The 2nd International Conference on Inovations

in Social Sciences Education and Engineering ( ICoISSEE )

August 07th, 2021

VALUATION OF FINANCIAL REPORTING QUALITY:

IS IT AN ISSUE IN THE FIRM’S VALUATION?
1*
Nur Fadjrih Asyik, Muchlis, Ikhsan Budi Riharjo
Program Studi Akuntansi, Sekolah Tinggi Ilmu Ekonomi Indonesia, Surabaya
Muchlis
Program Studi Akuntansi, Departemen Akuntansi, Muhammadiyah University,
Sidoarjo

[email protected]; [email protected]
*
Corresponding author: [email protected]

Abstract

The aim of this research is to test the determinant of financial report quality and its
consequences to the company’s value. The sample of this study is 85 go public
companies listed in the Indonesia Stock Exchange for 5 years observation period in
2016 until 2020. Hence, it has total of 425 observations. Data was analyzed using path
analysis. The results found that innate factors from financial reporting quality consists
of dynamic factor (operation cycle and sales volatility) as well as static factor (firm
size). These factors support to achieve financial reporting quality and able to provide
positive response to market. On the other hand, static factor (firm age) and
institution risk factor (leverage) are not able to produce financial reporting quality.
Thus, it cannot be considered as an economic decision making for an investor.

1. INTRODUCTION
The general overview on the financial report quality had been studied by many
researchers. Therefore, an agreement had been created to support the convergence
of accounting standard harmonization that will be impacted in the financial reporting.
Some phenomena in accounting scandal occurred in early 21 st century had showed us
the weakness in the financial reporting quality. The financial report quality depends
on the value on the accounting report, hence, it is important for a company to
provide high quality financial report. Research shows that quality financial report will
be impacted and useful to make an investment decision. The concept of quality
financial report is not only containing financial information but also non-financial
which will be useful to make an economic decision (Herath and Albarqi, 2017).
The quality of financial report will be studied from two different aspects. Firstly,
the quality of financial report shows the company’s performance which reflected on
the profit information. It can be said that financial report information has high quality
if profit obtained in the current year can be used as an indicator to generate profit in
the future (Dang et al., 2020), or as cash revenue in the future (Noury et al., 2020).
Secondly, the quality of financial reporting is related to the company’s market
performance which listed in the stock exchange. The strong relationship between
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August 07th, 2021

profit and stock’s market price proofed that financial reporting information will be
responded positively by either market or investors (Dang et. al., 2020).
Studies related to the quality of the financial reporting can be done by using
two different approaches. The first approach is to test the causes of the financial
report quality. In this approach is to examine the company’s internal causes or
characteristics. Those are dynamic innate (operational cycle and sales volatility),
static (company’s size and its age), and institution risk factor (leverage) (Fanani,
2009). The second approach is the external market’s respond to determine the
majority of which is using the financial reporting. This respond will be determined the
value of the company (Al-Dmour et al., 2018).
Lonkani (2018) stated that the company’s value is not merely related to the
external stakeholders’ relationship or the users of financial reporting such as
investors and creditors, however, it is also considering an implicit relationship to be
evaluated in the valuation process. Beside that the meaning of company’s valuation is
not solely for one group of people (in this case investors), who will obtain the
maximum level of gain from company’s operational activities. Yet, it will consist of
many different stakeholders who will have benefited from the company’s valuation.
This paper is to examine the determinant of the quality of financial reporting
and its consequences to the company’s valuation. The proxy of innate factors involve
dynamic factor (operational cycle and sales volatility), static factors (firm size and its
age), and lastly institutional risk factor (leverage).
This study contributes both theoretically and practically. Theoretically, this
research shows that valuation of clean surplus theory which determine the firm’s
market value reflected in the financial report component (Feltham & Ohlson’s, 1995).
This study is employed more than one financial reporting quality (Cornel & Landsman,
2003). Practically, the findings of this study will provide information to management
in order to produce a quality financial report, which will then be responded positively
by market and investors. Furthermore, a quality financial reporting will benefit
investors and stock market’s analysts (investors, brokers and market security analyst)
in making investment decision.

