THE EFFECTIVENESS OF AUDIT COMMITTEE INDEPENDENCE AND

EXPERTISE TO PREVENT EARNINGS MANAGEMENT PRACTICES IN

INDONESIAN LISTED MANUFACTURING COMPANIES
MELINDA LYDIA NELWAN *
BILLY IVAN TANSURIA
UniversitasKlabat
Abstract
This study revisited the topic related to the effectiveness of the audit
committee independence and expertise in preventing earnings management
practices. Studies in other countries that have relatively stricter regulations
showed the audit committee independence was effective to prevent earnings
management. Arguably, the practice may be different in Indonesia whose
regulation is considerably more lenient. On the other hand, studies related
to audit committee expertise is rarely done in Indonesia. Therefore, this
study aimed to examine whether the independence and expertise
characteristics of the audit committee were effective to prevent earnings
management. It utilized two of the earnings management models namely
the Modified Jones Model and the Performance-Adjusted Modified Jones
Model. This study was limited to Indonesian listed manufacturing
companies in 2009 to 2011. Consistent for both earnings management
models, the results show that audit committee independence is effective to
prevent earnings management. However, the results showed that audit
committee expertise did not affect earnings management practices.
Although only approximately 39% of the audit committee members in
Indonesian listed manufacturing companies were independent, the existence
of those independence members enabled the audit committee to effectively
conduct its monitoring role especially in preventing earnings management.
Nevertheless, accounting and/or financial expertise might not determine the
effectiveness of audit committees monitoring role.
Keywords: audit committee, earnings management, expertise, good
corporate governance, independence, Modified Jones Model,
Performance-AdjustedModified JonesModel
Abstrak
Studi ini meninjau kembali topik yang berhubungan dengan efektivitas
independensi dan keahlian dari komite audit dalam mencegah praktik
manajemen laba. Studise jenis yang dilakukan di Negara lain,yang mana
secara relative memiliki peraturan yang lebih ketat, menunjukkan bahwa
independensi dari komite audit efektif dalam mencegah praktik manajemen
laba. Di sisi lain, studi yang berhubungan dengan keahlian komite audit
masih jarang dilakukan di Indonesia. Untuk itu, penelitian ini bertujuan
untuk menyelidiki apakah karakteristik komite audit yang memiliki
independensi dan keahlian financial dan/atau akuntansi dapat secara efektif
mencegah praktik manajemen laba. Studi ini menggunakan dua model
*

Author can be contacted at: melinda.nelwan@unklab.ac.id

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manajemen laba yaitu Modified Jones Model dan Performance-Adjusted

Modified Jones Model. Adapun batasan dari studi ini adalah hanya
dilakukan pada perusahaan manufaktur yang terdaftar di Bursa Efek
Indonesia padaperiode 2009 sampai dengan 2011. Secara konsisten, hasil
yang diperoleh dengan menggunakan kedua model manajemen laba
menunjukkan bahwa independensi dari komite audit efektif dalam
mencegah praktik manajemen laba. Meskipun demikian, studi ini mendapati
bahwa keahlian yang dimiliki oleh anggota komite audit tidaklah
mempengaruhi manajemen laba. Walaupun hanya 39% dari anggota komite
audit perusahaan-perusahaan manufaktur di Indonesia yang dikategorikan
independen, hal tersebut memampukan komite audit untuk secara efektif
melakukan perannya dalam melakukan monitoring dan terutama dalam
mencegah kemungkinan terjadinya praktik manajemen laba. Sebaliknya,
keahlian financial dana kuntansi bukanlah merupakan factor penenentu
keefektifan komite audit dalam menjalankan peran monitoringnya.
Kata Kunci:

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independensi, keahlian, komite audit, manajemenlaba,

Modified Jones Model, Performance-Adjusted Modified
Jones Model, tatakelolaperusahaan

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1.

