Based on agency theory, the divergence of interest that arises from the separation between ownership and control lead to the possibility that managers might be tempted to behave
opportunistically to pursue their own interests at the expense of the shareholders15. The
writing and enforcement of contracts between principals and agents may not always be enough to resolve the agency conflicts (Hart, 1995). As discussed in Section 3.3 of Chapter 3, the monitoring mechanism plays an important role in controlling agents’ behaviour and thus helps minimise agency problems. It is presumed that the board of directors performs the monitoring function on behalf of the shareholders due to the investors’ inability to exercise full control over the corporation.
Agency theory posits that firms’ boards of directors play an important role for internal governance in monitoring managers and ensuring principal-agent incentive alignment (Fama and Jensen 1983). The ability to perform effective oversight duties thus indicates a quality board. The activities of a quality board involve a framework of effective and prudent control, thereby enabling close monitoring of the corporation’s management and control system, the assessment and management of risks faced by the firm, and the approval of the corporation’s strategy (Rizzotti and Greco 2013). With this monitoring activity, a quality board may thus ensure that managers’ actions are in line with the shareholders’ interests
thus reduces the likelihood of forced restatement.
14
In relation to the conceptual framework presented in Section 4.3, corporate governance variables include (1) board quality, (2) audit committee quality, (3) family control, and (4) political connection, while blockholder ownership variables include (5) family ownership, and (6) government-related institutional ownership.
15
It should be noted that not every agent would behave opportunistically all the time, neither can every agent be trusted at all times.
In Malaysia, the Malaysian Code of Corporate Governance – MCCG (2000) and MCCG (2007) – highlight the attributes of a quality board; these include independence, expertise, and diligence to ensure a strong internal control environment. The MCCG recommends that at least one-third of the board consists of independent non-executive directors to ensure that directors are subject to less management interference, and that independent judgement is given within the decision-making process. The MCCG further highlights the importance for directors to be financial experts so they are able to exercise their skills and knowledge in discharging their monitoring function effectively. More specifically, board diligence signals board quality. Not only is a diligent board is willing to devote substantial time to monitoring, but it also shows that the directors are fully committed and vigilant in discharging their oversight duties. A diligent board thus reflects board quality and is essential to minimising agency problems.
Given the characteristics of being independent, expert, and diligent, a board is viewed as high quality, such that they have a strong incentive to monitor, and thus reduce, the likelihood of forced restatement. Three factors may potentially drive such incentives. First, directors may want to protect their reputation as independent and expert monitors, because the market punishes directors associated with poor performance or corporate disaster (e.g., Fama 1980; Fama and Jensen 1983; Gilson 1990). Secondly, directors are subject to heavy penalties when they fail to exercise reasonable care in performing their monitoring duties. Thirdly, directors seek to protect shareholder wealth due to the significant losses they might incur from financial irregularities (e.g., Gilson 1990).
Prior studies have shown that board independence, expertise, and diligence, as direct measures of board quality, are related to a more effective monitoring function. Klein (2002) in the US, Peasnell et al. (2000) and Peasnell et al. (2005) in the UK, and Marra et al. (2011) in Italy found that board independence can better constrain discretionary accounting practices and reduce the extent of earnings management. Agrawal and Chadha (2005) further found that the presence of financially expert independent directors on a firm’s board reduces the possibility of financial misstatement. Ferris et al. (2003) found no evidence of shirking when directors with multiple directorships (diligent) are on the board. Johl et al. (2013) further showed that the interaction between board quality and audit quality is positively and significantly associated with abnormal accruals. The result suggests that board quality and audit quality can be substituted between each other to maintain the
quality of financial reporting. Overall, results from prior studies indicate that board quality helps improve managerial monitoring, thus reducing the likelihood of forced restatement. For the purpose of this study, three different measures are used as proxies for board
quality. First is the independence of the board of directors (Johl et al., 2013; Ang et al.