2. LITERATURE REVIEW
2.1 Quality of Financial Report
According to IASB (2018), the information quality revealed in the firm’s financial
report can help users in evaluating the benefit of the financial report. Therefore,
financial report must be presented accurately, comparable, verifiable, on time and
understandable. Hence, it must be transparent, and error free. It is important that
the financial report must be on time and predictable as an indicator to produce high
quality financial report (Gajevszky, 2015). The qualitative characteristics of financial
information consist of: relevance, accurate representation, understandable,
comparable, verifiable and lastly on-time.

2.2 Information Usefulness of Accounting

An organization which organized the accounting standard fully support that
financial report has the purpose of presenting financial information which will benefit
users. The purpose is to have a better understanding of the firm’s financial position
(IASB, 2018). Thus, users are able to make economic decision. Accounting information
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is used to evaluate the business performance and also it is useful for owners to do
some analysis in evaluating business operation. Financial ratio can be used as an
indicator to compare its performance against other firms within the same business or
industry standard (Vitez, 2019). This can help owners to understand how good its
company compare to others is.

2.3 Clean surplus theory

Clean surplus theory is a foundation theory that relevance to the accounting
information value. This theory mentions that the firm’s value is reflected in the
accounting data which is showing on the financial report (Ohlson, 1995). Clean
surplus theory had an impact on the development of financial accounting theory,
especially it is able to demonstrate that the firm’s value has an equal value with
dividend financial accounting variable or cash flow. This was then followed by more
research in predicting profit (Scott, 2015: 233; Schroeder et al., 2020). According to
Djaballah (2019), financial information has the function of forecasting and analysis
which describe the firm’s condition. It shows that financial report is not only as
information perspective for users but also has the benefits to evaluate the usage of
the financial report.

2.4 Conceptual Framework

Innate Factors
Dynamic Factors:
1. Operation Cycle (OC)
2. Sales Volatility (SV)
H6, H7, H8, H9, H10 H11

Static Factor: Financial

3. Firm Size (FS) Reporting Firm Value (FV)
4. Firm Age (FA) Quality

Institution Risk Factor: H12, H13, H14, H15, H16

5. Leverage (L)
Picture 1
The Conceptual Framework of Valuation of
Financial Reporting Quality and Firm Value

2.5 Hypothesis

2.5.1 Testing the impact of Innate Factors of Financial Reporting Quality to Firms’
Value
Innate factors of the quality financial reporting consist of operation cycle, sales
volatility, firms’ size and firms’ age. In this case firms’ operation cycle is the most
important variable in order to operate a company. Hence, it needs a firm’s operation
cycle which can be understandable by all employees (Arachchi et al., 2017). In regards
to high sales volatility shows that sales information has wrong estimation which can
cause un-persistence results (Nezami et. Al., 2018). The unstable sales proxied by
high sales volatility will make lower firms’ valuation and vice versa.
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Majority of the research found that size and age of a firm influences the value
of a company. Big firms have stable financial condition (Rouf, 2018). It is therefore
increase the company’s value, hence, it attracts investors. As a result increase the
stock market price, and will affect an increase on the value of one firm.
Based on the study of innate factors of the valuation of financial reporting on
the firm value. Thus, hypotheses can be formulated as follow:
H1: The longer operational cycle of a firm is resulted on the low firm’s value.
H2: The higher sales volatility of a firms is resulted on the low firm’s value.
H3: The bigger of a firm’s size resulted in higher firm’s value
H4: The longer of a firm’s age resulted in a higher firm’s value
H5: The higher of the leverage of a company resulted in high quality firm’s value

