THE INFLUENCE OF MULTIPLE DIRECTORSHIPS AND POLITICAL CONNECTION ON EARNINGS MANAGEMENT
(Study at Manufacturing Companies listed on LQ45 Index in Indonesia Stock Exchange Period 2013-2018)
UNDERGRADUATE THESIS
Submitted in accordance with requirements for the Bachelor‘s Degree in Accounting
PUTRA MULIA 11130821000014
ACCOUNTING DEPARTMENT
THE FACULTY OF ECONOMICS AND BUSINESS SYARIF HIDAYATULLAH STATE ISLAMIC UNIVERSITY
JAKARTA 1440 H/2019
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THE INFLUENCE OF MULTIPLE DIRECTORSHIPS AND POLITICAL CONNECTION ON EARNINGS MANAGEMENT
(Study at Manufacturing Companies listed on LQ45 Index in Indonesia Stock Exchange Period 2013-2018)
UNDERGRADUATE THESIS
Submitted in accordance with requirements for the Bachelor‘s Degree in Accounting
By:
Putra Mulia 11130821000014
Under Supervision of:
Hepi Prayudiawan,SE.,MM.,Ak.,CA ID. 197205162009011006
ACCOUNTING DEPARTMENT
THE FACULTY OF ECONOMICS AND BUSINESS SYARIF HIDAYATULLAH STATE ISLAMIC UNIVERSITY
JAKARTA 1440 H/2019
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ENDORSEMENT SHEET COMPREHENSIVE EXAMINATION
Today is Tuesday, 12nd July 2018 a Comprehensive Examination has been conducted on student :
Name : Putra Mulia
Student ID : 1113082100014
Department : Accounting
Thesis Title : The Influence of Multiple Directorships and Political Connection on Earnings Management (Study at Manufacturing Companies Listed on LQ45 Index in Indonesia Stock Exchange Period 2013-20018)
After careful observation and attention to appearence and capabilities relevant for comprehensive examination process, it was decided that the above student passed and given opportunity to thesis as one of the requirements to obtain a Bachelor of Economics in the Faculty of Economics and Business Syarif Hidayatullah State Islamic University Jakarta.
Jakarta, August 30th 2019
1. Zuwesty Eka Putri, M.Ak. (...) ID : 198004162009012006 Examiner I
2. Hepi Prayudiawan, S.E.,M.M.,Ak,CA (...) ID : 197205162009011006 Examiner II
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CERTIFICATION OF THESIS EXAMS SHEET
Today, September 25 2019 has been conducted on the student thesis examination:
Name : Putra Mulia
Student Number : 1113082100014
Department : Accounting (International Program)
Thesis Title : The influence of Multiple Directorships and Political Connection on Earnings Management (Study at Manufacturing Companies listed on LQ45 Index in Indonesia Stock Exchange Period 2013- 2018)
After careful observation and attention to appearance and capabilities relevant for thesis exam process, it was decided that above student passed and the thesis was accepted as one of requirements to obtain Bachelor of Accounting in the Faculty of Economic and Business Syarif Hidayatullah State Islamic University Jakarta.
Jakarta, 25 September 2019
1. Fitri Damayanti,SE.,M.Si ( ... )
NIP: 198107312006042003 Head of Examiner
2. Hepi Prayudiawan, SE.,Ak.,MM,CA ( ... )
NIP: 197205162009011006 Secretary
3. Atiqah, SE., MS.Ak ( ... )
NIP: 198201202009122004 Expert Examiner
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SHEET STATEMENT
AUTHENTICITY SCIENTIFIC WORKS
Signature below:
Name : Putra Mulia
Student Number : 1113082100014
Faculty : Economics and Business Department : Accounting
Hereby declare that in the writing of this mini thesis, I:
1. Do not use other people’s ideas without being able to develop and accountable
2. Do not use plagiarism of other people’s works
3. Do not use other people’s work without mention the original source or without the owner’s permission
4. Do not manipulate and falsify the data
5. Own work and able to work responsible for this work
If in the future there is a demand from the other side of my work, and have been accountably proved, was indeed found that i have violated the above statement, then I am ready to be sanctioned according to rules applicable in the Faculty of Economics and Business Syarif Hidayatullah State Islamic University Jakarta.
Thus statement truly made with sincerely.
Jakarta, August 31st 2019
(Putra Mulia)
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CURRICULUM VITAE PERSONAL DATA
Name : Putra Mulia
Place, date of birth : Jakarta, 31 December 1995
Address : Puri Ganda Asri Townhouse Blok A/2, Pondok Labu
Phone : +6281219726501
Email : [email protected] Nationality : Indonesia
FORMAL EDUCATION
University of Applied Science Würzburg-Schweinfurt (2014-2016) Syarif Hidayatullah State Islamic University Jakarta (2013-2019) MAN 4 Jakarta (2010-2013)
Rafah Islamic Boarding School (2007-2010) SDIT Miftahul Ulum Depok (2003-2007) SDN 03 Cinere (2001-2003)
INFORMAL EDUCATION
Brevet Pajak A and B PKN STAN Jakarta (2019)
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LBI Universitas Indonesia, IELTS Preparation (2018) ILP Cinere, TOEFL Preparation (2014)
ILP Cinere, English Course (2013-2014) ORGANIZATIONAL EXPERIENCE
Public Relation Manager at AIESEC in South Tangerang (2016)
Vice President of Finance and Legal at AIESEC in South Tangerang (2017) WORKING EXPERIENCE
Bank DBS Indonesia, Internship (2019) Dpointgroup Barcelona, Internship (2018) CONFERENCE AND TRAINING
National Election Conference AIESEC Indonesia (2018) National Functional Summit AIESEC Indonesia (2017) Management Board Conference AIESEC Indonesia (2016)
Training and Company Visit by the 16th ATV Universitas Indonesia (2016) Summer School at OTH Amberg-Weiden, Germany (2015)
Team Management Training held by FHWS (2015)
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PENGARUH RANGKAP JABATAN DAN HUBUNGAN POLITIK TERHADAP MANAJEMEN LABA (STUDI PADA PERUSAHAAN MANUFAKTUR YANG TERDAFTAR DI INDEX LQ45 DI BURSA EFEK
INDONESIA PERIODE 2013-2018)
ABSTRAK
Penelitian ini bertujuan untuk menginvestigasi pengaruh rangkap jabatan dan hubungan politik terhadap manajemen laba. Penelitian ini menggunakan sampel perusahaan manufaktur yang terdaftar pada Indeks LQ45 yang terdaftar di Bursa Efek Indonesia (BEI) periode 2013-2018. Teknik pengambilan sampel menggunakan purposive sampling dengan sampel sebanyak 7 perusahaan manufaktur untuk periode 2013 sampai dengan 2018. Pengujian hipotesis yang digunakan dalam penelitian ini adalah analisis regresi linier berganda dengan menggunakan SPSS versi 23.
