relationship between discretionary accrual and future profit.



Business Group, Earnings Management.

This study will examine the relationship between discretionary accrual and future profitability and the effect of discretionary accrual based on high family ownership, market capitalization, audit quality, independent board, and audit committee in the Indonesia Business Group. Data for discretionary accrual, market capitalization, audit quality, independent board, audit committee were collected from all listed firms in Indonesia Stock Exchange (IDX) from 2001-2008. Regression analysis techniques will be used to examine the factors of earnings management in the business group company in Indonesia.


1.1 Research Background.

The financial report is a company's financial information in an accounting period which can be used to describe the company's performance. Financial report aims to provide information concerning the financial position, performance, and changes in financial position of a company that will benefit for information users to make decision making (IAI, 2008). Financial report users are broadly classified into two users internal users and external users (Bernstein & Wild, 2000). Internal users, primary the managers of a company, are involved in making operating and strategic decisions for the business. As employees, they typically have completed access to a company's information system. Internally generated financial reports are specifically tailored to the unique information needs of an internal decision maker, such as CEO, CFO, or internal auditor.

External users are individuals who are not directly involved in the company's operations. The financial report also shows the accountability for the management of resources. Based on Financial Accounting Standards Board (FASB) the purpose of financial report is to provide useful information for business decision. Financial report is one source of formal published information as a means of accountability for the management of the owner of resource management. Financial report prepared on the basis of Financial Accounting Standards which consists of the balance sheet, income statement, cash flow statements, and reports changes in equity and notes to the financial statements. This information is also expected to be a guide for shareholders and potential investors to determine their investment interests of the issuer's shares.

One of the information contained in financial reports is information about the company's earnings. Earnings information as stated in the Statement of Financial Accounting Concepts (SFAC) No. 2 is a key element in the financial statements and is very important for those who use it because it has a predictive value. According to the Financial Accounting Standard Number 1, profit information is needed to assess potential changes in economic resources may be controlled in the future, generate cash flow from existing resources, and for the formulation of considerations about the effectiveness of the company in addition to utilizing resources (IAI, 2006). For shareholders and investors, profit means increased economic value (wealth) to be received, through the distribution of dividends. Profit is also used as a tool to measure the management performance of companies over a certain period, which generally concerns certain parties, especially in assessing the performance of management accountability in the management of resources entrusted to them, and can be used to estimate its prospects in the front.

The manager of the company knows internal information and corporate prospects more in the future than the owners (shareholders). Therefore, the manager shall provide signals about the condition of the company to the owner. The signal can be provided through the disclosure of accounting information such as financial reports. However, sometimes the information conveyed is not received in accordance with the actual condition of the company. If in a condition where the management had failed to achieve a specified profit target, the management will take advantage of the flexibility allowed by the accounting standards in preparing financial reports to modify the reported earnings. Management is motivated to show good performance in generating maximum value or benefit for the company so that management tends to choose and apply the accounting method that can provide better return information. Lately, the financial report became a source of misapplication of the information that the parties concerned. In financial reporting, managers can make earnings management to mislead the owners (shareholders) of the financial performance in the company.

Earnings management is a common phenomenon that occurs in companies (Das, Shroff, & Zhang, 2007). Practices undertaken to influence the rate of profit can happen legally and is not legal (Simon, 2002). Legal practices in the management of the business means profit to influence the rate of profit does not conflict with the financial reporting rules in Generally Accepted Accounting Principle, especially in Accounting Standards, in particular by taking advantage of opportunities to make accounting estimates, accounting method changes, and shifts period income or expenses. The earnings management illegally conducted (collectively, the financial fraud), conducted in ways that are not allowed by the Guidelines for the Generally Accepted Accounting Principle, by way of transactions reported income or expenses are fictitious by adding (a mark-up) or decrease (mark down) the value of the transaction, or perhaps by not reporting a number of transactions, which will generate profits in the value of the desired degree.

