Paper 1 - Ancella

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........
Asia Pacific Journal of Accounting and Finance

Volume 2 (1), December 2011
THE INFLUENCE OF EFFECTIVE BOARD OF COMMISSIONERS

AND AUDIT COMMITTEE ON THE INFORMATIVENESS OF
EARNINGS: EVIDENCE FROM INDONESIAN LISTED FIRMS
Ancella Anitawati Hermawan
Universitas Indonesia
Indonesia
Email: ancella_hermawan@yahoo.com
Abstract
The existence of governance structure such as board of commissioners and audit committee
implies a better monitoring function on the financial reporting process that will result in
higher informativeness of earnings. Nevertheless, the quality of the monitoring function
depends on how effective the board and the audit committee perform their duties. This study
examines how the effectiveness of the board of commissioners and audit committee in a twotier board structure influences the informativeness of earnings which is measured by Earnings
Response Coefficient (ERC). The level of effectiveness is defined as the extent to which the
board of commissioners and the audit committee perform their duties according to their
responsibilities, which is associated with the board and audit committee characteristics. This
study develops a score for board and audit committee effectiveness by using a checklist
which captures how the independence, activity, size, and competence characteristics are
reflected in the board of commissioners and audit committe. Previous studies find that these
characteristics are required to enable the board and audit commitee perform better
governance. Each question in the checklist will be scored 1 (Poor), 2 (Fair), or 3 (Good)
based on the information disclosed in company annual reports. Hypothesis testing is carried
out by using a multiple regression model of 357 observations (firm-year) with the sample
taken from companies listed on the Indonesian Stock Exchange during the period 2006-2007.
Results of this study provide robust evidence that a more effective board of commissioners
improves the informativeness of earnings. However, the results for the influence of the audit
committee effectiveness are still mixed. The findings indicate that the effectiveness of the
audit committee does not affect the informativeness of earnings, but further analysis indicates
that audit committee effectiveness has a positive effect on ERC when the board of
commissioners is not effective in performing its role. Based on these findings, this study
indicates that audit committee is an integral part of board of commissioners so that the role of
board of commissioners still have significant role in the monitoring function because the
audit committee actually act on behalf of and report to the board of commissioners.
Therefore, the role of audit committee will be more revealed when the board itself is actually
less effective. This is consistent with the objective of the audit committee formation which is
to provide a complementary function for the board of commissioners monitoring role.
Keywords: corporate governance, earnings quality, earnings response coefficient, effective
board of commissioner, effective audit committee.
1. INTRODUCTION
The financial crisis occurred in East Asia during 1997-1998 has shown that weak
corporate governance in East Asian companies has made East Asian countries become more
vulnerable to financial crisis (Mitton 2002). Poor governance standard in private and stateowned companies is considered to be one of the causes of financial crisis in East Asia (Leng
2004). In Indonesia, the financial crisis also initiates the awareness to apply the principles of
good corporate governance in companies. For public companies which are listed in
Indonesian Stock Exchange (IDX), the Capital Market and Financial Institution Supervisory
Agency (Bapepam-LK)1 has demonstrated efforts to improve the companys corporate
governance by issuing various regulations regarding the implementation of corporate
governance. One of the regulations is related to the general requirements for securities with
equity characteristics in the stock exchange (Attachment II Kep-305/BEJ/07-2004). This
regulation requires the mandatory existence of independent commissioners in the companys
board of commissioners2 and audit committee. Audit committee is a committee established
by the board of commissioners in order to assist the board of commissioners in carrying out
their duties and functions.
The objective of the audit committe formation in the corporate governance structure
is to increase the companys accountability and transparancy to its stakeholders by providing
a more relevant and reliable financial information. Therefore, the implementation of an
effective internal governance structure, i.e. board of commissioners and audit committee, in a
company should have a positive impact on the information quality of the companys financial
reports. Under the Bapepam-LK regulations, public companies listed in Indonesian Capital
Market are enforced to have this governance structure to support the financial reporting
process. But the effectiveness of the governance structure can vary for each company
depending on how board of commissioners and audit committee perform their functions. The
board and audit committee will be an effective governance structure only if they really
perform their duties tied to their supervisory function responsibilities.
The level of effectiveness in this study is defined as the extent to which the board of
commissioners and audit committee might perform their duties according to their main
respective responsibilities. There exist characteristics of the board and audit committee that
allow the governance structure to become more effective. The first characteristic is the level
of independence when performing their duties. In carrying out supervisory duties, the board
and audit committee must be unbiased and should consider all the company stakeholders
point of view. The positive influence of the independence of the board of directors and audit
1
Bapepam-LK stands for Badan Pengawas Pasar Modal dan Lembaga Keuangan (Capital Market and Financial
Institutions Supervisory Agency) which has the similar function as Securities Exchange Commision (SEC) in
the United States Capital Market.
2
Indonesia adopts a two-tier system board structure in a company, i.e. board of commissioners and board of
directors, where board of commissioners is completely separated from board of directors. The role of board of
commissioners is to supervise and monitor the board of directors who act as the companys executives. Most
corporate governance studies were conducted in the one-tier system board structure setting, and the term of
board of directors used in those studies did not have the same meaning as the board of directors in Indonesia.
But the role of the board of directors in the one-tier system is similar to the role of board of commissioners in
the two-tier system as in Indonesia. Therefore in this study, the term board will be used for board of directors in
the one-tier system, and the term of board of commissioners will be used for companies in Indonesia.
committees on earnings quality has been demonstrated by Beasley (1996) and Klein (2002).
In addition to their independencies, board and audit committees should play active roles in
carrying out their functions, so that their existences are not merely due to regulatory
compliance. Active roles of the board and audit committee can be reflected in the activities of
the board and audit committee. Most previous studies measure the activity of the board and
audit committee by the frequency of board and audit committee meetings within a period.
Xie et al. (2003) find that if the board and audit committees are increasingly active, the
quality of reported earnings will improve.
The size of the board and audit committee may also influence the effectiveness of the
board and audit committees. In organization theory, a larger number of people working in an
organization will make their work easier, because it can be allocated to more people and thus
result in work specialization. Larger sized board of commissioners and audit committees
will make increase the possibility to have more experts with various expertises. However,
increasing the number of people in the organization might slow the decision-making process
because there will be more opinions to consider. Also, more people in an organization tends
to lead to free rider problems. Vafeas (2000) finds that companies that have the smallest
number of board members (in this case 5 people) is considered more informative by market
participants, so that its financial statements have higher information content. Anderson et al.
(2003) also find that audit committee size has a positive effect on the information content of
earnings.
Another characteristic of the board and audit committees that influence their
effectiveness is competence, through its effect on the quality of work. Competence can be
obtained from knowledge and experience. To be able to evaluate the companys financial
reports based on the companys business activities, board of commisioners should have an
adequate knowledge and experience in the companys business and have the ability to
understand the financial performance reports. Audit committees have been assigned a specific
task related to financial reporting process, including internal control and audit process. Xie
et al. (2003) show the positive influence of finance knowledge background of the board of
directors and audit committee on the earnings quality.
If the effectiveness of the board of directors and audit committee is influenced by
those characteristics, then it should be measured comprehensively based on those
characteristics by using a score or index. The use of a score or index will enable better
measurement on the level of effectiveness of the role and power (strength) of the structure of
governance given to the board and audit committee as a whole compared to the measurement
of each characteristic individually (DeFond et al. 2005; Bushman et al. 2004). Until now,
only few literature provide empirical evidence regarding the impact of the effectiveness of
the role of the board and audit committee, measured by using a score or index, to the quality
of earnings. Most studies on the corporate governance and earnings quality usually focus on
the association of each of those characteristics to earnings quality. Therefore, there is still yet
few empirical evidence showing the effectiveness of board and audit committees based on
their characteristics together on earnings quality.
Investors perceptions about the quality of earnings is captured by how the investors
react to the earnings information in the capital market. Teoh and Wong (1993) shows that
investors are willing to pay a higher price for earnings of "high quality" because the high-
quality earnings are seen as sustainable profits. Therefore, earnings quality is measured based
on the response of investors on the information content of accounting earnings
(informativeness of accounting earnings). The magnitude of the change of abnormal retuns
associated with the change in unexpected earnings is called the earnings response coefficient
(ERC). The ERC will be high if investors perceive the informativeness of earning is high,
meaning that the earnings quality is high.
This study defines the ERC based on an association study approach using a returnsearnings regression with a long period of time, i.e. one year, similar to Niu (2006), Francis et
al. (2005), Anderson et al. (2003), and Warfield et al. (1995). Collins and Kothari (1989)
state that the event study approach is relevant for the ERC determinant analysis in short-term
period (e.g. only several days). Therefore, the relevance of event study approach for ERC
determinant analysis using annual data is limited. By using the association study approach,
the information content of earnings (ERC) will reflect the value relevance of earnings, not the
value of "new" information from the earnings announcements commonly reflected in the
ERC in the event study test. Thus, the quality of earnings will be measured based on the
informativeness of earnings that reflect the value relevance of earnings.
The results of this study are expected to contribute to the operationalization of the
board and audit committee effectiveness concept in the development of corporate governance
literature. This study focuses on a comprehensive measurement of the effectiveness of the
board and audit committee role in corporate governance implementation by using a
composite score. In previous studies, the influence of the board or audit committee is
measured using a separate variable for each characteristics of the board and audit committee
effectiveness. Each variable is usually measured by one measurement as a proxy. For
example, the activity of the board of commissioners measured by frequency or the number of
board meetings. Corporate governance research that uses score or index typically uses
corporate governance index, which includes all corporate governance aspects as a whole. By
using specific scores for the board and audit committee is expected to provide a more focused
analysis about the strength of corporate governance structure, i.e board of commissioners and
audit committee. The use of a comprehensive score will take into account the characteristics
of independence, activity, size, and the competence of the board of commissioners, and the
characteristics of the audit committee, namely the activity, size, and competence. By using a
score, each of these characteristics can be evaluated based on more than one measerement as
the proxy. Therefore, the assessment of the board and audit committee effectiveness can be
more comprehensive.
The fact that the audit committee is part of the board of commissioners makes the
audit committee position quite unique. The audit committee is responsible to the board of
commissioners. Board of commissioners and the audit committee both are expected to
perform an effective role in order to support good corporate governance in order to improve
the quality of reported earnings. However, with the position of a specific audit committee as
part of the board of commissioners, it needs to be analyzed further whether the effectiveness
of audit committee role on earnings quality is independent of the effectiveness of the board of
commissioners role. This study explores further the independence of the audit committee
effectiveness from the board of commissioners effectiveness in influencing the
informativeness of earnings. The result will be a contribution in the corporate governance
structure literature by providing further description about the audit committee role as part of
the board of commissioners, namely whether the audit committee can function effectively
without being affected by the effectiveness of the board of commissioners.
This study is also expected to contribute to the earnings quality literature relating to
corporate governance and informativeness of earnings. Most previous studies on earnings
management used discretionary accruals as a measure of earnings quality. In Indonesia,
studies on corporate governance and quality of earnings using ERC as a measure of earnings
quality are conducted by Tresnaningsih (2007) and Suaryana (2005). Both studies examine
the magnitude of the ERC associated with the existence of independent commissioners and
the audit committee. This study will provide a more comprehensive discussion about the
influence of effective corporate governance practices on the informativess of earnings, so it
will be able to enrich the literature of earnings response coefficient (ERC) relating to
corporate governance.
2. LITERATURE REVIEW
2.1. Corporate Governance Practice and Financial Statements
Financial statements prepared by a company are a manifestation of the corporate
governance principles of accountability and transparency for the companys stakeholders.
Therefore, one objective of having an internal governance structure, i.e. board of
commissioners and audit committee, is to ensure the financial reporting process to give a high
quality financial statements. There have been quite many studies of corporate governance
focusing on the association between corporate governance practices and financial statement
information (Bushman and Smith 2001). Those studies focus on the influence of corporate
governance structure in the form of the board of directors and audit committees in dealing
with the agency problem between management and owners in the financial reporting process.
Some studies examine whether the existence of audit committees will improve the financial
statements quality (e.g. DeFond and Jiambalvo 1991; Beasley 1996; Petra 2007). Several
other studies begin to emphasize the characteristics of the governance structure, namely the
independence, composition, and size of the board and audit committee (e.g. Dechow et al.
1996; Beasley 1996; Vafeas 2000; Peasnell et al. 2005; Klein 2002; Zhou and Chen 2004).
More recent studies of corporate governance and financial statements quality focus on other
characteristics of the governance structure, namely the activities of the board of directors and
audit committee as measured by frequency of meetings (Xie et al. 2003; Anderson et al.
2003; Zhou and Chen 2004; Petra 2007), and expertise of the board of directors and audit
committee in finance and accounting (Xie et al 2003; Bedard et al. 2004; Dhaliwal et al.
2007).
Most corporate governance studies which examine the financial statements quality use
discretionary accruals as a measure of the financial statements quality (e.g. Dechow et al.
