Corruption and earnings quality: further evidence and exploration from Indonesia

Sudaryono, Eko Arief; Widarjo, Wahyu; Probohudono, Agung Nur; Putra, Adhitya Agri; Aligarh, Frank Article Corruption and earnings quality: further evidence and exploration from Indonesia Cogent Economics & Finance Provided in Cooperation with: Taylor & Francis Group Suggested Citation: Sudaryono, Eko Arief; Widarjo, Wahyu; Probohudono, Agung Nur; Putra, Adhitya Agri; Aligarh, Frank (2024) : Corruption and earnings quality: further evidence and exploration from Indonesia, Cogent Economics & Finance, ISSN 2332-2039, Taylor & Francis, Abingdon, Vol. 12, Iss. 1, pp. 1-22, https://doi.org/10.1080/23322039.2024.2370913 This Version is available at: https://hdl.handle.net/10419/321525 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Cogent Economics & Finance ISSN: 2332-2039 (Online) Journal homepage: www.tandfonline.com/journals/oaef20 Corruption and earnings quality: further evidence and exploration from Indonesia Eko Arief Sudaryono, Wahyu Widarjo, Agung Nur Probohudono, Adhitya Agri Putra & Frank Aligarh To cite this article: Eko Arief Sudaryono, Wahyu Widarjo, Agung Nur Probohudono, Adhitya Agri Putra & Frank Aligarh (2024) Corruption and earnings quality: further evidence and exploration from Indonesia, Cogent Economics & Finance, 12:1, 2370913, DOI: 10.1080/23322039.2024.2370913 To link to this article: https://doi.org/10.1080/23322039.2024.2370913 © 2024 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group Published online: 27 Jun 2024. Submit your article to this journal Article views: 1188 View related articles View Crossmark data Citing articles: 2 View citing articles Full Terms & Conditions of access and use can be found at https://www.tandfonline.com/action/journalInformation?journalCode=oaef20 GENERAL & APPLIED ECONOMICS | RESEARCH ARTICLE Corruption and earnings quality: further evidence and exploration from Indonesia Eko Arief Sudaryono a , Wahyu Widarjo a , Agung Nur Probohudono a , Adhitya Agri Putra a,b and Frank Aligarh a,c a Faculty of Economics and Business, Universitas Sebelas Maret, Surakarta, Indonesia; b Faculty of Economics and Business, Universitas Riau, Pekanbaru, Indonesia; c Faculty of Islamic Economics and Business, Universitas Islam Negeri Raden Mas Said Surakarta, Surakarta, Indonesia ABSTRACT Corruption within corporate entities continues to be a relatively overlooked yet significant issue to date. This study seeks to investigate the impact of corruption on the quality of earnings. The sample comprises 846 firm-years listed on the Indonesian Stock Exchange. Earnings quality encompasses factors such as earnings persistence, earnings value relevance, and earnings predictability. Corruption is gauged by the corruption per capita in the region where the firms are headquartered. The data analysis employs regression models incorporating firm and province effects. Broadly, the findings of this study indicate that corruption diminishes earnings quality. Heightened corruption is associated with weakened controlling and monitoring functions, increased information asymmetry, and diminished managerial quality, all contributing to a decline in earnings quality. This research not only expands upon previous studies but also reaffirms the relevance of the social capital concept while presenting new empirical evidence within a context of a country with a higher corruption perception index, such as Indonesia. IMPACT STATEMENT The relationship between corruption and earnings quality becomes a new insight for public. Regulator and society can maintain the good norm and value to reduce the bad impact of corruption into social capital. Indonesia has an increasing corruption perception so regulator, society, and business participants can improve the controlling and monitoring function to avoid misbehavior. Specifically, business participants can avoid misbehavior of report the lower quality earnings. It is new evidence in Indonesia and expected to be a consideration to formulate public and business policy in Indonesia ARTICLE HISTORY Received 13 February 2024 Revised 9 May 2024 Accepted 13 June 2024 KEYWORDS Corruption; earnings quality; earnings persistence; earnings value relevance; earnings predictability REVIEWING EDITOR Chris Jones, Aston University, United Kingdom of Great Britain and Northern Ireland SUBJECTS Business, Management and Accounting; Finance; Economics 1. Introduction The primary objective of this study is to assess the impact of corruption on earnings quality. Unlike previous studies, which predominantly examined the influence of corruption on earnings quality at the national level and conducted cross-country analyses by considering law and regulation violations (El- Helaly et al., 2020; Lei & Wang, 2019; Lourenc¸o et al., 2018; Mamatzakis & Bagntasarian, 2022), this study focuses on the Indonesian context. Specifically, the relationship between corruption and earnings quality in Indonesia has traditionally