Earnings management cases are generally done by working with other parties such as the Office of Public Accountant (auditors), high state officials, suppliers, and other parties who have a financial relationship with the company. Earnings management actions has led in some cases the reporting of accounting scandals that are widely known such as Enron, Merck, WorldCom and other companies in the majority of United States (Cornett, Marcus, Saunders, & Tehranian, 2006). Enron Corporation had been proved to have manipulated earnings, which their executives manipulate Enron's auditors by institutions that can boost profits approaching $ 1 billion. In fact, Enron executives just enjoy the pseudo number is actually the profit they never get. Xerox Corporation had been proved to have manipulated accounting income, which was, did the accounting manipulation of Revenue Company of USD 6 billion. The amount was not equal to the estimated U.S. Securities and Exchange Commission (SEC) that the time value from 1997 to 2000 according to the U.S. capital market oversight was estimated only a $ 3 billion. WorldCom proved to manipulate the accounting expenses that were, did the accounting manipulations worth EUR 4 billion on the expenditure side. The scandal allegedly involving Arthur Andersen and the Walt Disney Company has proved to manipulate accounting earnings, the manipulation of accounting data for two fiscal years. According to Disney, income in 2001 was USD 613 million, or 29 cents per share, when in fact it only amounted to USD 358 million, or 17 cents per share (Sjahrir, 2002). A number of other cases of earnings management are also came to the public in the 2000s and led to a number of bankrupt companies. The case was revealed to the public that management conspired with certain parties in the accounting manipulated, therefore was the detriment of many parties.

Earnings management issues are not really a new thing in the practice of financial reporting in the business entity. This is due to the cruel market that the company could not meet the target or miss than expected by the market. The pressure to make these benefits are often felt the impact on revenue (income) for the management, so that the management do to affect earnings management income number that results in loss of quality concerned company's financial statements.

Recently, the financial statement has become a central issue in Indonesia, as a source of harmful misuse of the information that the parties concerned. In 1998 to 2001, there have been many financial scandals in companies involving issues of public financial statements that had issuance, such as PT. Lippo Tbk and PT. Kimia Farma Tbk (Boediono, 2005). Meanwhile, according to several news media, more and more companies conduct business group doing violations of financial reporting. It is evidence that financial report manipulation practice still did by the business group in Indonesia except the crisis period in 1997-1998 was going.

Business groups often play an important role in economic development by overcoming the market in Indonesia. Controlling shareholders of business groups in Indonesia are often used cross-shareholdings to strengthen their control over affiliated companies. Indonesian law does not restrict this practice, and difficult to obtain data on cross-shareholding. This practice reflects lack of confidence in Indonesia that the people who are not family members or close friends (Hanani, 2006). The founding families of equity shares are largely insulated from the market for corporate control, which can lead to entrenched management. While usually viewed as adverse outcome, this insulation management may actually lead to a lower incidence of earnings manipulation, as managers will have less pressure to manage earnings upward to avoid the discipline with the takeover (Jiraporn & DaDalt, 2007).

Earnings Management has relationship with business group. This is based on the results of Bhaumik and Gregorius (2009); Siregar and Utama (2008); Wang and Lin (2008); Singh, Nejadmalayeri, and Matrhur (2007) researches; But based on An and Naughton (2008); Yen et al. (2007) results no relationship between business group and earnings management. Based on the findings of BPK (Financial Audit Board) from 2003 to 2008 had been 210 cases of financial manipulated with a value of Rp. 30.18 Trillion and USD 470 million (Oktavina, 2009). This is what encouraged me to do research on "Business groups and Earnings Management: Evidence from Indonesia".

1.2 Research Objectives.

The purpose of this research is to investigate whether there are relationships between discretionary accrual and future probability and the effect of discretionary accrual based on high family ownership, firm size, audit quality, independent board, and audit committee in the Indonesia Business Group.

1.3 Research Contribution.

There are several contributions from this research. The first contribution is to provide the new evidence of academic literature regarding indicate of earnings management in the business group in Indonesia Stock Exchange from 2001 – 2008. Second, we can use the result of this research as a consideration to factors that indicate earnings management.

1.4 Structure of Research.

The research is organized as follows. The next section discusses the literature on hypotheses development business group and earnings management evidence from Indonesia. Chapter 3 describes the data and the variables. Chapter 4 examines empirically the investigated earnings management in the business group evidence from Indonesia in 2001 – 2008. Chapter 5 is conclusions.