Introduction
The asymmetric of information between management and shareholders is one of

the reasons why monitoring costs such as management audit incurred in order to align
the interests of management and shareholders. Managers tend to act based on their selfinterests because they have better knowledge about the corporation than shareholders
do, as reflected in agency theory (Jensen andMeckling, 1976). Indeed, although the
existence of audit committee as required in good corporate governance (GCG) is
expected to provide unbiased monitoring device to the corporation, managers still have
the incentives to expropriate corporate resources due to many motives, and this opens
the opportunity to engage in earnings manipulation.
Existing studies related to the relation between audit committee independence
and earnings management in different countries show that the independence of audit
committee is essential to prevent earnings management practices (e.g., Bedard et al.,
2004; Peasnell et al., 2005; Saleh et al., 2007). However, we argue that the code of
GCG in Indonesia regarding the audit committee is relatively more lenient because,
unlike the regulation in other countries (e.g. ASX, 2003), the regulations in Indonesia
only specified that at least one member is an independent commissioner (BAPEPAMLK, 2004; NCG, 2006). Hence, the degree of the audit committee independence in
Indonesia may affect the effectiveness of its monitoring role, specifically in preventing
earnings management practices.
Another specification regarding an audit committee as required by the
Indonesias code of GCG and BAPEPAM-LK is that at least one member of the audit
committee should come from an accounting and/or finance background (BAPEPAMLK, 2004; NCG, 2006). This is due to the extensive knowledge possessed by the
committee members regarding accounting and finance area that enable them to
scrutinize corporate financial reports and other related matters. Thus, the expertise of
the audit committee is also essential to prevent earnings management practices.
Focusing on the impact of corporate governance mechanism to earnings quality,
this paper investigated whether the characteristics of audit committee as one of the
corporate governance mechanisms is effective to prevent earnings management
practices among manufacturing companies listed in Indonesia Stock Exchange (IDX).
In particular, we analyzedthe impact of the audit committee independence and
expertiseon corporate earnings management practices using two earnings management

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model, the Modified Jones Model and the Performance-Matched Modified Jones
Model, which to our best knowledge are rarely used in similar study, especially in
Indonesian setting.

The purpose is to investigate whether the compliance to the

regulations ensure the effectiveness of the monitoring role of the audit committee.
Hence, this study is beneficial to answer the research question: Are audit committee
independence and expertise effective to prevent earnings management practices,
particularly among manufacturing companies listed in IDX, during the period of 2009 to
2011?
2.

Theoretical Framework and Hypothesis Development

2.1.

Earnings Management

Earnings management is a prevalent corporate activity that has been studied

across time. It refers to the action taken by the management to attain targeted level of
earnings which can be done through particular choices of accounting principles and/or
implementation of particular operating decisions (McKee, 2005).

Regarding the

accounting choices by the management, the continuum of earnings management can

vary from conservative accounting to fraudulent accounting.

On the end of this

continuum, fraudulent accounting is a choice of accounting principles that violates the

generally accepted accounting principles (GAAP) (Dechow and Skinner, 2000; McKee,
2005). Indeed, Healy and Wahlen (1999) regarded earnings management as judgment
by the management that is deliberately intended to manipulate financial reports. This
manipulation will then mislead and influence the decision makers in taking certain
actions that can be harmful to them. Therefore, on the one hand, earnings management
can be conducted legally whenever the accounting choices are in accordance with
GAAP; on the other hand, earnings management may be illegal when conducted overly
aggressive through the violations of GAAP.
There are some incentives why the management deliberately chooses to manage
earnings. Besides to avoid reporting losses, Dechow and Skinner (2000) described, for
example, an incentive for the management to manage earnings is because analyst and
money managers may provide incentives to management whenever they are able to
meet earnings forecasts. In this case, higher earnings may result in higher stock prices.
Better earnings performance may increase market value of a company, attract more
investors, and boost the managers reputation. Consequently, earnings management
becomes an inseparable practice among corporations.

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There are two parties within a company (i.e., management and shareholders) that
can typically have different interests that need to be aligned through an effective
mechanism. The contradicting interests can be caused by the information asymmetry
between those two parties (Jensen andMeckling, 1976). To a larger extent, information
asymmetry may drive the management to take maximum advantage on the expense of
shareholders by practicing earnings management. Although to some extent it may be a
good way of communicating the inside information from the management to investors,
earnings

management

can

be

harmful

particularly

when

the

management

opportunistically use earnings management to benefit themselves (Scott, 2003). In

