Maria Goreti Kentris INDARTI, Jacobus WIDIATMOKO / Journal of Asian Finance, Economics and Business Vol 8 No 4 (2021) 0769–0776

769

Print ISSN: 2288-4637 / Online ISSN 2288-4645

doi:10.13106/jafeb.2021.vol8.no4.0769

The Effects of Earnings Management and Audit Quality on

Cost of Equity Capital: Empirical Evidence from Indonesia

Maria Goreti Kentris INDARTI1, Jacobus WIDIATMOKO2

Received: December 15, 2020  Revised: March 06, 2021  Accepted: March 15, 2021

Abstract
The focus of this study is to investigate the effect of earnings management and audit quality on the cost of equity capital and also examines
whether audit quality acts as a moderating variable for the effect of earnings management on the cost of equity capital. The population in this
study are companies from the consumer goods industry sector listed on the Indonesia Stock Exchange (IDX) during the 2016–2018 period.
This sector was chosen because it is a sector that is able to survive in conditions of economic decline, so it becomes a good investment
opportunity in the future. The sample selection was carried out using purposive sampling technique. By using the Moderated Regression
Analysis (MRA) technique, the results show that earnings management has a positive effect on the cost of equity capital. Conversely,
companies with good audit quality will bear lower cost of equity capital. The moderating hypothesis test results show that audit quality
moderates the effect of earnings management on the cost of equity capital. This means that, even though the company carries out earnings
management, investors have more confidence in the results of audits conducted by qualified auditors so that the cost of equity capital is low.

Keywords: Earnings Management, Audit Quality, Cost of Equity Capital, Moderated Regression Analysis

JEL Classification Code: M4, M41, M42

1. Introduction by investors as compensation for this risk. The high cost

of equity capital will affect the company’s future growth.
The cost of equity capital is one of the main concepts Therefore, various efforts have been made by the company
in the financial literature and plays an important role in the to reduce the cost of equity capital, so that the company’s
financial and investment decisions of companies, namely, value can be maximized. Low cost of equity capital reflects
to ensure appropriate financial resources, determine the a low company risk, thus leading shareholders to assume
cost of funding and the impact of these resources on the that the value of the company is high. However, the facts
risk and return of the company (Pham et al., 2012; Salehi show that the cost of equity capital borne by the company
et al., 2020). Dhaliwal, Li, Tsang, and Yang (2011) state that has increased every year (Kiswanto & Fitriani, 2019).
the cost of equity capital is the same as the rate of return The importance of the cost of equity capital has prompted
required by investors in relation to existing risks. The higher researchers to examine various variables that influence
the risk of an investment, the higher the return required the cost of equity capital. These variables include earnings
management (Kiswanto & Fitriani, 2019; Meini & Siregar,
2014; O’Callaghan, Ashton, & Hodgkinson, 2018; Utami &
First Author and Corresponding Author. Associate Professor,
1
Pernamasari, 2020) and audit quality (Houqe et al., 2017;
Department of Accounting, Faculty of Economics and Business,
Universitas Stikubank Semarang, Indonesia [Postal Address: Jalan
Ningsih & Ariani, 2016; Setiawan & Daljono, 2014; Wiyadi
Kendeng Barat V/52, Sampangan, Semarang 50233, Indonesia] et al., 2017).
Email: kentris@edu.unisbank.ac.id Earnings management is an action taken to get the
Associate Professor, Department of Accounting, Faculty of
2
desired earnings, by misleading the market in relation to the
Economics and Business, Universitas Stikubank Semarang,
Indonesia. Email: jwidiatmoko@edu.unisbank.ac.id company’s actual performance (Caylor et al., 2015). It can
be done by selecting certain accounting methods (Diri, 2017)
© Copyright: The Author(s)
This is an Open Access article distributed under the terms of the Creative Commons Attribution and naturaly, cannot be separated from the characteristics
Non-Commercial License (https://creativecommons.org/licenses/by-nc/4.0/) which permits
unrestricted non-commercial use, distribution, and reproduction in any medium, provided the
in the agency relationship between shareholders and
original work is properly cited. management. Managers have better, more, and faster
770 Maria Goreti Kentris INDARTI, Jacobus WIDIATMOKO / Journal of Asian Finance, Economics and Business Vol 8 No 4 (2021) 0769–0776