2.5.2 Testing the impact of Innate Factors of Financial Reporting Quality on

Financial Reporting Quality
Firm’s operational cycle will determine the quality of financial report either
good or bad. A firm’s with longer operational cycle shows unexpected things as
inaccurate estimation will occur. Some errors of estimation will produce low accrual
value as a result it will have low quality of financial reporting (Dechow & Dichev,
2002).
Sales volatility exhibits the ability to forecast the cash flow in the future. High
sales volatility will produce low financial report performance, it is due to the some
noises in the firm’s profit (Cohen, 2006).
Furthermore, the firm’s size shows that a firm with a larger scale is more stable
with better operational condition. Thus, it is unlikely to have some errors on the
estimation. Besides that, a larger firm will have the ability to do some diversifications
as it will reduce errors on the estimation (Gu et.al. 2002).
The longer firm’s existence will have stronger operation. As a result the
financial performance will have small accrual variability (Gu et.al, 2002). Thus, a firm
is more trusted in regards to the leverage. Hence, creditors will be more confidence
in providing debts and also a firms will have some privileges in paying its debts
(Cohen, 2006).
Based on the arguments in the firm’s valuation about innate factors, thus,
hypotheses can be formulated as follows:
H6: The longer a firm’s operational cycle is resulted in low quality financial report.
H7: The higher sales volatility is resulted in low quality financial report
H8: The bigger of a firm’s size is resulted in high quality financial report
H9: The older of a firm’s age is resulted in high quality financial report
H10: The higher of a firm’s leverage is resulted in high quality financial report

Shin and Kim (2019) as well as Dempster and Oliver (2019) emphasized that
the high compliance on the accounting standard consistently will show the factual
condition of one firm. This research will use the accrual value as proxy in the
fundamental ability of a firm to sustain its existence. By using the higher standard
accrual size quality is resulted in low accrual usage. The higher number of quality
financial reporting is resulted in high prediction of the market value in the future
(Siladjaja and Anwar, 2020). Based on the innate factor of the quality financial report
evaluation, thus, a hypothesis can be formulated as follow:
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H11: The higher financial report quality is resulted in high of a firm’s valuation.

2.5.3 Testing of the Innate Factors of Financial Reporting Quality and its impact on
the Firm’s Value
As discussed earlier there are two approaches in studying financial reporting
quality. Elayan et. al (2016) found that there are some phenomenon in the stock
exchange to see high quality financial report performance. It is obviously to help
investors to predict a firm’s financial performance in the future. Eskandari and
Foumani (2016) shows that high quality financial report will influence the
management’s ability to predict the market reaction.
Based on the arguments about innate factor of the financial report quality and
its impact on a firm’s value. Hypotheses can be formulated as follows:
H12: The longer of a firm’s operational cycle is resulted in low quality of financial
report, hence, low firm’s valuation
H13: The higher sales volatility of a firm is resulted in low quality of financial report,
hence, low firm’s valuation
H14: The larger of a firm’s size is resulted in high quality of financial report, hence,
high firm’s valuation
H15: The older of a firm’s age is resulted in high quality of financial report, hence,
high firm’s valuation.
H16: The higher the leverage of a firm is resulted in high quality of financial report,
hence, low firm’s valuation.

3. RESEARCH METHODS/METHODOLOGY
3.1 Research Approach and Sample
This research is using quantitative approach and testing a theory by formulating
some hypotheses. Then, data is collected to support or argue the hypotheses that
had been formulated.
The population in this research is all of the companies listed in Indonesia Stock
Exchange (BEI). The purposive sampling is applied in this research, only companies
which had been doing their Initial Public Offering (IPO) in the Indonesia Stock Market
before 2016 with completed data will be included in the sample. Therefore, 85
companies with 5 years observations from 2016 to 2020 are included. Thus, a total of
425 observations.