order to avoid the misbehavior, a controlling and monitoring mechanism is important to
be employed inside a company. Therefore, studies have been conducted to examine
whether particular mechanisms are effective to prevent earnings management practices
(e.g., Davidson et al., 2005; Klein, 2002).
One mechanism to align management and shareholders interests is through a
GCG practice. The fall of several big corporations around 2000 to 2002 (e.g., Enron,
WorldCom) caused market confidence to diminish. The enactment of Sarbanes-Oxley
Act of 2002 (SOA) by the U.S. congress indicates that government and regulators were
concerned about the loss of public confidence over corporations financial practices.
SOA provides more rigorous requirements regarding corporate governance organs
within public companies, mainly to increase corporate transparency and accountability
and to promote more truthful and fairness representation of financial reporting (SEC,
2002). Since then the practice of GCG was more prevailing,hence stricter corporate
governance practices will be expected these days based on several reasons such as to
comply with the regulation, to avoid unlawful acts that can destroy its reputation, and to
be favorably valued by the market.
Although there are various ways to investigate earnings management, earnings
management studies are usually conducted by assessing accruals. There are two types of
accruals which are discretionary and nondiscretionary.

Discretionary accruals are

accruals that are managed through accounting choices by management and usually used
by the managers for income smoothing (Subramanyam, cited in Spohr, 2005).

In

contrast, nondiscretionary accruals are considered as accruals that are mandatory and
might not depend on the managements discretion to be incurred.

Given that

discretionary accruals are those that can vary according to the accounting choices and

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treatments by the managementand might be easily manipulated, this type of accruals is

usually used as proxy for earnings management.
2.2.

Audit Committee

The notion ofGCG arguably creates the expectancy for the company to provide
more transparent corporate practices.

TheGCG code usually outlines several

mechanisms that could improve stakeholders confidence towards publicly listed

companies. One of those mechanisms is the existence of an audit committee in every
listed company. This is because audit committee is considered as helping the board of
commissioners in performing their monitoring roles, specifically in the area of corporate
financial reporting.
More transparent corporate financial practices may lead the company to provide
more reliable financial information especially to the shareholders. The shareholders are
to be ensured that management is being accountable to them, and acting according to
their best interest. Therefore, the existence of audit committee is in line with the needs
for the company to be accountable to its shareholders. This is because the committee
might prevent the company to engage in unfavorable financial practices such as
earnings management that can result in providing unreliable financial information to the
shareholders.
In Indonesia, Capital Market Supervisory Agency and Financial Institution
(BadanPengawasPasar Modal danLembagaKeuangan [BAPEPAM-LK]) as the
regulator of capital market required every listed company to establish an audit
committee. As stated on the Decree of the Chairman of BAPEPAMnumber KEP41/PM/2003, every Indonesian public company is regulated to have an audit committee
by December 31, 2004.
Indonesias code of GCG, in particular, only requires an audit committee to be
chaired by an independent commissioner and one of its members to possess accounting
and/or finance background. Likewise, before 2012, BAPEPAM-LK only requires every
publicly listed company to have an audit committee with the characteristics in
accordance to what had been prescribed by the National Committee on Governance
(NCG). Given the circumstance,the independence and expertise of the audit committee
then became the focus of this paper.
2.2.1. Audit Committee Independence
It is essential for the audit committee members to be independent so that they
will not be biased in exercising judgment regarding companys financial reporting. It

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could also be an attribute to mitigate contracting costs (Deli andGillan, 2000). Bedard
et al. (2004) concluded, companies that had completely independent audit committee
members were able to reduce the propensity to manipulate their earnings aggressively.
In fact, Beasly (1996) asserted that companies with less independent board and without
an audit committee are most likely to engage in financial reporting fraud. Therefore, it
is expected that more independent audit committee will prevent earnings manipulations.
According to the Decree of the Chairman of BAPEPAM number KEP29/PM/2004, an audit committee should consist of at least three members within which
one of the members should be the independent commissioner of the companywho
serves as the chairman of the committee. Several criteria related to an independent
member are that he or she; (1) should not have a family relation with directors,
commissioners and the major shareholders of the company, (2) should not possess a
direct and indirect business relation with the company, (3) should not be a direct or
indirect shareholder of the company or other public companies, and (4) should not be a
person who is in charge to direct and control the activities of the company at least six
months before the appointment. These criteria are considerably essentialto isolate the
member from being controlled by certain parties.
A study by Bedard et al. (2004) examined the possibility to engage in earnings
manipulation among the companies whose audit committee members were 100 percent
independent compared to those whose audit committee members were majority
independent. They found that companies which have 100 percent independent audit
committee members were less probable to conduct aggressive earnings manipulation.
Peasnell et al. (2005), in their study, found that the upward management of earnings
occurred less in companies that had larger numbers of independent directors.Moreover,
another study conducted in Malaysia by Saleh et al. (2007) found that a company would
have fewer tendencies for earnings manipulation if all of its audit committee members
were independent. Those studiesprovide insight that the more independent the audit
committee, the more effective its monitoring role would be performed. Accordingly, by
considering the lenient requirements of the code of GCG in Indonesia, it was fairly
significant to investigate whether the independence of audit committee of Indonesian
listed companies was effective to prevent earnings management practices. Hence, the
argument leads to the hypothesis below;
H1:

Audit committee independence affects earnings management practices in

Indonesian listed manufacturing companies.

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2.2.2. Audit Committee Expertise

Studies show that, particularly,an audit committee which has members with
accounting and/or finance knowledge is more effective in performing its monitoring
role (e.g., McDaniel et al., 2002). Other than Indonesia, theexpertise characteristic is
also required by regulations in other countries which suggest that at least one audit
committeemember should be a financial expert (ABA, 1999; ASX Corporate
Governance Council, 2003; NCG, 2006; SEC, 2002).

In addition, McMullen and

Raghunandan (1996) stated that it will be more preferableif the financial expert member
is affiliated with accounting professional body, an experienced public accountant, an
auditor, or a financial officer.On the contrary, the regulation in Indonesia does not
permit an audit committee member to be affiliated with professional bodies (e.g., public
accountant, auditor, etc) that provided services to the company within six months before
his/her admission to the committee. Nevertheless, the knowledge and expertisecan
supposedlyenhancethe effectiveness of the audit committee members to oversee and
protect the integrity of companies financial reporting.
McDaniel et al. (2002) stated that the expertise of the members of an audit
committee enables them to assure the quality of the companies financial reporting. A
survey was conducted by McMullen and Raghunandan (1996) to several corporations
with different financial condition. They found that among the 51 companies that were
in financial problems only 6% of them have audit committee members that were
certified public accountant (CPA). On the other hand, 25% of 77 companies that were
not in financial problems had audit committee members who were CPAs. Indeed,
accounting or financial experts among the audit committee members may help to
improve quality of financial statement reporting.
An audit committee that has financial or accounting experts is considered to be
more qualified in executing its monitoring role, which to some extant might increase the
companys value.A study by Davidson et al. (2004) found that the information
regarding the existence of financial expertise within an audit committee caused the
market to react positively as reflected on the stock price.Their result showed that capital
market tended to favor a company whose directors were considered competent
inensuring the good conduct of financial reporting activities. Thus, possessing relevant
knowledge will cause audit committee members to competently examine and oversee
the financial reporting activities and this in turn might increase investors confidence in
the company.

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Employing audit committee members with financial expertise provides evidence

that financial statement manipulations can be prevented. To some extent, combined
with regular meetings, an audit committee that is more knowledgeable about accounting
and finance is more likely to minimize the occurrence of earnings manipulation within a
company (Saleh et al., 2007).

In contrast, company with fewer financial expert

members in the audit committee has a tendency to encounter financial problems

(RahmatandIskandar, 2009). At the end of the day, having more experts in the area of
accounting and finance within an audit committee should promote effectiveness in
controlling financial reporting process and hinder the managers propensity to
manipulate earnings. Thus, I conjectured that the accounting and/or financial expertise
is effective to prevent earnings management practices in Indonesia.

Hence, the

hypothesis would be;

H 2 : Audit committee expertise affects earnings management practices in Indonesian
listed manufacturing companies.
3.

Research Method

3.1.

Data and Sample

The population of this study consists of 133 listed manufacturing

companies.

Based on the initial purposive sampling criteria this study found 131

manufacturing companies that are consistently listed on the IDX which formed 393
firm-year observations.

