The Impact of Corporate Governance Regulations on Board Independence and Quality of Financial Information Reporting: A Proposed Study

Abstract

The recent corporate scandals revealed misreporting and poor quality of financial information reporting. The misreporting evidenced that board of directors couldn’t ensure its role of effective monitoring to minimize management’s conflicts, frauds and misrepresentations of information. These in turn, diverted the attention of regulators and policy makers towards independence of the board among others. Malaysia, like other countries, also advised independence of the board in its third code of corporate governance (MCCG 2012) introduced in March, 2012. The code recommended independence of the board to ensure effective monitoring of management. Agency theory and many CG regulations around the world posit that strengthening independence of the board improves firms’ reporting quality of financial information. Therefore, this paper proposes to investigate how some specific attributes of the new regulation regarding independence of the board impacted quality of financial information reporting in Malaysian listed companies. The paper proposes a pre and post analysis of the code by comparing 2 years pre (2010-11) and 2 years post (2013-14) context of the code. The proposed study will contribute to the limited literature with inconclusive results. Moreover, it will also provide insights for shareholders, banks, financial institution, security commission and Bursa Malaysia.

Keywords: Corporate GovernanceSeparate LeadershipIndependent chairProportion of independent directorsReporting Quality of financial information

Introduction

Financial reporting is a medium of communication between corporation and its stakeholders about different financial activities of the firm. The reporting aims to inform and updates public, government, shareholders, employees, bankers, suppliers, creditors and other stakeholders about financial health of the firm (Bello, 2009; Johnson, Khurana, & Reynolds, 2002; Kantudu & Samaila, 2015). Signaling theory also posits the decisions of outside stakeholders are highly depend upon the information public by corporations. The theory assumes that financial reporting is a sole source of information for outsiders which signals firms’ current as well as expected financial health in future (Akerlof, 1970). Good quality of reported financial information facilitates investors and other stakeholders in their decisions (Kamaruzaman, Mazlifa, & Maisarah, 2009).

Keeping in view of the importance of financial reporting, it should be reliable, relevant, meaningful and disseminated in time to assist its users (Hassan & Bello, 2013). Reported financial information reporting should be reliable, comparable and understandable in order to better serve all the stakeholders in their decision making (Kamaruzaman et al., 2009). The reporting is reliable if it carries what it aims to carry by following the norms and principles of international reporting standards. The financial information reporting should observe compliance to accounting standards as well as regulatory authorities in preparation of financial statements. Moreover, the reporting is reliable if it depicts true picture by reporting correct values free from errors and biasness (Bello, 2009; International Accounting Standard Board, 2008).

Financial reporting is reliable if representative, neutral and verifiable. It should be clear enough to be easily understood by its users without undue struggle (International Accounting Standard Board, 2008). It should also possess the qualities of relevancy and verifiability (Bello, 2009; Bushman, Chen, Engel, & Smith, 2004). Verifiability of reporting means the presentation and acquisition of financial information in a fair manner. Moreover, financial reporting is reliable if it passes any direct or indirect verification and cross validation of information the way these computed (Johnson, 2005).

However, it is very difficult to achieve the quality of reporting fully free from bias and errors. Financial statements are prepared on the basis of some projections and assumptions regarding future. The quality of financial reporting is affected when these assumptions deviate or turned otherwise (Johnson, 2005). International Accounting Standard Board also admit this fact by requiring a certain level of accuracy of the financial information (International Accounting Standard Board, 2008).

Financial reporting quality evolved as a topic of great interest for legislators, regulators, policy makers, shareholders, practitioners, academicians and researchers around the world since Cadbury report 1992. The topic got further popularity due to high public demand for transparency, integrity, reliability and disclosure of financial information after the accounting frauds of Enron, WorldCom, Marconi, and Parmalat, etc. (Hashim & Devi, 2007). Subsequently, the regulators and practitioners stressed upon strengthening corporate governance structure for ensuring good quality of financial reporting (Cohen, Krishnamoorthy, & Wright, 2004).

Malaysia, like other countries, also faced a number of accounting scandals like Perwaja Steel, Technology Resources Industries (TRI), Transmile, Megan Media, Malaysian Airlines System (MAS) and Port Klang Free Zone (PKFZ), Linear Corporation, Kenmark Industrial Co. Berhad and Sime Darby. These scandals revealed the fraudulent reporting of financial information which disclosed inefficiency of board structure and composition in Malaysian firms (Angabini & Wasiuzzaman, 2011; Norwani, Mohamad, & Chek, 2011). International and domestic forums like OECD (2011), UNCTAD, (2010) and CG blue print document also stressed upon structure, independence and nomination of the board (OECD, 2011; UNCTAD, 2010). Subsequently, Malaysia revised corporate governance regulations (MCCG 2007) by introducing new CG code - MCCG 2012 in March, 2012 (PwC, 2012). The code addressed independence of the board among others. Therefore, this paper proposes to investigate how some specific attributes of the code like separate leadership, independent chair and proportion of independent directors affected reporting quality of financial information of the Malaysian non-financial listed companies. The proposed two year pre and two year post analysis from 2010 to 2013 will highlight the impact of the code, if any.

Literature Review

Investors always have serious concerns and doubts about the quality of financial reporting. Board has a crucial role to ensure this quality especially in developing countries (AL-Dhamari & Ismail, 2014).Thus, this study focuses some existing and some of the newly recommended attributes of MCCG 2012 in relation to reporting quality of financial information.

Scope and Methodology

The proposed sample of the study is 300 listed companies selected through stratified random sampling from all sectors of Malaysian economy except banks, insurance and financial companies from a total of 960 companies listed on Bursa Malaysia at the end of financial year 2009 (www.bursamalaysia.com). Random sampling reduces the systematic bias by giving equal chance of selection to every unit of population. The proposed data for separate leadership structure, independent chair and proportion of independent directors will be collected through content analysis of the annual reports of the sample firms while the data for financial reporting quality will be extracted from DATASTREAM. Separate leadership and independent chair of the board will be measured by dummy variables coded as 1 for yes and 0 otherwise. Proportion of independent directors will be measured by proportion of independent director to total number of directors on the board. The reporting quality of financial information will be measured by Modified Jones Model of earning management (Beest, Braam, & Boelens, 2009). The paper proposes descriptive statistics, Pearson’s and Spearman’s correlation matrixes and multiple regressions through STATA package 13 for analyzing data of both sub periods (pre 2010-11 and post 2013-14) separately. The results of both periods are also proposed to be compared by conducting paired T test and Welch ANNOVA so that find the distinct impact of the code, if any.

Significance and Contribution of the Proposed Study

The MCCG 2012 recommended independence of the board for Malaysian listed companies. However, no empirical study has yet investigated the impact of MCCG 2012 on financial reporting quality after enactment of the code. Moreover, previous limited literature regarding the relationship between independence of the board and reporting quality is inconclusive and mostly based in developed countries (Klai & Omri, 2011). Therefore, the proposed study will not only contribute to the literature but will also provide policy insights for regulators, policy makers and authorities of developing countries.

Acknowledgment

The authors are thankful to Universiti Teknologi PETRONAS (UTP) that extended financial support for completing this research under URIF project.

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