ownership percentage is 16.9154 percent with the highest being
98.42 percent. This is similar to Madah Marzuki and Abdul Wahab’s (2016) study in which the
mean for direct ownership was 6.657 percent and the mean for indirect ownership was 16.553
percent. It can be observed from both studies that the indirect family ownership percentage is
much higher than direct family ownership, indicating the complexity of family ownership
pyramidal structures in Malaysian family firms. Moreover, the pyramidal structure of indirect
family ownership measured via different entities results in total ownership being greater than

Mean Median Maximum Minimum SD

Panel A: continuous variables

DAMODIFIED 0.290 0.278 1.471 ‒3.24 0.278
ACINDEP(%) 74.900 17.090 100.000 33.000 0.171
ETHNICITY 0.320 0.233 1.000 0.000 0.233
TOWN 24.730 26.053 114.380 0.000 26.053
DFOWN 7.822 14.197 60.760 0.000 14.197
IDFOWN 16.915 21.521 98.420 0.000 21.521
FAMPERCENT 25.400 23.980 86.660 0.000 23.980
ACMEMBER 3.455 3.000 6.000 3.000 0.668
ACMEET 4.616 4.000 13.000 2.000 0.972
QUALI 0.820 1.000 1.000 0.000 0.384
ROA (%) 2.981 13.279 142.340 ‒182.22 13.279
MBRATIO 1.209 3.117 66.600 ‒43.23 3.117
BOARDSIZE 7.620 1.974 16.000 3.000 1.974
TENURE 9.536 8.146 43.000 0.000 8.146
TOTALASSET(Log) 5.926 6.627 8.013 4.413 6.627
Panel B: dichotomous variables
1 0
CHAIRINDEP 107 (8.87) 1,099 (91.13)
BIG4 753 (62.44) 453 (37.56)
Panel C: types of firms Family Non-family
Number of firms 118 83
Notes: DAMODOFIED is absolute discretionary accruals based on Modified Jones Model. ACINDEP is the
percentage of independent non-executive directors in the audit committees. TOWN is the percentage of family
managerial ownership. DFOWN is the percentage of direct family managerial ownership; and IDFOWN that
of indirect family managerial ownership. ETHNICITY is the ratio of Bumiputera directors to total number of
directors on board. FAMPERCENT is the number of family members on the board/total no. of directors on the
board. ACMEMBER is the Log number of audit committees’ members ACMEET is Log number of audit
committees’ meetings. QUALI is and indicator variable with the value of “1” if at least one of the independent
directors in the audit committees has a degree in accounting and finance “0” indicate otherwise. ROA is the
return on asset. MBRATIO is the market value of equity/book value of equity. BOARDSIZE is the number of
directors in the board. TENURE is the total number of years of service of the CEO. TOTALASSET is Log 10
of total assets (RM’000). CHAIRINDEP is an indicator variable with the value of “1” if the Chairman is
independent non-executive directors and “0” otherwise. BIG4 is an indicator variable with the value of “1” if Table III.
audited by Big4 and “0” otherwise Descriptive statistics
JAEE 100 percent. The mean percentage of family members on the board is 25.4 percent, which is close
10,1 to the 29 percent found in Wan-Hussin’s (2009) study. Hence, about one-quarter of the boards of
family firms is made up of family members. There are on average 3.4552 audit committee
members, with the maximum number being 6 and the minimum being 3. Audit committees
conduct an average of 4.6161 meetings per year with the maximum being 13 and minimum
being only 2. The mean for QUALI is 0.8201 indicating that 82 percent of the AC members are
86 qualified to be members of audit committees.
The mean for ROAs is 2.98 percent, with the highest ROAs being 142.34 percent, whereas
the mean market-to-book ratio is 1.2087 percent. Similar to previous studies, the board is made
up of approximately seven to eight members (Abdul Rahman and Mohamed Ali, 2006;
Wan-Hussin, 2009). The mean for tenure is 9–10 years, which highlights the higher level
of experience possessed by the directors in Malaysia. The mean for log of total assets is
5.9264 percent. An interesting finding is that 91.13 percent firms have a non-independent
chairman. Finally, this study also finds an increase in the number of firms recently employing
non-Big 4 auditors with only 62.44 percent of firms employing Big 4 auditors unlike the findings
of Abdul Rahman and Mohamed Ali (2006) and Jaggi et al. (2009). This finding highlights the
change in the preference of firms in audit services.
Since family ownership variables will be used as the moderating variable, Table IV
analyzes the difference between family and non-family firms. The Kruskal–Wallis test