information than shareholders, resulting in information listed on the Indian capital market, which showed that
asymmetry (Meini & Siregar, 2014), which encourages audit quality was able to reduce the cost of equity capital.
management to carry out earnings management in order to However, different research results were shown by Wiyadi
maximize their own welfare. et al. (2017), which states that audit quality has no effect
Management behavior that underlies earnings on the cost of equity capital.
management is opportunistic behavior. Accounting This research is motivated by several elements, which
information plays a fundamental role as the basis for the are also the contributions of this research. First, until now,
allocation of capital in financial markets (Bhattacharya earnings management is still a central topic in theoretical
et al., 2013). Earnings is accounting information that is an and empirical research in the field of accounting (Beyer
important benchmark for investors in deciding to invest et al., 2019). Second, this study contributes to the current
in a company, so that management will adjust earnings to literature with a focus on investigating the effect of earnings
attract investors. However, rational investors will require management on the cost of equity capital by including the
a premium level on agency risk which is reflected in audit quality variable as a moderating variable. This is due to
the cost of equity capital (Utami & Pernamasari, 2020). the inconsistent results of research on the effect of earnings
Kim and Sohn (2013) state that earnings management management and audit quality on the cost of equity capital.
can reduce the quality of earnings information used by Following Baron and Kenny (1986), inconsistent research
investors, so that the market demands a high risk premium results provide opportunities for moderating variables in the
as a result of additional premium risk due to earnings relationship between independent and dependent variables.
management activities. As a consequence, the cost of
equity capital will increase. 2. Literature Review and
The results of previous research show that earnings Hypothesis Development
management practices will increase the cost of equity
capital of the company (Kiswanto & Fitriani, 2019; Utami & 2.1. Earnings Management and Cost
Pernamasari, 2020). O’Callaghan, Ashton, and Hodgkinson of Equity Capital
(2018), in their research on large private companies in the
UK, stated that earnings management will increase the cost Earnings information is basic information that users
of equity capital. However, different results are shown by must have before making a decision (Utami & Pernamasari,
Meini and Siregar (2014) and Febrininta and Siregar (2014), 2020). The importance of company earnings information
who found that earnings management has no effect on the has encouraged company management to manipulate
cost of equity capital. actual earnings information. It can be ascertained that
Based on agency theory, quality audits are considered managers have better, more, and faster information than
to have an important role in reducing agency conflicts. shareholders, resulting in information asymmetry (Meini
Qualified auditors act as powerful monitoring mechanisms & Siregar, 2014), which encourages management to carry
and send positive signals to the market. It is expected out earnings management in order to maximize their own
that investors will appreciate these companies to reduce welfare. Manipulation is carried out by adjusting earnings
information asymmetry, thereby reducing the cost of to the company’s goals. However, rational investors will
equity capital (Houqe et al., 2017). This occurs because put a price on agency risk that reflects the level of the cost
the reliable financial reporting that is guaranteed by the of equity capital (Utami & Pernamasari, 2020). Kim and
audit can increase management accountability and become Sohn (2013) state that earnings management can reduce
an effective tool for shareholders to monitor management the quality of earnings information used by investors,
duties. In addition, the existence of qualified auditors will so that the market demands a high premium risk as a
reduce the risk of information faced by investors because result of additional premium risk due to accrual earnings
their existence increases the credibility of financial reports management activities. As a consequence, the cost of equity
(Pham et al., 2020; Salehi et al., 2017). capital will increase.
Setiawan and Daljono (2014) examined the effect of Research by Meini and Siregar (2014), and Kiswanto and
audit quality on the cost of equity capital in manufacturing Fitriani (2019) examined the effect of earnings management
companies on the Indonesia Stock Exchange. The results on the cost of equity capital in Indonesia. Their results
show that companies audited by public accounting firms prove that earnings management has a positive effect on
affiliated to the Big Four have a lower cost of equity the cost of equity capital. This finding is supported by the
capital. The results of research by Ningsih and Ariani results of research O’Callaghan, Ashton, and Hodgkinson
(2016) show that audit quality has a negative effect on the (2018), as well as which show that the higher the level of
cost of equity capital. The same finding was also stated by earnings management, the higher the cost of equity capital
Houqe et al. (2017) who conducted research on companies of the company. Companies with a high level of earnings
 Maria Goreti Kentris INDARTI, Jacobus WIDIATMOKO / Journal of Asian Finance, Economics and Business Vol 8 No 4 (2021) 0769–0776 771

