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ARA
19,3
The impact of independent
directors and independent audit
committees on earnings quality
192 reported by Indonesian firms
Ferdinand T. Siagian
Maine Business School, University of Maine, Orono, Maine, USA, and
Elok Tresnaningsih
Department of Accounting, University of Indonesia, Jawa Barat, Indonesia
Abstract
Purpose – The purpose of this paper is to investigate whether independent directors and audit
committees that are chaired by an independent director as required by the Jakarta Stock Exchange
(JSX) affect the quality of reported earnings.
Design/methodology/approach – The paper uses both total discretionary accruals (DA) and
earnings response coefficient (ERC) as the proxies for earnings quality. It runs multivariate
regressions to examine the improvements in earnings quality after the firms meet the JSX
requirements.
Findings – It is found that both DA and ERC improve significantly after firms acquire independent
directors and independent audit committees. Lower DA occurs in the first and second years after the
firms meet the JSX requirements. There is an improvement in ERC in the first years after firms
meeting the requirements.
Research limitations/implications – The results suggest that independent directors and audit
committees do improve earnings quality.
Originality/value – This is the first paper that compares the quality of earnings before and after
firms acquire independent directors and independent audit committees. This methodology allows us
to examine the impact of meeting JSX independence requirements on earnings quality. The findings
contribute to the literature by showing the importance of having independent directors and an
independent audit committee in order to improve earnings quality. These findings are specifically
important for the capital market regulatory bodies, the shareholders, and the boards of directors, and
for other users of financial reports in general.
Keywords Corporate governance, Independent director, Earnings management,
Discretionary accruals, Audit committees, Earnings response coefficient, Indonesia
Paper type Research paper

Asian Review of Accounting
Vol. 19 No. 3, 2011
pp. 192-207
r Emerald Group Publishing Limited
1321-7348
DOI 10.1108/13217341111185128
1. Introduction
This paper investigates the impact of independent directors and audit committees that
are chaired by an independent director on the quality of reported earnings using public
firms in Indonesia. We specifically test whether earnings quality reported by
Indonesian public firms improves after they meet the requirements by the Jakarta
Stock Exchange ( JSX) to have at least 30 percent independent directors and an
audit committee with at least three members and chaired by an independent
director (hereafter, the JSX independence requirements). We define the years when
firms report to the JSX that they have met the independence requirements as the event
years and we compare the quality of earnings of the sample firms before and after
the event years.
Directors and audit committees that are independent from management are
important to support board of directors’ oversight function and to prevent poor
financial reporting. The JSX requires public firms to meet the independence Earnings quality
requirements as an effort to help the boards to improve the quality of reporting
earnings by improving the effectiveness and efficiency of internal and external audit
functions. Using a sample of 80 firms that are listed in the JSX from 1999 to 2004, we
find evidence that independent directors and independent audit committees improve
earnings quality. In our first test, we use the absolute level of discretionary accruals
(DA) as our proxy for earnings quality. We regress DA on a year dummy variable in 193
the earnings management model to see whether total DA is lower after the firms meet
the JSX independence requirements. We find significantly lower DA in the first and
second years after the firms meet the requirements. We use modified Jones model
(Dechow et al., 1995), Jones model ( Jones, 1991), and Kasznik model (Kasznik, 1999) to
measure DA. We find consistent results using the three different methods of measuring
DA. We also exclude extreme observations of the variables with the highest variances.
Our sensitivity results are consistent with the main results.
In our second test, we examine the improvement in the information content of
earnings or the earnings response coefficient (ERC) by regressing cumulative
abnormal return (CAR) on unexpected earnings (UE). We utilize an interaction variable
between UE and a year dummy variable to test the difference in ERC before and
after the firms meet the requirements. Our results show that ERC improves in the
first year after the firms meet the independence requirements. However, we do not
find evidence of higher ERC in the following year. Overall, our evidence indicates
that independent directors and independent audit committees improve earnings
quality.
Our study makes two important contributions. First, our study is the first study
that compares earnings quality of public firms in Indonesia before and after meeting
the JSX independence requirements. Our tests allow us to focus on the improvements in
earnings quality of the same set of firms. Other studies examine the difference between
firms that have and do not have independent directors or audit committees
(Klein, 2002; Bryan et al., 2004; Bradbury et al., 2006). By focussing on the improvement
in the earnings quality, our paper provides new evidence about the impact of acquiring
independent directors and independent audit committees on the quality of reported
earnings. Second, we use both DA and ERC as proxies for earnings quality and show
consistent results using both proxies, at least in the first year after the firms meet the
independence requirements.
The following section discusses related literature and presents the hypotheses
development. In section 3 we present the models and data. We report test results and
interpretations in section 4 and summarize our findings and conclusions in section 5.