1996; Klein 2002; Xie et al. 2003; Arsyah 2005; Jaggi and Leung 2007 ; Dhaliwal et al.
2007; Siregar and Utama 2008, Jiang et al. 2008). In contrast, DeFond and Jiambalvo (1991)
and Beasley (1996) used logit regression models to determine the probability of manipulation
in the financial statements. Warfield et al. (1995) begin to use informativeness of earnings in
addition to discretionary accruals to measure the earnings quality in their model which test
the effect of management ownership on the choice of accounting methods. More recent
researches in corporate governance associated with earnings quality start using the
informativeness of earnings based on the earnings response coefficient, as a measure of
earnings quality (Vafeas 2000; Bugshan 2005; Niu 2006; Petra 2007).
2.2. The Role of the Board of Commissioners (Board of Directors)
Board of commissioners is representing the companys shareholders to ensure all the
management actions are for the companys best interest. Fama (1980) stated that the board of
directors is the central of the internal control mechanisms to monitor managers. Some
previous studies showing that the board of directors has an important role in monitoring the
actions of management are from Fama and Jensen (1983), Weisbach (1988), Byrd and
Hickman (1992), Shivdasani (1993), And Brickley et al. (1994). Therefore, an effective
monitoring role of the board of directors is expected to also prevent management to present
low quality financial statements.
Based on the theory of the board of directors and previous empirical studies, the
characteristics of the board can affect the quality of financial statements, whether measured
by the level of earnings management or informativeness of earnings. According to Dhaliwal
et al. (2007), board characteristics that affect the effectiveness of the board's role were board
size, board independence, board shares ownership, and CEO-Chair duality (CEO who
becomes chairman of the board of directors). Some other literatures state that the board
activity as measured by the frequency of board meetings (Anderson et al. 2003) and the board
competence may also affect the board effectiveness.
The characteristics of the board of commissioners in Indonesia are slightly different
from the characteristics of the board of directors companies in the United States and other
countries which adopt a one-tier system for the board system. The companies in Indonesia
adopt two-tier system, which means there is a separation between the board of commisioners
and the board of directors, and therefore the situation of CEO-Chair duality will never occur.
However, the other characteristics such as independence, size, and expertise are also relevant
to the board of commissioners in Indonesia.
2.2.1. Board Independence
Independence status of board members is an important board characteristic in order to
maintain unbiased actions and decision making regarding the board monitoring function.
Based on the Bapepam-LK regulation in Attachment II Kep-305/BEJ/07-2004, the number of
independent commissioners3 should be proportional to the number of shares owned by noncontrolling shareholders, and must be at least 30% (thirty percent) of the total members of the
board of commissioners. Independent commissioners must meet the following criteria:
Do not have any affiliated relationship with the controlling shareholders of the listed
company.
Do not have any affiliated relationship with the director and/or the other commissioners
of the listed company.
3
The independent commissioners is similar to the independent outside directors in the one-tier system board of
directors.
Do not hold any director position in other companies that are affiliated with the listed
company;
Understand the rules and regulation in capital market.
By having independent board members that meet such requirements, the board
function is expected to be more effective because the independent board members have no
conflict of interests when performing their duties. Jensen (1993) states that there are three
characteristics that influence the board monitoring potential, i.e. board size, board
composition, and board leadership structure. Board composition represents the board
independence. Chtourou et al. (2001) state that the board independence depends on three
characteristics, i.e. presence of independent directors in the board, separation of CEO and
chairman of the board, as well as existence of an independent nominating committee.
An independent board will be able to perform independent oversight functions more
effectively, including the monitoring of financial statements quality. Beasley (1996) finds
that the presence of independent directors in the board will reduce the probability of fraud in
financial statements. The finding indicates that increasing the proportion of outside directors
in the board can effectively improve the monitoring of management actions which may
include creating fraud in the companys financial statements. Peasnell et al. (1998) examine
the association between the board compositions with earnings management. Their study find
that when management has strong incentive to increase profit or when the target profit is not
achieved, outside directors can hamper the earnings management actions. Klein (2002) also
proves that a company with an independent board would be less likely to report abnormal
accruals. Other empirical evidences of independent board of directors reduce earnings
management are given by Xie et al. (2003) and Ahmed and Duellman (2007). Peasnell et al.
(2005) also prove that companies with higher proportion of outside directors in the board will
be less likely to perform opportunistic earnings management.
Several other studies show that the independent board will enhance the
informativeness of earnings. Anderson et al. (2003) use a regression model of abnormal
returns and unexpected earnings to get the earnings response coefficient (ERC), which is the
coefficient of unexpected earnings variable in the model, as the value of the information
content of earnings. They find that the informativeness of earnings will be higher if the board
is more independent, and this finding is supported by Ahmed et al. (2006). Niu (2006) uses
both abnormal accruals and earnings response coefficients to examine the influence of board
independence on earnings quality. The results show that there are significant negative
influence of the independent board on abnormal accruals and significant positive influence of
the independent board on ERC. Meanwhile, Petra (2007) uses a multivariate regression
model with the earnings response coefficient as the dependent variable. The results also
support the previous studies that find independent outside directors has a significant and
positive effect on ERC. In contrast, Vafeas (2000) finds no effect of board independence on
informativeness of earnings.
Most studies that examine the independence of the board of directors in general use
the proportion of independent outside directors as the independence measurement. But board
tenure also has some influence on the board independence. Anderson et al. (2004) examine
board tenure, i.e. the average years of board members serve as the companys board of
directors. Board tenure is used as a proxy of management's ability to influence the directors
opinion in the decision-making process. The longer the board tenure, the higher the
possibility of managements potential to influence the board's decision. Their result shows
that the board's tenure has a significant positive impact on the cost of debt. This finding
indicates that the longer the board tenure, the board and the management will have a close
relationship to each other and the board will become less independent. This situation will be
considered by creditors as a less effective corporate governance, and therefore the cost of
debt will increase. Therefore, board independence is important for the boards effectiveness
in performing monitoring functions, including the quality of the financial statements.
2.2.2. Board Activity
In addition to independency, board characteristic that can influence the board
monitoring effectiveness is its activities in term of conducting the board meeting. Board
which is active and have routine meetings will be able to conduct more systematic oversight
and to find problems earlier. Vafeas (1999) concludes that the board activity is an important
dimension and that the frequency of meetings influences the company operating performance.
However, Vafeas also finds that the higher the frequency of board meetings, the company
stock price declines. Xie et al. (2003) find that a frequent board meeting reduces the
occurrence of earnings management. This finding is supported by Zhou and Chen (2004) who
find that the frequency of meetings of the board is negatively associated with earnings
management for the low earnings management group in their sample of banks.
Anderson et al. (2003) examine the effect of board activity as measured by the
number of meetings on the earnings response coefficient, and they find that board activity
positively influence ERC. Their study also find the relation between independent boards and
board meetings frequency in influencing the informativeness of earnings. Information content
of earnings increase if there is more independent directors in the board while the frequency of
board meetings is low. Information content of earnings will also increase if the frequency of
board meetings is high while the number of independent directors in the board is small. Firth
et al. (2007) find that the frequency of board meetings can improve the quality of accounting
information, as measured by earnings response coefficients and discretionary accruals.
Therefore, board activity as represented by the frequency of board meetings is also an
important characteristic for the effectiveness of the board's role in monitoring the
management actions, particularly relating to the financial statement reporting process.
2.2.3. Board Size
The number of board members could affect the effectiveness of the board
performance. However, existing literatures still show mixed results on the association of
board size and board effectiveness. Jensen (1993) states that a smaller board size would be
more effective in performing the monitoring function, because free-riding problems among
directors increase with board size. Yermack (1996) finds that there is a positive stock price
reaction to the announcement of board size reduction and a negative stock price reaction to
the announcement of board size increase. Thus, the market seems to prefer a smaller board
size in the corporate governance structure than a larger board size. There are some evidences
that companies with smaller board size perform better in the market. Mak and Kusnadi
(2005) find that the size of the board has a negative association with the firm value in
Singapore and Malaysia. These studies support the view of Jensen (1993). However, several
other studies argue that larger board size is better than small board size. Dalton et al. (1999)
suggest that a larger board size allows having a better connection with the environment and
more experts in the board. Zahra and Pearce (1989) also state that larger board can be more
effective because they are not susceptible to managerial domination, are more likely to be
heterogeneous in members educational and technical backgrounds, and are more likely to
resist managerial domination to protect shareholders interests. Monks and Minow (1995)
also argue that larger board can commit more time and effort to overseeing management,
because larger board from firms with several committees allow for fewer committee
assignments per director.
Evidence relating to the influence of board size on the reliability of financial reporting
is also still diverse. Vafeas (2000) finds that the information content of earnings is high if the
company has a small board size with a minimum of five board members. Beasley (1996) also
finds that larger board size increases the possibility of fraud in the financial statements,
suggesting that larger board is not effective compared to smaller board. However, Chtourou
et al. (2001) find that board with a larger size will reduce the income decreasing earnings
management. Anderson et al. (2004) also find that board size is negatively associated with the
cost of debt, suggesting that larger board provide better monitoring of the financial reporting
process. However, Anderson et al. (2003) find no significant effect of board size on earnings
response coefficients. Although the results from previous studies are still mixed, the board
size may have an influence on the effectiveness of the monitoring role of the board.
2.2.4. Board Competence
Most previous studies about board competence focus on the competence of
independent outside directors. Competencies of independent board members are an important
factor for the effectiveness of the board functions (Beasley 1996; Gerety and Lehn 1997; Xie
et al. 2003). Those studies mainly focus on the one-tier corporate governance system,
therefore the remaining board members are assumed to have better knowledge and experience
regarding the companys business because they are the inside directors. The effectiveness of
independent board members monitoring role will depend on their experience, knowledge, and
educational backgrounds, so that they can have the capability to understand the companys
business operations. Moreover, the independent board member must also have the
competence in understanding the companys financial statements, because the financial
performance reported is one of the information used in evaluating the management actions.
Therefore, the independent board members financial expertise and knowledge is required to
ensure the quality of the financial information reported in the financial statements. Chtourou
et al. (2001) find that the capability in finance owned by the outside directors will make the
board more effective in preventing the existence of earnings management. Xie et al. (2003)
find a negative effect of background knowledge of the board about the company and finance
on earnings management. Park and Shin (2004) show that the independence of the board as a
whole does not reduce earnings management in Canada. The influence of independent board
members that are from financial intermediaries reduces the earnings management. This
indicates that not only the independence characteristic is the determinant of the board
monitoring role effectiveness, but also the independent board members financial expertise. In
10
two-tier governance system, all members of the board of commissioners are not directly
involved as executives in the company. Therefore, the importance knowledge and
competence is not only applied to independent commissioners, but also for non-independent
commissioners, to ensure the effectiveness of the board of commissioners role.
Several other studies examine whether board tenure affects the effectiveness of the
independent boards role. The longer the outside directors act as the companys board; they
can have better understanding about the company and therefore improve their governance
competence. Beasley (1996) find that the likelihood of financial fraud decreases with the
increase of the average tenure of outside directors. Chtourou et al. (2001) find a negative
association between the averages outside directors tenure with the level of earnings
management. Chen et al. (2006) also find that the chairman of the board who has inadequate
experience will have a low ability to detect fraud. However, Park and Shin (2004) show no
association between the board average tenure with the earnings management. Anderson et al.
(2004) examine the board characteristic in term of the age, which is the average age of all
members of the board and become a proxy for the business experience of the members of the
board. Their result also shows that board age does not affect the companys cost of debt.
2.3. The Role of Audit Committee
The audit committee is a vital component of corporate governance structures to
promote accountability and transparency by high quality financial statements. Some studies
on the role of audit committees suggest that the existence of audit committee is associated
with fewer financial reporting problems. Dechow et al. (1996) show that companies that are
the subject of SEC enforcement actions are less likely to have an audit committee. McMullen
(1996) also prove that companies which have reliable financial statements are more likely to
have an audit committee. However, Beasley (1996) find that the existence of audit
committees does not significantly affect the likelihood of financial statement fraud. Peasnell
et al. (1999) also find that the existence of an audit committee does not have a significant
effect on earnings management. Eventhough the results are still mixed, the role of an
effective audit committee could have an effect on the quality of financial reporting. Dhaliwal
et al. (2007) suggest three characteristics that determine the governance strength of the audit
committee, i.e. the audit committee size, independence, and meeting frequency. In addition,
Chen and Zhou (2007) find that audit committees with greater financial expertise dismissed
Arthur Andersen earlier, meaning that the audit committee perform more effectively if the
competence is higher. Based on those studies, audit committee role on the quality of financial
reporting is influenced by its characteristics, namely independence, size, frequency of
meetings, and financial expertise.
2.3.1.
Audit Committee Independence