management are considered to have high risks. As a mechanism is a manifestation of the external mechanism
consequence, investors will ask for a high rate of return as a for corporate governance. A qualified external auditor will
consequence of the risks they bear. Based on the logic and help minimize earnings manipulation by management,
empirical findings, the following hypothesis is formulated. thereby reducing the asymmetry of information between
the two parties (Alzoubi, 2018). Qualified external auditors,
H1: Earnings management has a positive effect on the who are members of the Big Four public accounting firms,
cost of equity capital. have a strong incentive to provide or maintain high quality
audits due to the fact that they have: (1) a higher number of
2.2.  Audit Quality and Cost of Equity Capital clients; (2) significant resources to support the audit process
(recruitment, training and technology); (3) the possibility of
The presence of qualified auditors within a company can suffering a greater loss if they do not report violations, such
act as a powerful monitoring mechanism for management as termination of employment with clients, loss of reputation
and serve to convey positive signals to the market. (Rusmin, 2010). In addition, the reliability and fairness
Qualified auditors are also considered to play an important of financial reports that have been verified by a qualified
role in reducing agency conflicts. Reliable financial external auditor will improve the quality of financial
reporting guaranteed by a qualified auditor can improve information and reduce earnings management, which will
management accountability and be an effective tool for have an impact on lowering the cost of equity capital.
shareholders to monitor management tasks (Ningsih &
Ariani, 2016). As earlier literature suggests that high audit H3: Audit quality weakens the positive influence of
quality will enhance the confidence of investors in the earnings management on the cost of equity capital.
financial reporting issued by external auditors (Alawaqleh
et al., 2021). It is hoped that investors will appreciate these 3.  Research Methods
companies for reducing information asymmetry and as a
bonding mechanism so that there is greater supervision of 3.1.  Population and Sample
management (Houqe et al., 2017). Companies with strict
governance and good performance will voluntarily use This study uses manufacturing companies in the
qualified auditors to maintain their good reputation and consumer goods industry sector, which are listed on
show that they have nothing to hide. This condition will be the Indonesia Stock Exchange from 2016 to 2018 as the
responded positively by investors because the company is population. This sector was chosen because the consumer
considered to have low risk, so the required rate of return goods industry is a sector that is able to survive in a
will be low. Consequently, the cost of equity capital borne downturn in economic conditions, so it becomes a good
by the company will be low. investment opportunity in the future. The sample selection
Research by Setiawan and Daljono (2014) shows that method used was purposive sampling, with the following
companies audited by public accounting firms affiliated criteria: (1) presenting financial reports for the period 2016
to the Big Four have a lower cost of equity capital. This is to 2018 and (2) having complete data.
because the quality of the audit increases the transparency
of the reporting and disclosure of the company, so that the 3.2. Operational Definition and
risk of the company is assessed low by investors, which will Variables Measurement
ultimately lower the rate of return demanded by investors.
This finding is supported by the results of research by Houqe The cost of equity capital as the dependent variable is
et al. (2017), which shows that audit quality can reduce the proxied by using the Ohlson (1995) model. The model
cost of equity capital. Therefore, the hypothesis is formulated calculate the cost of equity capital using the formula as
as follows: follows:

H2: Audit quality has a negative effect on the cost of r = (Bt + Xt + 1 - Pt) / (Pt)
equity capital.
Where:
2.3. Earnings Management, Audit Quality Pt : Share price in period t
Bt : Book value per share for period t
and Cost of Equity Capital Xt+1 : Earnings per share in period t + 1
Based on the perspective of agency theory, external r : Cost of equity capital
auditors can be used as a monitoring mechanism to align Earnings per share for the next year (Xt + 1) is estimated
interests between shareholders and management. This using random walk model.
772 Maria Goreti Kentris INDARTI, Jacobus WIDIATMOKO / Journal of Asian Finance, Economics and Business Vol 8 No 4 (2021) 0769–0776

Random Walk: CEC = 

α + β1EM + β2AQ + β3EM_AQ + β4LEV
+ β5SIZE + e
E(Xt + 1) = Xt + d
Where: Where:
E(Xt + 1) : Estimated earnings per share in period t + 1 CEC : Cost of equity capital
Xt : Earnings per share in period t α : Constant
d : Drift Term (average earnings per share β : Regression coefficient
for 5 years) EM : Earnings management
AQ : Audit quality
Earnings management is measured using a specific LEV : Leverage
accrual model, namely the ratio of working capital accruals SIZE : Firm size
to sales. This method is considered more appropriate with e : Error term
sales because earnings management occurs a lot in sales
accounts (Nelson et al., 2005). The formula used to calculate
earnings management is:
4.  Results and Discussion

Earnings Management (EM) = Working Capital Accural 4.1.  Descriptive Statistics

/ Sales
Working Capital Accural = ∆CA - ∆CL - ∆Cash Based on the criteria for selecting the sample,
131 data were obtained. After transforming the data to
Where: achieve residual normality, there were 16 outliers released so
∆CA : Change in current assets in period t that the number of data analyzed was 115. Table 1 presents
∆CL : Changes in current liability in period t descriptive statistics for all research variables in the form
∆Cash : Change in cash and cash equivalents in of minimum values, maximum values, mean values, and
period t deviation standard.
The average cost of equity capital is negative, indicating
Referring to the research of Setiawan and Daljono
that the companies in the sector under study have a relatively
(2014), audit quality is measured using the dummy variable,
low risk. A positive number on the average value of
namely, the value of 1 for companies audited by firm
earnings management means that the sample companies are
affiliated with Big Four audit firms and 0 for the opposite.
aggressively managing earnings. The information in Table 1
Auditors at Big Four audit firms are considered to have high
also shows that 43% of the sample companies were audited
values of independence, objectivity, and honesty. This study
by Big Four audit firms and the remaining 57% were audited
used two control variables, namely, leverage and firm size.
by non-Big Four audit firms. Based on the descriptions of the
Leverage is measured by debt-to-total asset and company
three variables, it can be concluded that, although the sample
size is measured by the natural logarithm of the company’s
companies on average carry out earnings management
total assets (Widiatmoko & Indarti, 2019).
aggressively, the level of return demanded by investors is
3.3.  Data Analysis Techniques relatively low due to low corporate risk. This occurs because
of investor confidence in external auditors who are members
The data analysis technique used in this study is of the Big Four audit firms.
moderated regression analysis (MRA) with the following The leverage variable as a control variable shows a
equation: minimum value of 0.1872, a maximum value of 31.0367,

Table 1:  Descriptive Statistics

Variables N Minimum Maximum Mean Std. Deviation
CEC 115 -1.8402 1.5870 -0.2203 0.4546
EM 115 -0.7822 1.4720 0.0008 0.2000
EM_AQ 115 -0.7822 1.4720 -0.0162 0.1857
LEV 115 0.1872 31.0367 1.3833 3.1440
SIZE 115 16.3490 26.6234 21.6833 1.8137
Variables N Audit Firm Total (%) Audit Firm Total (%)
AQ 115 Big Four 50 (43%) Non Big Four 65 (57)
Note: CEC: Cost of Equity Capital, EM: Earnings Management, AQ: Audit Quality, LEV: Leverage, Size: Firm Size.
 Maria Goreti Kentris INDARTI, Jacobus WIDIATMOKO / Journal of Asian Finance, Economics and Business Vol 8 No 4 (2021) 0769–0776 773