2. Literature review and hypotheses development

Directors and audit committees that are independent from management should
improve the firms’ reporting system and the quality of reported earnings because they
are not subject to potential conflicts of interest that reduce their monitoring capacity.
Usually, independent directors also serve as experienced professionals in other firms
or large organizations and therefore, care about their reputation (Nguyen and Nielsen,
2010). Fama and Jensen (1983) also note that the majority of independent directors
are managers or decision makers who care about their reputation. Outside independent
directors also possess technical expertise both in management and decision making.
Luan and Tang (2007) find that appointment of outside directors on the board is
positively related to firm performance. Therefore, independent directors are expected
ARA to be professionals and to be able to protect the interests of the shareholders and other
19,3 users of financial statements by monitoring the financial reporting system. Beasley
(1996) finds that a larger proportion of outside members on the board of directors is
associated with significantly less likelihood of financial statement fraud. Peasnell et al.
(2006) find that the likelihood of managers making income-increasing abnormal
accruals to avoid reporting losses and earnings reductions is negatively related to the
194 proportion of outsiders on the board.
An audit committee is responsible to help the board with financial and accounting
matters, including the internal and external audit functions and financial reporting.
Abbott et al. (2010) find an association between audit committees’ oversight and
internal audit activities. Xie et al. (2003) state that well structured and functioning
audit committees are able to reduce earnings management. They find that the
committee members’ financial knowledge, the meeting frequency of the board, and the
meeting frequency of the audit committee are associated with lower earnings
management. They also find that audit committee independence is negatively
associated with earnings management. Their findings are also supported by
Bedard et al. (2004).
Peter and Cotter (2009) investigate whether audit committees are associated with
improved earnings quality for a sample of Australian listed companies prior to the
introduction of mandatory audit committee requirements in 2003. They use two
measures of earnings quality based on models developed by Jones (1991) and Dechow
and Dichev (2002). Their results indicate that formation of an audit committee reduces
intentional earnings management but not accrual estimation errors. Klein (2002) finds
that firms with an audit committee report earnings with less abnormal accruals
content than firms without an audit committee. He also finds that the proportion of
independent directors is negatively related with the level of abnormal accruals.
Because audit committee’s function is so important, it is critical to have an audit
committee that is independent from management. An independent audit committee
can avoid pressures from top management and will be able to provide better support
about financial matters to the board. Carcello et al. (2008) find that independent audit
committee members with financial expertise are most effective in mitigating earnings
management.
Independent directors and independent audit committees increase the likelihood
that the board will effectively exercise its oversight function without influence from top
management. As a result, the board can reduce the managers’ opportunistic behavior
and improve financial reporting processes. This will help mitigate some of the agency
problems that cause low quality of earnings. We expect that the quality of financial
reporting system after the firms acquire independent directors and independent audit
committees will improve and the level of earnings management will be lower. We
hypothesize the following (in alternative format):

H1. The level of earnings management is lower after firms acquire independent
directors and independent audit committees.

High-quality earnings provide relevant information to the users and can be used by the
users to make informed decisions. Investors would use more earnings information in
making decisions if they perceive that the reported earnings are of high quality.
Reported earnings are the product of firms’ reporting systems. If a reporting system is
good (poor), the quality of the reported earnings will be good (poor). Unfortunately,
most investors do not have the information to evaluate the quality of the firms’ Earnings quality
reporting systems. Therefore, they look at the quality of factors that contribute to
the quality of a reporting system. Independent directors and independent audit
committees are factors that contribute to a good reporting system. When the investors
observe that a firm has independent directors and an independent audit committee,
they presume that there is a monitoring function that is independent from the
management and they perceive that the quality of the reported earnings is high. 195
Studies find positive associations between the qualities of various factors that
contribute to good reporting system and information content of earnings. Anderson
et al. (2003) find that audit committee characteristics, such as independence, activity,
and size, are positively associated with the information content of earnings (ERC).
Similarly, Bryan et al. (2004) find a positive association between ERC and the
independence and financial skills of the audit committee members suggesting that
independence and financial skills are important characteristics in improving earnings
quality. We expect that the information content of earnings (ERC) will improve
after firms acquire independent directors and independent audit committees. We
hypothesize the following (in alternative format):

H2. The informational content of earnings is higher after firms acquire independent
directors and independent audit committees.

3. Research design
3.1 Sample selection
We use a sample of Indonesian firms because in 2001 the JSX required all listed firms
to have independent directors and an independent audit committee that is chaired
by an independent director. This allows us to have a set of public firms that just
meet the JSX independence requirements to test whether there is improvement in
earnings quality after they meet the JSX independence requirements. We use data from
the Pusat Referensi Pasar Modal Bursa Efek Jakarta, Indonesian Capital Market
Directory, and JSX Corner Brawijaya University. Our sample consists of 80 firms
that are listed in the JSX from December 31, 1999 to December 31, 2004. We exclude
firms in banking, financial and insurance, real estate and property, and
telecommunication industries because they have different financial statement
formats or are highly regulated.
The sample periods are from 2000 to 2003. Year 2000 is the year before the JSX
regulation is issued, and 2003 is the second year after most firms have implemented the
JSX requirements. The firms in our sample are firms that have met the JSX
independence requirements by the end of 2001. These firms must have complete
financial data from 1999 to 2004, use Indonesian currency in their financial reports,
use December 31 as their fiscal year-end, and have positive equity. Panel A of Table I
presents the sample selection process.
We define the event year in our study as the years the firms report that they have
met the JSX requirements. To test our hypotheses we define three periods around
the event years: the years prior to the event years (PRE-EVENT) and the first years
after the event years (POST-EVENT1) and the second years after the event years
(POST-EVENT2). We include POST-EVENT2 because we would like to investigate
whether the improvement continues to the following year. Of them, two (78) firms have
1999, 2001, and 2002 (2000, 2002, and 2003) as their PRE-EVENT, POST-EVENT1, and
POST-EVENT2, respectively.
ARA Number
19,3 Criteria of firms