Mean K-Wallis test ( family non-family)

Panel A: continuous variables

DAMODIFIED 0.290 0.0001***
ACINDEP 74.900 0.019**
ETHNICITY 0.320 0.0001***
TOWN 24.730 0.0001***
DFOWN 7.822 0.0001***
IDFOWN 16.915 0.0001***
FAMPERCENT 25.400 0.0001***
ACMEMBER 3.455 0.230
ACMEET 4.616 0.260
QUALI 0.820 0.490
ROA 2.981 0.002***
MBRATIO 1.209 0.002***
BOARDSIZE 7.620 0.0001***
TENURE 9.536 0.0001***
TOTALASSET 5.926 0.092*
Panel B: dichotomous variables
CHAIRINDEP 0.22
BIG4 0.008***
Notes: DAMODOFIED is absolute discretionary accruals based on Modified Jones Model. ACINDEP is the
percentage of independent non-executive directors in the audit committees. TOWN is the percentage of family
managerial ownership. DFOWN is the percentage of direct family managerial ownership; and IDFOWN that
of indirect family managerial ownership. ETHNICITY is the ratio of Bumiputera directors to total number of
directors on board. FAMPERCENT is the number of family members on the board/total no. of directors on the
board. ACMEMBER is the Log number of audit committees’ members ACMEET is Log number of audit
committees’ meetings. QUALI is and indicator variable with the value of “1” if at least one of the independent
directors in the audit committees has a degree in accounting and finance “0” indicate otherwise. ROA is the
return on asset. MBRATIO is the market value of equity/book value of equity. BOARDSIZE is the number of
directors in the board. TENURE is the total number of years of service of the CEO. TOTALASSET is Log 10
of total assets (RM'000). CHAIRINDEP is an indicator variable with the value of “1” if the Chairman is
Table IV. independent non-executive directors and “0” otherwise. BIG4 is an indicator variable with the value of “1” if
χ2 K-Wallis test audited by Big4 and “0” otherwise. *,**, ***Significance at 10, 5 and 1 Percent levels, respectively
statistic shows that all the variables used for this study are significantly different at the 1, 5 Effect of audit
and 10 percent levels, except for chairman independence, number of audit committee committee
members, number of audit committee meetings and audit committee’s qualification. The log independence
of total assets is only significant at the 10 percent level, which implies no significant
difference in the size of the firms between family and non-family firms.
An important consideration in regression is that no perfect collinearity exists between
the independent variables. Based on the Pearson correlation matrix in Table V, two high 87
correlation values are observed. The first collinearity is between the percentage of family
members on the board and the total ownership of the family members on the board, which is
at 72.7 percent. The second collinearity issue is between indirect family ownership and the
moderating variable of indirect ownership and board ethnicity (IDFOWN×ETH) which is at
75.3 percent. Multicollinearity is only considered to be severe if the correlation coefficient
between the independent variables is greater than 0.8 (Gujarati and Porter, 2009).
Furthermore, based on the variance inflation factor, as the values are below three for most
variables and the common cutoff for multicollinearity is ten (Hair et al., 2010), there is no
evidence to suggest any multicollinearity issue in this study.