and an average value of 1.3833 with a standard deviation of negative correlation with earnings management, meaning that
3.1440. These results indicate that the average level of debt the presence of qualified auditors will be able to minimize
owned by the company is above its total assets. Meanwhile, earnings management practices. However, when the company
the company size variable shows a minimum value of is audited by a qualified public accounting firm, earnings
16.3490, a maximum value of 26.6234, and an average management will reduce the cost of equity capital. This can
value of 21.6833 with a standard deviation of 1.8137. This be seen in the negative relationship between the interaction
condition shows that the distribution of data for company of earnings management and audit quality with the cost of
size is relatively even. equity capital. These results indicate that in determining
the expected rate of return, investors are more based on the
4.2.  Pearson Correlation Matrix quality of the external auditors who audit the company.

Table 2 shows that the magnitude of the correlation 4.3.  Test Results of Moderated Regression Analysis
between the independent variables is below 0.5, which means
that in this study there is no collinearity problem. These results The results of the residual normality test as seen in Table 3
are in accordance with the results of the multicollinearity show the z-skewness number of 0.181, between ±1.96,
test presented in Table 3. Earnings management has a so that the residuals in the regression model are normally
significant positive relationship with the cost of equity distributed. Based on Table 3, the multicollinearity test
capital. This means that earnings management actions will results show that all variables have a variance inflation
be responded negatively by the market, thereby increasing factor (VIF) value of less than 10, the durbin-watson value
the return demanded by investors. Conversely, audit quality is 1.605, is between the du 1.583 and 4-du values of 2.417,
has a significant negative relationship with the cost of equity and the heteroscedasticity test shows that all variables has
capital. The financial statements audited by Big Four KAP are a significance value above 0.05, so that in the regression
seen to provide better quality information, thereby reducing model there are no multicollinearity, autocorrelation, and
the cost of equity capital. The audit quality variable has a heteroscedasticity problems.

Table 2:  Pearson Correlation Matrix

EM AQ CEC EM_AQ LEV SIZE

EM Pearson Correlation 1 -0.168* 0.583** -0.124 0.936** -0.221**
Sig. (1-tailed) 0.036 0.000 0.093 0.000 0.009
N 115 115 115 115 115 115
AQ Pearson Correlation -0.168* 1 -0.395** 0.133 -0.100 0.318**
Sig. (1-tailed) 0.036 0.000 0.079 0.144 0.000
N 115 115 115 115 115 115
CEC Pearson Correlation 0.583** -0.395** 1 -0.294** 0.534** -0.324**
Sig. (1-tailed) 0.000 0.000 0.001 0.000 0.000
N 115 115 115 115 115 115
EM_AQ Pearson Correlation -0.124 0.133 -0.294** 1 -0.111 -0.058
Sig. (1-tailed) 0.093 0.079 0.001 0.118 0.270
N 115 115 115 115 115 115
LEV Pearson Correlation 0.936** -0.100 0.534** -0.111 1 -0.194*
Sig. (1-tailed) 0.000 0.144 0.000 0.118 0.019
N 115 115 115 115 115 115
SIZE Pearson Correlation -0.221** 0.318** -0.324** -0.058 -0.194* 1
Sig. (1-tailed) 0.009 0.000 0.000 0.270 0.019
N 115 115 115 115 115 115
Note: CEC: Cost of Equity Capital, EM: Earnings Management, AQ: Audit Quality, LEV: Leverage, Siz: Firm Size.
** Significant at the Level of 1%, * Significant at the Level of 5%.
774 Maria Goreti Kentris INDARTI, Jacobus WIDIATMOKO / Journal of Asian Finance, Economics and Business Vol 8 No 4 (2021) 0769–0776

Table 3:  Moderated Regression Analysis Results

Unstandardized Collinearity Heteroscedasticity

Model Coefficients t Sig. Statistics Test

B Std. Error Tolerance VIF t Sig.