been explored through an analysis of anti-corruption disclosures. In contrast to these earlier studies, this study uniquely delves into the impact of corruption at the local level on firms’earnings quality. This is achieved by incorporating social capital as the principal mechanism that influences managerial behavior within firms (Cho et al., 2020; Jha, 2019). Social capital posits that corruption at the local level, where firms are headquartered, shapes social norms and values through CONTACT Eko Arief Sudaryono [email protected] Faculty of Economics and Business, Universitas Sebelas Maret, Surakarta, Indonesia ß2024 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group This is an Open Access article distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. The terms on which this article has been published allow the posting of the Accepted Manuscript in a repository by the author(s) or with their consent. COGENT ECONOMICS & FINANCE 2024, VOL. 12, NO. 1, 2370913 https://doi.org/10.1080/23322039.2024.2370913 interactions with local government institutions and is subsequently absorbed into the corporate culture of these firms. There are some studies that find the relationship between corruption and corporate reporting. Lewellyn and Bao (2017) examine the national-level corruption on earnings management globally and find corruption increases earnings management. Sousa et al. (2023) find inconsistent relationship between corruption and earnings management in Latin American, North America, and Caribbean. Chen et al. (2020), Hope et al. (2020), and Xu et al. (2019) find the relationship between corruption and reporting quality in China. Previous studies examine the relationship between corruption and corporate reporting in the context of lower diversity of cultures. Since corruption can affect reporting behavior by culture absorption, it is important to examine the relationship between corruption and corporate reporting in the context of higher diversity of cultures such as Indonesia. Different with Latin American, North America, Caribbean, and China; there are a lot diversity from culture, ethnicity, religion, to sects of belief in Indonesia that can be absorbed as corporate culture for firms (Christy et al., 2022; Supriatna et al., 2023). In this case, it is important to examine the local corruption level in the Indonesian provinces on earnings quality since each province has different social capital belief and norm that can be absorbed by firms. In contrast, Lourenc¸o et al. (2018) suggest that corruption, which promotes a society’s misbehavior, can be prevented by firms. One solution for firms that do not absorb corrupt behavior is to have effective corporate governance (Boateng et al., 2021). Hofmann and Schwaiger (2020) suggest that lower social capital has two impacts on firms: misbehavior by managers and firms with better corporate governance mechanisms. In this case, earnings quality can still be improved if firms in a corrupt society have good corporate governance (Asogwa et al., 2019; Hashmi et al., 2022; Lustrilanang et al., 2023). Furthermore, corporate governance helps firms maintain earnings quality and achieve firm stability (Thoha et al., 2022). Some studies have found that corporate governance, such as CEO characteristics, can improve financial reporting (Zalata et al., 2019a,2019b,2022). This study makes several contributions. First, it extends the relationship between corruption and earnings quality, where previous studies (El-Helaly et al., 2020; Lei & Wang, 2019; Lourenc¸o et al., 2018; Mamatzakis & Bagntasarian, 2022) do not capture social capital in the location where firms are headquartered. Second, this study contributes to the literature by providing evidence that corrupted social capital can affect firms’culture and managers’behavior in reporting lower-quality earnings. Third, this study contributes to extending the effect of corruption on earnings attributes. Some studies have examined the effect of corruption on earnings attributes of accrual quality (Y. Chen et al., 2020; Picur, 2004), classification shifting (Lei & Wang, 2019), accrual earnings management (Lourenc¸o et al., 2018;A.H. Nguyen & Duong, 2020; H. Xu et al., 2019), real earnings management (H. Xu et al., 2019), and earnings smoothing (Picur, 2004). This study provides evidence of earnings attribute quality, especially the attributes of earnings persistence, value relevance, and predictability. Fourth, this study provides new evidence of corruption and earnings quality in Indonesia, where the corruption perception index continues to increase. Earnings quality is an important issue because there are some earnings manipulation and misstatement cases that lead to earnings becoming invalid information. In 2018, PT Garuda Indonesia boosted their earnings to USD 809.85 thousand by recognizing a 15 years contract value as current revenue all at once (Uly, 2019). Earnings manipulation and misstatements fail to provide high-quality