Total firms listed in JSX from December 31, 1999 to December 31, 2004 excluding
firms in banking, financial and insurance, real estate and property, and
telecommunication industries 170
196 Firms that have not met the JSX requirements until December 31, 2002 74
Firms with foreign currency financial reports 4
Firms with fiscal year other than December 31 1
Firms with negative equity 11
Total firms in the sample 80
Table I.
Sample selection Note: JSX, Jakarta Stock Exchange

3.2 Empirical test

Our H1 (H2) predicts significantly improved DA (ERC) in POST-EVENT1 and POST-
EVENT2. We conduct two separate tests using two periods at a time instead of one test
using all three periods to simplify the models. For that purpose we form two groups
of firms with different test periods. Group YEAR1 (YEAR2) consists of data from
PRE-EVENT and the POST-EVENT1 (POST-EVENT2). We run separate tests for
each group but the tests are not independent because the PRE-EVENT period is
included in both tests.
Recent studies use different proxies for earnings quality. The most commonly used
proxies for earnings management is the total DA (Becker et al., 1998; Balsam et al.,
2003; Jenkins et al., 2006) and the information content of earnings or ERC (Teoh and
Wong, 1993; Balsam et al., 2003; Bryan et al., 2004; Jenkins et al., 2006). We use both
proxies to test whether our results are consistent using different methods of measuring
earnings quality.
In testing H1 we follow Becker et al. (1998), Klein (2002), Lobo and Zhou (2006), and
Bradbury et al. (2006) that use the absolute total discretionary accruals (ABDAC) that
is based on the modified Jones model (Dechow et al., 1995). DA is calculated using the
following model:

DAit ¼ ACCRit  ð^ a0 ð1=TAit1 Þ þ ^a1 ðDREVit  DRECit Þ=TAit1

þ^a2 PPEit =TAit1 Þ

where ACCR is the total accruals scaled with previous year’s total assets; TA the total
assets; DREV the change in revenue; DREC the change in accounts receivable; PPE the
gross fixed assets.
Following Lobo and Zhou (2006) we estimate a0, a1, and a2 cross-sectionally during
the pre-event period using the following regression:

ACCRit ¼ a0 ð1=TAit1 Þ þ a1 DREVit þ a2 PPEit þ eit

The regression model to test H1 includes control variables that are known to affect
earnings management such as audit quality (AUDIT), cash flow from operation (CFO),
the level of debt (HILEV), firm size (SIZE), and increases in number of shares
outstanding (SHARING). We estimate the following regression to test H1: Earnings quality
ABDACit ¼ a0 þ a1 POST- EVENTit þ a2 AUDITit þ a3 CFOit
þ a4 HILEVit þ a5 SIZEit þ a6 SHARINGit þ eit