6.2 Multivariate analysis

Hausman test is used to determine whether the fixed or random effects regression model is
better in analyzing the data and fixed effect is found to be better than the random effect.
Consistent with Fraser et al. (2006), endogeneity issues are tested using the Granger causality
test. The independent variables are tested with the dependent variables to ensure that the
variables are exogenous. No endogeneity issue is found between the variables. The first
analysis (Panel A, Table VI) tests the relationship between earnings management and control
variables prior including all the independent variables tested in this study. The significance of
the control variables and the overall R2 value are noted. The results in Panel A of Table VI
show that all variables are significant at the 10 percent level except for percentage of family
members on the board, audit committee members, audit committee meetings and CEO tenure.
In contrast to Chan and Li’s (2008) findings, more qualified audit committees’ members are
positively associated with higher earnings management at 1 percent significant level. The
finding is consistent with Spira (1999) that the appointment of audit committees’ members is
“ceremonial” and fails to improve audit the effectiveness of committee.
Contrary to Jaggi et al.’s (2009) findings, ROAs are positively related to absolute DAC.
Therefore, high-performance firms are associated with a greater scale of earnings
management, confirming the findings of Abdul Rahman and Mohamed Ali (2006) and Wan
Ismail et al. (2010). Furthermore, chairman independence is found to be positively associated
with absolute DAC at the 10 percent level of significance, suggesting that firms may
possibly pre-select independent directors to be appointed as chairman based on affiliation
and network rather than to uphold the objectivity of the code. This result is also consistent
with our earlier finding on the positive relationship between the audit committee’s
independent directors’ appointment and absolute DAC.
Consistent with Wan Ismail et al. (2010), the market value of equity over the book value
of equity is also positively associated with absolute DAC at the 1 percent significance level,
suggesting that earnings management is more prominent in high performance and growth
firms because growth firms can employ more sophisticated financial reporting systems that
make it difficult for auditors to detect manipulation of reported figures and, thus, provide
the manager with an additional opportunity to manage the reported earnings (Wan Ismail
et al., 2010). Big 4 audit firms are also found to be negatively associated with earnings
management at the 1 percent significance level. Larger board size is found to be positively
associated with earnings management at the 1 percent significance level. Finally, the
negative relationship between total assets and absolute DCA shows that smaller firms are
 88
10,1

matrix
JAEE

Table V.
Pearson correlation
FAM DFOWN × IDFOWN × DFOWN × IDFOWN ×
DAMODIFIED ACINDEP DFOWN IDFOWN ETHNICITY PERCENT AC AC ETH ETH VIF