2.1 Earnings Management.

There is no common definition of earnings management in the literature and authors use a wide range of expressions to describe the same phenomenon or its different aspects. Here are the definitions of earnings management:

“Earnings management is given the availability of alternative ways to manage earnings” (Beneish, 2001, p. 3)

“Earnings management is choosing an accounting treatment that is either opportunistic (maximizing the utility of management only) or economically efficient” (Francis, 2000, p. 3)

“Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers” (Healy & Wahlen, 1999, p. 368).

Beneficial (the first definition) earnings management enhances the transparency of reports. The pernicious (the second definition) involves outright misrepresentation and fraud. The third is manipulation of reports within the boundaries of compliance with bright-line standards, which could be either opportunistic or efficiency enhancing. Earnings management is a collection of managerial decisions that result in not reporting the true short-term, value-maximizing earnings as known to management. Earnings management can be Beneficial (it signals long-term value), pernicious (it conceals short- or long-term value), Neutral (it reveals the short-term true performance). The managed earnings result from taking production/investment actions before earnings are realized, or making accounting choices that affect the earnings numbers and their interpretation after the true earnings are realized (Ronen & Yaari, 2008).

There are two types of earnings management: efficient earnings management and opportunistic earnings management (Siregar & Utama, 2008). Efficient earnings management is to improve earnings in formativeness in communicating private information and opportunistic earnings management is management reports earnings opportunistically to maximize his/her utility. According to Burgstahler and Dichev (1997) present evidence that is consistent with the opportunity perspective. Inversely Gul, Leung, and Srinidhi (2000) present evidence that the behavior of discretionary accruals (a proxy for earnings management) is consistent with the efficient perspective, because discretionary accruals have a significant positive relationship with future probability.

There are three factors that can be associated with the emergence of earnings management practices (Gumanti, 2000). First, accrual management, this factor is usually associated with any activity that may affect cash flow and profit personally is the authority of the managers (manager's discretion). Second, An application of the Necessary Accounting Policies, these factors related to the manager's decision to implement a mandatory accounting policies applied by the applying company is earlier than the stipulated time or postpone it until the application of these policies. Third, changes Assets in Voluntary. These factors usually associated with the efforts of managers to replace or change a particular accounting method among many to choose methods that are available and recognized by the Generally Accepted Accounting Principles.

The factors that motivate the management to manage earnings are bonus scheme, Long term debt contract, Political motivation, taxation motivation, Chief Executive Officer, and Initial Public Offering. Reason of bonus scheme is the existence of asymmetric information about the company's financial result can set the management to maximize net profits of their bonuses. Based on Gaver and Austin (1995) research is provided evidence that earnings management have relationship with annual bonus plans.

The second factors is Long-Term Debt contracts, the closer a company to customer debt, management will tend to choose accounting procedures that can 'move' profits in next period to this period, which aims to reduce the possibility of companies experiencing technical default. Based on Lee (2006) research shows how the debt contract affects a manager's earnings management strategy. The third factor is Political motivation, Key (1997) find evidence that earnings management have relationship with political motivation. The fourth factor is taxation motivation (Ayers, 2002; Key, 1997); One of the incentives that can trigger managers to make a profit engineering is the desire to minimize taxes or the total tax to be paid company. This is because profits are often used as the basis for decision making, arrange contracts and a manager's performance appraisal. The fifth factor is CEO (Bergstresser & Philippon, 2006), that the use of discretionary accruals to manipulate earnings is more pronounced at firms where the CEO's potential total compensation is more closely tied to the value of stock and option holdings. The sixth factors is IPO (Jackson, 2004; Kao, Wu, & Yang, 2009; Lee & Masulis; Nagata & Hachiya, 2006; Spohr, 2002) the new company's first offering of its shares of capital markets do not yet have a market price, so there is a problem how to set the value of shares on offer. Therefore, information such as net income can be used as a signal to prospective investors about the value of the company, so the management company will go public tend to make a profit management to obtain higher prices for shares.