One important factor that enables the audit committee to exercise oversight over
financial reporting effectively is its independence. Carcello and Neal (2000) find that by
increasing the proportion of directors who are not independent (inside or "grey" directors) in
the audit committee, the smaller the probability the auditor will issue a going-concern report.
This finding suggests that the independence of audit committees could affect the objectivity
and independence of external auditors. Anderson et al. (2004) find that independent audit
11
committee has a negative effect on the cost of corporate debt. This indicates that the
independence of audit committee has an influence on the audit committee's role as a
corporate governance structure.
The findings of previous studies about the effect of audit committee independence on
the reliability of financial reporting information still vary. Bedard et al. (2004) find that audit
committee with all members who are independent members, has a significant negative effect
on aggressive earnings management. Xie et al. (2003) find that an independent audit
committee has a negative effect on the likelihood of earnings management. Anderson et al.
(2003) also find that an independent audit committee has a significant positive effect on the
reliability of financial reporting measured by earnings response coefficients. Abbott et al.
(2004) find that an independent audit committee has a negative impact on the restatement of
financial statements. Zhou and Chen (2004) find that independent audit committee has an
important role to restrict earnings management actions in banks with high earnings
management. Klein (2002) finds that an independent audit committee may hamper the
financial statements manipulation, especially when there is a majority of independent
directors in the audit committee, although it is not necessary that all audit committee
members are independent. However, other empirical studies find no evidence of an
association between the audit committee with the quality of financial reporting. Lin et al.
(2006) find no significant effect of audit committee independence on the occurrence of
earnings restatement. Petra (2007) also shows that the existence of an independent audit
committee does not have a significant effect on the magnitude of the information content of
earnings.
2.3.2. Audit Committee Activity
Similar to the board of directors, audit committee activity will determine whether the
audit committee perform its functions effectively. An active audit committee is expected to
perform its duties based on the audit committee charter effectively. Audit committee that
conducts frequent meetings is more probable to function more effectively. Anderson et al.
(2004) find that the cost of corporate debt decreases with increasing number of audit
committee meetings. This indicates that the activity of the audit committee in the form of
regular meetings will improve corporate governance.
Menon and Williams (1994), Beasley et al. (2000), Anderson et al. (2003), Xie et al.
(2003), and Zhou and Chen (2004) show that the frequency of audit committee meetings has
a positive and significant impact on the quality of financial reporting. Abbott et al. (2004)
find that audit committee that meets at least four times a year has a negative impact on the
restatement of financial statements. However, Bedard et al. (2004) find that the frequency of
audit committee meetings has no effect on earnings management. Lin et al. (2006) also find
no significant effect of the number of audit committee meetings on the occurrence of earnings
restatement.
2.3.3. Audit Committee Size
Similar to the board of directors, the size of the audit committee can influence the
effectiveness of the audit committees monitoring role. Anderson et al. (2004) find that audit
committee size has a negative effect on the cost of corporate debt. This indicates that the
12
creditor considers companies with larger audit committee size have better corporate
governance, so the cost of debt can be lower. Lin et al. (2006) also find that there is a
negative influence of the size of the audit committee on the occurrence of earnings
restatement. Furthermore, Zhou and Chen (2004) find that size of audit committee has an
important role to prevent earnings management in banks with high earnings management. In
constrast, Anderson et al. (2003) find that companies with smaller size audit committee have
higher information content of earnings. However, Bedard et al. (2004) find no evidene that
audit committee size affects earnings management.
2.3.4. Audit Committee Competence
Audit committee duties are closely related to the process of preparing and audit of
financial statements, therefore audit committee should have competence in accounting or
finance to be able to function effectively. In Indonesia, the regulation of Bursa Efek
Indonesia and Bapepam-LK requires at least one member of the audit committee has an
educational background in accounting or finance.
Previous studies on the effects of audit committee competence in accounting and
finance on the effectiveness of the audit committee monitoring of role is still diverse. Bedard
et al. (2004) find that the presence of at least one audit committee financial expert has a
negative effect on income decreasing earnings management. Xie et al. (2003) find that the
financial background of the audit committee may reduce earnings management. Choi et al.
(2004) and Park and Shin (2004) find that audit committee members who have experience in
financial institutions conduct effective monitoring to reduce earnings management. Abbott et
al. (2004) find that audit committee with at least one member of an expert in finance having a
negative impact on the restatement of financial statements. Zhou and Chen (2004) examine
the influence of the characteristics of the board of directors and audit committees on earnings
management in the commercial banks as measured by loan loss provisions. They find that the
expertise of audit committee members in governance has a negative effect on earnings
management, but only for banks that have low earnings management. Bedard et al. (2004)
also find that the audit committee expertise has a negative and significant effect on abnormal
accruals.
Dhaliwal et al. (2007) distinguish the term expertise in accounting, finance and
financial supervision, in examining the effect of audit committee financial expertise to
accruals quality. They find that the accounting expertise of audit committees has a positive
influence on the quality of accruals. This indicates that the audit committee should have
specific knowledge in accounting, and it is not enough to simply have knowledge in finance.
The hypothesis testing of audit committee financial expertise in Dhaliwal et al. (2007) is
moderated by the effectiveness of the corporate governance mechanisms of the board of
directors and audit committee, which was measured by using an index based on the
characteristics of the board and audit committee.
However, Anderson et al. (2004) find no effect of finance and accounting background
of audit committee on the cost of corporate debt. This indicates that the lender does not really
consider the background of the audit committee as the determinant of the corporate
governance and financial information quality for the lending decision. Lin et al. (2006) also
13
find no significant effect of audit committee financial expertise on the occurrence of earnings
restatement.
3. HYPOTHESIS DEVELOPMENT
The quality of reported earnings is determined by the companys financial reporting
process. An effective performance of the supervisory functions, i.e. board of commissioners
and audit committee, as the implementation of good corporate governance is expected to
ensure the process produces higher quality of reported earnings. In general, the hypotheses of
this study state that the stronger the corporate governance, the lesser distortion (noise) in
accounting earnings information. Thus, the performance of the board of commissioners and
audit committee could affect the quality of reported earnings. Earnings response coefficient
(ERC) represents the market reactions to earnings announcement based on how investors
value the information content of the earnings information. ERC should be greater for firms
with better governance because the earnings quality should be better.
The board of commissioners perform their function effectively if they can prevent
opportunistic management actions. Board effectiveness is affected by several characteristics,
such as board independence, board activity, board size, and board competence (Zhou and
Chen 2004). Opportunistic management actions can result in low earnings quality, because
the reported earnings is managed to fufill the management interests. Thus, the quality of
reported earnings can be influenced by the board effectiveness in performing their duties, and
the board effectiveness depends on the board characteristics. Board characteristics will affect
the board effectiveness simultaneously, therefore it is better to measure the board
characteristics comprehensively by using an index or a score. Therefore, the board score will
represent the board characteristics based on several characteristics measurement. The score
will reflect the degree of board of commissioners effectiveness in carrying out their duties.
If the board of commissioners has a high score, the board role is more effective and the
informativeness of earnings reported is expected to be higher. The first hypothesis of this
study is:
H1: The board of commissioners effectiveness score has a positive influence on
earnings response coefficients.
The audit committee is a part of the board of commissioners that specifically
responsible for monitoring the corporate financial reporting. If the audit committee is
performing their duties effectively, the earnings quality will be high. Similar to the board of
commissioners, the effectiveness of the audit committee's role is influenced by several
characteristics that have been demonstrated in previous studies, i.e. audit committee
independence, activity, size, and competence. Various previous studies have shown that
there is a positive association between audit committee characteristics with the ERC
(Anderson et al. 2003; Bryan et al. 2004; Suaryana 2004). The influence of these
characteristics is also measured by an index or a score to be able to measure all the
characteristics comprehensively. In Indonesia, all the companies listed in the Indonesian
Capital Market have audit committee with independent members, in compliance with the
regulations of IDX and Bapepam-LK. Therefore, the difference in the degree of audit
14
committee effectiveness is assumed only influenced by the characteristics of audit committee

activity, size and competence. If the audit committee effectiveness score is high, then the
audit committee should exercise supervision over the financial reporting process more
effectively, and the informativeness of earnings is high. The second hypothesis of this study
is:
H2: The audit committee effectiveness score has a positive influence on earnings
response coefficients.
4.
RESEARCH METHOD
4.1. Data Collection and Sample Selection