After removing companiesthat reported their financial

statement not in IDR, the fiscal year ended other than on December 31, and the financial
and governance data are not available, we ended up with 309 firm-year observations
(103 firms). After the initial regressions using both the Modified Jones Model and
Performance-Adjusted Modified Jones Model, we further removed the data with Cooks
Distance residuals equal to or larger than 3 which conspicuously abnormal compared to
others. The final sample size is reduced to 303 firm-year observations taken from 101
firms. The sample selection can be seen on Table 1.
Insert Table 1 here
The financial data of this study are taken from corporate financial reports
published in IDX website and/or company websites. Additionally, in obtaining data
regarding audit committee independence and expertiseweobtained the corporate annual
reports and performed content analysis.

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3.2.

Research Model

Several earnings management models are widely used in extant studies. Two of
the models are the Modified Jones Model and the Performance-Adjusted Modified
Jones Model.

Dechow et al. (1995) described the first model in their study that

compares several earnings management models. Dechow et al. (1995) stated that the
original Jones Model was modified to eliminate the conjecture tendency of the Jones
Model to measure discretionary accruals with error when discretion is exercised over
revenues (p. 199). The modification was done by adjusting the changes in revenues by
the changes in receivables during the period of observation. Kothari et al. (2005)
proposed a model that is called as the Performance-Adjusted Modified Jones Model.
Their model considers offering further control on firms performance, because they
argued that firms classified as having abnormally high or low levels of earnings
management are those that manage more than would be expected given their level of
performance (p. 165). Hence, those two models were used in this study to provide
comparison and ensure the robustness of the results.
The first model used to obtain the earnings management for cross-sectional
analysis in this paper is stated below:
TA it /A it-1 = 0 (1/A it-1 ) + 1 (REV it - REC it / A it-1 ) + 2 (PPE it /A it-1 ) + it

(1)

TA is the total accruals which obtained from the differences between operating profit
after taxes and cash flows from operating activities. The1/Ait-1is replaced the constant
in the original Jones Model (Jones, 1991),REV are the changes in revenues, REC are
the changes in accounts receivables andPPE is the gross amount of Property, Plant and
Equipment, while the it is the error term which is basically the estimated discretionary
accruals that proxies for earnings management.The REV, REC, PPE are scaled by
lagged total assets, which like Kothari et al. (2005) state is intended to alleviate the
heteroskedasticity which is the non-constant variance of the residuals that would
possibly violate the OLS assumption.
The second earnings management model used in this study was developed by
Kothari et al. (2005):
TA it /A it-1 = 0 (1/A it-1 ) + 1 (REV it -REC it /A it-1 ) + 2 (PPE it /A it-1 ) + 3 ROA it-1 +
it

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(2)

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The difference with previous model is on the addition of return on assets (ROA) as part
of the regression model. ROA is the ratio of earnings to total assets. By adjusting with
ROA, they called this model Performance-Adjusted Model. The reason for them to
adjust the traditional discretionary accruals model is to tackle the issue that accruals are
related to the contemporaneous and past performance of the firms. Following Chen et
al. (2007), this study includes lagged ROA to the model.
Using both discretionary accruals based on the ModifiedJones Model and the
Performance-Adjusted Modified Jones Model, the regression model is as follows,
DACC it = 0 + 1 AC_IND it + LnTA it + LEV it + ROA it + it

(3)

Where, DACC is the discretionary accruals measured by the residuals in

Modified-Jones Model and Performance-Adjusted Modified Jones Model.AC_IND
represents the audit committee independence, measured by the ratio of independent
members to total audit committee members.LnTA is the firm size measured by the
natural logarithm of total assets.LEV is the leverage, measured by the ratio total
liabilities to total assets.ROA representsfirm performance, measured by the ratio of
earnings to total assets. Firm size (LnTA),leverage (LEV) and firms performance
(ROA) are several control variables that are generally used in earnings management
studies (e.g., Saleh et al., 2007). Therefore, following previous research we included
those control variables in the regression model.
To examine the impact of audit committee expertise on earnings management
practices the regression model is as follows:
DACC it = 0 + 1 AC_EXP it + LnTA it + LEV it + ROA it + it
Where, AC_EXPis the audit committee expertise, measured by the ratio of members
whose background is accounting and/or finance to total audit committee members.
Other variables are the control variables described above.
4.

Results

4.1.

