Financial Reporting Quality, Debt Maturity, and Chief Executive Officer Career Concerns on Investment Efficiency.
| Autor | Aulia, Darlin |
| Cargo | Indonesia - Report |
Introduction
Various countries have policies to increase investment from domestic and foreign capital. This is done by governments because the investment activity will also encourage the country's economic activities, increase its output, and achieve savings of foreign exchange or even increase incoming foreign investment. In general, investment can be interpreted as a decision to spend current funds to buy real assets or financial assets with the purpose of obtaining income (Haming & Basalamah, 2010). Therefore, it is expected that companies can utilize their resources to achieve investment efficiency or avoid investment inefficiency conditions. Therefore, it is important to examine factors affecting this investment efficiency.
One of the factors affecting investment efficiency is financial reporting quality. The relationship between financial reporting quality and investment efficiency is related to the reduction of information asymmetry between firms and external capital providers. For example, higher financial reporting quality would allow firms with capital needs to attract additional capital by displaying projects that have a positive NPV to investors and mitigate adverse selection issues in securities issuance (this will mitigate underinvestment). Higher financial reporting quality can limit managerial incentives to engage in activities that degrade corporate value, such as empire-building in companies with excess capital (in other words, limiting overinvestment). This can be achieved if better financial reporting quality enables better contracting to prevent inefficient investment and enhance investors' ability to monitor management's investment decisions (Biddle, Hilary, & Verdi, 2009).
One way to mitigate the presence of information asymmetry is to improve financial reporting quality (Bushman & Smith, 2001; Healy & Palepu, 2001). McNichols and Stubben (2008) also argue that asymmetry of information can be minimized by improving the quality of financial reporting, because this will also increase outsiders' ability to monitor management. Therefore, if associated with investment efficiency, with high financial reporting quality then the problem of underinvestment (rejecting positive net present value/NPV projects) and overinvestment (carrying out negative NPV projects) will be reduced.
In addition to financial reporting quality, several other factors also affect investment efficiency. One of them is debt maturity. As mentioned by Gomariz and Ballesta (2014), the management of corporate funds is also a concern in improving investment efficiency, because managing the activities of operational and non-operational companies requires funds. Funding sources can include obtaining loans from certain parties. Every loan has its own maturity. Gomariz and Ballesta (2014) found that the use of short-term debt can mitigate investment inefficiency. Shorter maturities on debt can be used to mitigate information asymmetry problems because, from the borrower's perspective, firms are able to signal the lenders that they are good firms and thus able to obtain better loan terms in subsequent loan renewal; and from the perspective of the lender, shorter maturities will enable them to have more control and increase monitoring of management. The role of debt is relevant in the context of Indonesia: based on data on the Indonesia Stock Exchange, Indonesia has a relatively low number of debt issuers when compared with other ASEAN countries. Thus, it can be deduced that private debt is still a major financial source for many companies, in addition to issuing shares.
Non-financial factors should also be considered when discussing organizations' investment efficiency. Such factors include the role of parties that exist within a company or organization. There are various stakeholders in the organization, which all have goals and interests to be achieved. This study also considers the role of the CEO, which is responsible for determining strategic policy, mainly related to companies' investment policies, in accordance with the duties and responsibilities contained in Law No. 40 year 2007 Limited Liability Companies Act (Law n. 40, 2007).
Under this Act, the role of the CEO is very important. Therefore, this study includes the role of CEO, especially their career concerns, in determining investment decisions. Since the CEO is responsible for all of a company's activities, it is imperative that his/her career concerns will also affect his/her investment decisions. In this study, CEO career concerns are measured with reference to CEO age and CEO appointment. According to Xie (2015), CEO age and appointment have an influence on a company's investment decisions. Young and newly appointed senior CEOs are considered to be more efficient in investing because they are more willing to take risks to enter new business lines, thus avoiding underinvestment and cautious attitudes towards investment, as they want to build a good reputation that will mitigate the condition of overinvestment. On the other hand, older and long-standing CEO tend to keep the status quo, and their investment decisions are thus inefficient (Xie, 2015).
Based on the above explanations, the purpose of this research is to analyse the effect of financial reporting quality, debt maturity, and CEO career concerns on investment efficiency. Previous studies tend to focused more on analysing financial factors, whereas this research combines both financial and non-financial factors that can affect investment efficiency. This study extended previous studies by examining financial reporting quality and debt maturity as examined in Gomariz and Ballesta (2014) and CEO career concerns in Xie (2015).
Literature Review
Financial reporting quality and investment efficiency
There are several ways to overcome the problem of information asymmetry. One of them is by improving the quality of financial reporting. High quality financial reporting can improve the monitoring of management to prevent opportunistic actions. The role of high quality financial reporting in mitigating information asymmetry is mainly related to investment decisions.
Investment efficiency can be improved by improving the quality of financial reporting (see, for example, Biddle & Hilary, 2006; Bushman & Smith, 2001; Healy & Palepu, 2001; Lambert, Leuz, & Verrecchia, 2007). The relationship between financial reporting quality and investment efficiency is related to the reduction of information asymmetry between firms and external capital providers. Higher financial reporting quality makes managers more accountable by allowing better monitoring, and can mitigate information asymmetry so that adverse selection and moral hazard can be avoided. On the other hand, higher quality financial reporting can also improve investment efficiency by enabling managers to better make investment decisions through better identification of projects for internal decision makers (Bushman & Smith, 2001; McNichols & Stubben, 2008). If external parties suspect that the quality of information in financial reporting is low, then they will tend not to invest in the company, which will limit the company's ability to exploit positive NPV projects, and will cause underinvestment conditions. Lower financial reporting quality, which means higher information asymmetry will mitigate outsider ability to monitor management, will increase moral hazard. This would include management that makes investment decisions for the purpose of empire building, such as undertaking negative NPS projects (hence overinvestment).
Biddle and Hilary (2006), Biddle, Hilary and Verdi (2009), and Gomariz and Ballesta (2014) find that high financial reporting quality can mitigate the problem of overinvestment and underinvestment. Based on the previous explanation, we propose the following hypothesis:
H1: Financial reporting quality is positively associated with investment efficiency.
H1a: Higher financial reporting quality can mitigate overinvestment.
H1b: Higher financial reporting quality can mitigate underinvestment.
Debt maturity and investment efficiency
A shorter maturity of debt can be used to mitigate the problem of information asymmetry from the borrower perspective (Berger & Udell, 1998; Flannery, 1986; Ortiz-Molina & Penas, 2008), since the company can signal that it is a good company, and thus potentially allow it to obtain better price conditions at the next loan renewal. Meanwhile, from the lender perspective, the shorter maturity allows better control and monitoring of managers (Diamond, 1991, 1993). Theoretical models (Childs, Mauer, & Ott, 2005; Myers, 1977) predict that the greater flexibility of shorter debt maturity is useful in improving investment inefficiency, although there is limited evidence for this, particularly in relation to overinvestment. The role of a manager's discretion in reducing debt and making disciplined investment decisions has been discussed in the literature (Jensen, 1986; Myers, 1977), and there is some evidence that debt mitigates overinvestment (D'Mello & Miranda, 2010). However, the literature has also emphasized the role played by debt maturity under conditions of asymmetric information, which indicates that the use of short-term debt is the mechanism that could mitigate the asymmetric information and agency costs between shareholders, creditors, and management.
From the point of view of creditors, Flannery (1986) suggests that under conditions of asymmetric information with a good project, a shorter maturity is preferable to send signals to the market and mitigate the...
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