3.2 Research Variables

3.2.1 Innate Factors
Dynamic Factors:
1. Operation Cycle (OC)
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Operation Cycle is measured by using the time average between

purchasing inventory and the cash flow received by the seller. It is the whole
business transaction from the customer (Dechow, 1994)

(ARit+ARit-1)/2 (Invit+Invit-1)/2
Operation Cycleit = +
Salesit /360 COGSit /360

Keterangan:
ARit = Account Receivables i year t
ARit-1 = Account Receivables i in the previous year
Invit = Inventory i year t
COGSit = Cost of Goods Sold i year t

2. Sales Volatility (SV)

Sales Volatility is the degree of sales spread or spread index distribution of
sales
(Dechow dan Dichev, 2002).

(Sales of 5 Yearit )
Sales Volatilityit =
Asset Totalit

Keterangan:
Sales of 5 Yearit = Sales firm i since 2016-2020
Total Asset Yearit = Total Asset firm i since year t

Static Factor:
3. Firm Size (FS)
Firm size is the scale of one company (Dechow dan Dichev, 2002).
Firm Sizeit = Logaritma Total Assets

4. Firm Age (FA)

Firm age is the length of the operation of a firm (Gu et al., 2002).
Firm age = Year observation – Year founded

Institution Risk Factor:

5. Leverage (L)
Leverage is funding for operational or investment from external (DeAngelo
et al., 1994).

Liability Totalit
Leverageit =
Asset Totalit

Keterangan:
Liability Totalit = Total debt firm i year t
Asset Totalit = Total assets firm i year t

3.2.2 Financial Reporting Quality (FRQ)

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Financial Reporting Quality is measured by using accrual quality which is revenue

that is acknowledged at the time of a firm’s existence. Due to the hand-over of
goods to external and some expenses or liabilities from the purchase of goods.

CFOit-1 Salesit Aset Totalit+1 Equity Book Valueit+

Accrual Qualityit = 0+ 1 +2 +3 +4
Asset Totalit Asset Totalit Asset Totalit Equity Market Value

Description:
TAit = Firm’s Net Income minus cash flow of firm i year t
CFOit-1 = Operational cash flow firm i year t
Asset Totalit = Total Assets firm i year t
Salesit = Sales firm i year t
Equity Book Value = Stock price * number of stock shares firm i year t
Equity Market Value = Equity total * number of stock shares firm i year t

3.2.3 Firm Value (FV)

Firm value is measured by using Tobin’s Q ratio which represents the firm’s
value by combining both book value and market equity’s value. This
measurement is better as it summarized future information which relevant to
investment decision. Furthermore, it provides information about market’s
perception toward firm’s valuation from many different factors such as
investors. According to Suhadak et al. (2020) the larger ratio of Tobin's Q shows
that a firm has good and positive prospect.

3.3 Statistics Analysis

Data was analyzed using path analysis. One of an important components in
doing path analysis is path diagram. Path diagram is produced to represent
causal relationship among research variables.
Structural Model I: FV = 0 + 1OCit + 2SVit + 3FSit + 4FAit + 5Lit + it
Structural Model II: FRQ = 0 + 1OCit + 2SVit + 3FSit + 4FAit + 5Lit + it
Structural Model III: FV = 0 + 1FRQit + it
Structural Model IV: FV = 0 + 1OCit + 2SVit + 3FSit + 4FAit + 5Lit + 5FRQit + it
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4. RESULTS AND DISCUSSIONS

Tabel 1 exhibits descriptive statistics in this research.

Tabel 1
Descriptive Statistics
Minimu
N m Maximum Mean Std. Deviation
Operation Cycle (OC) 425 .00 4861.52 144.77 426.09
Sales Volatility (SV) 425 .00 58526.67 1119.39 5133.43
Firm Size (FS) 425 5.89 15.97 11.59 1.68
Firm Age (FA) 425 2.00 63.00 31.48 1.52
Leverage (L) 425 .00 3.32 .41 .39
Financial Reporting Quality 301331.4
425 .00 7253.63 24311.82
(FRQ) 6
Firm Value (FV) 425 0.02 41.87 2.24 4.68
Valid N (listwise)
Sources: Indonesian Stock Exchange

1.2 F-test
The purpose of the F test is to confirm whether independent variable in the
regression model is feasible to be included in the research to examine the dependent
variables. Result of the F-test is presented in Table 5.