DAMODIFIED 1.000
ACINDEP 0.078*** 1.000 1.38
DFOWN 0.018 ‒0.039 1.000 2.67
IDFOWN 0.089*** 0.003 0.023 1.000 1.86
ETHNICITY ‒0.070** ‒0.024 ‒0.217*** ‒0.193*** 1.000 1.56
FAMPERCENT 0.092*** ‒0.004 0.466*** 0.574*** ‒0.358*** 1.000 2.34
DFOWN × AC 0.078*** 0.336*** 0.357*** 0.061** ‒0.095*** 0.143*** 1.000 1.45
IDFOWN × AC 0.134*** 0.432*** 0.026 0.328*** ‒0.057 0.209*** 0.356*** 1.000 1.53
DFOWN ×
ETH ‒0.001 ‒0.043 0.641*** ‒0.003 0.154*** 0.290*** 0.184*** ‒0.004 1.000 2.14
IDFOWN ×
ETH 0.028 0.004 ‒0.046 0.753*** 0.170*** 0.357*** 0.001 0.258*** 0.101*** 1.000 1.12
Notes: DAMODOFIED is absolute discretionary accruals based on Modified Jones Model. ACINDEP is the percentage of independent non-executive directors in the
audit committees. TOWN is the percentage of family managerial ownership. DFOWN is the percentage of direct family managerial ownership; and IDFOWN that of
indirect family managerial ownership. ETHNICITY is the ratio of Bumiputera directors to total number of directors on board. FAMPERCENT is the number of family
members on the board/total no. of directors on the board. ACMEMBER is the Log number of audit committees’ members ACMEET is Log number of audit committees’
meetings. QUALI is and indicator variable with the value of “1” if at least one of the independent directors in the audit committees has a degree in accounting and finance
“0” indicate otherwise. ROA is the return on asset. MBRATIO is the market value of equity/book value of equity. BOARDSIZE is the number of directors in the board.
TENURE is the total number of years of service of the CEO. TOTALASSET is Log 10 of total assets (RM'000). CHAIRINDEP is an indicator variable with the value of “1”
if the Chairman is independent non-executive directors and “0” otherwise. BIG4 is an indicator variable with the value of “1” if audited by Big4 and “0” otherwise. *,**,
***Significance at 10, 5 and 1 Percent levels, respectively
Dependent variable: DAMODIFIED
Effect of audit
Panel A Panel B committee
Expected direction Coefficients t-Stat Coefficients t-Stat independence
C 0.019 0.200 0.508*** 2.800
ACINDEP ± 0.136*** 4.020
ETHNICITY – −0.022 −0.790
DFOWN ± ‒0.002 ‒1.06 89
IDFOWN ± 0.000 0.010
FAMPERCENT – 0.052 1.170 0.038 0.660
ACMEMBER −0.002 −0.130 0.003 0.210
ACMEET −0.004 −0.580 0.000 −0.060
QUALI 0.062*** 4.620 0.052*** 4.080
ROA – 0.003** 1.970 0.003*** 5.600
CHAIRINDEP – 0.028* 1.740 0.054*** 3.260
MBRATIO – 0.006** 2.300 0.006** 2.220
BIG4 – ‒0.042*** ‒3.23 ‒0.024* ‒1.74
LOGBSIZE – 0.253*** 3.710 0.371*** 3.330
LOGTENURE – 0.003 0.120 0.023 0.890
LOGASSET – ‒0.222*** ‒3.78 ‒0.135*** ‒3.60
2
R 28.54 32.20
Wald χ2 177.44 1,469.07
Notes: DAMODOFIED is absolute discretionary accruals based on Modified Jones Model. ACINDEP is the
percentage of independent non-executive directors in the audit committees. TOWN is the percentage of family
managerial ownership. DFOWN is the percentage of direct family managerial ownership; and IDFOWN that
of indirect family managerial ownership. ETHNICITY is the ratio of Bumiputera directors to total number of
directors on board. FAMPERCENT is the number of family members on the board/total no. of directors on the
board. ACMEMBER is the Log number of audit committees’ members ACMEET is Log number of audit
committees’ meetings. QUALI is and indicator variable with the value of “1” if at least one of the independent
directors in the audit committees has a degree in accounting and finance “0” indicate otherwise. ROA is the
return on asset. MBRATIO is the market value of equity/book value of equity. BOARDSIZE is the number of
directors in the board. TENURE is the total number of years of service of the CEO. TOTALASSET is Log 10
of total assets (RM’000). CHAIRINDEP is an indicator variable with the value of “1” if the Chairman is Table VI.
independent non-executive directors and “0” otherwise. BIG4 is an indicator variable with the value of “1” if Regression
audited by Big4 and “0” otherwise. *,**, ***Significance at 10, 5 and 1 Percent levels, respectively output (PCSEs)