The population of this study is the entire company listed on the Indonesia Stock
Exchange (BEI) during the year of 2006 and 2007. The sample selection is based on the
following criteria:
1. Companies are not in the financial industry, because their characteristics are very specific
and can lead to bias in the results.
2. Companies with fiscal year end at December 31.
3. Companies continue to be listed on the Stock Exchange during the study period, i.e. year
2006 - 2007 (never exposed to delisting, the stock suspension, or go private).
4. Companies also continue to be listed on the Stock Exchange during the period of 2008 to
be able to obtain data Cumulative Abnormal Return up to 3 months after the end of the
fiscal year observation period.
5. Companies also continue to be listed on the Stock Exchange during the period 2002 2005 and had complete data for quarterly reports to obtain data for the value of variance
of unexpected earnings and earnings persistence variables.
6. Companies do not engage in corporate control actions, such as mergers, acquisitions,
divestitures, througout the study period.
7. Companies have annual reports with detailed information about corporate governance in
accordance with Bapepam and LK regulation No. Kep-134/BL/2006 regarding the
Obligation of Issuer or Public Company to Submit Annual Report.
8. Companies have complete stock price data and Individual Stock Price Index during the
observation period.
This study uses secondary data from the following sources:
1. The company's annual report issued by companies listed on the Indonesia Stock
Exchange. The company's annual reports obtained through the IDX website, corporate
website, Capital Market Research Center (PRPM), Bapepam-LK, and Corporate
Secretary.
2. Quarterly earnings data obtained from the company's quarterly financial statements
reported to the IDX. The data is retrieved from the library database of Master of
Management Program, Faculty of Economics and Business, University of Indonesia.
3. Monthly stock price data obtained from Bloomberg data.
4. Individual Stock Price Index (IHSI) obtained from Yahoo! Finance.
15
5. Composite Stock Price Index (IHSG) obtained from the monthly report issued by the BEI
(JSX Statistics).
6. Data of companys beta value obtained from Bloomberg based on weekly stock price data
for one year starting nine months before the end of fiscal period up to three months after
the end of the fiscal period of the study.
7. The data regarding the company's corporate governance is taken from companys annual
reports for the year of 2006 and 2007. In accordance to the Decision Letter of the
Chairman of Bapepam and LK. No. Kep-134/BL/2006, the company's annual report
should present information about the company's corporate governance structure in detail.
If the 2006 data cannot be obtained from the 2006 annual report, it is obtained from the
2007 report whenever possible.
8. Other information required is obtained through the company's press releases and other
sources.
4.2. Regression Models
This study examines the influence of corporate governance variables on the ERC by
using annual data. Therefore, the approach in this study is more of an association study,
because it uses a longer event window. The regression model to test the ERC in association
study approach does not consider the determination of timing (i.e. the definition of event,
window and estimation window), which usually need to be set for the event study approach
(Collins and Kothari 1989). Although there is time interval difference between event study
and association study, the two approaches do not have obvious characteristic differences.
Both approaches attempt to examine the effect of independent variables on the dependent
variable based on cross-sectional for a given period. In the event study the main focus is the
impact of independent variables against the dependent variable by using the event window to
control the effect of other variables. However, with a short window, event study can also
ignore the influence of many independent variables. In contrast, association study is more
likely to use independent variables with data using a longer time period, but the ERC
obtained is influenced by other variables. Thus, a return with the long window is not a
compelling reason for not using event study approach in testing the ERC (Kwak and
Armitrage, 2008). Following the model used by Anderson et al. (2003), the model in this
study uses a multivariate regression model of cumulative abnormal return with unexpected
earnings to test the research hypotheses:
CARit = 0 + 1UEit + 2 DBOARDSCOREit + 3 DAUDCOMSCOREit + 4 DAUDQUALit + 5 DSIZEit
+ 6 DRISK it + 7 DGWTHOPPit + 10 DPERSISit + 8 DVARUEit + 8 DLEVit + 9UEit * DBOARDSCOREit +
10UEit * DAUDCOMSCOREit + + 11UEit * DAUDQUALit + 12UEit * DSIZEit + 13UEit * DRISK it +

14UEit * DGWTHOPPit + 15UEit * DPERSISit + 16UEit * DVARUEit + 16UEit * DLEVit + it
Where CAR it is cumulative abnormal market-adjusted monthly return of company is stock