information to users. In this study, earnings quality includes persistence, value relevance, and predictability. Earnings persistence is important to users of information and decision-makers by showing them that earnings are persistent, sustained, and stable. Persistent earnings show that firms can consistently maintain their business processes and recur in the future (Aharony et al., 2000; C. J. P. Chen et al., 2001; Graham & King, 2000). In the performance evaluation context, earnings persistence provides information on management’s ability to maintain their performance more consistently from time to time. In the performance prediction context, earnings persistence helps decision makers predict future performance more accurately because persistent earnings provide sustainability information features (Collins et al., 1994). When earnings are persistent and can be used to predict future performance, it is relevant to make decisions. Earnings persistence, value relevance, and predictability complement each other to provide high-quality 2 E. A. SUDARYONO ET AL. earnings information. Since managers’incentives can be affected by market and political forces, managers can determine accounting, including earnings and information quality, by considering the conditions of the market and political environment (Ball et al., 2003). This study examines the effect of corruption on the earnings quality of manufacturing firms on the Indonesian Stock Exchange. Earnings quality includes persistence, value relevance, and predictability. Hu et al. (2023) explained that most corruption and bribery occur in the supply chain process by manufacturing firms. In Indonesia, manufacturing firms such as PT Krakatau Steel and PT Grand Kartech in 2019 were corruption cases (Kompas.Com, 2019). 2. Background Political force can provide managers with incentives related to cash holdings, investments, and stock prices (Fan et al., 2008; Jens, 2017; Wu et al., 2012; N. Xu et al., 2016). Local corruption is a political factor. Corruption refers to the abuse of power to gain private benefit (Cuervo-Cazurra, 2016). Figure 1 shows that Indonesia had a growing corruption perception index score from Indonesia to 2012–2019. The corruption perception index represents how corrupt the country is. A higher corruption perception index indicates a higher level of corruption in the bureaucracy of a country (Setyobudi & Setyaningrum, 2019). This indicates that Indonesia experienced a higher level of corruption in the last eight years. Corruption has an impact on earnings quality. First, higher political corruption reflects lower regulation implementation, law enforcement, (Seligson, 2002) and poor government effectiveness (Friedman et al., 2000). This leads managers to be less concerned about the litigation risk of earnings manipulations (H. Xu et al., 2019). Boonlert-U-Thai et al. (2006) explain that lower regulations and law enforcement lead to lower earnings information quality. Second, the secret illegal movement characteristic causes corruption, resulting in higher information asymmetry (Chaney et al., 2011). Third, since managers tend to have lower quality when surrounded by a politically corrupt culture (Athanasouli & Goujard, 2015), lower-quality managers fail to maintain earnings quality (Demerjian et al., 2013; Simamora, 2021). 3. Theoretical literature review 3.1. Corruption Corruption is defined as the abuse of power to gain private benefits (Cuervo-Cazurra, 2016). Specifically, it refers to a criminal act in public government offices (Shleifer & Vishny, 1993). It becomes a culture for local individuals in a certain region, where corruption allows them to believe that the abuse of power is common and acceptable (DeBacker et al., 2015; Fisman & Miguel, 2007). These individuals then join firms while bringing about beliefs in unethical behavior, such as corruption (Liu, 2016). Pricewaterhouse Coopers (2016) explains that corruption leads firms to bear the costs of law violations and have a bad Figure 1. Corruption perception index score in Indonesia. COGENT ECONOMICS & FINANCE 3 reputation. Smith (2016) suggested that firms in regions with higher corruption have different financial policies than those in less corrupt regions. Since corruption is identical to misbehavior in public government offices, it is often associated with political connections and forces (Y. Chen et al., 2020). Chaney et al. (2011) found that firms’political connections reduce their earnings quality. Hope et al. (2020) found that directors who have a position in government offices have an impact on information transparency. Zhang (2018) also found that corruption reduction decreases firms’fraud. In 2020, Indonesia ranked 102nd based on the corruption perception index from a total of 180 countries (Transparency International, 2021). The Indonesian corruption perception index still increased from 2015 to 2019 due to the rise in political risk and the decline in law enforcement (Komisi Pemberantasan Korupsi, 2020). 