Tabel 5
Results of F-test Model 1
ANOVAa
Model 1 Model 2
Model
F Sig. F Sig.
b
1 Regression 22.182 .000 26.580 .000b
Residual
Total
a. Dependent Variable: Model 1 (Firm Value) Model 2 (Financial Reporting
Quality)
Source: Analyzed Financial Report, 2021

Table 5 shows that the value of F-test 22.182 (model 1) and 26.580 (model 2)
with sig. 0,000 < 0,05, hence, it can be concluded that the model is feasible.

1.3 Hypotheses Test (T-test)

4.4.1 Structural Model Test I (Hypotheses 1 until Hypotheses 5)

The purpose of T-test (hypotheses test) is to know whether there is an impact
on the independent variable with significant level of 0.05 (α = 5%). The following is
the result of T-test (Table 6) based on the structural model I:
Structural Model I: FV = 0 + 1OCit + 2SVit + 3FSit + 4FAit + 5Lit + it
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Table 6
Results of Model 1 (H1, H2, H3, H4, H5)
Coefficientsa
Standardized
Model Coefficients t Sig. Description
Beta
1 (Constant) 13.550 7.839 .000 -
Operation Cycle (OC) -.002 -4.541 .000 Hypothesis supported
Sales Volatility (SV) -.000 -3.854 .000 Hypothesis supported
Firm Size (FS) .958 6.598 .000 Hypothesis supported
Firm Age (FA) -.001 -1.471 .142 Hypothesis not supported
Leverage (L) -.041 -.073 .942 Hypothesis not supported
a. Dependent Variable: Firm Value (FV)
Source: Analyzed Financial Report, 2021

4.4.2 Structural Model Test II (Hypothesis 6 until Hypothesis 10)

Table 7 shows the result of T-test with significance level 0,05 (α = 5%). Hence,
the formula for structural model II as follows:
Structural Model II: FRQ = 0 + 1OCit + 2SVit + 3FSit + 4FAit + 5Lit + it

Table 7
Results of Model 2 (H6, H7, H8, H9, H10)
Coefficientsa
Standardized
Model Coefficients t Sig. Description
Beta
1 (Constant) -90008.271 -10.237 .000 -
Operation Cycle (OC) .546 .199 .842 Hypothesis not supported
Sales Volatility (SV) -1.260 -4.641 .000 Hypothesis supported
Firm Size (FS) 8388.561 11.354 .000 Hypothesis supported
Firm Age (FA) 1.762 .510 .610 Hypothesis not supported
Leverage (L) -3737.551 -1.318 .188 Hypothesis not supported
a. Dependent Variable: Financial Reporting Quality (FRQ)
Source: Analyzed Financial Report, 2021
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August 07th, 2021

4.4.3 Structural Model Test III (Hypothesis 11)

Table 8 is the result of the structural model test III with significance level of 0.05
(α = 5%). The formula as follows:
Structural Model III: FVit = 0 + 1FRQ + it
Table 8
Results of Model 3 (H11)
Coefficientsa
Standardized
Model Coefficients t Sig. Description
Beta
(Constant) 2.354 9.952 .000 -
Financial Reporting Quality (FRQ) -1.630 -1.746 .081 Hypothesis not supported
a. Dependent Variable: Firm Value (FV)
Source: Analyzed Financial Report, 2021

4.4.4 Structural Model Test IV (Hypothesis 12 until Hypothesis 10)

Table 9 is the result of the structural model test III with significance level of 0.05 (α
= 5%). The formula as follows:
Structural Model IV: FV = 0 + 1OCit + 2SVit + 3FSit + 4FAit + 5Lit + 5FRQit + it