Earnings management patterns can be done by: taking a bath, Income minimization, Income maximization, and Income smoothing. Taking a bath occurred during the period when incurred regeneration, including a new CEO turnover. If the manager had to report losses, then it would report a large amount. With this action the manager hopes to increase the profits that will come and blame for losses the company may be delegated to the old manager. Taking a bath also have the others definition the one-time overstatement of charges against income to reduce assets, which reduces future expenses (Jordan & Clark, 2004; Sevin & Schroeder, 2005). The second pattern is income minimization, the way this is done at the company's profitability is very high, therefore that if the period of expected future profits plummeted can be overcome by taking profits earlier period (Burgstahler & Dichev, 1997). The third pattern is income maximization, done when have declining profits. The action on income maximization aims to report higher net income for the purpose of the bonus. This pattern is done by companies that violate the debt agreement (Kury, 2007). The last pattern is income smoothing, Conducted by the company reported earnings smoothing so as to reduce fluctuations in earnings that are too large because most investors prefer a relatively stable profits (Fond & Park, 1997).

Earnings management often must have a stealth quality to be fully effective. For example, recording and disclosing a nonrecurring gain on the sale of an investment normally will not be counted toward meeting the consensus earnings expectations of Wall Street. However, an earnings management that can undetectably increase earnings may make it possible for a firm to issue shares at higher prices.

Until now earnings management is the most controversial areas in financial accounting (Mohanram, 2003). The counter-party to profit management as investors, argues that a reduction in earnings management reliability of financial reporting information that can be misleading in decision-making. On the other side of the pro-earnings management such as managers, they are assuming that earnings management is flexible to protect themselves and the company in anticipation of unexpected events.

Broad statements about whether earnings management is either good or bad are difficult to make. Much depends on the steps taken and the motivation for the earnings management. Good earnings management might include real actions taken or accounting flexibility that is exercised within the boundaries of GAAP, if full disclosure is provided about current and prospective financial performance (Mulford & Comiskey, 2002).

2.2 Business Group in Indonesia.

Business groups are collections of publicly traded firms in a wide variety of industries, with a significant amount of common ownership and control, usually by a family (Khanna & Palepu, 1999). According to Left (1978) Business group is multi company firm which transact in different market but which does so under common entrepreneurial and financial control. Business groups often play an important role in economic development by overcoming the market in Indonesia. In Indonesia, business group virtually interchangeable with conglomerate since most business group comprise strategically and technologically unrelated companies (Hanani, 2006). Regardless of how diversified they are, most Indonesian business groups are controlled and managed by their founders and the founders families and longtime friends. Business group has a robustly large and often beneficial effect on the financial performance of member firms.

Indonesian business groups engage seriously in different forms of agency problems or management opportunism (Simanjuntak, 2001). Four years after the crisis, Attorney's Office has revealed numerous cases of inflated project value that smell of subsequent looting. The success rate has been very meager, given that the people involved were once the success rate is very small, considering that the people involved at all "part of the inner circle of politics. The stock market explosion was attributable partly due to massive emotional advertisement that used to communicate to the public a very good image about future earnings and potential for capital gain. News about shares the stock being blown up was oversubscribed. The excess demand is blown.

The fact that the subscribers include the customer parties that are closely related to the share issuers does not bother investors much. In at least one In the case of listed companies, for example, borrowed assets were shown among at least one case of companies' listed. Checking the truth about corporate reporting is an extremely difficult proposition. However, Opinions of accountants, lawyers and appraisers are generally affirmative of the statements issued by management. Pyramidal structure makes monitoring even more difficult. Through intra-group mergers and acquisition, the firm is made less tractable even for the trained professionals. The Capital Market Agency Board took a permissive attitude toward such practices. It thus fell victim to its past policy of initially inviting as many firms as possible to be listed in the stock market; a company will be pressured to improve its governance.

There are also other problems of opportunism, given conglomerate as the dominant form of organization among the groups of big business. Interlocking directorship is almost universal among large business groups. A director of a company can serve as a commissioner on one or more related companies. Managers within the business groups of usually allowed establishing their own businesses. Conflict of interest is not considered a major problem.

The relationship between ownership and governance is probabilistic in nature and conjecturally the probability of opportunistic behavior on the side of management tends to increase with the level of power concentration within the company. As a consequence, this power gets more concentrated where majority ownership and management are fused in one hand. Such is the case in the majority of Indonesian firms. It applies to private firms and state enterprises as well. The resulting management opportunism happens to be widespread and blatant, and must have contributed to the severity of the crisis.