for 12 months starting from nine months before the end of year t until three months after the
end of year t; UE it unexpected earnings per share before extraordinary items of company i in
year t divided by stock price at end of year t; DBOARDSCORE it is dummy variable (1,0)
with value 1 if the board of commissioners effectiveness score of company i in year t is
16
greater than or equal; DAUDCOMSCORE it is dummy variable (1,0) with a value of 1 if the
audit committee effectiveness score of company i in year t is greater than or equal to 22 (total
11 questions on the score checklist multiplied with the middle score, i.e. 2), and 0 if
otherwise; DAUDQUAL it is dummy variable (1,0) with a value of 1 if firm i in year t is
audited by Big 4 external auditors, and 0 if otherwise; DSIZE it is dummy variable (1,0) with
a value of 1 if company i's market value of equity in year t is greater than or equal to the
median, and 0 if otherwise; DRISK it dummy variable (1,0) with a value of 1 if the company
i's risk as measured by beta, computed based on weekly price data for 12 months starting
from nine months before the end of year t until three months after the end of year t, is greater
than or equal to the median, and 0 if otherwise; dummy variable (1,0) with value 1 if the
company i's growth opportunities as measured by market value of equity divided by book
value of equity in year t is greater than or equal to the median, and 0 if otherwise;
DGWTHOPP it dummy variable (1,0) with value 1 if the company i's growth opportunities as
measured by market value of equity divided by book value of equity in year t is greater than
or equal to the median, and 0 if otherwise; DPERSIS it is dummy variable (1,0) with value 1
if the persistence of company is profits as measured by first order autocorrelation of profit
during the 16 quarters prior to year t is greater than or equal to the median, and 0 if otherwise;
DVARUE it is dummy variable (1,0) with value 1 if the coefficient of variation of company
is unexpected earnings for 16 quarters prior to year t is greater than or equal to the median,
and 0 if otherwise; DLEV it is dummy variable (1,0) with value 1 if the ratio of total debt
over total debt plus equity of company i in year t is greater than or equal to the median, and 0
if otherwise.
4.3. Variables for Regression Analysis
The score for board of commissioners and audit committee effectiveness
determination in this study follows Botosan (1997) approach in determining the financial
statements disclosure level score to test the effect of the disclosure level on the cost of equity.
The score is computed based on a checklist of certain characteristic factors to asses the
effectiveness of board of commissionner and audit committee. The checklist was compiled
with reference to a list of questions prepared by the Indonesian Institute for Corporate
Directorship (IICD)4 for their corporate governance index determination in 2005, with some
modifications in accordance with the literatures that support this study. The complete
checklists for the board score and audit committee score is provided in Appendix 1. In
accordance with the assessment methods used in the IICD questionnaires, for each question
there are three possibilities of assessment: Good, Fair and Poor. Some questions have only
two possibilities, i.e. Good and Poor. Value assigned for Good is 3, Fair is 2 and Poor is 1.
For questions with inadequate information to assess will be considered as Poor. The
assessment is based on corporate governance information disclosed in the companys annual
report. Cronbach alpha test is used to test the reliability of the questions used in the checklist
of board and audit committee score. The final score for the board of commissioners and audit
commitee is the total sum of the score for each characteristics based on the questions on the
4
IICD is an independent organization that assesses the corporate governance implementation in Indonesian
companies and publishes the corporate governance index for each company that participated in the evaluation
program.
17
checklists.5 As in the study of Dhaliwal et al. (2007), the total score will be converted into
dummy variables. Dhaliwal et al. (2007) used two thresholds in the range of values from 1 to
3 for the conversion of the score to a variable with the value of 1, i.e. when the value obtained
is greater than or equal to 2, and 0 if otherwise. This study uses 17 questions to the
calculation of score board with the possible values for each question is 1, 2 or 3. Therefore,
this study used thresholds of 34 (17 questions multiplied by the value 2) to convert the total
score of the board of commissioners to the dummy variable value.6 The use binary values
(1,0) for the score is used to avoid multicollinearity problems in data processing.
The model uses several control variables, i.e. size as measured by companys market
value of equity; Risk as measured by beta computed based on weekly price data for 12
months starting from nine months before the end of the year until three months after the end
of the year; growth opportunities as measured by companys growth opportunities as
measured by market value of equity divided by book value of equity; earnings persistence as
measured by first order autocorrelation of profit during the 16 quarters prior to year t;
variance of unexpected earnings as measured by the coefficient of variation of company is
unexpected earnings for 16 quarters prior to year t is greater than or equal to the median;
leverage as measured by the ratio of total debt over total debt plus equity of company in a
year.
An additional test is performed in this study to find out whether each of the board and
audit committee characteristics used in the effectiveness score, i.e. independence, activity,
size, and competence, is associated with the quality of earnings. The model for the additional
test uses each characteristics score as the explanatory variable. To ensure the robustness of
the results both main model and additional testing conducted the sensivity analysis.
Sensitivity analysis follows the steps of multicollinearity and heteroscedasticity as used in the
main model, so that the results obtained did not contain multicollinearity and
heteroscedasticity problems. Sensivity analysis is carried out by performing a regression on
the main independent variables separately in each model, using the logarithm value of the
dependent variable. The hypothesis testing is further analyzed to see whether the
effectiveness of the board of commissioners has some influence on the effectiveness on audit
5
To determine whether the four characteristics of the board of commissioners may form a construct, factor
analysis is conducted. The results meet the standards of KMO and Bartletts Test (> 0.50 and p < 0.05), buat the
anti-image correlation value for the board size score variable (BSSCORE) < 0.50, which means that the factor
analysis should be reconducted withoud BSSCORE. The results still meet the standards of KMO and Bartletts
Test (> 0.50 and p < 0.05), anti-image correlation value for all variables > 0.5. However, the communalities
extraction for board activity variable (BASCORE) and board expertise variable (BESCORE) both are < 0.50
and the total variance explained is only 48.08%. The value of the communalities extraction for each variable
should be > 0.50 and the total variance explained should be > 60%. Therefore, the characteristics of the board of
commissioners with the data obtained cannot form a construct. Similar analysis is also conducted for the three
audit committee characteristics. The results meet the standards of KMO and Bartletts Test (> 0.50 and p <
0.05), buat the anti-image correlation value for all variables > 0.50. The value of the communalities extraction
for each variable is > 0.50, but the total variance is slightly below 60%, i.e. 56.73%. Thus, the characteristics of
the audit committee with the data obtained is almost able to form a construct. However, due to the inability to
form a construct for the board of commissioners, this study does not use factor analysis approach to compute the
score of board of commissioners and audit committee.
6
Defond et al. (2005) and Brown and Caylor (2006) use the median as the threshold for converting variables
into binary variables. This study also uses median as the threshold in the sensitivity analysis, and the results are
still robust.
18
committee in performing each functions related to the quality of earnings. Meanwhile the
additional testing is also conducted by testing the association of each characteristic score to
the ERC.
5. RESULTS
5.1. Sample Description
Based on the sample criteria as described above, the sample for study is 207
companies, which consists of 150 firms that have complete data for 2006 and 2007, 9
companies with 2006 data only and 48 companies with data year 2007 only. Total number of
observation is 357 observation. Sample distribution by industry is presented in Table 1.
Table 1 shows that the majority of the sample is from the manufacturing industry
(basic industry and chemicals, various industries, and consumer goods), which is about
47.83% of the total sample. The second majority in the sample is the trade, services and
investment industries which is 23.19%, and followed by property, real estate, and
construction industries with 15.46% proportion. The remaining are scattered in various other
industries.
5.2. Validity of Board of Commissioners Score and Audit Committee Score
Cronbach's coefficient alpha, which is a measure of internal consistency of a repeated
measures, in this case the questions in the checklist, is used to test the validity of DBSCORE
and DACSCORE. Based on the value obtained from observations, the value of coefficient
alpha of the Board of Commissioners score for the four categories in the checklist is 0.607,
while the value of coefficient alpha of the Audit Committee score for the three categories in
the checklist is 0.796. There is no standard statistical test of significance for alpha value.
Value of coefficient alpha of the Board of Commissioners score and the Audit Committee
score in this study are not much different from the value of coefficient alpha of disclosure
index in Botosan (1997), which is 0.64. Thus, the score of the Board of Commissioners and
the Audit Committee which is used in this study is considered to be quite valid.
5.3. Descriptive Statistics
The descriptive statistics based on the original data that have been winsorized is
presented in Table 2. Based on the normality tests, model shows that dependend variables
represent a normal distribution.
Based on Table 2, the minimum value of board score in this study is slightly above
the possible minimum value, which is 17 (17 questions multiplied by the value of 1), but the
maximum score is slightly below the possible maximum possible score, which is 51 (17
questions multiplied by the value of 3). The average board score is around the Fair score (17
questions multiplied by the value of 2). It can be concluded on average the board of
commissioners in this study are still moderately effective, because some of them still have
low board scores. The audit committee score has an average of 20.63, slightly under the value
for Fair assessment, which is 22 (11 questions multiplied by the value of 2). The minimum
and the maximum score is at the possible minimum and maximum level (11 questions with
19
the value of 1 and 3). This indicates that the effectiveness of the audit committee's role in this
study on average is still not too good.
The average CAR and UE during the period of study is positive, 21.07% and 6.20%
respectively. DAUDQUAL has an average value of 0.4650, which indicates that 46.50%
observations are audited by Big 4 auditors. This result shows that Big 4 auditors are not
dominating. SIZE has an average value amounting to Rp 4,360,178 million. This indicates
that on average the size of companies included in the sample is quite large, although the
variation is quite large. RISK reflects the company's risk as measured by the companys beta.
The average value of beta is 0.7928, which means that on average the companies in sample of
this study have lower risk than the market because the beta value is below 1.00, but is in line
with market risk because the value is positive. The low average value of beta can be caused
by the presence of several observations that do not have enough transactions during the study
period. This problem is often found in a thin capital market, as in The Indonesian Capital
Market. GWTHOPP has an average value of 1.8666. This reflects that on average companies
in the sample have fairly good growth opportunities because the average value is above 1.
PERSIS has an average value of 0.0139, which means that the level of earnings persistence
for companies in the sample is relatively very low. VARUE has an average value of 4.4818,
which means the deviation of unexpected earnings is relatively low for companies in the
sample, but the variation of the value of this variable is quite high. LEV has an average value
of 0.3844, which means 38.44% of total financing of companies in the sample is in the form
of loans.
5.4. Correlation Analysis
The Pearson correlation coefficients among variables used in the research model is
presented on Table 3. In the correlation analysis, the variable values to be converted into
binary values are still expressed in the original value of the measurement.
UE is positively and significantly correlated to CAR, which means if UE increases,
CAR also increases. This relationship represents the basis of the return-earnings association
model which represents the effect of earnings on returns. The coefficients of UE in such
model will indicate the magnitude of a change in abnormal returns as a result of a change in
earnings which is called the Earnings Response Coefficient (ERC).
The correlation coefficient between the independent variables in the model is
relatively small, on average below 0.70. Therefore, the likelihood of multicollinearity
problems in the model using the independent variables becomes smaller. Moreover, the
correlation coefficient between UE variable with all the other independent variables is below
0.10 and insignificant. This weak correlation will be able to reduce the problems in research
models that uses the interaction of UE variable with other independent variables.
Correlation betweem BSCORE and ACSCORE is positive and significant and the
correlation coefficient is 0.530, which is quite large compared to the correlation coefficient
between other independent variables. This correlation indicates that the higher the
effectiveness of the board of commissioners, the higher the effectiveness of the audit
committees. The audit committee is part of the board of commissioners, with specific tasks to
support the duties of the board of commissioners. Therefore, it can be expected that there
must be a correlation between the board of commissioners and the audit committee.
20
Large companies usually are more exposed to public and therefore they are more
concerned in their image and reputation. Therefore, large companies generally have more
incentives to implement good corporate governance in order to have a good reputation. Both
ACSCORE BSCORE is positively and significantly correlated to size. It shows that large
companies have more effective board of commissioners and audit committee. Moreover,
BSCORE and ACSCORE also have a positive and significant correlation with DAUDQUAL.
It means that companies having effective board of commissioners and audit committee are
more possible to use Big 4 auditors, and therefore the audit quality in these companies
assumed to be better. The correlation coefficients between ACSCORE and DAUDQUAL is
greater than between BSCORE and DAUDQUAL. According to the Bapepam-LK current
regulation, audit committee is responsible to propose and recommend external auditor to be
used by the company. The results indicates that the correlation between effective audit
committee and audit quality is stronger than between audit quality to effective board of
commissioners. It means that the effectiveness of audit committe is correlated with the
process of external auditor appointment and the audit quality. The correlation of effective
board of commissioners and audit quality can be explained by the higher possibility to
appoint external auditors who have better audit quality by an effective board of
commissioners, based on the recommendation of an effective audit committee.
DAUDQUAL is also significantly and positively correlated to SIZE. DAUDQUAL measures
the audit quality proxied by Big 4 auditors. Audit conducted by Big 4 auditors assumed to
have higher quality than non-Big 4 auditors. The correlation reveals that large companies tend
to use Big 4 auditors, and therefore are more likely to have higher audit quality.
SIZE has a positive and significant correlation to RISK. In general, firms risk is
negatively correlated to firm size, since smaller companies generally have a greater risk than
larger companies. In this study, RISK is measured by each companys beta for one year.
Beta measurement is based on the company's stock price in the market. Generally, small
companies stock are rarely traded in the capital markets so the number of transactions is very
small. This can cause a low beta value when calculated. GWTHOPP has positive and
significant correlation to SIZE. This indicates that large companies have greater growth
opportunities. One possible reason is large companies generally have a better ability to access
information on a variety of alternative of opportunities and have sufficient resources to
support growth by taking the new opportunities. PERSIS also has a positive and significant
correlation to SIZE. It indicates that the earnings of larger companies are more persistent
than the earnings of small companies which tend to fluctuate.
5.5. Hypothesis Testing Results
The hypotheses are tested using a multivariate regression model, and the regression
output is presented on Table 4.
5.5.1. The Influence of the Board of Commissioners Effectiveness on the Informativeness
of Earnings
Based on regression results in Table 4, the coefficient of UE*DBSCORE is positive
and significant at = 1%. This result shows that the board of commissioners effectiveness
score has positive and significant effect on the ERC. It can be concluded that the quality of
21
earnings which reflected in the information content of earnings is higher if the company has
an effective board of commissioners. The evidence in this study supports the findings of
Zhou and Chen (2004) which state that the characteristics of the board of directors can
restrict earnings management is the size, independence and meeting frequency. In contrast to
Zhou and Chen (2004), this study measures the effectiveness of the board of commissioners
by adding competence as another characteristic of the board of commissioners. The
effectiveness of the board of commissioners represents good corporate governance, and
therefore can increase the quality of corporate financial reporting. This research finding
reinforces the findings of previous studies stating that the board of directors characteristics
can prevent the existence of earnings management practices which can reduce the
information content of earnings (Chtourou et al. 2001; Zhou and Chen 2004; Petra 2007).
The sensitivity analysis of this finding proves that the influence the effectiveness of the board
of commissioners on the quality of earnings is robust.
5.5.2. The Influence of the Audit Committee Effectiveness on the Informativeness of
Earnings
Based on regression results in Table 4, the coefficient of UE*DACSCORE is positive
but not significant at = 5%. This result shows that the audit committee effectiveness score
has no effect on the ERC, which means that an effective audit committee does not increase
the investors response to earnings reported by the company. This finding strengthens the
findings of some previous studies that examined the association between the existence audit
committee and earnings quality. Beasley (1996) proves that the existence of the audit
committee has no impact on the probability the company to commit fraud in the financial
statements. Peasnell et al. (2005) also find no association between audit committee with
earnings management. This study finds that even the existing audit committee is effective, it
is still do not influence the earnings quality.
Some other previous studies examine the association of a certain audit committee
characteristic with earnings quality. The finding in this study is consistent with the study of
Anderson et al. (2003) and Petra (2007) that found the existence of an independent audit
committee does not have an influence on information content of earnings (ERC). Lin et al.
(2006) and Xie et al. (2003) also state that there is no association between the existence of an
independent audit committee with the quality of earnings as measured by earnings
restatement and discretionary accruals respectively. Furthermore, Lin et al. (2006) also find
no association between audit committee expertises with earnings restatement. In Indonesia,
Tresnaningsih (2007) finds that the ERC in the first year after the audit committee formation
is significantly higher than the year prior to the formation. However, Tresnaningsih (2007)
also proves that the ERC after the first year of audit committee formation does not increase
significantly compared to the year prior to the formation. This result indicates that investors
do not see any significant increase in earnings quality after the audit committee is formed.
The finding of this study that there is no influence of audit committee effectiveness on
ERC may indicate that although the audit committee has already functioned effectively, its
role may be hidden because audit committee is actually part of and report to the board of
commissioners. The close correlation between the board of commissioners and the audit
committee is proven in the correlation analysis. Therefore, the influence of audit committee
22
effectiveness on the quality of earnings may not be clearly visible when viewed
simultaneously with the influence of the effectiveness of the board of commissioners. In fact,
because the audit committee is part of report to the board of commissioners, the follow-up
actions of the audit committee report regarding the corporate financial reporting are in the
hands of board of commissioners, therefore the influence of audit committees on earnings
quality could ultimately depend on the effectiveness of the board of commissioners.
This study further examines whether the effectiveness of the board of commissioners
affects the influence of the effectiveness of the audit committee on the quality of earnings.
By adding a new interaction variable UE*DACSCORE*DBSCORE in the regression model,
the effect of audit committee effectiveness on the quality of earnings is moderated by the
effectiveness of the board of commissioners. The regressions result presented in Table 5
shows that UE*DBSCORE and UE*DACSCORE has a positive and significant coefficient at
= 1%, while UE*DACSCORE*DBSCORE has a negative and significant coefficient at =
1%. The total effect of the effectiveness of the audit committee with effective board of
commissioners based on the results is total = 12 + 13DBSCORE. Thus, the total effect of the
effectiveness of the audit committee with effective board (i.e. DBSCORE = 1) are as follows:
= 0.571
11
12 * DBSCORE = -1.099 * 1 = -1.099
total
-0.528
Meanwhile, when the board of commissioners are not effective (i.e. DBSCORE = 0),
the influence of the audit committee effectiveness on the ERC is represented by the
coefficient 11 which is positive and significant. It indicates that an effective audit committee
can substitute the function of the board of commissioners in the monitoring role of earnings
quality, especially when the board of commissioners are not effective.
Although the value of total is negative (i.e. -0.528), it is not necessarily statistically
and significantly different from zero. In order to test whether the effectiveness of audit
committee under an effective the board of commissioners have an influence on the ERC, the
significance of the total effect was tested statistically. Regression analysis is conducted using
UE*DACSCOREDBSCORE, where the coefficient of this variable is the total effect value of the
influence of the audit committee effectiveness on the ERC under an effective board of
commissioners. The value of UE*DACSCOREDBSCORE is the sum of the value of
UE*DACSCORE with the value of UE* DACSCORE*DBSCORE. Regression result is
presented in Table 6.
Based on the results in Table 6, UE*DACSCOREDBSCORE has a negative but
insignificant coefficient, which means that the total effect of the effectiveness of the audit
committee on the ERC under the condition of an effective board of commissioners, is not
significant. This finding suggests that the influence of the effectiveness of the audit
committee on the quality of earnings is not visible when the board of commissioners is
effective. However, when the board of commissioners is not effective, then the effectiveness
of audit committees has a positive and significant effect on earnings quality. Thus, the results
suggest that the functions of audit committees could be a substitution of the functions of an
ineffective board of commissioners.
23
Another possible reason for the finding of this study regarding no influence of the
audit committee effectiveness on ERC is the fact that audit committee is part of and report to
the board of commissioners. Therefore, investors are more likely to respond to the
effectiveness of the board of commissioners than the audit committee effectiveness. In
addition, the audit committee is a new element in the governance structure compared to the
board of commissioners. Some investors may have little knowledge about the duties and
functions of the audit committee. Moreover, the appointment of the board of commissioners
must be approved by the General Meeting of Shareholders, while the appointment of audit
committees is conducted by the board of commissioners. Therefore, investors are more
familiar with board of commissioners functions, and more likely to respond to the board of
commissioners effectiveness. Previous studies regarding the association between the board
of commissioners and audit committee related to earnings quality have not discussed
specifically about the effectiveness of their function. Therefore, the findings of this study
only confirm that the characteristics such as independence, activity, size, and competence that
is found in the previous study have self-impact on the level of the effectiveness in the board
and audit committee function as corporate governance mechanism. Each characteristic that
were tested separately in previous studies became the important factor that supports the
effectiveness of the board of commissioners and audit committee. Up to this point there is no
specific study that discuss about the board of commissioners and audit committee
effectiveness especially in developing countries, some studies only shows the characteristics
such as independence, activity, size, and competence separately associated to the earnings
quality or informativeness of earnings. Therefore, this study tries to measure the effectiveness
based on the combination of those characteristics. In Indonesia this study is considered as the
first that focuses on board of commissioners and audit committee effectiveness related to
earnings quality
This study provides evidence that the results of audit committee research regarding
the influence of audit committee effectiveness on the informativeness of earnings are still
mixed. Audit committee effectiveness is not significantly associated with ERC in the main
model, when the board effectiveness variable is in the model, but is significant when it is
tested independently without the board score in the model. This result may be explained
further by the result in the sensitivity analysis. Audit committee score has an influence on the
quality of earnings if the score is based solely on the audit committee activity characteristics.
It indicates that the effectiveness of the audit committee is more determined by how the audit
committee performs its functions, than by the size and the competence of the audit
committee. If the board of commissioners effectiveness score is not included in the model,
the audit committee effectiveness become significantly influential to the informativeness of
earnings. This finding suggests that because the audit committee is established by the board
of commissioners as an integral part of the board of commissioners, the influence of the audit
committee effectiveness becomes less dominant than the effectiveness of board of
commissioners. In addition, this study shows evidence of a positive and significant effect of
the audit committee effectiveness on the earnings quality for 2007 data alone. Alternatively,
this result can also be due to bias from the less efficient market in the developing countries
where in actuality information are not always reflected in the stock price.