Hasil penelitian ini menunjukan bahwa rangkap jabatan dan hubungan politik berpengaruh terhadap manajemen laba. Hasil ini konsisten apabila menggunakan akrual diskresioner dengan model Jones (1995)
Kata Kunci: akrual diskresioner, hubungan politik, manajemen laba, rangkap jabatan
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THE INFLUENCE OF MULTIPLE DIRECTORSHIPS AND POLITICAL CONNECTION ON EARNINGS MANAGEMENT (STUDY AT MANUFACTURING COMPANIES LISTED ON LQ45 INDEX IN
INDONESIA STOCK EXCHANGE PERIOD 2013-2018)
ABSTRACT
This research aims to investigate the influence of multiple directorships and political connection on earnings management. The sample of this research is manufacturing companies on LQ45 index in Indonesia Stock Exchange (IDX) in period 2013-2018. The method used is purposive sampling method with a sample of 7 manufacturing companies for the period 2013 until 2018. Hypothesis testing is run with multiple regression estimation method using SPSS version 23.
The result of this research indicates that multiple directorships and political connection influence earnings management. These results are consistent when the measurement of discretionary accruals is using modified Jones (1995) model.
Keywords: discretionary accruals, earnings management, multiple directorships, political connections
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FOREWORD Assalamualaikum Wr.Wb
All Praises be to Allah the Almighty for all of His blessings that the writer has finally completed this undergraduate thesis. In retrospect, the work was not merely as a result of the writer‘s own efforts, but also due to strong and endless support of many individuals who have been accompanying him in every step of the way – from the moment he entered UIN Jakarta back in 2013 up until now. As such, the writer would love to give the highest gratitude and acknowledged to:
1. Papa, Irwandi, ST and Mama, Yen Mareni, for their unconditional love, unwavering care, guidance, and prayer throughout the writer‘s life;
2. Adik, Berlianda Abdillah and Qonita Afiyah Putri, for their cheers and unconditional support to the writer.
3. Prof.Dr.Amilin,SE.,Ak.,M.Si.,CA.,BKP.,QIA.,CRMP as the Dean of Economics and Business Faculty.
4. Yessi Fitri, SE.,M.Si.,Ak as the Head of Accounting Department in Faculty of Economics and Business UIN Jakarta.
5. Fitri Damayanti, SE.,M.Si as the Secretary of Accounting Department in Faculty of Economics and Business UIN Jakarta.
6. Hepi Prayudiawan,SE.,MM.,Ak.,CA as the undergraduate thesis supervisor who has been helping, guiding and advising me throughout the research process.
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7. Prof.Dr. Margareth Gferer as mentor, for her motivation and support to achieve the double degree program.
8. Prof. Manfred Kiesel as the head of International Program in FHWS, for his assistance during the study process in Wurzburg
9. Prof. Reiner Wehner as the mentor in FHWS, for every assistance during my college life in Wurzburg
10. Mardani Bonyx S.Far.,Apt as the staff in academic division, for every help related to administrative and academic stuffs in FEB UIN.
11. Destarani Bella Shabrina, S.Sn as my special supporter, thank you for your caring and assistance during the writer‘s thesis process.
12. All lecturers and staffs of Accounting Department at UIN Jakarta, for the knowledge and support during the writer‘s study process in UIN Jakarta.
13. All lecturers and Staffs of Business Administration Department at FHWS, for the knowledge and support during writer‘s study process in Wurzburg.
14. Ira and Ida as my friend, for every ups and down during our college life in Wurzburg and Jakarta.
15. All of my Indonesian friends in Wurzburg, for the food and experience during the writers stay in Wurzburg.
16. All of my Indonesian friends in Barcelona, for the help since day one of writers life in Barcelona.
17. PPI Barcelona, for the chance to involve in organization.
18. All Spanish, Korean, German, Turkish, Jordan and Thai friends – currently scattered all over the globe – who have been responding to the writer‘s
xii
never-ending and sometimes random chats via WhatsApp, Instagram and other social media these past three years.
19. Diko and Abdul as friend, for sharing their knowledge about SPSS.
20. All of my classmates in International Accounting 2013, Aji, Afri, Panji, Riski, Ryan, Banan, Melinda, Wulan, Fita, Raisa, Syarah and (Almh) Indri, thank you for the experience and journey for these past six years.
I‘m glad to know you all.
21. Other individuals whom the writer have met somewhere in these six years.
You have contributed, however small, to the writer‘s journey.
In closing, I realize that this thesis is far from perfection, thus suggestions and constructive critics from all parties are very welcome. It is hoped that this thesis is beneficial not only for the writer but also for others, especially those in academic world.