List agent problems discussed above are not intended to be complete. However, it is enough to describe how business has been caught in Indonesia is endemic opportunism before the crisis. The practices of discriminatory policies are partially responsible for opportunism. The belief that economic development is best achieved through a strong government in the economy is rooted in the Indonesian elite with a large state ownership of business and big bureaucracy. The public sector has proven highly vulnerable to all kinds of opportunism. The severity of agency problems in an Indonesian business group is at least partly caused by the existence of a large public sector.

2.3 Hypotheses Development.

2.3.1 Earnings Management and Future Profitability.

This research tests whether earnings management is efficient or opportunistic by examining discretionary accruals' ability to signal future profitability. If earnings management is efficient, then discretionary accruals will have a significant positive with future profitability. If opportunistic, discretionary accruals will have a significant negative relationship or significant relationship with future profitability (Siregar & Utama, 2008). Hypothesis that can be developed is

Hypothesis 1: There is a relationship between discretionary accruals and future profitability.

2.3.2 Family Ownership (DFAM).

The connection between ownership structure and performance has been the subject of an important and ongoing debate in the corporate finance literature (Demsetz & Villalonga, 2001). Family firms play a major role in leading economic growth throughout the world (Zahra, 2003). Ownership gives manager the powers to make decisions about the level and scope of their firm's operations. Most companies are still controlled by family ownership (Siregar & Utama, 2008). Owner families are generally perceived to have higher ownership ratios of private firms such as perception encourages the public belief that the owner family increases wealth and transfers it from generation to generation by tunneling funds from public to the private firms (Chang & Shin, 2007). Equity ownership structure affect the manager shareholders agency conflict (Anderson, Mansi, & Reeb, 2003).

The ownership structure will affect the behavior and company performance (Pierce, 2003). Family ownership will create value and improve company performance, if accompanied by some form of control and management of these families (Villalonga & Amit, 2006).

Family businesses in Indonesia have a major impact on growth of economies through generation of employment, productivity, and innovation. Based on Romano, Tanewski, and Smyrnious (2000) maintained that business ownership, independence, and family control factors affect owners' financing decisions.

The opportunistic earnings management is higher in firms with business groups compared to firms without business group (Kim & YI, 2006). He suggests that firms with business group give their controlling shareholders more incentive to engage in earnings management.

Anderson et al., (2003) argue that investigate the impact of founding family ownership structure on the agency cost of Debt. They fined that founding family ownership is common in large, publicly traded firms and is related, both statistically and economically, to a lower cost of debt financing. They results are consistent with the idea that founding family firms have incentive structures that result in fewer agency conflicts between equity and debt claimants. This suggests that bond holders view founding family ownership as an organizational structure that better protects their interests.

Wu, Chua, and Chrisman (2006) examines the effects of family ownership and management on two dimensions of small business equity financing, His use of equity financing and use of public equity financing within the agency theory of financing. His results show that family involvement and agency issues interactively and separately influence equity financing in small business.

Villalonga and Amit (2006) findings suggest that the classic owner-manager conflict in nonfamily firms is more costly than the conflict between family and nonfamily shareholders in founder-CEO firms. However, the conflict between family and nonfamily shareholders in descendant-CEO firms is more costly than the owner manager conflict in nonfamily firms. Hypothesis that can be developed is

Hypothesis 2: The effect of discretionary accruals on future profitability is stronger for firms with higher family ownership

2.3.3 Firm Size (DSIZE).

Fields, Lys, and Vincent (2001) found that company size and leverage are significantly influenced by changes in accounting methods. It was explained that the change of accounting rules that required (mandatory) and some only a few cannot be detected. In other words, company size and leverage may affect earnings management behavior. Monitoring and mechanisms that both companies may be able to limit management to manipulate whether profit which aims to reduce profits and increase the profits because these profits can be manipulated to mislead other parties interested in taking decisions. Possible existence of the audit committee and independent auditors of quality can be limiting management misbehavior.

Lee and Choi (2002) company size and auditor type are positively related with each other, He also examine whether or not auditor type is still a determinant in explaining the cross-sectional variation of earnings management when company size is controlled. His findings show that small companies tend to more frequently manage earnings to avoid losses than do large companies. He fined mixed results regarding the relation between earnings management and auditor type. When company size is controlled, however, auditor type becomes insignificant in explaining the cross-sectional variation of earnings management to avoid losses. The inverse relation between company size and earnings management remains significant after auditor type is controlled. Thus, company size, not auditor type, appears to play a primary role in discriminating between companies that do and do not manage earnings to avoid losses.