where ABDAC is the absolute total discretionary accruals; POST-EVENT the year
dummy variable; 1 for the years after the event years and 0 for the years prior to the 197
event years; AUDIT the auditor dummy variable: 1 for firms audited by Big-4 audit
firm and 0 otherwise; CFO the cash flow from operating activities scaled by beginning
of year total assets; HILEV the high leverage firm dummy variable; 1 if the firm’s
debt-to-asset ratio is in the highest quartile and 0 otherwise; SIZE the natural Log
of total assets; SHARING the increase in outstanding shares dummy variable; 1 if there
is more than 10 percent increase in outstanding shares and 0 otherwise.
Our first hypothesis predicts that DA after the event will be lower after controlling
for variables that affect earnings management (a1o0). We include audit quality
as a control variable because high-quality auditors limit earnings management
(Becker et al., 1998; Chung et al., 2005; Lobo and Zhou, 2006; Jenkins et al., 2006). We use
a dummy variable for audit quality to separate firms that are audited by Big-4 and
non-Big-4 audit firms. CFO is included as a control variable because firms with higher
CFO tend not to elevate earnings through DA (Becker et al., 1998; Chung et al., 2005;
Lobo and Zhou, 2006).
We control for debt because managers of high leverage firms have higher incentives
to manage earnings through DA (Sweeney, 1994; Klein, 2002; Lobo and Zhou, 2006;
Jenkins et al., 2006). We calculate debt-to-assets ratio and we divide our sample into two
groups. The high-debt group includes firms that have debt-to-assets ratio in the
highest quartile.
We control for firm size because it has been associated with incentives to manage
earnings (Watts and Zimmerman, 1978; Lobo and Zhou, 2006; Chung et al., 2005;
Xie et al., 2003). Finally, we control for firms that significantly increase their number
of shares outstanding because managers have incentives to use DA to increase
earnings for a seasoned equity offering (Teoh and Wong, 1993; Bedard et al., 2004). We
consider an increase in shares outstanding by more than 10 percent as a significant
increase.
Table II shows the descriptive statistics of various variables used in testing H1 for
each period. We find that ABDAC and CFO vary significantly while SIZE does not
vary as much. More than 75 percent of firms are audited by Big-5 or Big-4 audit firms,
about one-third of the firms have high leverage, and there is only a small percentage of
firms that experience more than a 10 percent increase in outstanding shares. From the
period-to-period analysis we find that the average ABDAC decreases from 0.100 in
PRE-EVENT to 0.073 in POST-EVENT1. The average is even lower in POST-EVENT2
(0.066). The mean difference t-tests for ABDAC show that the mean in POST-EVENT1
is significantly lower than that in PRE-EVENT (t ¼ 3.43) and the mean in
POST-EVENT2 is also significantly lower than that in PRE-EVENT (t ¼ 4.05).
The average of the control variables is relatively constant showing that the CFO and
SIZE do not change significantly in the years under study. The number of firms audited
by Big-5 or Big-4 audit firms, firms with high leverage, and firms with significant
increase in outstanding shares is also relatively constant.
To test the impact of meeting the JSX requirements on ERC we regress the CAR on
UE. To get the CAR we calculate daily abnormal returns (AR) and cumulative
ARA PRE-EVENT POST-EVENT1 POST-EVENT2
19,3
N 80 80 80
ABDAC Minimum 0.002 0.000 0.000
Maximum 0.366 0.312 0.312
Mean 0.100 0.073 0.066
198 Median 0.092 0.051 0.046
SD 0.075 0.069 0.058
CFO Minimum 0.362 0.282 0.142
Maximum 0.437 0.362 0.369
Mean 0.074 0.067 0.076
Median 0.073 0.066 0.074
SD 0.103 0.104 0.092
SIZE Minimum 4.582 4.542 4.534
Maximum 7.438 7.418 7.438
Mean 5.801 5.837 5.851
Median 5.811 5.824 5.837
SD 0.571 0.557 0.564
AUDIT Proportion 0.788 0.763 0.775
HILEV Proportion 0.250 0.250 0.250
SHARINC Proportion 0.063 0.025 0.013
ABDACit ¼ a0 þ a1 POST- EVENTit þ a2 AUDITit þ a3 CFOit þ a4 HILEVit
þ a5 SIZEit þ a6 SHARINGit þ eit

Notes: ABDAC, absolute discretionary accruals; CFO, cash flow from operations; SIZE, natural log of
total assets; PRE-EVENT, the years prior to the event years; POST-EVENT1, the first years after the
event years; POST-EVENT2, the second years after the event years; AUDIT, 1 if audited by Big-5 or
Big-4 audit firm, 0 otherwise; SHARINC, 1 if outstanding shares increase by more than 10 percent,
Table II. 0 otherwise; HILEV, 1 if total debt to total assets ratio is in the highest quartile, 0 otherwise; Event
Descriptive statistics of Years, the years the firms meet the JSX independence requirements; JSX, Jakarta Stock Exchange;
variables in DA model DA, discretionary accruals

abnormal return (CAR) using the following formulas:

ARit ¼ ðRit  Rmpit Þ

CARit ¼ SARit

where AR is the abnormal return; R the stock return that is calculated as follows:
(Stock price index itStock price index it1)/Stock price index it1; Rmp the market
return that is calculated as follows: (Market indextMarket indext1)/Market indext1.
The UE is the difference between realized accounting earnings and the market
expected earnings. We calculate the UE as follows:

UE ¼ ðAEit  AEit1 Þ=MCt1

where AE is the actual earnings before extraordinary items; MC the market

capitalization.
Because our test examines the change in the slope coefficient (ERC) after the firms
meet the JSX independence requirements, we use a year dummy variable and interact
the variable with the UE. We estimate the following regression to test H2: Earnings quality
CARit ¼ g0 þ g1 POST- EVENTit þ g2 UEit þ g3 UEit POST- EVENTit
þ g4 MVBVit þ g5 UEit MVBVit þ g6 SIZEit þ g7 UEit SIZEit
þ g8 BETAit þ g9 UEit BETAit þ Zit