Wassalamualaikum Wr.Wb
Jakarta, 25 September 2019
Putra Mulia
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TABLE OF CONTENT
COVER ... i
CERTIFICATION OF SUPERVISOR ... ii
CERTIFICATION OF COMPREHENSIVE EXAM ... iii
CERTIFICATION OF THESIS EXAMS SHEET ... iv
STATEMENT OF ORIGINALITY ... v
CURRICULUM VITAE ... vi
ABSTRACT ... viii
FOREWORD ... x
TABLE OF CONTENT ... xiii
LIST OF TABLE ... xvii
LIST OF FIGURE ... xviii
LIST OF APPENDIX ... xix
CHAPTER 1 ... 1
INTRODUCTION ... 1
A. BACKGROUND ... 1
B. PROBLEM FORMULATION ... 6
C. PURPOSE AND BENEFIT... 7
1. Purposes of Research ... 7
2. Benefits of Research ... 7
xiv
CHAPTER 2 ... 9
STUDY LITERATURE ... 9
A. INTRODUCTION ... 9
B. LITERATURE ... 9
1. Agency Theory and Stewardship Theory ... 9
2. Corporate Governance ... 12
3. Corporate Structure ... 14
4. Multiple Directorship ... 15
5. Political Connection ... 19
6. Earnings Management ... 21
C. PREVIOUS RESEARCH ... 30
D. HYPOTHESIS ... 37
1. Multiple Directorships and Earnings Management ... 37
2. Political Connection and Earnings Management ... 40
3. Conclusion ... 42
CHAPTER 3 ... 43
RESEARCH METHODOLOGY ... 43
A. SCOPE OF RESEARCH... 43
B. SAMPLING METHOD ... 43
C. COLLECTION DATA METHOD ... 45
1. Library Research ... 45
2. Documentation Research ... 45
xv
D. DATA ANALYSIS METHOD ... 46
1. Descriptive Statistic ... 46
2. Classical Assumption Test ... 46
3. Test of Hypothesis ... 49
E. RESEARCH VARIABLES OPERATIONALIZATION ... 50
1. Dependent Variable ... 50
2. Independent Variables ... 52
CHAPTER 4 ... 55
FINDING AND ANALYSIS... 55
A. GENERAL DESCRIPTION OF RESEARCH OBJECT ... 55
1. Research Object Description ... 55
B. ANALYSIS AND DISCUSSION ... 56
1. Descriptive Statistics Analysis ... 56
2. Classical Assumption Test ... 57
3. Test of Hypothesis ... 62
C. HYPOTHESIS EVALUATION ... 66
1. The Influence of multiple directorships on earnings management .... 66
2. The Influence of political connection on earnings management ... 67
CHAPTER 5 ... 69
CONCLUSION ... 69
A. CONCLUSION ... 69
B. SUGGESTIONS AND RECOMMENDATION ... 69
xvi
1. Suggestion ... 69
2. Recommendation ... 70
REFERENCES ... 72
APPENDIX ... 82
xvii
LIST OF TABLE
NO DESCRIPTION
2.1 Differences between Accrual and Real Earnings Management ... 27
2.2 Summary of Previous Research on Multiple Directorships ... 31
2.3 Summary of Previous Research on Political Connection ... 34
2.4 Conceptual Framework ... 37
3.1 Data Sampling Procedures ... 45
3.2 Variable Operationalization ... 54
4.1 Detail of Research Sample ... 55
4.2 Descriptive Statistics Analysis in Period 2013-2018 ... 56
4.3 Klomogrov-Smirnov Test Result ... 59
4.4 Multicollinearity Test Coefficients ... 60
4.5 Heteroscedasticity Test with Park Test ... 61
4.6 Autocorrelation Test ... 62
4.7 Simultaneous Test (T-test) ... 63
4.8 Coefficient Determination Test (R2) ... 63
4.9 Partial Test (Test) ... 64
xviii
LIST OF FIGURE
NO DESCRIPTION
4.1 Normality Test with Histogram ... 57 4.2 Normality Test with Probability plot ... 58
xix
LIST OF APPENDIX
NO DESCRIPTION
1 Sample Companies List ... 82
2 Composite measurement ... 82
3 Multiple Directorship measurement ... 83
4 Political Connection measurement ... 84
5 SPSS Test result ... 86
1 CHAPTER 1 INTRODUCTION A. Background
Good Corporate Governance (GCG) is an important goal to be achieved by a business entity in its aspiration to maintain sustainability of its activities.
Its implementation relies on corporate governance framework, which is defined as ―a set of relationships between a company‘s management, its board, its shareholders and other stakeholders‖ (OECD, 1999, p. 11). It is a systematic framework built to manage and respond to the agency problem where the divergence of interest of the managers from those of shareholders create an opportunity for the former to transgress their limited duties for their self-bene fits. The 1997-1998 Asian Financial Crisis, the Enron and WorldCom cases in the US at the early 2000s and the recent emission scandal of Volkswagen in Germany are the few examples of how corporate failure in ensuring the integration of good corporate governance results in managerial abuses which cause detrimental effects for the company and, to some extent, the economy in general.
While corporate governance covers many aspects of the management of a company, its concept is very relatable to the corporate financial reporting.
In Principle v (five) on Disclosure and Transparency, it calls on companies to make use of financial reporting standards to deliver high quality financial information for its users (OECD, 2015). As it is known, financial reports contains information that will be used for their users to base their economic
2 decisions (IASPlus, 2016). Also, they project how much stewardship functions have been exercised by company directors and managers who are given the mandate by the company shareholders to allocate company resources for business activities effectively and efficiently. Essentially, corporate governance ensures that the output of business activities, represented in financial reports, remain relevant, useful and beneficial for everyone – managers, shareholders and stakeholders of the company.
The International Financial Accounting Standards (IFRS) – to which the Indonesian FRS is converging to – dictate some categories of financial information to be disclosed in financial statement. One of the information that is particularly scrutinised by both stakeholders and shareholders of a business entity is earnings. It is a valuable indicator of accountability of managers/directors, predictor of company‘s growth as well as measurement of earning power in the future (Kieso, Weygandt, and Warfield, 2010). Its attribute as a measurement of earning power – the ability of a company to generate profit from the invested capital after taking into account the company‘s liabilities – is especially important for the shareholders whose maintain interest is improving its own wealth as they invest in the company.
At the same time, since it works as a measurement of managerial performance, it is used as a bargaining chip for the managers in obtaining fair compensation for their work in the company (Godfrey, Hodgson, Tarca, Hamilton, and Holmes, 2010). As a result, in a pursuit of maximising their own utility, managers try to manipulate earnings so that it looks better for the company‘s
3 image, even if the numbers do not match the reality on the ground (Healy, 1985; Watts and Zimmerman, 1978). These Activities are called as earning management.