Table 9
Results of Model 4 (H12, H13, H14, H15,H16)
Coefficientsa
Financial Firm Total
Reporting Value Effect
Quality
Operation Cycle (OC) .546 -.002 -.001 Hypothesis supported
Sales Volatility (SV) -1.260 -.000 -0.000 Hypothesis supported
Firm Size (FS) 8388.561 .958 8036.241 Hypothesis supported
Firm Age (FA) 1.762 -.001 -.002 Hypothesis not supported
Leverage (L) -3737.551 -.041 153.240 Hypothesis not supported
a. Dependent Variable: Firm Value (FV)
Source: Analyzed Financial Report, 2021

5. Interpretation of Research Findings

The direct test negatively of operation cycle to the firm’s value is supported
(H1). However, there is no direct impact on operation cycle to the financial reporting
quality (H6). This study is supported indirect impact negatively on operation cycle to
the firm’s value toward financial reporting quality (H12). This result is supported
Arachchi et al. (2017) dan Dechow dan Dichev (2002). It shows that the longer
operational cycle causes higher uncertainty. Thus, it makes an interference on the
accrual and reducing the ability in predicting cash flow in the future. This findings are
in favor of direct impact negatively of sales volatility to the firm’s value (H2) and also
direct impact negatively of sales volatility to the financial reporting quality (H7).
Furthermore, this research is agreed that there is indirect impact negatively on sales
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volatility to the firm’s value through financial reporting quality (H13). This results
support Nezami et al. (2018) dan Cohen (2006). The fact describes high sales
volatility. Yet, research shows that profit is still able to predict cash flow in the future
as the generated profit does not contain too many problems (Dechow dan Dichev
2002).
There is a direct impact positively on the firm’s size to the firm’s value (H3) as
well as direct impact positively of the firm’s size to the financial reporting quality
(H8). This study is also supported indirect impact positively of the firm’s size to the
firm’s value through financial reporting quality (H14). This research supports Rouf
(2018) dan Gu et al. (2002). It can be said that the firm’s size is a static innate factor,
it means that the firm’s size can have an impact on the financial report quality as it
has the ability to do some diversifications on the business portfolio variations and
relatively high politic cost. The result is better not to support direct impact positively
on firm’s age to the firm’s value (H4) and direct impact positively on firm’s age to the
financial reporting quality (H9). Results also not supported indirect impact positively
of the firm’s age to the firm’s value through financial reporting quality (H15). As a
result this study does not support Rouf (2018) dan Gu et al. (2002). Descriptive
statistic data shows the average of the firms’ age is 31 years. However, there is also a
firm that is only 2 years of age. Therefore, this firms does not have too many
experiences in running a company’s operations. Further, findings do not support
direct impact negatively on leverage to the firm’s value (H5) and direct impact of
leverage to the financial reporting quality (H10). Besides that, this study does not
support indirect impact positively of leverage on the firm’s value through financial
reporting quality (H16). This research does not support Rouf (2018) dan Cohen
(2006). In this research the average leverage is relatively small that is .14, hence, it
cannot be the main factor that can increase creditor’s confidence to loan their money
to the company.

CONCLUSION
The quality of financial reporting is related to the overall company’s performance. It is
reflected in the firm’s profit. The first opinion stated that quality profit is reflected on
the sustainability of stable net profit. Later, the second opinion claimed that the
quality of financial reporting is related to the market’s performance in the stock
exchange. The stronger relationship between profit and market reward shows that
high financial report performance. The findings of this research exhibits information
on the innate factors from the financial reporting quality. It involves some factors
such as dynamic factor (operation cycle and sales volatility) and static factor (firm
size). These factors are needed to achieve financial reporting quality and is able to
provide positive respond to the market. On the other hand, static factor (firm age)
and institutional risk factor (leverage) are not able to produce high quality financial
reporting. Hence, these factors are not used by investors to make an economic
decision.
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