significantly (at the 1 percent level) associated with higher degrees of earnings management.
Consistent with Jaggi et al. (2009) and Abdul Rahman and Mohamed Ali (2006), this
suggests that smaller firms possibly attempt to meet analyst figures in order to establish
their reputation in the market.
In the second part of the analysis (Panel B of Table VI), the effect of adding independent
variables to the control variables and its effect on R2 are observed. It is observed in Panel B
that R2 has increased from 28.54 to 32.20 percent after including the independent variables
and among the independent variables, only percentage of independent non-executive
directors in the audit committee is significant at the 1 percent level. Percentage of
independent non-executive directors in the audit committee has a positive association with
earnings management, consistent with Wan-Hussin’s (2009) argument that appointing
independent directors is an illusion to shareholders of active board monitoring. Even though
full compliance is a positive signal to the market, it is indecisive whether the increase
reduces earnings management or only acts as a signal to the market of the full compliance of
a firm. Chen et al. (2015) found that even after companies in Singapore complied with the
corporate governance standards, they have failed to reduce earnings management activities.
This is also consistent with the managerial hegemony theory in which the appointment of
independent director’s appointment in the audit committee is only symbolic and the
JAEE independent director acts as a passive observer of the board (Cohen et al., 2008).
10,1 Mere compliance with present regulations will not hinder the issues on earnings
management in Malaysian firms. The effectiveness of audit committee independence
depends on the quality of appointed independent directors and their ability to effectively
execute their audit tasks (Tsui and Gul, 2003). This study does not suggest that independent
directors should be disregarded but rather scrutinizes the role of the appointed independent
90 director. As there is no clear and consistent definition or guideline on the classification
and appointment of independent directors (Mulgrew et al., 2014; Crespí-Cladera and
Pascual-Fuster, 2014), firms can appoint them as a sign of compliance to generate stock
market interest without focusing on the effectiveness of their assigned audit tasks.
Components of family ownership – direct family ownership and indirect family ownership –
and also board ethnicity are found to be insignificant. The insignificant results of both direct and
indirect family ownership may be due to the lack of variation in the percentage of ownership
over the six-year period. In this part of the regression analysis, total family ownership is
excluded due to its high correlation with direct and indirect family ownership variables.
In the third part of the analysis (Table VII), total family ownership is used as the moderating
variable to observe the effect of total ownership on earnings management activities. Despite the
insignificance of direct and indirect family ownership variables from the earlier regression in