Various studies have been conducted to relate corporate governance issues and the level of earnings management. In this thesis, two issues are explored, which are multiple directorship and political connections. Multiple directors, as the name suggests, are directors who hold directorship appointment in more than one company. Given that Indonesian companies follow the two-tier board system as opposed to the unit the unitary board system, it is more likely that multiple directorship occurs. Furthermore, the appointment will be more obvious with clear demarcation of responsibilities if a commissioner in a particular company works as director in another vice versa (Millet-Reyes and Zhao, 2010). Some rules have been enacted to formally acknowledge and regulate it with the earliest for private entities was introduced in 2010 by the Commission for the Supervision of Business Competition (Komisi Pengawas Persaingan Usaha or KPPU) which disallows multiple directorship practices for directors who aim to monopolise certain industry or to play unfairly against their companies‘ competitors. This is similar to the Clayton Act in the US which allows multiple directorship or interlocking directorate if the practice does not create amti-competition and monopolistic business environment (Axinn and Yoerg, 1984). The supporters in favour of multiple directors‘ base their argument on the fact that it is bound to happen given the high competition in the market to get the best and the
4 brightest leading the company (Fama, 1980). On top of monopoly argument, the opponents of this view, however, see this practice as a disservice for the companies involved where it is argued that multiple directors will have a lack of focus to perform their duties as they work for many companies simultaneously (Jiraporn, Kim, and Davidson, 2008). Recently, the Indonesian Financial Services Authority (Otoritas Jasa Keuanagan or OJK) issued Regulation No. 33/POJK.04/2014 on Directors and Board of Commissioners of Issuers of Public Companies which provides legal platforms for multiple directors to continue their work albeit with more defined conditions.
In its relationship with earnings management, similar to the general pros and cons, multiple directorships is argued to be influencing earnings management in a variety of ways. Chiu, Teoh and Tian (2013) believe that the shared directorship will facilitate the spread of and, if implied, enhance earnings management activities in those companies with multiple directors, especially if the company have weak management control. On the other hand, it is argued that the case of interlocking directors reduces earnings management as these individuals have better understanding on financial reporting where they serve for other companies and they are in the position to uphold their reputation (Jiraporn et al, 2008; Shu, Yeh, Chu, and Yang, 2015).
While investigations about this relationship has been extensively conducted in other countries, few were conducted using Indonesian context where, for instance, corporate structure is divided into two separate boards which is argued to result in a different degree of governance effectiveness as compared
5 to a single board structure (Millet-Reyes and Zhao, 2010). It is possible to that the result of the study here differs from the previous studies, which were commonly conducted in a single board structure environment.
Another interesting phenomenon observed in Indonesia‘s business scene is politically-connected companies. These firms have either at least one large shareholders with 10% of voting and above or one director (commissioner or executive director) is a member of parliament, a minister or the head of state or affiliated with political party (Faccio, 2006). Cultivated during Soeharto‘s era and to a large extent, provide undue benefits for the companies involved, directors in these companies may form poorly and to compensate that, they will manage company‘s earnings (Apriliani, 2015;
Faccio, 2006). Political connections in terms of involvement of politicians also deteriorate information effectiveness and quality as greater transparency harms in the interest of politicians in expropriating the benefits from the shareholders and stakeholders (Piotroski, Wong and Zhang, 2015). In essence, political connections work in tandem with earnings management activities that are problematic for the company. However, the reverse is true under assumptions that as political connections increase political visibility or public scrutiny, failure to bring about greater accountability and better reporting quality will cost the firm even more than the internal benefits reaped from doing it (Braam, Nandy, Weitzel and Lodh, 2015; Chaney et al., 2011).
Some attempts have been made to reduce political connections in Indonesia companies, starting with the state-owned enterprises (SOEs) by the
6 virtue of government regulation which prohibits directors of state-owned entities from being affiliated any political party or standing for political office.
However, no regulation has been enacted for private companies. As such, it is still relevant to examine how the relationship between company‘s political connections influences earnings management practices in today‘s Indonesian companies.
This research is developed from the prior research done by Chiu, Teoh and Tian (2013) and Braam et al (2015). The differences of this study with the previous study are the author compiles the independent variables which are multiple directorship and political connection to investigate their influence towards earnings management using modified Jones model‘s proxy.
Moreover, the population of this study is manufacturing companies listed on LQ45 in Indonesia Stock Exchange (IDX) in period 2013-2018. Meanwhile, the previous research is done in other countries with different population.
Based on the reason above, the writer wants to propose a little about
―The Influence of Multiple Directorships and Political Connection on Earnings Management (Study at Manufacturing Companies listed on LQ45 Index in Indonesia Stock Exchange Period 2013-20 18)”
B. Problem Formulation
Based on the research problems explained earlier, the following research questions were formulated:
7 1. Does the practice of multiple directorships influences earnings
management?
2. Does the practice of political connection influences earnings management?
C. Purpose and Benefit 1. Purposes of Research
In the earlier part, it has been established briefly how corporate governance relates with the quality of financial information, especially so in terms of earnings. It is also noted that two issues related to governance, namely multiple directorships and political connections can influence the managers to use earnings management in positive or negative ways. As these are investigated in this research, the main objectives for the study are:
1. To analyze the influence of multiple directorships on earnings management.
2. To analyze the influence of political connection on earnings management.
2. Benefits of Research
It is expected that this research will make positive contributions as theoretical and practical to the following parties:
a. Regulators
Results from the investigations are expected to assist regulators in designing, evaluating and improving the existing rules pertaining to multiple
8 directorship and political connections of members of the board of directors and commissioners in public companies.
b. Researchers
Currently, there are very few studies in Indonesia that specifically investigate the influence of multiple directorships as one issue in corporate governance with various firm-specific parameters. While for political connections, this study is focusing its discussion on a specific industry with a more recent timeframe. This study is thus expected to increase understanding of multiple directorship practices, with respect to the relationship between political connections and earning management activities, this could help in further researches involving multiple directorships, political connections and earnings management.
c. Companies
It is expected that the study results will provide recommendations for companies to improve their corporate governance, especially for their busy managers and act accordingly with respect to political connections and earnings management.
d. Investors
This research should help investors in choosing which company they will invest into by looking into the presence of interlocking directorate and political connections of a particular company.
9 CHAPTER 2 STUDY LITERATURE A. Introduction
In order to understand the case of multiple directorships and political connections in a firm and their relationships with earnings management practices, this chapter discusses the theories and any relevant information related to both issues. The discussion highlights some prior studies that are used in the development of the context and concept of this research in Indonesia. The final section of this chapter explains the proposed hypotheses for investigating the relationships between multiple directorships and earnings management as well as political connections and earnings management.
B. Literature
1. Agency Theory and Stewardship Theory
Agency theory, the main theme of discussion in this entire study, was first initiated by Jensen and Meckling (1976). There are two parties involved in the theory (principal and agent), bound to a set of contract, with different responsibilities. The principal, as the owner of the business entity, provides capital for running the business activities. Whereas the agent acts on behalf of the principal to manage those capital and run the company. Although both parties are in the same goals, when exercising the contract, they have separate interest. The principal is motivated to grow the company for the sake of maximising their own wealth while the agent works solely to gain private benefits, financial or otherwise, for his/her services as based on the positive
10 accounting theory where he or she is driven by his/her self-own interest (Whittington, 1987).