where CAR is the cumulative abnormal return; POST-EVENT the year dummy
199
variable; 1 for the years after the event and 0 for the years prior to the event years;
UE the unexpected earnings; MVBV the growth dummy variable; 1 if the ratio of
market-to-book value of equity is above the median and 0 otherwise; BETA the risk
dummy variable; 1 if the beta coefficient is above the median and 0 otherwise; SIZE the
size dummy variable; 1 if the natural log of market capitalization at the beginning of
the year is above the median and 0 otherwise.
Our hypothesis predicts that after controlling for growth, risk, and size there is an
increase in ERC after firms acquire independent directors and independent audit
committees, which is the coefficient on the interaction variable UE  POST-EVENT
(g340).
We use three control variables in our regression model to test H2; the ratio of market
value and book value of equity (MVBV) as our proxy for growth, BETA as our proxy
for firm’s risk level, and firm size (SIZE). We use the market model to get the firm
BETA and we calculate the natural log of total market capitalization for SIZE.
We include the MVBV as a control variable in our model because investors’
response to reported earnings is affected by market perception about the firm’s growth
(Collins and Kothari, 1989; Lipe, 1990; Teoh and Wong, 1993; Anderson et al., 2003).
Also, MVBV is positively associated with earnings persistence (Collins and Kothari,
1989) and therefore, MVBV is used as a proxy for both growth and earnings
persistence. BETA and SIZE are included as control variables because studies
find that investor response to UE is affected by the firm risk (Teoh and Wong,
1993; Anderson et al., 2003) and firm size (Chaney and Jeter, 1992; Teoh and Wong, 1993;
Anderson et al., 2003).
Table III shows the descriptive statistics of variables that may affect ERC for each
period.
The standard deviation of CAR, UE, and BETA is relatively high showing that
these variables vary considerably among firms in our sample. The average of UE is
negative in all periods suggesting that in the test period our sample firms experienced
a decline in earnings. The average decline in earnings in POST-EVENT1 looks
smaller than in PRE-EVENT period. However, the average decline in earnings in
POST-EVENT2 is the highest. From the period-to-period tests we find that the average
CAR increases significantly in the POST-EVENT1 period, but decreases significantly
in POST-EVENT2.
The MVBV in POST-EVENT1 decreases significantly and continues to decrease
in POST-EVENT2. BETA increases in POST-EVENT1 and drastically decreases in
POST-EVENT2.

4. Empirical results
In this section we report the tests results. We first report the main results for the tests
using DA and ERC, and then we discuss the sensitivity tests using alternative
methods.
ARA PRE-EVENT POST-EVENT1 POST-EVENT2
19,3
N 80 80 80
CAR Minimum 1.030 0.903 1.291
Maximum 1.022 1.162 1.334
Mean 0.029 0.080 0.066
200 Median 0.046 0.043 0.109
SD 0.419 0.402 0.512
UE Minimum 2.790 4.775 2.239
Maximum 2.379 3.663 3.303
Mean 0.037 0.013 0.102
Median 0.021 0.000 0.040
SD 0.592 0.915 0.720
MVBV Minimum 0.082 0.096 0.074
Maximum 12.184 7.581 6.801
Mean 1.860 1.441 0.863
Median 1.206 1.031 0.618
SD 1.830 1.416 0.894
SIZE Minimum 3.682 3.624 3.506
Maximum 7.900 8.248 7.893
Mean 5.439 5.344 5.256
Median 5.373 5.378 5.251
SD 0.726 0.780 0.796
BETA Minimum 1.918 1.114 0.078
Maximum 3.895 3.533 1.658
Mean 2.609 2.684 0.889
Median 2.580 2.687 0.878
SD 0.315 0.337 0.296
CARit ¼ g0 þ g1 POST- EVENTit þ g2 UEit þ g3 UEit POST- EVENTit þ g4 MVBVit
þ g5 UEit MVBVit þ g6 SIZEit þ g7 UEit SIZEit þ g8 BETAit þ g9 UEit BETAit þ Zit

Notes: CAR, cumulative abnormal return; UE, unexpected earnings; MVBV, market to book value of
equity; SIZE, natural log of market capitalization; BETA, market systematic risk; PRE-EVENT, the
Table III. years prior to the event years; POST-EVENT1, the first years after the event years; POST-EVENT2,
Descriptive statistics of the second years after the event years; Event Years, the years the firms meet the JSX independence
variables in ERC model requirements; JSX, Jakarta Stock Exchange; ERC, earnings response coefficient

4.1 Analysis of DA model

Our first model tests whether DA decreases significantly after the firms acquire
independent directors and independent audit committees using observations in each
group YEAR1 and YEAR2.
Panel A of Table IV presents the correlation test between ABDAC and POST-
EVENT variables for firms in Group YEAR1 and firms in Group YEAR2. We focus on
the correlation between ABDAC and POST-EVENT because this correlation shows the
direction and significance of ABDAC in the years after the event. For both group
YEAR1 and YEAR2 we find significant negative correlation between ABDAC and
POST-EVENT suggesting that the DA in POST-EVENT1 and POST-EVENT2 is lower
than that in PRE-EVENT. This finding is consistent with our first hypothesis.
Panel B of Table IV presents the correlation coefficients among variables used in the
regression model for each year. The correlations using multiple years are not
Panel A: Correlations of ABDAC and POST-EVENT in group YEAR1 and YEAR2
Earnings quality
Group YEAR1 Group YEAR2
ABDAC 0.269* 0.309*
0.001 0.000