2014; Chakravarthy et al., 2014). With board independence, the directors have no interest
to perform in order to win management’s good graces, thus, they are free to speak out regarding management misdeeds and protect shareholders’ interests (Clarke, 2006). There are concerns among independent directors to secure their reputation of being experts in decision control, thus there is a low likelihood for them to collude with the management for the expropriation of shareholders’ wealth (Fama and Jensen 1983). Overall, board independence improves monitoring of managers, which reduces the likelihood of forced restatement.
Second are financially expert directors (Badolato et al., 2014). A financially sophisticated
board is an important factor that helps constrain managerial propensity to engage in
opportunistic financial reporting (Xie et al., 2003; Bedard et al., 2004). Board members with
financial expertise are valuable since the firm’s board is responsible for monitoring duties that require a certain degree of accounting sophistication. A financially expert board improves corporate governance since the board is expected to be able to understand how the accounting policies applied may affect a firm’s financial position and performance, review whether the accounting policies are conservative or aggressive, assess the acceptability of certain judgement and estimates applied (for example on a company’s reserves and assets valuation), and evaluate the quality of a firm’s financial reports. The presence of financial expertise on the board may improve the overall evaluation of a firm’s financial reporting quality since more attention and time will be devoted to discussing imperative issues that relate to the credibility and reliability of financial information, which
reduces the likelihood of forced restatement (McDaniel et al., 2002).
Third are multiple directorships which are a proxy for board diligence (Saleh et al., 2005; Sharma and Iselin, 2012). Multiple directorships provide directors with the incentive for more diligent monitoring due to the diverse knowledge and experiences that they gained from different management practices and policies of different companies (Beasley, 1996). Multiple directorships are even indicative of high directorial diligence as the appointment to various firms’ boards are due to superior performance demonstrated by the director in previous firms (Fama and Jensen, 1983; Vafeas, 1999). With high diligent quality, it is
unlikely for directors with multiple directorships to shirk from their responsibilities as they might suffer from a reputation loss (Wan Hussin and Ibrahim, 2003; Sharma and Iselin, 2012). Therefore, directors with multiple directorships tend to carry out better monitoring which may reduce the likelihood of forced restatement taking place.
In addition to this, this study takes board size and board meetings as control variables. Board size is included to control for the effect that it might have on forced restatement. This is because the number of board members would determine that sufficient members are available to carry out various corporate functions and the discharge of responsibilities (MCCG 2000), thus the ability to constrain earnings misstatement and reduce the possibility of forced restatement. For example, large-sized boards are believed to improve synergetic monitoring due to various expertise on the board (Zahra & Pearce II 1989), thus reducing incidences of forced restatement (Cao, Myers & Omer 2012). However, there is also the possibility that a large board size gives rise to problems of free-riding and communication breakdown, resulting in monitoring inefficiency (Jensen 1993). Board size is, in particular, an important control variable for methodological reasons. Previous research suggests that omission of this variable leads to omitted variable bias and the distortion of the coefficient
for board independence (see e.g., Knyazeva et al., 2013). Board meetings are also included
to control for the effect that the number of board meetings might have on the occurrence of forced restatement. Xie et al. (2003) claim that the frequency of board meetings is expected to constrain aggressive accounting activities, hence forced restatement, due to the time allocated by the board to meet and discuss issues on firm’s financial reporting. Alternatively, the frequency of board might also indicate firms’ ongoing financial problems
which in turn increase the possibility of forced restatement (Sharma et al., 2009). Hence,
board meetings might impact on the likelihood of forced restatement.
Based on the above discussion, this study posits that board quality improves the effectiveness of a board’s oversight duties that helps minimise reporting errors and deter the management from engaging in opportunistic behaviour. This means that there is less likelihood for income-decreasing, income-increasing or zero-effect forced restatement to take place. Overall, a quality board is capable of constraining utility maximising managerial behaviour, which might lead to a reduction in the likelihood of forced restatement. The following hypothesis is thus developed:
H1: There is a negative relationship between board quality and the occurrence of forced financial restatement.