Descriptive Statistics

The descriptive statistics of 303 observations are presented on Table2. On

average, the total accruals of all firms are around Rp. 89 Billion. The total assets are
around Rp. 4 Trillion which on average the firms could be categorized as relatively
large. Approximately, revenues are Rp. 4,8 Trillion, receivables are Rp. 401 Billion,

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(4)

and gross property, plant, and equipment are Rp. 2 Trillion. ROA has a mean of
approximately 8% which shows that approximately the return is 8 times the invested
assets. Leverage is around 69%, meaning that on average total liabilities are 69% more
than total assets.

On average, 39% of audit committee members are classified

independent and 64% of the members have accounting and/or financial background.
This shows that generally firms are complied with the regulations of audit committee
independence and expertise as posed by BAPEPAM-LK.
Insert Table 2 here

4.2.

Hypothesis Tests

To test the hypotheses, there are several preliminary regressions that have been
done. The first regression using the Modified Jones Model is conducted to determine
the discretionary accruals that become the measure of earnings management. The
second regression was performed using the Performance-Adjusted Modified Jones
Model to get another measure of discretionary accruals.Table 3 shows the descriptive
statistics of the discretionary accruals which are the unstandardised residuals of the two
earnings management models (i.e., the discretionary accruals of the Modified Jones
Model and the discretionary accruals of the Performance-Adjusted Modified Jones
Model). According to Lindelauf (2011), the unstandardised residuals are usually used
to detect whether there are more negative or positive accruals and whether firms
manage their earnings upwardly or downwardly.

On average, the undstandardised

residuals from both models are negative, implies there are more downward-managed
earnings.
Based on the two initial regressions, the hypothesis testing was being conducted,
to examine whether audit committee independence, and then, audit committee expertise
affect the earnings management practices proxied by both discretionary accruals
acquired using the Modified Jones Model and the Performance-Adjusted Modified
Jones Model, yielding two tests for each hypothesis (i.e., labeled a and b). All the
regressions were done in STATA using robust standard error to control for
heteroskedasticity, in addition, the standard error is adjusted using cluster to control for
autocorrelation problem.
Insert Table 3 here

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4.3.

Audit Committee Independence and Discretionary Accruals of Modified Jones Model

The result for the first hypothesis was conducted using the discretionary accruals
acquired from the Modified Jones Model.

Table 4 shows that the adjusted R2 is

approximately 24% which means that 24% of earnings management can be explained
by audit committee independence and other control variables. Overall, the model is
significant (p-value of the F-test is 0.000). Moreover, it is shown that the independence
of audit committee is negative and significant (p-value = 0.028), therefore H 1a is failed
to be rejected.
Insert Table 4 here

It is shown that audit committee independence affects the earnings management

practices of a company. The predicted sign is consistent with previous studies that
show as the audit committee becomes more independent the company will less likely to
practice earnings management.

Therefore, this study shows that the independence

characteristic would determine the effectiveness of audit committee monitoring role in

Indonesia. Although the majority of the audit committee members are not independent
(on average only 39% of the members are independent), the requirement that at least
one of the audit committee members should be independent might still be effective in
preventing earnings management practices.
Among the control variables only Leverage that is not significant (p-value =
0.186) and the result indicated that the predicted sign is not consistent with previous
study. The result also shows that firm size has a positive and significant impact on
discretionary accruals (p-value = 0.001) which is consistent with a prediction that the
larger the company, the higher the discretionary accruals, meaning the company is more
likely to conduct earnings management.

ROA is positive and significant (p-value =

0.000) however the sign is not consistent with the prediction that company whose
financial performance is better will be less likely to manage its earnings.
4.4.

Audit Committee and Discretionary Accruals of Performance-Adjusted Modified Jones

Model

The next hypothesis is to examine the impact of audit committee independence

on discretionary accruals using the Performance-Adjusted Modified Jones Model. The
results are similar to previous test. The adjusted R2 is around 27%. The result shows
that the relation between audit committee independence and earnings management is
significant (p-value = 0.029). Therefore, H 1b is failed to be rejected which means audit

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committee independence affects earnings management. The overall results including

the control variables are consistent with that of H 1b which can be seen on Table 5.
Insert Table 5 here

4.5.

Audit Committee Expertise and Discretionary Accruals of Modified Jones Model

Table 6 presents the result of the regression between audit committee expertise
and discretionary accruals using Modified Jones Model.