6.
24
CONCLUSION, IMPLICATION AND LIMITATION
This study was conducted based on the conceptual framework that good corporate
governance, through effective roles of the board of commissioners and audit committee will
affect the company's financial reporting process. Oversight function performed by the board
of commissioners and audit committee should be able to prevent opportunistic management
actions that are not aligned with shareholders interest. Earnings reported by companies with
more effective board of commissioners and audit committee are expected to have higher
information content than other companies. This study aims to examine the influence of the
effectiveness board of commisioners and audit committee on earnings response coefficient
(ERC) which reflects the investors perception of the quality of reported earnings based on
the information content of earnings. This study uses scores to measure the effectiveness of
the board of commissioners and audit committee, based on certain characteristics, i.e.
independence, activity, size, and competence of the board of commissioners, as well as
activity, size, and competence of audit committee.
This study finds that the boards of commissioners effectiveness score has a positive
and significant influence on ERC. Therefore, if the board of commissioners performs their
functions more effectively, the information content of earnings will be higher, which
represents higher quality of earnings. This finding is robust based on the results of sensitivity
analysis, and is also consistent with the findings of some previous studies which state that the
board of directors characteristics can prevent earnings management, thus increasing the
information content of earnings (Chtourou et al. 2001; Zhou and Chen 2004; Petra 2007). In
contrast, this study find no significant influence of audit committees effectiveness score on
ERC. This finding indicates that the information content of earnings does not depend on
effectiveness of the audit committee. This result is consistent with Petra (2007) who also
found no association between audit committee characteristics and ERC. However, the
sensitivity analysis provided evidence that the audit committee effectiveness score has
positive and marginally significant influence on ERC, when the research model does not
include the board of commissioners effectiveness score. It can be concluded that the
influence of the audit committee effectiveness on the informativeness of earnings is affected
by the effectiveness of the board of commissioners. This may be due to the fact that audit
committee is part of and report to the board of commissioners. Further testing conducted in
this study finds that the effectiveness of the audit committee positively influences the
informativeness of earnings when the board of commissioners is not effective. Therefore, it
can also be concluded that an effective audit committee can subtitute ineffective board of
commissioners in performing monitoring function on the financial reporting process.
There are some implications of this study which find that board effectiveness has a
positive influence on the informativeness of earnings. In order to ensure that the board of
commissioners is effective, the policy regarding the characteristics of the board must be
carefully reevaluated. As for the independence of the board of commissioners, the regulatory
bodies may need to review the minimum proportion and qualification requirements of
independent commissioners in the board of commissioners. Also, the regulatory bodies
should increase the control of the company compliance with such regulations. To enhance the
activity of the board of commissioners, the company should be required to disclose a more
25
detailed board of commissioners report that describes the results of the board monitoring on
management performance. There may be a need for a policy regarding the board size that is
associated with the companys size. Most companies in the sample have three members in the
board of commissioners, althought the company size varies. And as for the board
competence, the regulatory bodies may need to set a similar requirement as for the audit
committee, that at least there is one member of the board that has a finance background.
The addtional test in this study shows that audit committee effectiveness has a
positive influence on ERC when the board is not effective. The implication of this finding is
that the policy regarding the audit committee should be also reevaluated in order to ensure
that the audit committee is effective. The finding of this study indicates that investor put more
attention to audit committee activity, therefore the company should be required to disclose a
more detailed information about audit committee activities. In term of competence, the policy
shoud state that the qualification requirement is strictly accounting background for at least
one member of the audit committee. Finance background alone may not be adequate for
audit committees to function effectively.
There are some limitations of this study. Assessment for the score calculation is based
solely on information extracted from annual reports; therefore it is subject to errors and
inconsistencies in interpretation. Furthermore, this study assumed that if a company did not
disclose the complete information about corporate governance, then the company has weak
corporate governance and will be given a Poor score. This assumption may not be accurately
reveal the true corporate governance condition in a company. The disclosure level about
corporate governance can be quite different in 2006 compared to 2007, and therefore the
score can be very different for each year. The corporate governance disclosure level in 2006
is generally lower than in 2007 Because the Bapepam and LK regulation about the mandatory
requirement to disclose the detailed data of the board of commissioners and the audit
committee effectively only since the 2006 annual reports, thus it is likely that in 2006 many
listed companies have not implemented the requirement optimally. Assessment criteria used
to obtain ratings of Good, Fair and Poor can also contain bias due to the less accurate
determination of the criteria. The earnings persistence and the variance of unexpected
earnings are computed by using quarterly earnings per share for 16 quarters before the study
period. This study did not use annual data because of the data limitations for a longer time
period required for time series analysis. Quarterly data has some drawbacks. It may be less
reliable since it not audited by external auditors, and it can be subject to seasonal factors. This
study uses data that is converted into binary data 1 and 0 to overcome the problem of
multicollinearity. The implication is that the variation of data is reduced.
Future studies are expected to investigate further to clarify how the role of an
effective audit committee can substitute the performance of a less effective board of
commissioners. It also needs to be further investigated whether the opposite condition can
occur, i.e. an effective board of commissioners could substitute the functions of a less
effective audit committee. In addition, future studies may explore the role of the board and
audit committee with a case study approach or by direct survey, so that it can directly observe
the monitoring activities of the board of commissioners and the audit committee in a
company and capture the characteristics that influence the effectiveness of the board of
26
commissioners and audit committee. It is also important to examine the influence of board of
commissioners and audit committee effectiveness on the companys peformance.
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APPENDIX
Table 1. Sample Distribution