3.2. How corruption affects corporate managers’behavior: the concept of social capital Social capital collectively explains the characteristics of people’s behavior in the same social group (Adler & Kwon, 2002; Woolcock, 2001). Social capital provides a norm in a specific region that promotes how people treat one another, especially in the context of the values of obligation, mutual trust, and a dense network to generate effective oversight (Jha, 2019). Regarding corporate activities, the values of the norm in a specific region of society where the firms are headquartered also matter (Fukuyama, 1995), especially to determine how firms’managers will behave (James S. Coleman, 1990; Spagnolo, 1999). Social capital impacts organizational actions, including financial reporting. Solomon (2004) explains that people tend to consider ethical values in society when deciding on business decisions. Since firms’ culture and norms sync with the regional social norms where the firms are headquartered, managers tend to consider similar norms when they make a strategy for financial reporting (Cho et al., 2020; Jha, 2019). Jha (2019) formulated the relationship between social capital and financial reporting, where better social capital brings specific norms to organizational culture. Corruption is an indicator of social capital value. As part of society, government institutions also contribute to social capital. Corrupted government institutions can also contribute to the corrupt behavior of other members of society, including the community and firms. By interacting with society, government institutions can promote corrupt behavior in communities and firm managers. Corruption encourages society members to have lower levels of trust (Andriani, 2021; Banerjee, 2016), legal violations (Andriani, 2021; Bondeli et al., 2021), and fraud (Banerjee, 2016). In the context of firms’managers’behavior, corruption affects managers’behavior to perform fraudulent actions, including financial reporting, which can reduce earnings quality. There is some argument as to why corrupt social capital reduces earnings quality. Controlling and monitoring functions play important roles in maintaining earnings quality (Gaio & Raposo, 2011). Since firms are active responders to regulation and law dynamics (Galang, 2012), there is a possibility that they tend to absorb corruption culture into the organization and their managers (Y. Chen et al., 2020). Second, lower earnings quality can result from higher information asymmetry (H. Xu et al., 2019) because corruption has the characteristic of secret moves, which leads to information asymmetry (Chaney et al., 2011). Third, managers tend to be of lower quality in regions with higher levels of corruption (Athanasouli & Goujard, 2015). A corruption culture allows managers to do bribes to regulators of business contracts and benefits (H. Xu et al., 2019). Lower-quality managers tend to manipulate earnings because they fail to improve performance (Picur, 2004; Simamora, 2021). 3.3. Agency theory Agency theory explains the relationship between managers and owners, especially the agency conflict that happens between managers and owners (Jensen & Meckling, 1976). Agency conflict occurs when managers fulfill more their interests than owners’interests. Agency conflict can be manifested in lower earnings quality. Lower earnings quality comes from the condition of information asymmetry where managers have more information about firms’activities than owners. Owners’interests of higher information quality cannot be fulfilled when there is information asymmetry (Islam et al., 2022). 4 E. A. SUDARYONO ET AL. Corruption in the region where firms are headquartered enhances the condition of higher information asymmetry. First, corruption captures higher hidden transactions which indicates higher information asymmetry (Chaney et al., 2011). Second, corruption also is an indicator of ineffective governance since weaker law and regulation implementation occur (Seligson, 2002). Nguyen and Truong (2022) explain that information asymmetry cannot be mitigated if there is no effective governance implementation. 3.4. Framework of theory Framework of theory is the framework that explain the use of the theory in the context of the research. In this case, framework of theory explains how the concept of social capital and agency theory capture the relationship between corruption and earnings quality. The framework of theory can be seen in Figure 2. Figure 2 shows that corruption is external condition. Corruption promotes information asymmetry (secret moves) and ineffective governance (weak law and regulation enforcement). In this case, corruption becomes social capital that is also absorbed by firms’managers. Firms’managers have behavior that relate to corruption behavior. Since there is a conflict between managers and owners, managers fulfill their interests and avoid owners’interests by performing corrupted behavior under internal conditions of information asymmetry and ineffective governance. The result of corrupted managers’behavior is lower earnings quality. 