Panel B: Correlations of variables in DA model for each period

AUDIT CFO HILEV SIZE SHARINC 201
ABDAC POST-EVENT2 0.027 0.238* 0.079 0.108 0.121
POST-EVENT1 0.139 0.515* 0.005 0.079 0.151
PRE-EVENT 0.199 0.221* 0.244* 0.099 0.157
AUDIT POST-EVENT2 0.131 0.146 0.296* 0.061
POST-EVENT1 0.016 0.183 0.230* 0.099
PRE-EVENT 0.146 0.031 0.169 0.134
CFO POST-EVENT2 0.144 0.154 0.021
POST-EVENT1 0.025 0.205 0.000
PRE-EVENT 0.223* 0.103 0.011
HILEV POST-EVENT2 0.087 0.052
POST-EVENT1 0.121 0.077
PRE-EVENT 0.268* 0.069
SIZE POST-EVENT2 0.221*
POST-EVENT1 0.018
PRE-EVENT 0.057
ABDACit ¼ a0 þ a1 POST- EVENTit þ a2 AUDITit þ a3 CFOit þ a4 HILEVit
þ a5 SIZEit þ a6 SHARINGit þ eit

Notes: Group YEAR1, sample of firms with observations from years PRE-EVENT and
POST-EVENT1; Group YEAR2, sample of firms with observations from years PRE-EVENT and
POST-EVENT2; PRE-EVENT, the years prior to the event years; POST-EVENT1, the first years after
the event years; POST-EVENT2, the second years after the event years; Event Years, the years the Table IV.
firms meet the JSX independence requirements; JSX, Jakarta Stock Exchange; DA, discretionary Correlations of variables
accruals. *Significant at 0.05 level (two-tailed) in DA model

appropriate because the results will be the average of the correlations of the different
years. The table shows that ABDAC and CFO are negatively correlated in each year
suggesting that firms with higher CFO report higher quality earnings (lower DA).
There is also positive correlation between AUDIT and SIZE suggesting that larger
firms tend to be audited by Big-4 audit firms.
The regression results are presented in Table V.
Consistent with our first hypothesis we find that the coefficient on POST-EVENT
is negative and significant at 1 percent level in both YEAR1 and YEAR2. These
findings suggest that the levels of earnings management in POST-EVENT1 and in
POST-EVENT2 are significantly lower than that in PRE-EVENT.
The estimated coefficients on AUDIT are negative and significant in both Group
YEAR1 and Group YEAR2 confirming that firms audited by Big-4 or Big-5 audit firms
tend to manage earnings less than other firms for both periods. This is consistent with
the contention that Big-4 or Big-5 audit firms provide higher quality audit.
The estimated coefficients on CFO are negative and significant at 1 percent. This is
consistent with the prediction that firms with higher CFO tend to manage earnings
less. SHARING has a positive and significant coefficient only in Group YEAR2. In
ARA Group YEAR1 Group YEAR2
19,3 Variable Predicted sign Coefficient t-statistic Coefficient t-statistic

Intercept 0.073 1.320 0.076 1.415

POST-EVENT  0.042 3.948** 0.040 3.843**
AUDIT  0.028 2.169* 0.028 2.180*
202 CFO  0.239 4.605** 0.142 2.588*
HILEV þ 0.011 0.841 0.008 0.599
SIZE ? 0.012 1.221 0.010 1.029
SHARINC þ 0.021 0.817 0.066 2.411*
N 158 158
Adjusted R2 0.198 0.174
Durbin-Watson statistic 2.024 1.802
F-statistic 7.528 6.508
p-value (F-statistic) 0.000 0.000
ABDACit ¼ a0 þ a1 POST- EVENTit þ a2 AUDITit þ a3 CFOit þ a4 HILEVit
þ a5 SIZEit þ a6 SHARINGit þ eit

Notes: ABDAC, absolute discretionary accruals; CFO, cash flow from operations; SIZE, natural log of
total assets; AUDIT, 1 if audited by Big-5 or Big-4 audit firm, 0 otherwise; SHARINC, 1 if outstanding
shares increase by more than 10 percent, 0 otherwise; HILEV, 1 if total debt to total assets ratio is in the
highest quartile, 0 otherwise; N, sample size adjusted for outliers (observations outside þ SD); Group
YEAR1, sample of firms with observations from years PRE-EVENT and POST-EVENT1; Group
YEAR2, sample of firms with observations from years PRE-EVENT and POST-EVENT2; PRE-
Table V. EVENT, the years prior to the event years; POST-EVENT, the first and second years after the event
Regression results years; Event Years, the years the firms meet the JSX independence requirements; JSX, Jakarta Stock
for DA model Exchange; DA, discretionary accruals. **Significant at 1 percent; *significant at 5 percent

POST-EVENT2, earnings management is higher in firms that increase their

outstanding shares significantly. We do not find significant results in Group YEAR1
suggesting that in the first years after the event years, firms that issue a significant
amount of stocks do not have higher DA. However, these firms have significantly
higher DA in the second years after the event years. One possible explanation is that
the influence from independent directors and independent audit committees is very
strong in the first years after the event years and deteriorate in the second years.
Although positive as predicted, the coefficient on HILEV is not significant. This
implies that the level of earnings management is not associated with leverage.
It is possible that high leverage firms experience high monitoring and therefore,
it is difficult for the managers to manage earnings. SIZE has a positive but
insignificant coefficient. We do not have a prediction about the coefficient on
SIZE because the relationship between firm size and earnings management is still
not clear.