Kamarudin, Ismail, and Ibrahim (2003) research also studies the effect of the firm's size on the tendency to smooth income. The sample comprises 200 companies listed in the Kuala Lumpur Stock Exchange within the period of 1993-1999. His result indicates that income smoothing was present although its percentage is low. The univariate test has found that smaller firms have greater tendency to smooth income rather than larger firms. Earnings smoothing may be related to company size, the existence of incentives, bonuses, and the deviation of actual earnings expectations with profits that have been predicted previous (Margaretha, 2003). Hypothesis that can be developed is:

Hypothesis 3: The effect of discretionary accruals on future profitability is stronger for firms with greater market capitalization.

2.3.4 Auditor's Size (AUDIT).

Public accountant's has position as an independent party which provides fairness opinion on the financial statements and auditor's profession is a profession that public confidence is also starting a lot of questionable especially when supported by evidence of the increasing litigation against accounting firms. And professional accountant has an important role in the provision of reliable financial information for the government, investors, creditors, shareholders, employees, debtors, also for the community and other parties concerned.

In performing its duties, the auditor requires trust in the quality of services provided to users. Important for users of financial reports to see Public Accounting Firm as an independent party and competent, because it will affect the value or whether the services have been provided by the Public Accounting Firm to the user. If the user feels Public Accounting Firm provides a useful and valuable, then the value of the audit or audit quality also improved, so that Public Accounting Firm is required to act with high professionalism.

Teoh and Wong (1993) argued that audit quality positively related to earnings quality, as measured by the Earnings Response Coefficient (ERC). The study this time assessing the quality of auditors by the big four auditors grouping with non big four, because one of the five of big Public Accountant such as Arthur Andersen have expressed collapsed. Hypothesis that can be developed is:

Hypothesis 4: The effect of discretionary accruals on future profitability is stronger form firms audited by non-big 4 auditors.

2.3.5 Independence Board (BOD).

Osma (2008) analyses the role of boards of directors in constraining research and development (R&D) spending manipulation. Extant research on earnings management indicates that independent directors reduce accounting accruals manipulation. However, there is limited evidence on their effectiveness in limiting potentially value reducing R&D cuts motivated by short-term earnings pressures. Using a large sample of UK firms, his study whether independent boards are efficient at detecting and constraining this type of real earnings management. The results indicate that independent directors have sufficient technical knowledge to identify opportunistic reductions in R&D, and efficiently constrain opportunistic R&D spending. This evidence supports the emphasis recent policy statements have put on increasing the number of independent directors on corporate boards.

Jaggi, Leung, and Gul (2009) found that independent corporate boards of Hong Kong firms provide effective monitoring of earnings management, which suggests that despite differences in institutional environments, corporate board independence is important to ensure high-quality financial reporting.

Saleh, Iskandar and Rahmat (2005) study assesses the effectiveness of some board characteristics to monitor management behavior with respect to their incentives to manage earnings. Examination of the data shows that the ratio of independent board members is not significantly related to earnings management in firms with duality status.

Black and Bernard (2002) find evidence that low-profitability firms increase the independence of their boards of directors. But there is no evidence that this strategy works. Firms with more independent boards do not perform better than other firms. His results support efforts by firms to experiment with board structures that depart from the conventional monitoring board. Hypothesis that can be developed is:

Hypothesis 5: The higher the proportion of independent board member, the weaker the effect of discretionary accruals on future profitability.

2.3.6 The Existence of an Audit Committee (AUDCOM).

Audit committees in accordance with decision rule. 29/PM/2004 is a committee established by the board of commissioners to perform supervisory duties corporate management (Istana, 2008). The existence of audit committees is very important for the management of the company. An audit committee is a new component in the system of corporate control. In addition the audit committee is considered as a liaison between the shareholders and board of commissioners with the management in dealing with problem control. Based on the JSE Circular, SE-008/BEJ/12-2001, membership of the audit committee consists of at - least three people including the chairman of the audit committee. Members of this committee from the commissioner of only one person, committee members come from commissioner is an independent commissioner and the company audit committee chairman. Another member is not an independent commissioner should come from an independent external party.