The adjusted R2 is

approximately 23%, which means about 23% of earnings management practices can be
explained by the expertise of audit committee and other control variables. The model is
significant (p-value = 0.000). However, the variable that captures audit committee
expertise is not significant at any confidence level (p-value = 0.573). Thus, H 2a is
rejected, meaning audit committee expertise does not affect earnings management. The
results for control variables are consistent with previous tests.

Insert Table 6 here

Although on average the audit committee members have accounting and

financial background this expertise may not be effective in preventing earnings
management. It can be argued that it is more important for audit committee members to
be independent that to have particular expertise. This is because the expertise may not
guarantee the members to conduct true and fair control over the companys financial
reporting process. Consequently, the discretion to manipulate financial information
should also be controlled through other monitoring mechanism within the firms.
4.6.

Audit Committee Expertise and DACC of Performance-Adjusted Modified Jones Model

The result on Table 7 is based on the regression between audit committee

expertise and earnings management. The earnings management in this regression is
proxied by the unstandardized residuals of Performance-Adjusted Modified Jones
Model. The result shows that H 2b is rejected, because the p-value is larger than 0.05 (pvalue = 0.697).

Therefore, audit committee expertise does not affect earnings

management. The results for control variables are also similar to previous tests.
Insert Table 7 here
It should be noticed that the predicted sign of the relation between audit
committee expertise and discretionary accruals is not consistent with previous results.
On this regression and it is similar to previous regression, the sign is positive. Although

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this cannot be proven statistically in this paper, the resultsimply that as the audit
committee becomes more expert the propensity for earnings management practices
might increase.

5.

Conclusion, Implication and Limitation

5.1.

Conclusion

The demand for more transparent and accountable financial reporting is of a

particular interest of extant corporate governance and earnings management studies. As
one of the corporate governance mechanisms, the existence of audit committee is
deemed beneficial to improve awareness to report true and fair performance of the
companies. An audit committee is expected to assist in aligning management interests
to that of the shareholders.
Similar to the Indonesias code of GCG, before 2012, BAPEPAM-LK as the
regulator of the capital market in Indonesia only endorses those two characteristics in
the regulation. The regulation requires an audit committee to be at least chaired by an
independent commissioner as well as to have at least one member with accounting
and/or finance background.

This regulation is arguably more lenient compared to

regulations from other countries (e.g., Australia).

This study found that audit committee independence negatively and significantly
affect earnings management practices. The results implied that as an audit committee
become more independent, it would be more likely to prevent a company in practicing
earnings management. Thus, it could be argued that although the regulation regarding
audit committee independence is more lenient in Indonesia, it is relatively effective to
ensure the effectiveness of the audit committee monitoring role. However, this study
did not find a significant effect of the expertise of audit committee on preventing
earnings management.

Arguably, the accounting or financial knowledge of audit

committee members could not determine the effectiveness of the audit committee
monitoring role in preventing a company to engage in earnings management.
5.2.

Implications

At the end of the day, minimum compliance with the regulation may not
determine the effectiveness of audit committee role. Companies that are only motivated
by regulation compliance will be less concerned whether the existence of an audit
committee within a firm is beneficial or not. They would only comply in a minimum
level with the incentive of not being persecuted by the regulator or influential

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stakeholders. On the contrary, companies that are concerned with whether the firm is
well governed may take further steps to ensure they surpass the requirements of the
regulation. This would relatively assure that these companies will perform better in their
financial reporting and be less engage in manipulating earnings. To some extent, the
effectiveness of corporate governance mechanism within a firm may improve the
transparency and accountability of a company which is then expected to contribute on
the increasing investors confidence in the company and capital market as a whole.
5.3.