No.
Industry
1
3
4
5
6
7
8
9
Agriculture
Mining
Basic Industry and Chemicals
Various Industries
Consumer Goods Industry
Property and Real estate
Infrastructure, Utilities, and Transportation
Trade, Services, and Investments
Total
Number
Percentage
8
7
37
34
28
32
13
48
207
3.86%
3.38%
17.87%
16.43%
13.53%
15.46%
6.28%
23.19%
100%
Table 2. Descriptive Statistics

Minimum
CAR
-1.1204
UE
-1.8651
BSCORE
19.0000
ACSCORE
11.0000
DAUDQUAL
0.0000
SIZE (Rp million )
1.388
RISK
-1.2900
GWTHOPP
-12.2426
PERSIS
-0.8162
VARUE
-163.6185
LEV
-0.0116
Maximum
2.5799
2.1091
49.0000
33.0000
1.0000
63,559,178
2.7390
21.2613
0.8029
145.2913
2.3896
Mean
0.2107
0.0620
33.7703
20.6303
0.4650
4,360,178
0.7928
1.8666
0.0139
4.4818
0.3844
31
Standard Deviation
4.9780
5.1980
0.7400
0.4760
0.4995
11,607,880
0.5615
3.1229
0.2880
34.3248
0.4075
Total number of observations: 357. Data is winsorized for outliers based on the 3 standard deviations of the
mean.
CAR = cumulative abnormal market-adjusted monthly returns for 12 months starting from nine months before
the end of year t until three months after the end of year t, UE = unexpected earnings per share before
extraordinary items in year t divided by stock price at end of year t-1, BSCORE = total score of the
commissioners, ACSCORE = total score of the audit committee, DAUDQUAL = 1 if the company is audited by
Big 4 auditors, and 0 if otherwise, SIZE = market value of equity, RISK = beta value for the nine months before
end of year t until three months after the end of year t, GWTHOPP = market value of equity divided by book
value of equity, PERSIS = value of first order autocorrelation of income before extraordinary items quarterly for
16 quarters prior to year t, VARUE = value of the variance of unexpected quarterly earnings before
extraordinary items during the 16 quarters prior to year t, LEV = ratio of total debt divided by total debt plus
equity.
Table 3. Pearson Correlation Analysis

CAR
UE
BSCORE
ACSCORE
DAUDQUAL
SIZE
RISK
GWTHOPP
PERSIS
VARUE
LEV
CAR
1.000
UE
0.175 **
(0.001)
-0.053
(0.315)
-0.092
(0.084)
-0.195 **
(0.000)
0.000
(0.999)
0.069
(0.193)
0.086
(0.104)
-0.074
(0.161)
0.022
(0.677)
-0.022
(0.682)
1.000
0.075
(0.157)
0.066
(0.215)
-0.046
(0.387)
-0.067
(0.209)
0.018
(0.728)
-0.050
(0.346)
0.061
(0.251)
-0.052
(0.323)
-0.072
(0.176)
BSCORE
ACSCORE
DAUDQUAL
SIZE
RISK
GWTHOPP
PERSIS
VARUE
LEV
1.000
0.530 **
(0.000)
0.178 **
(0.001)
0.192 **
(0.000)
0.071
(0.181)
0.112 *
(0.035)
0.096
(0.069)
-0.022
(0.683)
-0.109 *
(0.040)
** Significant at = 1% level (2-tailed)

* Significant at = 5% level (2-tailed)
Numbers in parentheses indicate p-value
1.000
0.251 **
(0.000)
0.262 **
(0.000)
0.020
(0.700)
0.171 *
(0.001)
0.055
(0.300)
0.030
(0.573)
-0.128 *
(0.016)
1.000
0.238 **
(0.000)
0.039
(0.464)
0.150 **
(0.004)
0.203 **
(0.000)
-0.004
(0.939)
0.016
(0.760)
1.000
0.123 *
(0.020)
0.398 **
(0.000)
0.104 *
(0.050)
0.044
(0.412)
-0.002
(0.965)
1.000
0.108 *
(0.041)
0.034
(0.527)
-0.066
(0.214)
0.102
(0.053)
1.000
0.054
(0.307)
0.010
(0.846)
-0.180 **
(0.001)
1.000
-0.061
(0.254)
-0.085
(0.110)
1.000
-0.027
(0.617)
1.000
32
Table 4. Regression Output

CARit = 0 + 1UEit + 2DBSCOREit + 3DACSCOREit + 4DAUDQUALit + 5DSIZEit + 6DRISKit +
7DGWTHOPPit + 8DPERSISit + 9DVARUEit + 10DLEVit + 11UE*DBSCOREit + 12UE*DACSCOREit +
13UE*DAUDQUALit + 14UE*DSIZEit + 15UE*DRISKit + 16UE*DGWTHOPPit + 17UE*DPERSISit +
18UE*DVARUEit + 19UE*DLEVit + it.
Expected Sign
Unstandardized
t
Sig.
B
(Constant)
0.232
2.277
0.012 **
UE
0.192
0.958
0.169
DBSCORE
0.000
-0.002
0.499
DACSCORE
-0.043
-0.491
0.312
DAUDQUAL
-0.199
-2.287
0.011 **
DSIZE
-0.225
-2.323
0.010 **
DRISK
0.157
2.029
0.022 **
DGWTHOPP
0.172
1.894
0.029 **
DPERSIS
-0.012
-0.152
0.440
DVARUE
0.066
0.864
0.194
DLEV
-0.057
-0.739
0.230
UE*DBSCORE
+
0.779
2.713
0.003 ***
UE*DACSCORE
+
0.215
1.068
0.143
UE*DAUDQUAL
+
-0.508
-2.332
0.010 **
UE*DSIZE
0.103
0.462
0.322
UE*DRISK
-0.201
-1.089
0.138
UE*DGWTHOPP
+
-0.103
-0.555
0.290
UE*DPERSIS
+
-0.043
-0.167
0.433
UE*DVARUE
-0.246
-1.173
0.121
UE*DLEV
0.135
0.611
0.271
Adjusted R-squared
0.101
Durbin-Watson stat
1.898
F-statistic
3.105
Prob(F-statistic)
0.000
*** Significant at level = 1% (one-tailed)
** Significant at level = 5% (one-tailed)
* Significant at level = 10% (one-tailed)
mean.
extraordinary items in year t divided by stock price at end of year t-1, DBSCORE = dummy variable (1,0) with
value 1 if the board of commissioners effectiveness score of company i in year t is greater than or equal to 34
(total 17 questions on the score checklist multiplied with the middle score, i.e. 2), and 0 if otherwise,
DACSCORE = dummy variable (1,0) with a value of 1 if the audit committee effectiveness score of company i
in year t is greater than or equal to 22 (total 11 questions on the score checklist multiplied with the middle score,
i.e. 2), and 0 if otherwise, DAUDQUAL = 1 if the company is audited by Big 4 auditors, and 0 if otherwise,
DSIZE = dummy variable (1,0) with a value of 1 if company i's market value of equity in year t is greater than
or equal to the median, and 0 if otherwise, DRISK = dummy variable (1,0) with a value of 1 if the company i's
risk as measured by beta, computed based on weekly price data for 12 months starting from nine months before
the end of year t until three months after the end of year t, is greater than or equal to the median, and 0 if
otherwise, DGWTHOPP = dummy variable (1,0) with value 1 if the company i's growth opportunities as
measured by market value of equity divided by book value of equity in year t is greater than or equal to the
median, and 0 if otherwise, DPERSIS = dummy variable (1,0) with value 1 if the persistence of company is
profits as measured by first order autocorrelation of profit during the 16 quarters prior to year t is greater than or
equal to the median, and 0 if otherwise, DVARUE = dummy variable (1,0) with value 1 if the coefficient of
variation of company is unexpected earnings for 16 quarters prior to year t is greater than or equal to the
median, and 0 if otherwise, DLEV = dummy variable (1,0) with value 1 if the ratio of total debt over total debt
plus equity of company i in year t is greater than or equal to the median, and 0 if otherwise.
33
Table 5. Regression Output with DBSCORE as a Moderating Variable for UE*DACSCORE

7DGWTHOPPit + 8DPERSISit + 9DVARUEit + 10DLEVit + 11UE*DBSCOREit + 12UE*DACSCOREit +
13UE*DACSCOREit*DBCSCOREit + 14UE*DAUDQUALit + 15UE*DSIZEit + 16UE*DRISKit +
17UE*DGWTHOPPit + 18UE*DPERSISit + 19UE*DVARUEit + 20UE*DLEVit + it.
Expected Sign
Unstandardized
t
Sig.
B
(Constant)
0.215
2.128
0.017 **
UE
0.183
0.921
0.179
DBSCORE
0.000
0.003
0.499
DACSCORE
-0.018
-0.212
0.416
DAUDQUAL
-0.212
-2.463
0.007 ***
DSIZE
-0.229
-2.389
0.009 ***
DRISK
0.158
2.062
0.020 **
DGWTHOPP
0.186
2.059
0.020 **
DPERSIS
-0.007
-0.095
0.462
DVARUE
0.064
0.852
0.197
DLEV
-0.058
-0.758
0.225
UE*DBSCORE
+
1.353
3.892
0.000 ***
UE*DACSCORE
+
0.571
2.433
0.008 ***
UE*DACSCORE*DBSCORE
?
-1.099
-2.865
0.002 ***
UE*DAUDQUAL
+
-0.523
-2.423
0.008 ***
UE*DSIZE
0.095
0.430
0.334
UE*DRISK
-0.052
-0.275
0.392
UE*DGWTHOPP
+
-0.153
-0.829
0.204
UE*DPERSIS
+
-0.089
-0.352
0.363
UE*DVARUE
-0.287
-1.381
0.084 *
UE*DLEV
-0.062
-0.272
0.393
Adjusted R-squared
0.120
Durbin-Watson stat
1.899
F-statistic
3.423
Prob(F-statistic)
0.000
mean.
extraordinary items in year t divided by stock price at end of year t-1, DBSCORE = dummy variable (1,0) with
value 1 if the board of commissioners effectiveness score of company i in year t is greater than or equal to 34
(total 17 questions on the score checklist multiplied with the middle score, i.e. 2), and 0 if otherwise,
DACSCORE = dummy variable (1,0) with a value of 1 if the audit committee effectiveness score of company i
in year t is greater than or equal to 22 (total 11 questions on the score checklist multiplied with the middle score,
i.e. 2), and 0 if otherwise, DAUDQUAL = 1 if the company is audited by Big 4 auditors, and 0 if otherwise,
DSIZE = dummy variable (1,0) with a value of 1 if company i's market value of equity in year t is greater than
or equal to the median, and 0 if otherwise, DRISK = dummy variable (1,0) with a value of 1 if the company i's
risk as measured by beta, computed based on weekly price data for 12 months starting from nine months before
the end of year t until three months after the end of year t, is greater than or equal to the median, and 0 if
otherwise, DGWTHOPP = dummy variable (1,0) with value 1 if the company i's growth opportunities as
measured by market value of equity divided by book value of equity in year t is greater than or equal to the
median, and 0 if otherwise, DPERSIS = dummy variable (1,0) with value 1 if the persistence of company is
profits as measured by first order autocorrelation of profit during the 16 quarters prior to year t is greater than or
equal to the median, and 0 if otherwise, DVARUE = dummy variable (1,0) with value 1 if the coefficient of
variation of company is unexpected earnings for 16 quarters prior to year t is greater than or equal to the
median, and 0 if otherwise, DLEV = dummy variable (1,0) with value 1 if the ratio of total debt over total debt
plus equity of company i in year t is greater than or equal to the median, and 0 if otherwise.
34
Table 6. Regression Output with UE * DACSCOREDBSCORE