Dependent variable: DAMODIFIED

Exp. Coeff. t-Stat

C 0.522*** 2.85
ACINDEP ± 0.076* 1.77
ETHNICITY – −0.001 −0.03
TOWN ± −0.002* −1.65
TOWN × ACINDEP ± 0.003** 2.09
TOWN × ETH ± −0.001 −0.89
FAMPERCENT – 0.025 0.46
ACMEMBER 0.005 0.38
ACMEET −0.0002 −0.05
QUALI 0.053*** 4.46
ROA – 0.003*** 5.71
CHAIRINDEP – 0.051*** 3.38
MBRATIO – 0.006** 2.28
BIG4 – −0.022 −1.55
LOGBSIZE – 0.376*** 3.65
LOGTENURE – 0.027 0.97
LOGASSET – −0.134*** −3.56
R2 32.23
Wald χ2 1,603.61
Notes: DAMODOFIED is absolute discretionary accruals based on Modified Jones Model. ACINDEP is the
percentage of independent non-executive directors in the audit committees. TOWN is the percentage of family
managerial ownership. DFOWN is the percentage of direct family managerial ownership; and IDFOWN that of
indirect family managerial ownership. ETHNICITY is the ratio of Bumiputera directors to total number of
directors on board. FAMPERCENT is the number of family members on the board/total no. of directors on the
Table VII. board. ACMEMBER is the Log number of audit committees’ members ACMEET is Log number of audit
Regression output committees’ meetings. QUALI is and indicator variable with the value of “1” if at least one of the independent
(PCSEs) – Audit directors in the audit committees has a degree in accounting and finance “0” indicate otherwise. ROA is the return
committee on asset. MBRATIO is the market value of equity/book value of equity. BOARDSIZE is the number of directors in
independence, the board. TENURE is the total number of years of service of the CEO. TOTALASSET is Log 10 of total assets
ethnicity and earnings (RM'000). CHAIRINDEP is an indicator variable with the value of “1” if the Chairman is independent non-executive
management directors and “0” otherwise. BIG4 is an indicator variable with the value of “1” if audited by Big4 and “0”
(total ownership) otherwise. *,**, ***Significance at 10, 5 and 1 Percent levels, respectively
Panel B of Table VI, one important observation from the result in Table VII on family ownership Effect of audit
is that total family ownership is negatively related (at 10 percent significance level) to earnings committee
management, thus supporting the alignment effect theory. Chau and Leung (2006) summarized independence
the non-monotonic relationship as the lower the level of family ownership, which is within the
range of 5–25 percent, the more dominant the alignment effect. However, at higher levels of
ownership, it is argued that the entrenchment effect is more dominant as family members
manipulate earnings at the expense of minority shareholders. As the mean for total family 91
ownership is 24.73 percent, it can be argued that low levels of family ownership strengthen the
interest of various stakeholders resulting in lower earnings management activities.
As given in Table VII, the percentage of independent non-executive directors in the audit
committee variable also highlights the ineffectiveness of audit committees’ independence in
mitigating earnings management activities at the 10 percent significant level. This is further
exacerbated when total family ownership is used as the moderating variable, whereby a
positive association between audit committee independence moderated by total family
ownership and earnings management is observed at the 5 percent significance level. These
results suggest that a higher percentage of independent non-executive directors is less
effective in controlling earnings management in firms with greater family control than in
non-family-controlled firms. These results are consistent with H1a, indicating that family
ownership has a significant influence and moderates the association between percentage of
independent non-executive directors and earnings management. Crespí-Cladera and
Pascual-Fuster (2014) showed that more than 50 percent of independent directors’
misclassifications and a higher number of independent directors does not necessarily result
in better practices of corporate governance. Mulgrew et al. (2014) noted the lack of
consistency in defining the independence of directors but this issue has not been fully
addressed. More notably, independent directors face challenges in the light of the different
expectations of the shareholders. Therefore, unbiased and balanced decisions from well-
experienced independent directors that meet the competing interests of various stakeholders
are crucial for greater transparency of a firm.
Consistent with Abdul Rahman and Mohamed Ali (2006), this study finds no evidence of
the effect of ethnicity on earnings management; hence, H2 is not supported by the findings.
Additionally, family ownership is not found to have any significant moderating effect on the
relationship between ethnicity and earnings management; hence, H2a is also not supported.
A possible explanation for this may be associated with the NEM, which is more liberalized
with less government intervention in the board decisions of a firm (Wan Jan, 2011) and,
hence, enables firms to rely more on the competitiveness and efficiency of the Malays in
improving their productivity and less on their political affiliations.

6.3 Sensitivity analysis using direct family ownership and indirect family ownership
In the final part of the analysis (Table VIII), sensitivity analysis is conducted on separate
regressions for both direct family ownership (Panel A) and indirect family ownership
(Panel B) as the moderating variables.
Based on the above analysis, consistent with the findings in Table VII, positive associations
are observed between audit committee’s independence and earnings management when both
direct and indirect family ownerships are used as the moderating variables. However, only the
moderating effect of indirect family ownership is highly significant at the 1 percent significance
level. This suggests that there is a higher tendency to manage earnings in firms where the
family has higher indirect ownership and where there are more independent audit committee
members. The consistency of the results shows that family ownership strongly influences the
propensity of managers to manage earnings. This finding supports previous studies in
Malaysia and other countries on the importance of family institutional structure in mitigating
earnings management (Hashim and Ibrahim, 2013; Jaggi et al., 2009; Marra et al., 2011;
JAEE Dependent variable: DAMODIFIED
10,1 Panel A: direct ownership Panel B: indirect ownership
Exp. Coeff. t-Stat Coeff. t-Stat