Limitations

We acknowledged that there are some limitations of this study. First, it was
conducted only on single industry that potentially had different characteristics with
other industries. Therefore, the external validity of this study might be considered low.
Second, this study considers only two characteristics of audit committee: independence
and expertise. Third, the period of this study was only limited to 2009 to 2011. Longer
period might possibly infer different results. However, it should be noticed that shortly
before 2009, there was global financial crisis which might also affect the corporate
governance and accounting practices on Indonesian companies, and on 2012 there are
other characteristics that was specified by the regulations concerning audit committee.
Fourth, the earnings management models that were used in this study were limited to
the Modified-Jones Model and Performance-Adjusted Modified Jones Model.
Given the limitations, there are several recommendations that can be made for
further research related to this topic. First, to increase the external validity, similar
study could be conducted across industries to examine whether audit committee
characteristics provide different effects on different industries. Second, further study
could also employ other characteristics of an audit committee besides independence and
expertise, as specified by the regulations (e.g., activity). Third, future research can be
conducted to compare the effectiveness of the audit committee characteristics before
and after global financial crisis. Fourth, another study could be conducted to compare
the relation between audit committee characteristics and earnings management using
other earnings management models. Additionally, future research should also employ
more control variables on the study.

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Appendix
Table 1
Sample Selection
Observations Firms
Criteria:
Consistently listed between 2009 to 2011
Minus:
1. Financial Statements not reported in IDR
2 Annual Reports ended on other than Dec
31
3. Incomplete Data
Sample
Minus: Cook's Distance 3
Final Sample

393
33
33

131
11
11

12
39
309
6
303

4
13
103
2
101

Table 2
Descriptive Statistics

Mean

Median

Std.
Deviation

ACC

89,478.81

(4,669.46)

1,302,083.00

TA

4,170,706.00 850,470.00 13,500,000.00

303

REV

4,829,989.00 904,236.00 15,000,000.00

303

REC

401,056.50

153,239.00 1,136,091.00

303

GROSS PPE

2,443,003.00 544,714.00 5,444,840.00

303

ROA

0.078557

0.063000

0.245861

303

LEV

0.690221

0.477963

1.054952

303

INDEP_AC

0.388944

0.333333

0.190072

303

EXPERT_AC 0.635039

0.666667

0.274783

303

Variables

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N
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Table 3
Descriptive Statistics of Discretionary Accruals

Variable

Std.
Deviation

Mean

Median
Minimum Maximum
DACC_MJ
0.0298665 0.02162 0.1756205 -0.98762
1.0933
DACC_PAMJ 0.0228949 0.01141 0.1790246 -1.01155
1.08175

N
303
303

Table 4
Regression Results of Audit Committee Independence and Discretionary Accruals
of Modified Jones Model
Variables

Coefficients

P>t

INDEP_AC
-0.100*
0.028
LnTA
0.025***
0.001
LEV
-0.012
0.186
ROA
0.309***
0.000
Constant
-0.348***
0.001
Dependent
DACC_MJ
Observations
303
R-squared
0.251
Adj. R-squared
0.241
F-test
10.850
Prob> F
0.000
Legend: *** p<0.001, ** p<0.01, * p<0.05

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Table 5
Regression Results of Audit Committee Independence and Discretionary Accruals
of the Performance-Adjusted Modified Jones Model
Variables

Coefficients

P>t

INDEP_AC
-0.099*
0.029
LnTA
0.029***
0.000
LEV
-0.012
0.173
ROA
0.311***
0.000
Constant
-0.404***
0.000
Dependent
DACC_PAMJ
Observations
303
R-squared
0.267
Adj. R-squared
0.257
F-test
11.710
Prob> F
0.000
Legend: *** p<0.001, ** p<0.01, * p<0.05

Table 6
Regression Results of Audit Committee Expertise and Discretionary Accruals of
the Modified Jones Model
Variables

Coefficients

P>t

EXPERT_AC
0.015
0.573
LnTA
0.023**
0.001
LEV
-0.010
0.238
ROA
0.301***
0.000
Constant
-0.368***
0.000
Dependent
DACC_MJ
Observations
303
R-squared
0.241
Adj. R-squared
0.231
F-test
9.880
Prob> F
0.000
Legend: *** p<0.001, ** p<0.01, * p<0.05

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Table 7
Regression Results of Audit Committee Expertise and Discretionary Accruals of
thePerformance-Adjusted Modified Jones Model
Variables

Coefficients

P>t

EXPERT_AC
0.011
0.697
LnTA
0.027***
0.000
LEV
-0.010
0.217
ROA
0.303***
0.000
Constant
-0.419***
0.000
Dependent
DACC_PAMJ
Observations
303
R-squared
0.257
Adj. R-squared
0.247
F-test
10.820
Prob> F
0.000
Legend: *** p<0.001, ** p<0.01, * p<0.05

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