7DGWTHOPPit + 8DPERSISit + 9DVARUEit + 10DLEVit + 11UE*DBSCOREit +
12UE*DACSCOREitDBSCORE + 13UE*DAUDQUALit + 14UE*DSIZEit + 15UE*DRISKit +
16UE*DGWTHOPPit + 17UE*DPERSISit + 8UE*DVARUEit + 19UE*DLEVit + it.
Expected Sign
Unstandardized
t
Sig.
B
(Constant)
0.252
2.487
0.007 ***
UE
0.311
1.584
0.057 *
DBSCORE
-0.008
-0.091
0.464
DACSCORE
-0.029
-0.337
0.368
DAUDQUAL
-0.201
-2.313
0.011 **
DSIZE
-0.229
-2.358
0.009 ***
DRISK
0.145
1.878
0.031 **
DGWTHOPP
0.162
1.779
0.038 **
DPERSIS
-0.019
-0.244
0.404
DVARUE
0.063
0.820
0.206
DLEV
-0.057
-0.736
0.231
UE*DBSCORE
+
0.830
2.708
0.004 ***
UE*DACSCOREDBSCORE
?
-0.006
-0.040
0.484
UE*DAUDQUAL
+
-0.427
-1.976
0.025 **
UE*DSIZE
0.071
0.318
0.375
UE*DRISK
-0.178
-0.945
0.173
UE*DGWTHOPP
+
-0.162
-0.865
0.194
UE*DPERSIS
+
-0.064
-0.251
0.401
UE*DVARUE
-0.232
-1.109
0.134
UE*DLEV
0.045
0.198
0.422
Adjusted R-squared
0.098
Durbin-Watson stat
1.918
F-statistic
3.035
Prob(F-statistic)
0.000
Appendix 1. Checklists for Board of Commissioners and Audit Committee Effectiveness Scores
Part 1. Board of Commisioners Score
No.
Description
A. Board Independence
1
Among board of commissioners, how many are independent

commissioners?
If more than 50% of the board is independent, the company will
be given a good score. Firms with 30% to 50% of the board
made up of independent commissioners will earn a fair score.
If less than 30% of the board is independent, or no information,
the company will earn a poor score.
Is the chairman an independent commissioner?
If the chairman is an independent commissioner, the firm will
earn a good score and poor score otherwise or if no
information.
Good
Fair
Poor

No.
Description
Does the company state in its annual report the definition of

independence?
Firms with a clear definition of independence in the annual
report will earn a good score. A poor score will be given if
the company does not define independence or if no information.
Among board of commissioners, how many are employees of
shareholders or affiliated companies owned by shareholders?
If there is more than 50% of the board, or no information, the
company will be given a poor score. If there is 30% to 50% of
the board, the firm will earn a fair score. If less than 30% of
the board, the company will earn a good score.
Does the company have a nominating committee and
remuneration committee?
Firms that have both committees will earn a good score.
Firms that have at least one of the two committees will earn a
fair score. A poor score will be given to the company that
does not have any of these committees or if no information.
What is the average years the Board of Commissioners tenure?
If the average tenure of the board is less than 5 years, the
company will receive a good score. If the average
tenure of board is between 5 and 10 years, the score is fair,
and if the average tenure is more than 10 years, the score will
be poor.
35
Good
Fair
Poor
Good
Fair
Poor
B. Board Activities
No.
Description
Does the company clearly describe the board responsibilities?

If board responsibilities are clearly stated and disclosed, the
firm will receive a good score. Company that has not defined
board responsibilities or no information will earn a poor
score.
How many meetings were held during the year?
If the board meets more than six times, the firm earns a good
score. If 4 6 meeting, the firm is scored as fair, while less
than four times or no information is scored as poor.
What is attendance performance of the board members during
the year?
If the overall board attendance for the year is greater than 80%,
the firm earns a good score. If attendance is 70 -80% receives
a fair score, and less than 70% or no information receives a
poor score.
Does the company have a separate board of commissioners
report describing their responsibilities in reviewing firms
financial statement?
Firms will receive a good score if they produce a board of
commissioners report as part of the annual report. A score of
poor will be awarded if there is no report from the board or
no information.
10

No.
Description
11
Does the BOC conduct annual performance assessment of the

BOD?
If the board evaluates the performance of the top executive
officer, the company received a good score and poor score
otherwise or no information.
12
Does the board conduct assessment of the business prospects

prepared by the BOD?
If the board assess the business prospects, the company
received a good score and poor score otherwise or no
information.
36
Good
Fair
Poor
Good
Fair
Poor
Good
Fair
Poor
C. Board Size
No.
Description
13
What is the size of the board of commissioner?

A good score will be given to firm with 5 10 board members.
Firm with board size of 11 15 members received a fair
score. Boards with size of 16 or more or less than 5 members,
or no information will receive a poor score.
13
What is the size of the board of commissioner?

A good score will be given to firm with 5 10 board members.
Firm with board size of 11 15 members received a fair
score. Boards with size of 16 or more or less than 5 members or
no information will receive a poor score.
D. Board Expertise and Competence

No.
Description
14
Does the board member have a sophisticated knowledge about

accounting and finance?
If there is more than 50% of the board has the knowledge, the
company will be given a good score. If there is 30% to 50% of
the board, or no information, the company will earn a poor
score.
Does the board member have sufficient experience about
business (i.e. has the experience as a member of the board of
commissioners in any company including this company or as a
CEO in other company)?
If there is more than 50% of the board has the experience, the
company will be given a good score. If there is 30% to 50% of
the board, or no information, the company will earn a poor
score.
15

No.
Description
16
Does the board member have a sophisticated knowledge about

the companys business?
If there is more than 50% of the board member has the
knowledge, the company will be given a good score. If there is
30% to 50% of the independent board member, the firm will
earn a fair score. If less than 30% of the independent board
member, or no information, the company will earn a poor
score.
What is the average age of the board?
If the average age of the board is more than 40 years old, the
company will receive a good score. If the average age of the
board is between 30 and 40 years old, the score is fair, and if
the average age is below 30 years old, the score will be poor.
17
37
Good
Fair
Poor
Good
Fair
Poor
TOTAL SCORE
Part 2. Audit Committee Score

No.
Description
A. Audit Committee Activities

15
Assess the responsibilities fulfilled by the audit committee

during the year, include the following items:
1. Evaluating internal control
2. Propose auditor
3. Financial report review
4. Evaluating legal compliance
5.Prepare a complete audit committee
report for disclosure.
In each category, if the responsibility is fulfilled, firms will
receive a good score. If the responsibility is not fulfilled,
or no information, the company will receive a poor score.
How many meetings were held during the year?

If the audit committee meets more than six times, the firm
will earn a good score. If 4 6 meeting, the firm will
earn a fair score, while less than four time or no
information will be scored as poor.
What is attendance performance of the audit committee

members during the year?
If the overall audit committee attendance for the year is
greater than 80%, the firm earns a good score. If
attendance is 70 -80% receives a fair score, and less
than 70% or no information receives a poor score.

No.
Description
Does the audit committee evaluate the scope, accuracy,

cost effectiveness, independency and objectivity of
external auditor?
If the audit committee evaluates all of the items, the firm
has a good score, If only some part of the items was
evaluated, the score will be fair. And if none of the items
was evaluated, the score will be poor.
B. Audit Committee Size

No.
9
Description
38
Good
Fair
Poor
Good
Fair
Poor
Good
Fair
Poor
What is the size of the audit committee?

If there are 3 people in the audit committee the score will
be fair, and if there is more than 3 person in the audit
committee, the score will be good. If there is no
information, the score will be poor.
C. Audit Committee Expertise and Competence

No.
Description
10
Does the audit committee have an accounting background?

If the company has more than 1 person with accounting
background, the firm will earn a good score. If the
company has only 1 person with accounting background,
the firm earns a fair score, and if none has accounting
background or no information, the score will be poor.
11
What is the average age of the audit committee?

If the average age of the audit committee is more than 40
years old, the company will receive a good score. If the
average age of the audit committee is between 30 and 40
years old, the score is fair, and if the average age is
below 30 years old, the score will be poor.
TOTAL SCORE

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Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Asia Pacific Journal of Accounting and Finance

THE INFLUENCE OF EFFECTIVE BOARD OF COMMISSIONERS

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Audit Committee Independence

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

committee effectiveness is assumed only influenced by the characteristics of audit committee

4.1. Data Collection and Sample Selection

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

10UEit * DAUDCOMSCOREit + + 11UEit * DAUDQUALit + 12UEit * DSIZEit + 13UEit * DRISK it +

Where CAR it is cumulative abnormal market-adjusted monthly return of company is stock

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

CONCLUSION, IMPLICATION AND LIMITATION

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Faculty of Economics University of Indonesia Graduate Program in Accounting,

Table 1. Sample Distribution

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Table 2. Descriptive Statistics

Table 3. Pearson Correlation Analysis

** Significant at = 1% level (2-tailed)

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Table 4. Regression Output

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Table 5. Regression Output with DBSCORE as a Moderating Variable for UE*DACSCORE

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Table 6. Regression Output with UE * DACSCOREDBSCORE

Among board of commissioners, how many are independent

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Does the company state in its annual report the definition of

Does the company clearly describe the board responsibilities?

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Does the BOC conduct annual performance assessment of the

Does the board conduct assessment of the business prospects

What is the size of the board of commissioner?

What is the size of the board of commissioner?

D. Board Expertise and Competence

Does the board member have a sophisticated knowledge about

Hermawan, The Influence Of Effective Board Of Commissioners And Audit ........

Does the board member have a sophisticated knowledge about