4.2 Analysis of ERC model

Our second test examines whether ERC improves significantly after the event years.
Table VI presents the correlation coefficients among variables that we use in the ERC
Model for group YEAR1 and YEAR2. Because we use interaction variables in our
model the main effect of the independent variable on the dependent variable cannot
 POST-
Earnings quality
Group EVENT UE UE*POST-EVENT UE*MVBV UE*SIZE UE*BETA

CAR YEAR2 0.1100 0.0460 0.0290 0.0500 0.0180 0.0790

YEAR1 0.0820 0.0670 0.1140 0.1390 0.1120 0.1240
POST-EVENT YEAR2 0.0470 0.1010 0.1450 0.1300 0.0050
YEAR1 0.2080* 0.1420 0.2390* 0.0410 0.2080* 203
UE YEAR2 0.6500* 0.6270* 0.4280* 0.6450*
YEAR1 0.6420* 0.7060* 0.4100* 0.5120*
UE  POST-EVENT YEAR2 0.0160 0.4690* 0.6340*
YEAR1 0.1990* 0.5780* 0.3010*
UE  MVBV YEAR2 0.1700* 0.3800*
YEAR1 0.0780 0.5110*
UE  SIZE YEAR2 0.1910*
YEAR1 0.0800

CARit ¼ g0 þ g1 POST- EVENTit þ g2 UEit þ g3 UEit POST- EVENTit þ g4 MVBVit

þ g5 UEit MVBVit þ g6 SIZEit þ g7 UEit SIZEit þ g8 BETAit þ g9 UEit BETAit þ Zit

Notes: CAR, cumulative abnormal return; UE, unexpected earnings; MVBV, market to book value of
equity; SIZE, natural log of market capitalization; BETA, market systematic risk; Group YEAR1,
sample of firms with observations from years PRE-EVENT and POST-EVENT1; Group YEAR2,
sample of firms with observations from years PRE-EVENT and POST-EVENT2; PRE-EVENT, the
years prior to the event years; POST-EVENT, the first and second years after the event years; Event Table VI.
Years, the years the firms meet the JSX independence requirements; JSX, Jakarta Stock Exchange; Correlations of variables
ERC, earnings response coefficient. *Significant at 0.05 level (two-tailed) in ERC model

be interpreted. The focus is on the significance level and direction of CAR and UE
variables in the model.
The dependent variable CAR in both groups does not have significant correlation
with any other variables. UE has a significant positive correlation with POST-EVENT
variable in Group YEAR1 suggesting that UE in the POST-EVENT1 is higher than in
the PRE-EVENT period. Different from that of Group YEAR1, the correlation between
UE and POST-EVENT is not significant in Group YEAR2.
The regression results of testing the improvement in the ERC after the event are
presented in Table VII.
Consistent with our hypothesis that ERCs in the years after acquiring independent
directors and independent audit committee are higher than that in the years before, we
find that the estimated coefficient on the interaction variable POST-EVENT  UE is
positive and significant at 1 percent level for group YEAR1. This finding suggests that
in the first years after the event years, the investors react more positively to reported
earnings. The ERC coefficient in POST-EVENT1 is 0.106, which is the summation
of the coefficient on UE (0.138) and the coefficient on POST-EVENT  UE (0.244).
However, we do not find significant estimated positive coefficient on POST-EVENT  UE
in Group YEAR2. The coefficient is positive but insignificant meaning that although
there is an improvement in ERC in the second year, the coefficient is not significantly
higher than that in the PRE-EVENT period. This finding may indicate that the
investors’ response to reported earnings that improve in POST-EVENT1 decrease in
POST-EVENT2.
ARA Group YEAR1 Group YEAR2
19,3 Variable Predicted sign Coefficient t-statistic Coefficient t-statistic

Intercept 0.013 0.172 0.082 0.800

POST-EVENT 0.068 0.950 0.160 2.105*
UE þ 0.138 1.616 0.180 1.659
204 UE  POST-EVENT þ 0.244 2.292* 0.208 1.263
MVBV 0.041 0.537 0.187 1.986*
UE  MVBV þ 0.208 2.119* 0.255 1.808*
SIZE 0.125 1.902* 0.096 0.984
UE  SIZE ? 0.291 2.344** 0.062 0.490
BETA 0.074 1.109 0.274 3.212**
UE  BETA  0.107 0.971 0.086 0.446
N 156 156
Adjusted R2 0.077 0.091
Durbin-Watson statistic 2.019 2.039
F-statistic 2.440 2.741
p-value (F-statistic) 0.013 0.005
CARit ¼ g0 þ g1 POST- EVENTit þ g2 UEit þ g3 UEit POST- EVENTit þ g4 MVBVit
þ g5 UEit MVBVit þ g6 SIZEit þ g7 UEit SIZEit þ g8 BETAit þ g9 UEit BETAit þ Zit

Notes: CAR, cumulative abnormal return; UE, unexpected earnings; MVBV, market to book value of
equity; SIZE, natural log of market capitalization; BETA, market systematic risk; N, sample size after
adjusted for outliers (observations outside þ SD); Group YEAR1, sample of firms with observations
from years PRE-EVENT and POST-EVENT1; Group YEAR2, sample of firms with observations from
years PRE-EVENT and POST-EVENT2; PRE-EVENT, the years prior to the event years; POST-
Table VII. EVENT1, the first years after the event years; POST-EVENT2, the second years after the event years;
Regression results for the Event Years, the years the firms meet the JSX independence requirements; JSX, Jakarta Stock
ERC model Exchange; ERC, earnings response coefficient. **Significant at 1 percent; *significant at 5 percent