Using the assumption that the two parties are ‗utility maximisers‘ and are driven by personal interests, the divergence of interest will be inevitable between the principal and agent, giving rise to the agency problem. Since the goal of a firm is principal-centric (i.e. maximising principal‘s wealth), the solution to the problem rests on correcting the agent‘s interest to be in line with that of the principal by means of incentives, monitoring and bonding activities (Godfrey et al., 2010). Given the logical assumptions used, the agency theory succeeded to explain a lot of problematic managerial behaviour, such as earnings manipulation and also provided a basis for stronger corporate governance as separation of ownership and control became apparent (Abdullah and Valentine, 2009).
Over the years, agency theory has gained further acceptance in the academic discourse, but there were debates on the use of the assumed inherent opportunistic and individualistic behaviour of the agent. Donaldson and Davis (1991) proposed an alternative assumption with their stewardship theory. As the name suggests, agents do not necessarily work for themselves; they can work to attain the interest of the principal and are assumed to be cooperative and trustworthy. The argument was further extended by Daily, Dalton, and Canella (2003) who believed that it is in managers‘ self-interest to exercise their stewardship functions well in order to improve their standing in the corporate world. Corporate governance mechanisms are thus supposed to
11 ensure the optimization of managers‘ stewardship functions for achieving organizational goals.
While this theory was perceived to counter the agency theory entirely, in the subsequent study by Davis, Schoorman, and Donaldson (1997), it was argued that the stewardship theory merely complements the agency theory by taking into account the selfless behaviour of agents in their aspiration to further maximize their utilities, thus expanding the understanding of principal- agent relationship as well as the governance activities involved in managing it.
It is also worth noting in their paper that with the presence of asymmetric information – a situation arising due to managers handling more company operations than the shareholders – agency conflict is more likely to occur (Davis et al., 1997). This is something the agency theory has already postulated before, rendering the use of stewardship theory on its own inadequate without first looking at the agency theory.
As it will be further discussed in the later section, corporate governance functions to reduce asymmetric information problem, a source of agency conflict in a company. This cements the fact that corporate governance is based on the agency theory. In the same way, unethical behaviour of managers, such as earnings manipulation, arises as a result of the agency problem, something that has already been explained extensively in the agency theory. Thus, linking these two components using the agency theory as their considerations is appropriate and relevant to this study.
12 2. Corporate Governance
In 1999, the Organization for Economic Cooperation and Development (OECD) published the Principles of Corporate Governance. It outlines the definition of corporate governance to mean the following (OECD, 1999):
1. Internal mechanisms to control and operate a firm.
2. A set of relationship between the company‘s management, board, shareholders and stakeholders.
3. Framework to develop and execute company objectives and monitor company‘s performance in terms of effectiveness and efficiency.
Corporate governance is also defined as a check and balance system where upon its implementations, it is based on six values: transparency, accountability, responsibility, independence, fairness and equality (National Committee on Governance, 2006).
Exploring the Principles further, corporate governance seeks to correct some key areas that are the ingredients for agency problem to materialize. Firstly, it seeks to reduce information asymmetry as exemplified by the Principle V (five) on Disclosure and Transparency which points out the possibility of managers not being truthful about the information it releases to the shareholders so that they are not well-informed to make decisions.
Secondly, it tackles the self-interest motivation of the managers and controlling shareholders in the Type I and Type II agency problem respectively as emphasized by continuous calls for the company to provide equitable and fair treatment of all shareholders and stakeholders. Thirdly, it
13 highlights the importance of monitoring and oversight functions of the Board –explicitly stated in the Principle VI (six) – which is crucial in ensuring the mitigation of the other two problems.
Other than mitigating the agency conflict, implementation of GCG can improve performance and operational efficiency, effectively connect companies to the capital market, lower the risk perception by creditors and improve company reputations in the eyes of investors (IFC Indonesia, 2014).
In turn, this should improve the company‘s worth and beyond that; deepen the domestic financial market development (Veronica and Bachtiar, 2005).
With the said benefits, a company faces better prospect of growth and it will be unlikely that management engages in dishonest behaviour. Even if they still try to fulfil their personal interest that are at odds with the interest of the owners, the monitoring and oversight aspect of the corporate governance processes are in place to detect and prevent the intention to progress further.
In these regards, it becomes relevant to incorporate the elements of corporate governance for this study that is investigating one channel that the management use to benefit them, namely earnings management. That is, how some components of governance, such as the nature of directorships and the political aspect of governance in terms of political connections can influence the quality of oversight and monitoring requires preventing the deterioration of quality of financial information as a result earnings manipulation.
14 3. Corporate Structure
One area of corporate governance that deals with the issue related to principal-agent relationship is the corporate structure. The structure must be able to ―ensure the strategic guidance of a company, the effective monitoring of management by the board, and the board‘s accountability to the company and the shareholders‖ (OECD, 2015, p. 51). From this objective alone, it is clear that the structure will have at least two compartments, one for managing the company operation and one for overseeing the actions of those who manage the company. By convention, the former is called non-executive director and the latter is called executive director.
While there are some variations as to the structure itself, the two most common forms of the board are one-tier/unitary board and two-tier/dual board.
In the unitary board, both types of director sit in the same board whereas in dual board, the executive directors work together in the management board and the non- executive ones form the supervisory board. In Indonesia, the 2007 Limited Liability Company Act (Undang-Undang Perseroan Terbatas Tahun 2007) mandated the dual board for the corporate structure. Different from the usual dual board in East European countries, the boards of directors are appointed by the general meeting of shareholders instead of the supervisory board. Nonetheless, the role of the board of directors and supervisory board, or the board of commissioners, remains the same.
According to Aste (1999) stated in Millet‐Reyes and Zhao (2010), dual board present different strengths than the unitary board. First, there is a clear
15 demarcation of responsibilities between two boards. Second, the relative size of each board is smaller, giving way for quicker decision-making processes to occur. Third, the two boards can have greater flexibility to nominate its members which can improve diversity. All these should put the dual board to be more effective in the implementation of good corporate governance.
However, it is also noted that there are problems associated with dual board system. First, interlocking directorate occurs more often. Second, there will be a practice of ‗political appointment‘ where former executive directors are appointed immediately as non-executive directors and vice versa, which can disproportionally strengthen their influence in the company. All these can potentially impact the effectiveness of the dual board in implementing good corporate governance.