(Constant) 0.756 0.398 1.899 0.060 0.541 0.590
EM 1.010 0.456 2.217 0.029 0.117 8.542 -1.123 0.264
AQ -0.218 0.068 -3.206 0.002 0.847 1.180 1.877 0.063
EM_AQ -0.031 0.010 -3.016 0.003 0.956 1.046 0.710 0.479
LEV 0.100 0.485 0.206 0.837 0.120 8.350 1.032 0.304
SIZE -0.039 0.019 -2.082 0.040 0.856 1.169 0.372 0.710
Z skewness 0.181
Adjusted R Square 0.464
F Statistics: 20.728
Sig. 0.000
Note: Dependent Variable: CEC: Cost of Equity Capital, EM: Earnings Management, AQ: Audit Quality, LEV: Leverage, Size: Firm Size.

The coefficient of determination in Table 3 shows a value capital costs. The explanation that can be given to this
of 0.464, which means that 46.4% of the variation in the cost result is that earnings management can lower the quality of
of equity capital can be explained by earnings management earnings information delivered by the company, so that the
variables, audit quality, the interaction between earnings company is seen as risky by investors. Therefore, the market
management and audit quality, leverage, and company size, will demand higher premium risk as a result of the additional
while the remaining 53.60% explained by other variables risk caused by accrual earnings management activities. As a
outside the model. The calculated F value shows a significant result, the cost of equity capital will increase. Research by
number of 20,728 at the level of 0.000, which means that Meini and Siregar (2014) and Kiswanto and Fitriani (2019)
together the earnings management variables, audit quality, conducted in Indonesia, show that earnings management
the interaction between earnings management and audit has a positive effect on equity capital. These findings are
quality, leverage, and firm size affect the cost of equity supported by the findings of O’Callaghan, Ashton, and
capital, so the model is declared feasible. Hodgkinson (2018), which show that the higher the level
The results of hypothesis testing of earnings management of earnings management, the higher the equity capital costs
variables show a beta coefficient value of 1.010 with a incurred by the company. Companies with a high level of
significance level of 0.029. Therefore the first hypothesis, earnings management are considered to have high risk by
which states that earnings management has a positive effect the market. As a result, investors will request a high rate of
on the cost of equity capital, is accepted. The audit quality return as a consequence of the risk they bear.
variable has a beta coefficient of -0.218 with a significance The results of the second hypothesis testing indicate that
level of 0.02, which means that audit quality has a significant audit quality as measured by audit firm affiliation to Big
negative effect on the cost of equity capital, as hypothesized. Four and non-Big Four audit firms has a negative effect on
The interaction between earnings management variables and the cost of equity capital. Audit quality is seen as a positive
audit quality shows a beta coefficient value of -0.031 with signal for the quality of information presented by the
a significance value of negative effect and a significant level company (Houqe et al., 2017). This is because the quality
of 0.003. As predicted, audit quality moderated the effect of of the audit increases the transparency of the reporting and
earnings management on the cost of equity capital. Testing disclosure of the company, so that the risk of the company
of leverage and firm size as control variables shows that firm is assessed low by investors, which will ultimately lower
size has a significant negative effect on the cost of equity the rate of return demanded by investors. The results of this
capital, but leverage has no effect on the cost of equity capital. study are in line with the findings of Setiawan and Daljono
(2014), and Houqe et al. (2017), which shows that audit
4.4. Discussion quality can reduce the cost of equity capital.
The test on the third hypothesis shows that audit quality
Based on the information in Table 3, it can be seen moderates the effect of earnings management on the cost of
that earnings management has a positive effect on equity equity capital. Even though the company carries out earnings
 Maria Goreti Kentris INDARTI, Jacobus WIDIATMOKO / Journal of Asian Finance, Economics and Business Vol 8 No 4 (2021) 0769–0776 775

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