In Group YEAR2 the dummy variable POST-EVENT has a significant negative

coefficient. This suggests that CAR in the second years after the event years is
significantly lower than in the years prior to the event years. UE has a negative, non-
significant estimated coefficient in both Group YEAR1 and Group YEAR2. The
negative coefficient shows that in the PRE-EVENT years investors react negatively to
UE. This is inconsistent with our prediction. We predict that if the reported earnings
have information content for the investors, UE should make investors revise their
expectations. This negative coefficient, albeit insignificant, may be caused by the fact
that the year 2000 is the end of the crisis, but in that year Indonesia is still full of
political instability, insecurity, riots, and bomb explosions. Therefore, it is possible that
investors’ trust on the capital market is very low either because of the economic crisis
or high uncertainty of the future. Indonesian investors may have perceived that the UE
are caused by earnings manipulation rather than by real performance of the firms.
The coefficient on MVBV  UE is positive and significant in both groups.
This finding is consistent with the contention that investors are more responsive
to UE of firms with high growth rate. SIZE  UE has a significant negative
coefficient in sample Group YEAR1 showing investors’ response to UE for large firms
is smaller than that of small firms. The coefficients on the interaction variable
BETA  UE in both groups are insignificant. The coefficient is positive in Group
YEAR1 and negative in Group YEAR2. The relation between firm risk and ERC is Earnings quality
still not clear.
Overall, the results support the contention that independent directors and
independent audit committees improve firms’ earnings quality. The impact is stronger
in the first years after the event years because both DA and ERC show significant
improvement. Only DA is still significantly better in the following year.
205
4.3 Sensitivity analysis
For sensitivity tests we conduct additional tests by changing how we measure the DA
and by eliminating extreme values in our observations. To examine whether our results
are sensitive to how we measure DA we also estimate DA using Kasznik (1999) and
Jones (1991) models. We find consistent evidence that there is a decrease in DA after the
event using both methods of estimating DA. We find that CFO is the only control
variable that is consistently negatively associated with DA for all three methods. The
effects of other control variables on DA vary.
Following Lobo and Zhou (2006) we re-run our DA and ERC tests by eliminating
observations with extreme values. Considering our sample size we exclude
observations in the highest and lowest 3 percent of ABDAC or CFO for the DA
model, and exclude observations in the highest and lowest 3 percent of UE, MVBV, or
CFO for the ERC model. These variables are chosen because they have the highest
variances. The results are consistent with our main test for both H1 and H2. Therefore,
we can conclude that our main results are not driven by extreme values in the most
volatile variables.

5. Conclusions
Using firms that are listed in the JSX we test whether independent directors and
independent audit committees improve the quality of reported earnings. We measure
earnings quality using two proxies, DA and ERC, and identify the event year as the
years the firms report that they have met the JSX requirements to have at least 30
percent independent directors and an audit committee with a minimum of three
members that is chaired by an independent director.
We find significantly lower earnings management (DA) in the first and second years
after the firms meet the JSX independence requirements. This result supports our first
hypothesis. We conclude that the JSX regulation requiring independent directors and
independent audit committees is effective in improving earnings quality by reducing
total DA in both the first and second years following the years of meeting the JSX
requirements.
We also find that the ERC in the first years after the event years is significantly
higher than in the years before the event years. This result is consistent with our
second hypothesis. We do not find that the improvement is maintained to the second
years after the event years suggesting that the improvement in ERC is only temporary.
One possible explanation is that investors do not think that the positive influence of
independent directors and independent audit committees is long term.
We conduct sensitivity tests using different models of measuring DA and using
regressions that exclude extreme observations of the most volatile variables to make
sure that our results are not driven by the measurement methods or extreme variables.
The results of our sensitivity tests are consistent with our main tests for both
hypotheses. Therefore, in general we conclude that independent directors and
independent audit committees have positive impacts on the quality of reported
ARA earnings. Our conclusion is consistent using both DA and ERC to measure earnings
19,3 quality.
Overall, our results suggest that the JSX requirements to have independent board
members and independent audit committee do improve the quality of earnings
reported by Indonesian firms and therefore, are beneficial for the users of financial
statements. The implication is that Indonesian firms should have independent
206 directors and an independent audit committee to improve the quality of their financial
reporting.
For future research it is important to examine the association between the
improvement in earnings quality and the qualities and composition of the independent
board members and audit committee members. For example, audit committee members
with accounting background are more likely to contribute more to the effectiveness
of the committee than those without accounting background. Therefore, firms that
have independent board members and audit committee members with higher
qualifications may be more effective in improving earnings quality. It is also important
to examine the association between the improvement in earnings quality and the board
activities such as meeting frequency to find out whether their activity is associated
with effectiveness.
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Corresponding author
Ferdinand T. Siagian can be contacted at: fsiagian@maine.edu

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