4. Multiple Directorship
The need for multiple directors is explained using a simple demand- supply relationship posited by Fama and Jensen (1983). They raised a point on the nature of director‘s market which continues to search for the best talent available for any directorship position. With that signal and given the scarcity of those talents, it is only sensible that one talent will be valued and sought after highly by many companies. The individual will see this demand as recognition of his work and thus is willing to take up offers from more than one entity to boost his reputation. In that sense, multiple directorship signals directors‘ quality.
16 Aside from the reputation factor, multiple directorships can be triggered by the intensity of firm‘s transaction and size. In the first place, as firms make use of resources to conduct its business, directors have a role in bridging the resource holders and the firm‘s owners (Pfeffer and Salancik, 1978). It is therefore important for them to have strong relationship with external environment while being able to minimise the risk of environmental uncertainty and the presence of environment- dependent transaction cost involved in such arrangements (Hillman, Canella, and Paetzold, 2000). Other than strong relationship, tackling the two issues necessitates the need of directors/agents with informational network, justifying the possibility of appointing busy managers who have stronger informational network (Yusoff and Alhaji, 2012).
Booth and Deli (1995) cited in Ferris, Jagannathan, and Pritchard (2003) stated that when a particular company experience more transactions with external parties, directors with diverse connection to these parties are required in managing the more complex contracting activities. Applying the same logic, as a business entity grows, its businesses expand, thus requiring agents/directors who have skills and vast knowledge of acquiring sources of capital for the benefit of the firm and thus its shareholders. Busy managers are perceived as possessing such characteristics and it is in the company‘s interest to use them. For instance, one busy manager is actually close with a potential business partner because the latter has been in business with another company that is served by this same manager. The social/networking skill that this
17 manager has can help to smoothen company transactions, possibly bringing good deals for the company itself.
The case of multiple directorships presents some advantages for the firm. Chen, Lai, and Chen (2015) contend that with busy managers, the company will incur lower agency costs because the said managers are high- flyer individuals with proven capabilities to lead or monitor a company as the executive or non-executive directors respectively. Their self-interest digresses little from shareholders‘ since they want to ensure the company performs well to improve their expertise, hence their selling points in the market. These selling points will further encourage the use of their skills in other companies, thus benefiting the managers themselves in the future. Other than that, the firm will gain from the perspective of strategic management (Chen et al., 2015).
This is especially important when the firm should resort to major corporate actions, such as merger and acquisition (MandA) or raising capital. With multiple directors, their connections and networks fill in the gap on available strategies that the company can be used. The directors can compare and contrast practices from all the firms they are assigned to, giving them the advantage of choosing best practices and benchmark for the firm‘s performance.
Despite the advantages, the presence of busy directors can be detrimental to the company. Firstly, the agency cost rises as a result of them being overwhelmed by the monitoring and supervision workload as they serve different companies. In a study conducted by Core, Holthausen, and Larcker
18 (1999) for example, it showed that at the presence of multiple directors, the company‘s CEO received higher compensation packages even though the firm performance was lower. In this regard, the less supervised managers use the golden opportunity to serve themselves at the expense of shareholders‘ needs (Chen et al., 2015). Secondly, the company faces the impact from multiple directors‘ learning cost as they have to adjust and gain skills required conducting proper governance in the company. It is expected that at the beginning of their term, their performance is weak before improving rapidly later on. With lower efficacy of governance after the appointment of multiple directors, the company faces the risk of an increase in undesirable management activities that are attributed to weak governance (Chen et al., 2015).
Finally, multiple directors who usually are seen as outside directors face the challenge of obtaining information from the executive directors, especially CEO of the different company they serve into (Adams and Ferreira, 2007; Raheja, 2005). The assumption here is that the directors serve in companies of different industry than where they come from originally. This is quite relevant in Indonesia, as the implementation of Commission for the Supervision of Business Regulation No. 7/2009 regarding the Guidelines of Interlocking Directorate prohibits any director to serve in companies of the same industry. It creates information gap for the multiple directors as they may come from one industry they are familiar of, only to serve another company in an unfamiliar industry. With the presence of asymmetric
19 information, multiple directors cannot achieve the best outcome of governance they hope for. Thus their supervisory and oversight role is not optimal.
5. Political Connection
A company is said to be politically connected if at least one of their directors or one large shareholder with more than 10% voting rights is a member of parliament, a minister or head of state or affiliated to a political party (Faccio, 2006). This type of company exists in Indonesia due to rampant corruption and weak enforcement of investor protection laws (Carney and Child, 2013; Chaney et al., 2011; Faccio, 2006).
Prior research showed that firms seek political connection due to the benefits associated with the influence of the politicians or public office holders. In a country where political instability could occur easily, political connection is valued for providing protection and reputation for the connected company (Fisman, 2001). Furthermore, political connection is used to facilitate many business interests. One, the firm can lobby for the implementation of regulation to restrict the entrance of other companies in the market (Bunkanwanicha and Wiwattanakantang, 2009). Two, it is able to make use of the perceived good reputation and politicians‘ networks to obtain more credit facilities from financial institutions, often at lower rate than others without the connection (Boubakri, Cosset, and Saffar, 2012). Three, political connections provide certainty for the company during an economic crisis as it has higher chance of being granted some bailouts from the government (Faccio, 2006). From here, political connections should impact positively on
20 the firm‘s performance and also its value and managers may not be incentivised to unethically exaggerate financial information, unless they have strong self-interest to do so.
Accordingly, however, political connections are perceived to lower the quality of the firm‘s financial reports (Chaney et al., 2011; Zhaoming, Xinyi, and Hong, 2010). One study revealed that accounting choices are tied to the political costs related to the outcome of financial reports while another study showed that discretionary accruals are used to hide expropriation activities by the managers (Piotroski et al., 2015; Watts and Zimmerman, 1978). The reason is that the firm which enjoys such connections will not have the incentive to increase transparency for the fear of political scrutiny as well as enhancing the directors‘ self-interest (Chaney et al., 2011; Faccio, 2006;
Ramanna and Roychowdhury, 2010). Also, it was found that politically- connected firms fared worse than their non-connected counterparts, especially during the election period or if they are doing business in politically-charged areas (Bertrand, Kramarz, Schoar, and Thesmar, 2006). That is because the connected firms are expected to pay back for the favours and benefits obtained from the politicians and often times it is done during election times where politicians seek for re-election into their respective political office. With lower incentive to transparency and easily fluctuating performance in the highs and lows of political situation, it gives a strong case for management to conduct some degree of manipulation of financial information, for example in earning figures.