4. Empirical literature review and hypothesis development 4.1. Corruption and earnings quality Corruption captures the condition of the information environment and impacts information quality, including earnings quality. First, corruption promotes lower regulations and law enforcement (Seligson, 2002). Corruption shows poor governmental effectiveness (Friedman et al., 2000). Regulation and law enforcement are important for determining the effectiveness of controlling and monitoring functions. Controlling and monitoring functions play important roles in maintaining earnings quality (Gaio & Raposo, 2011). Since firms are active responders to regulation and law dynamics (Galang, 2012), there is a possibility that they tend to absorb corruption culture into the organization and their managers (Y. Chen et al., 2020). In this case, firms are less obedient to the law and regulations (Shleifer & Vishny, 1993), and are less concerned about litigation risk (H. Xu et al., 2019). Lower regulations and law enforcement lead to higher earnings manipulation (H. Xu et al., 2019) and lower earnings quality (Boonlert-U-Thai et al., 2006). Second, lower earnings quality can result from higher information asymmetry (H. Xu et al., 2019) because corruption has the characteristic of secret moves, which leads to information asymmetry (Chaney et al., 2011). Information asymmetry captures information risk and uncertainty (Deakins & Hussain, 1994). Figure 2. Framework of theory. COGENT ECONOMICS & FINANCE 5 Chaney et al. (2011) also found that regions with higher political corruption provide higher information risk and uncertainty due to lower financial reporting quality. Third, managers tend to be of lower quality in regions with higher levels of corruption (Athanasouli & Goujard, 2015). A corruption culture allows managers to do bribes to regulators of business contracts and benefits (H. Xu et al., 2019). This shows that managers fail to implement an effective and efficient managerial function because they use bribes rather than other lawful alternative strategies. Lower-qual- ity managers tend to manipulate earnings because they fail to improve performance (Picur, 2004; Simamora, 2021). Demerjian et al. (2013) and Simamora (2021) found that lower-quality managers lead to lower earnings quality. Earnings quality refers to the ability of earnings information to inform a firm of its condition (Menicucci, 2020; Schipper & Vincent, 2003). Based on agency theory, the lower controlling and monitoring functions provided by corruption cultures fail to reduce agency conflict and information asymmetry, leading to lower earnings quality. The types of earnings quality depend on the context and earnings information users (Menicucci, 2020). In this study, earnings quality includes persistence, value relevance, and predictability. Damijan (2023) explained the concept of corruption. In the early stage, corruption was defined as the abuse of power by the government because the government has greater power than other institutions, including law and regulation violations. Damijan (2023) also explains that the corruption definition was developed in the 19 th century as a systematic process to use privileges for private benefits. In the 20 th century, corruption not only covered the government’s behavior but also individuals, including private organizations (Damijan, 2023). Based on the definition of corruption, the corruption concept is initiated from the abuse of power by government institutions, and it also applies to individuals in private organizations, including firms’managers. Firms’managers can be corrupted by breaking laws or abusing their powers. In the concept of social capital, corrupted firm managers come from the social norms around firms that have been absorbed, leading managers to report lower-quality earnings. 4.2. Hypotheses Earnings persistence refers to the ability of earnings to recur (Francis et al., 2004). This also shows the relationship between current and future earnings. Earnings persistence evaluates how persistent, sustained, and consistent the earnings are. Earnings persistence is useful in predicting future earnings using current earnings information. Earnings persistence can be reduced if firms face higher levels of uncertainty. This uncertainty makes it difficult for firms to engage in persistent and sustainable business activities (Canina & Potter, 2019). The risk of business uncertainty can be attributed to the culture of organizational corruption. As corruption promotes weaker regulation implementation and law enforcement, firms will absorb it by implementing weaker monitoring and controlling functions. Strict monitoring and controlling functions are needed to ensure persistent and sustainable business activities. Weaker monitoring and controlling functions lead firms to fail in mitigating