C 0.516*** 2.71 0.520*** 2.93

ACINDEP ± 0.115*** 3.53 0.096*** 2.87
ETHNICITY + −0.025 −0.74 −0.0003 −0.01
92 DFOWN/IDFOWN ± −0.002** −2.21 0.0006 1.07
DFOWN/IDFOWN × ACINDEP ± 0.002 1.29 0.002*** 3.47
DFOWN/IDFOWN × ETH ± 0.0005 0.22 −0.002 −1.04
FAMPERCENT – 0.037 1.39 −0.002 −0.73
ACMEMBER 0.005 0.32 0.007 0.50
ACMEET −0.0002 −0.05 −0.002 −0.36
QUALI 0.050*** 4.11 0.049*** 4.27
ROA – 0.004*** 5.50 0.003*** 5.67
CHAIRINDEP – 0.052*** 3.20 0.044*** 3.33
MBRATIO – 0.006** 2.26 0.006** 2.26
BIG4 – −0.024* −1.84 −0.021 −1.41
LOGBSIZE – 0.326*** 3.88 0.348*** 3.33
LOGTENURE – 0.024 0.90 0.022 0.96
LOGASSET – −0.133*** −3.85 −0.130*** −3.57
2
R 34.47 32.98
Wald χ2 3,119.99 946.18
Notes: DAMODOFIED is absolute discretionary accruals based on Modified Jones Model. ACINDEP is the
percentage of independent non-executive directors in the audit committees. TOWN is the percentage of family
managerial ownership. DFOWN is the percentage of direct family managerial ownership; and IDFOWN that
of indirect family managerial ownership. ETHNICITY is the ratio of Bumiputera directors to total number of
directors on board. FAMPERCENT is the number of family members on the board/total no. of directors on the
Table VIII.
Regression output board. ACMEMBER is the Log number of audit committees’ members ACMEET is Log number of audit
(PCSEs) – Audit committees’ meetings. QUALI is and indicator variable with the value of “1” if at least one of the independent
committee directors in the audit committees has a degree in accounting and finance “0” indicate otherwise. ROA is the
independence, return on asset. MBRATIO is the market value of equity/book value of equity. BOARDSIZE is the number of
ethnicity and earnings directors in the board. TENURE is the total number of years of service of the CEO. TOTALASSET is Log 10
management (direct of total assets (RM’000). CHAIRINDEP is an indicator variable with the value of “1” if the Chairman is
and indirect independent non-executive directors and “0” otherwise. BIG4 is an indicator variable with the value of “1” if
ownership) audited by Big4 and “0” otherwise. *,**, ***Significance at 10, 5 and 1 Percent levels, respectively

Nahar, 2010; Wang, 2006). As proposed by the signaling theory, companies send signals to the
market to avoid any adverse effect of shareholders’ reactions by increasing the number of
independent directors in the audit committee. This trend of increasing independent directors is
found to be more prominent after the 1997 Asian Financial Crisis (Puchniak and Lan, 2015). No
significant evidence is found when direct ownership is used as the moderating variable. It was
observed in Table II that most firms are owned in majority via indirect ownership as opposed
to direct ownership. One plausible reason could be because control rights of firms in Malaysia
are owned via indirect ownership (Ishak and Napier, 2006). As both indirect and total
family ownership positively moderate the relationship between audit committee independence
and earning management at the 1 percent and 5 percent levels, respectively, H1a of this study
is supported.