As stipulated in the Kep-29/PM/2004 are rules requiring companies to form audit committees, audit committee duties include (Nasution & Setiawan, 2007):

Conduct a review of the financial information will be issued a company, such as financial statements, projections and other financial information
Conduct a review of the company's adherence to laws and regulations in the field of capital markets and other legislation relating to corporate activities,
Conduct a review of the implementation of the examination by internal auditors
Report to the commissioner of the risks faced by companies and implementation of risk management by the board of directors
Conduct a review and report to the board of commissioners of complaints relating to the issuer
Maintain confidentiality of documents, data, and trade secrets.

Zahn and Tower (2004) investigate the link between audit committees and earnings management providing a more comprehensive simultaneous analysis of the influence of audit committee features using a sample of 485 firm-years from Singapore's publicly traded firms during the 2000–2001 calendar periods. Empirical findings indicate firms with a higher proportion of independent audit committee members are more effective at constraining earnings management. Firms with audit committees that are more diligent and/or lack the presence of independent directors serving simultaneously on a substantial number of boards and committees are more effective at constraining earnings management.

Bedard, Chtourou, and Courteau (2004) examine the relationship between audit committee characteristics and the extent of corporate earnings management as measured by the level of Income-increasing and income-decreasing abnormal accruals. Using two groups of U.S. firms, one with relatively high and one with relatively low levels of abnormal accruals in the year 1996, He find a significant association between earnings management and audit committee governance practices. He fined that aggressive earnings management is negatively associated with the financial and governance expertise of audit committee members, with indicators of independence, and with the presence of a clear mandate defining the responsibilities of the committee. The association is similar for both income-increasing and income-decreasing earnings management, suggesting that audit committee members are concerned with both types of earnings management and do not exhibit an asymmetric loss function similar to that of auditors.

Klein (2002) study examines whether audit committee and board characteristics are related to earnings management by the firm. A negative relation is found between audit committee independence and abnormal accruals. A negative relation is also found between board independence and abnormal accruals. Reductions in board or audit committee independence are accompanied by large increases in abnormal accruals. The most pronounced effects occur when either the board or the audit committee is comprised of a minority of outside directors. These results suggest that boards structured to be more independent of the CEO are more effective in monitoring the corporate financial accounting process.

Saleh, Iskandar, and Rahmat (2007) found that the presence of a fully independent audit committee reduces earnings management practices. It was also found that firms which had more knowledgeable audit committee members and held more audit committee meetings recorded fewer earnings management practices compared with other firms. Hypothesis that can be developed is:

Hypothesis 6: The effect of discretionary accruals on future profitability is weaker for firm with audit committee than firms without audit committee.

2.4 Research Model.

Following Subramanyam (1996) in the Siregar and Utama (2008) research, to test Hypothesis 1, I use the following research model:


Earnings can be measured into three variables: CFO, non-discretionary accruals (NDAC), and discretionary accruals (DAC). DAC is the variable of interest and if the type of earnings management is efficient, the coefficient () will be positive. If the type of earnings management is opportunistic, the coefficient will be zero or negative. The others variables are included as control variables.

To test hypothesis 2 to hypothesis 6, following previous work (Ghosh, Kallapur, & Moon, 2006; Siregar & Utama, 2008; Teoh & Wong, 1993) which allows the DAC coefficient is influenced by the hypothesized variables.

The effect of discretionary accruals on future profitability is moderated by DFAM, DSIZE, AUDIT, BOD, and AUDCOM. In this research model each of five variables interacts with DAC. I use interacting variables because the resulting coefficient will show the incremental effect of each variable on the relationship between discretionary accruals and future profitability. For example, if DFAM = zero, then the effect of the discretionary accruals on future profitability is , and if DFAM = one, then the effect of discretionary accruals on future profitability is . is the difference between DFAM = zero and DFAM = one, which is the interacting variables coefficient. Each of those five variables is also included as an independent variable to control the possibility that each variable has a direct influence on future profitability (Siregar & Utama, 2008).