21 6. Earnings Management
Scholars have debated a lot on the definitions of earnings management due to different motives and ways involved to do so (Beneish, 2001).
Regardless of the differing opinions, the philosophy behind earnings management is that the managers manipulate financial information to ensure that their self-interest is served, whether in terms of fulfilling the fiduciary duties or protecting the company from inadequate and inflexible business contracts (Scott, 2012). Thus, it is quite appropriate that this study takes a more general definition of earnings management as stated by Scott (2012, p.
423) which is ―the choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective‖.
1. Motives for Earnings Management
As stated earlier, manipulation of earnings can be driven either by the desire to protect one‘s reputation (in terms of being able to fulfil the fiduciary duties) or to protect the company from contractual problems. In that sense, earnings manipulation can be seen from opportunistic and efficiency perspectives. Under the opportunistic perspective, managers manipulate accounting numbers with malicious intent (e.g. getting overcompensated, protecting reputation). In doing so, the quality and decision-usefulness of financial information is deteriorated, which means that opportunistic earnings management is bad for the company (Jones, 2015). However, under the efficiency perspective, manipulation is done to reduce information mismatch or gap between managers and shareholders
22 or investors. This is in line with the previous discussion on earnings quality, in which managers disclose information as a way to tell the external parties about the company‘s conditions. Because this manipulation essentially put earnings figures closer to the real value, this is beneficial for the company (Godfrey et al., 2010).
Focusing on the opportunistic earnings management, there are five general motives as to why managers to engineer earnings value that departs from its real value. These are explained below.
a. Bonus Plan Motive
In some companies, executive bonuses are tied to earnings target. As such, there is an incentive for them to play around with earnings so as to meet their target bonuses (Healy, 1985). Usually this is done with short-term target in mind, thus earnings management is done to ensure higher earnings today at the expense of future earnings.
b. Debt Covenant Motive
In the eyes of creditor, they want to gain comfortable interest from lending their money to the firm and thus stipulate some earnings target or leverage ceiling for the company to adhere to. If the company want to get more lending at or below the current interest rate, the management may proceed to manipulate earnings upwards for meeting the earnings target. Consequently, higher earnings can correspond to higher asset value which will reduce leverage ratio (DeFond and Jiambalvo, 1994)
23 c. Political Cost Motive
This motive concerns the company with a degree of political visibility, such as being politically-connected or state-owned enterprises. The condition gives rise to political cost where the company is under constant public monitoring (Godfrey et al., 2010).
The management want to ensure that they stay under the radar as it continues to obtain benefits from the political exposure. This is done by ensuring the firm‘s earnings are maintained at certain acceptable level (Scott, 2012).
d. Expectation and Reputation Motive
Skinner and Sloan (2002) cited in Scott (2012) found out that companies are punished more severely if they underperform rather than them being rewarded for outperforming the market‘s expectations.
Because of that, management is incentivised to manipulate earnings highly during bearish business cycle. This incentive is intensified as the management‘s reputation is linked to the company‘s performance.
Thus, earnings management work to avoid market punishment on both the company‘s share price and managers‘ reputation
e. Initial Public Offering (IPO) Motive
For companies wishing to be listed in a stocks exchange, they must provide some financial information on their worth in the market.
The management want to obtain as much capital as possible from the IPO, which can only be done by projecting an image of healthy and
24 profitable company (Marquardt and Wiedman, 2004). That gives a reason to overstate financial data, including earnings prior to IPOs.
2. Mechanism for Earnings Management
According to Mohanram (2003) and Trueman and Titman (1988), there are various ways in which earnings management is exercised. They are:
a. Taking a bath
The management enhances current loss by writing off assets and recognizing expected future costs. In this way, they want to polish future earnings because of the present turbulence within the company (e.g. the company is under stress or restructuring).
b. Income Minimisation
While the way it is done is similar to taking a bath, the goal is to lower current earnings that are way above forecasts, which can raise public scrutiny, especially if the company is politically visible. The ways to do so include rapid write-offs of capital and intangible assets or expensing, instead of capitalising, advertising and research and development (RnD) costs.
c. Income Maximisation
This is done with the bonus plan motive in mind, as the compensation packages of company executives are tied to earnings
25 target. Conversely, the practice is used to meet the conditions required in the debt covenant.
d. Income Smoothing
The practice ensures certain trend of company‘s earnings with little or no fluctuations of earnings in place. This can be driven by both the interest of investors and managers. Sometimes, investors prefer steady performance of the company at all times and it helps them in their decision-making. Meanwhile, for risk-averse managers, it is favourable that they can be compensated at relatively predictable level while being perceived to be doing well, even though they do not really do anything for the company (Lambert, 1984).
3. Types of Earnings Management
Earnings management takes place when managers choose some accounting policies or engage in real manipulations (Jones, 2015). For accrual earnings management, it can be done by either choosing a favourable accounting policy directly or playing around discretionary accruals, such as inventory valuation and receivable provisions and write- offs (Li, 2009). Although total accruals are composed of normal and discretionary accruals, discretionary accruals are measured to identify the degree of accrual-based earnings management because the managers engage directly in its creation while for normal accruals; they are natural mechanisms to capture adjustments on company‘s performance (Dechow et al., 2010).
26 As far as accrual earnings management is concerned, once it is conducted beyond what can be managed by the company, more earnings management practices will follow in the future. If the management has raised earnings upwards, the future earnings will be lower and vice versa.
This concept is called accrual. Reverse (Allen, Larson, and Sloan, 2013;
Marquardt and Wiedman, 2004). While earnings management in itself can be used with shareholders‘ interest in mind, accrual reverse will indicate opportunistic earnings management that are detrimental for the shareholders. This is where the good corporate governance practices come into play to ensure earnings management do not fall into the accrual reverse form. Meanwhile, it also means that the presence of earnings management over the years can symbolise dishonest behaviour on managers‘ part.