7. Summary and conclusion

This study aimed to investigate the effect of audit committee independence, ethnicity
and, subsequently, the moderating effect of family ownership on earnings management.
A fixed effect panel regression of 1,206 firm-year observations of firms listed on Bursa
Malaysia was carried out for the reporting period of 2004–2009. Much of the evidence Effect of audit
reveals the lack of effectiveness of the role of independent directors in the audit committee. committee
It may enlighten regulators on issues related to the appointment of independent directors independence
in ensuring that well-qualified and objective independent directors are appointed.
Currently, loose guidelines exist in the selection process of the independent directors to be
appointed as audit committee members. Further studies should closely investigate the
level of training programs conducted to improve the level of expertise of audit committee 93
members. Despite the increase in RMCCG’s (2007) requirement for audit committee’s
independence and expertise, there is little evidence of industry-specific experience of the
independence directors in Malaysia. The minimal membership requirement in the
professional accounting bodies may be inadequate in complex business operations.
Industry expertise entails complex understanding of specific accounting treatments that
are vastly different between industries and the most qualified ones are those with
practical management and industry-specific experience and not those who are merely tied
to only “accounting and finance knowledge.”
Since family ownership is highly concentrated in Malaysia, there is also a need to
observe whether independent directors chosen by family firms are based on their
credibility rather their political affiliations. In the case where multiple directorships are
held, the obligation rests on the nominating committee to decide on whether the appointed
independent directors are capable of fulfilling the audit committee’s tasks. Although it is
argued that the establishment of audit committees is a solution to earnings management
activities, there are no clear guidelines on the appointment of audit committee members in
family firms, particularly on the formation of transparent audit committees and the tasks
required for more effective audit committees. An in-depth understanding of the possible
different roles of audit committees in family firms is needed for more accountable financial
reporting. Independent directors in the audit committees of family firms should be diligent
enough to understand the operating activities of a firm and contribute to the audit process.
The findings also support previous studies that firms appointing audit committee
members are essentially based on the need to fulfill stakeholder’s expectations and stock
exchange listing requirements (Makhaiel and Sherer, 2017) without focusing on the need of
audit committees for various tasks and the expertise required for their organization. There
is a need for audit members to not just be qualified on paper but to be able to understand the
operational process and to have the credibility to make decisions or act as whistle blowers in
closely tied family businesses. Engaging audit members with the right qualification but
lacking the knowledge of family business culture and operations may not be optimal for
their roles in effectively reducing earnings management activities.
Despite its contributions, this study has several limitations which call for future
studies. To begin, further studies should look into the substitution effect of audit
committee’s independence and disclosure index of firms to investigate if there is any
significant relationship between the appointment of more independent audit committee
members and firm’s transparency. In addition, further studies should look into the
industry experience of the audit members to understand the relationship among their
expertise, work experience and their ability to effectively execute their tasks. Although
we find no evidence to suggest that board ethnicity influences earnings management,
a study of different cultural environments in western and Asian countries may also help
to shed light on the influence of cultural diversity of the board on the managerial
decision-making process. Furthermore, as noted earlier, the earnings management model
used in this study is the Modified Jones Model (1991). Future studies should investigate
the existence of earnings management with other models such as Kothari et al. (2005) or
the Dechow and Dichev (2002) model to further evaluate the effectiveness of different
earnings management models.
JAEE Note
10,1 1. Under the Malaysian perspective, the political influence in most listed firms in Malaysia has exist
since the formation of National Economic Policy (NEP) in 1970 and more significant later in year
1991 after the establishment of National Development Policy.

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About the authors

Wan Masliza Wan Mohammad is currently Assistant Professor in Finance at the College of Business
Administration, University of Bahrain. She holds a Bachelor Degree in Accounting and Finance from
Lancaster University, UK and later obtained her Master in Accountancy from UiTM, Malaysia. Her
current research is in the area of corporate governance, earnings management and Islamic banking.
She has published her works in the International Journal on Social Science Economics & Art, Journal of
Business Policy and Research and Corporate Ownership and Control. She is also a fellow member and
reviewer of World Business Institute (WBI) in the area of banking research.
Shaista Wasiuzzaman is Assistant Professor (Mathematical Finance) at Universiti Teknologi Brunei.
Her current research is in the areas of corporate finance, corporate governance and Islamic Banking.
Shaista Wasiuzzaman is the corresponding author and can be contacted at: shaistaw76@gmail.com

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