3.1 Data Source and Sample.

The focus of this research is to examine the relationship between discretionary accrual and future profitability and the effect of discretionary accrual based on high family ownership, market capitalization, audit quality, independent board, and audit committee in the Indonesia Business Group. I will investigate the relationship between discretionary accrual and future profitability using regression. My sample consists of business group in Indonesia Stock Exchange in the year 2001-2008. I will collect the data from Indonesia Capital Market Data (ICMD), firm annual report, and financial statement which are published in Indonesia Stock Exchange website. The initial sample consisted of all companies listed on Indonesia Stock Exchange during 2001-2008.

I will use Conglomeration Indonesia book and also Top Companies and Big Groups in Indonesia book that provide a list of business groups in Indonesia along with firms belonging to each group. To test the hypothesis I make a dummy variable taking the value of one for firms with high family ownership and no business groups and zero otherwise. The firms that category “high family ownership and no business groups” are likely to engage in more efficient earnings management than the other categories (high family ownership and belonging to business group, low family ownership and not belonging business groups).

3.2 Empirical Methodology.

The independent variables in this research is discretionary accrual (a proxy for earnings management) and the dependent variable in this research is high family ownership, market capitalization, audit quality, independent board, and audit committee. In this research Regression method analysis will help to test the hypothesis.

3.2.1 Earnings Management.

Earnings management can be measured by discretionary accruals are calculated by how much the difference of total accruals (TACC) and nondiscretionary accruals (NDACC). In this research, to calculate DACC is used Modified Jones model. Modified Jones model, which is the development of the Jones model to detect earnings management, is better than the other models in line with the results of research (Dechow, Sloan, & Hutton, 1994). A model calculation for dependent variables follows:

From the regression equation above, NDACC can be calculating by reenter the coefficients:


3.2.2 Future Probability (FP).

Future Probability can be measured by:

CFO t + 1 = one year ahead cash flows from operation

NDN t + 1 = one year ahead non discretionary net income (EARN – DAC)

ΔEARN t + 1 = one year ahead change in earnings (EARN t + 1 – EARNt)

3.2.3 Family Ownership (DFAM).

Family firms can provide an interesting setting to test issue relating to earnings management. Samples are classified as firms with high family ownership (proportion of family ownership > 50%) and low family ownership (proportion of family ownership < 50%)[1].

3.2.4 Firm Size (DSIZE).

The larger the firm size, the less earnings management may be feasible (Kim, Liu, & Rhee, 2003). The growth of size tend to engage more in earnings management (Aussenegg, Inwinkl, & Schneider, 2009). The firm size can be measured by the number of capitalization market shares outstanding multiplied by year-end closing stock price, then the results actions are logged so that the value is not too large to enter the model equations.

3.2.5 Auditor's Size (AUDIT).

Auditor brand name measured by auditor size (big 4) is associated with earning quality (Lin & Hwang, 2009). I use variable dummy, where one for firms audited by Big 4 auditors (high audit quality) and zero for firms audited by non-Big 4 auditors (low audit quality). Auditor's size is used to measure audit quality.

3.2.6 Independent Board (BOD).

The components within the board are essential ingredients for effective monitoring. The appointment of managers as directors (i.e. insiders) is important because they have more information about the organization compared to outside directors. However, domination by insiders may lead to transfer of wealth to managers at the expense of the stockholders. Therefore, outside directors are appointed on the board mainly to obtain independent monitoring mechanism over the board process thereby reducing agency conflicts and improve performance (Saleh et al., 2005). The proportion of independent board members is calculated from the number of independent commissioners divided by the number of commissioners' on the board.

3.2.7 The Existence of an Audit Committee (AUDCOM).

The audit committee primary oversees the firm's financial reporting process. It meets regularly with the firm's outside auditors and internal financial managers to review the corporation's financial statements, audit process, and internal accounting controls (Klein, 2002). The existence of an audit committee is measured as a dummy variable, where one for firms with an audit committee and zero otherwise.

3.3 Empirical Model.

In this research, regression method analysis will help me to test the Hypothesis. The main dependent in this research is earnings management on the future probability. The regression include five kind of independent variables such as family ownership, firm size, auditor's size, independent board, the existence of an audit committee. Here is the schema of relationship between dependent variable and independent variable:


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[1] I employ a 50% cutoff, because in general ownership > 50% entitles the investors to exercise control over the company, including over earnings management activity. Accounting standards regarding equity investment also stipulate this cutoff to indicate the existence of control (Siregar & Utama, 2008)

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