In the case of real earnings management, managers engage in manipulating real business activities, such as on advertising, RandD, timing for the purchase and disposal of capital assets and overproduction practices (Cohen and Zarowin, 2010). Essentially, real earnings management is designed to deceive stakeholders on some financial reporting targets using regular operational activities which may not be beneficial for the firm‘s value (Roychowdhury, 2006). Since the manipulation occurs due to the deviation of normal practices, the impact will be two-fold: increase (decrease) of current earnings and decrease (increase) of future cash flows. For instance, overproduction in present
27 period increases current earnings but will generate higher inventory holding costs due to excesses of inventory that is directly related to cash flows from operations.
Although real earnings management presents greater long-term costs for the firm than accruals, managers believe that to depend only on accrual earnings management will incur private costs, minimally in the short run, on them (Scott, 2012). The reasons are (1) the use of accruals will more likely be detected by auditors and regulators and (2) once accruals can no longer cover the difference between true earnings figures and the desired target earnings at the reporting date, real manipulation is impossible to be conducted (Roychowdhury, 2006). This preference prevailed in politically-connected firms, where management will more likely to replace accruals with real earnings management that are not easily measured and detected. This preference is stronger when companies are in the political spotlight with intense public monitoring (Braam et al., 2015).
Aside from the fact that the two types of earnings management differ in the target of manipulation, Table 2.1 summarises other differences between accrual and real earnings management.
Table 2.1
Differences between Accrual and Real Earnings Management
Type Accrual Real
Impact on cash flows Inderect Direct
Detection risk High Low
Management motive For long-term targets, e.g. income smoothing
For short-term target, such as executive compensation target or market expectation
28
Sources: modified and adapted from Roychowdhury (2006); Achleitner, Günther, Kaserer, and Siciliano (2014); Braam et al. (2015) by the author.
In recent years, there are more studies that make use of real and accrual- based earnings management to showcase the level of earnings quality. One reason is that the management have been aware of the fact that from the past major scandals, such as Enron and WorldCom, accounting regulations have been strengthened to prevent accrual-based earnings management. In one study, with the introduction of SOX in 2002, accrual-based earnings management declined sharply while real earnings management picked up the pace (Cohen, Dey, and Lys, 2008). This showed that companies today use a combination of accrual and real earnings management with preference towards the latter, making it relevant to bring real earnings management calculation in the study of earnings manipulation.
However, it is important to acknowledge that real earnings management are relatively new in the discussion of earnings quality. Its measurement is still subject to further evaluations, as compared to a variety of measurements of accrual-based earnings management that have been robustly discussed over many studies. A recent study by Cohen, Pandit, Wasley, and Zach (2015) challenged researchers to find more robust alternative(s) for measuring real earnings management, by basing their argument on the fact that the current measurement is prone to misspecifications that could lead to validity problems in studies
29 concerning real earnings management. In order to provide more reliable interpretation on earnings quality, accruals are used as a proxy for earnings management. At the same time, they correspond well with the accrual accounting system used in all Indonesian companies (Dechow et al., 2010).
4. Accrual-based Earnings Management Model
The measurement of accrual-based earnings management usually focuses on valuing the discretionary accruals that quantitatively reflect the degree of managers‘ discretions in the financial reporting processes (Beneish, 2001). The most famous and widely used method is the Jones (1991) model. This model uses a logical premise that the changes in the firm‘s economic conditions can induce earnings management to occur, which is why it uses the changes in sales and the changes in plant, property and equipment (PPE) as the measuring variables. This model was later modified by Dechow et al. (1995) by adjusting sales figures with the value of receivables. The new model is called modified Jones model.
A new measurement of discretionary accruals was introduced in Dechow and Dichev (2002) model which focuses on the use of cash flows from three different time periods and working capital as they argued that accruals need to assume future cash flows for the company. There is also the Beneish (1997, 1999) model that uses unweighted and weighted probabilities of earnings manipulation. These two models look into the accruals quality instead of the value of the accruals itself.
30 With regards to the various methods to measure discretionary accruals, in this study, it uses Modified Jones Model (1995) model. First of all, the test on modified Jones model or Dechow et al. (1995) model showed that it was statistically significant in relations to the incidence of fraudulent activities, where earnings management will occur (Jones, Krishnan, and Melendrez, 2008). Furthermore, the modified Jones model was said to be the most relevant in the context of Malaysia and Thailand (Selahudin, Zakaria, Sanusi, and Budsaratnagoon, 2014). Given that Indonesian economy quite resembles Malaysia and Thailand where (1) family-controlled firms are prevalent, (2) political connections are common and (3) the three countries are considered as emerging economies, the same line of argument on the appropriateness of the modified Jones model should hold for Indonesia.
C. Previous Research
The issue of multiple directorships has been explored by various scholars in the last decade (see Ferris et al. (2003), Chiu et al. (2013), Iturriaga and Rodríguez (2014), Kiel and Nicholson (2006), Shu et al. (2015), Latif, Kamardin, Mohd, and Adam (2013), Kamardin, Latif, Mohd, and Adam (2014)). The results observed no particular trends which relate multiple directorships and other variables, such as firm performance, board monitoring and earnings management (see Table 2.2 below).
The study of multiple directorships is applicable in Indonesia given the rarity of the research and that the practice itself is allowed and regulated by
31 the authorities. Furthermore, many prior studies were mostly conducted in the developed market setting, such that this study which uses the setting of an emerging market can contribute in terms of whether the impact of multiple directorships is similar across various market setting. Only a few studies have been conducted in similar markets as Indonesia, like in Malaysia and Thailand, thus this study should further enrich the knowledge regarding the multiple directors and their impacts on various business aspects.
Table 2.2
Summary of Previous Studies on Multiple Directorships No
Title (Researcher,
year)
Research Methodology
Research Result Differentiation Similarities
1 Too Busy to Mind the Business?
Monitoring by directors with Multiple Board
Appointment.
Ferris, S.P., Jagannatahan , M., and Pritchard, A.C, (2003)
The sample are US firms with total asset above
$100 Million
Uses Multiple Directorship as variable
Multiple
Directorship and Board Monitoring did not support the idea of limiting the
number of
directors‘
appointment for any individual director.
2 Board Interlocks and Earnings Management Contagion, Accounting Review, 88(3), 915- 944. Chiu, P.C., Teoh, S.H., and Tian, F.
(2013)
The samples are 118 US firms from 1997 to 2001
Uses Multiple Directorship as variable
Positive
correlation among variables and it is stronger when the interlocked director holds leadership or accounting related position