uncertain business conditions and unpredictable events. Eldridge et al. (2013) found that a control system was related to uncertainty mitigation. Lower earnings persistence also comes from lower manager ability (Demerjian et al., 2013; Simamora, 2021), especially in corrupt regions, since most lower-ability managers are in regions with higher corruption levels (Athanasouli & Goujard, 2015). H1: Corruption reduces earnings persistence Earnings value relevance refers to the relevance of earnings to be used in decision making. In the stock market context, decision making occurs when investors use earnings information to make stock investment decisions (Francis et al., 2004). Investors’decisions are reflected in stock returns, which are represented as the earnings response coefficient (Collins et al., 1994). The negative responses of investors to earnings information show that earnings are less relevant to decision-making. Lower earnings relevance comes from firms that absorb corrupt culture into their organizations. Cao et al. (2019) found that the stock market responds negatively to firms headquartered in corrupt regions. Investors’assessment of irrelevant earnings information comes from the argument that corruption provides lower controlling and 6 E. A. SUDARYONO ET AL. monitoring functions, higher asymmetric information, and lower managerial quality. Previous studies have found that lower controlling and monitoring functions (Ujan & Mukhlasin, 2019), higher information asymmetry (Lin et al., 2007), and lower managerial quality (Fanani & Merbaka, 2020; Simamora, 2021) lead to lower earnings value relevance. H2: Corruption reduces earnings value relevance Earnings predictability is the ability of earnings to predict future performance. Future performance is reflected in the relationship between current stock returns and future earnings as a future earnings response coefficient (Collins et al., 1994). Future earnings responses show how far future earnings can be reflected in the current stock returns. As corruption brings a lower reputation (Pricewaterhouse Coopers, 2016) and higher earnings manipulation(H. Xu et al., 2019), earnings cannot be used to predict future performance. In addition, lower earnings predictability can be attributed to the arguments that corruption provides lower controlling and monitoring functions, higher information asymmetry, and lower managerial quality. Previous studies have found that lower controlling and monitoring functions (Suh & Fernando, 2013), higher information asymmetry), and lower managerial quality (Fanani & Merbaka, 2020; Simamora, 2021) lead to lower earnings predictability. H3: Corruption reduces earnings predictability 5. Research design 5.1. Sample The research sample included manufacturing firms listed on the Indonesian Stock Exchange from to 2008–2016. Manufacturing firms always adjust their selling prices because of market uncertainty from the distributor to the end customer (Rasmussen, 2013). In this case, there is higher revenue and earnings variability (H. Ahmed & Azim, 2015). It leads to lower earnings persistence and is hard to be used to predict future performance. First, revenue and earnings variability in manufacturing sectors can bring uncertainty for managers and lead to opportunist behavior of earnings management that can reduce earnings quality (Rigamonti et al., 2024). Second, complex characteristic of supply chain manufacturing sector can also bring risk of bribery and corruption, such as government subside or price control that bring firms to political transaction (Arsandi, 2022; Demir et al., 2022; Kim et al., 2023; Mauro, 1997). The total sample included 846 manufacturing firm years, as shown in Table 1. 5.2. Empirical model This study examined the effects of corruption on earnings quality. Earnings quality is measured using a model of earnings persistence, earnings value relevance, and predictability. The earnings persistence model is shown in Equation (1) (Demerjian et al., 2013; Francis et al., 2005; Li, 2019). The earnings value relevance and predictability model is shown in Equation (2) (Collins et al., 1994). ROAtþ1or ROAtþ1,tþ3¼aþb1ROAtþ1þe(1) Rt¼aþb1Et−1þb2Etþb3Etþ1,tþ3þb4Rtþ1,tþ3þe(2) Coefficient b1 in Equation (1) represents earnings persistence, which shows the relationship between current and future earnings. Coefficient b2 in Equation (2) represents earnings value relevance, which shows the current earnings response coefficient. Coefficient b3 in Equation (2) represents earnings Table 1. Sample. Sample Firm-year Manufacturing firms listed on the Indonesian Stock Exchange (2008–2016) 909 Less: Incomplete data (63) Total 846 COGENT ECONOMICS & FINANCE 7 6.6. Regression analysis for each province This study also examines the effect of corruption on earnings quality for each province since this research uses corruption in the local government level. In this research, there are 4 provinces of Jakarta, East Java, West Java, and East Kalimantan. There are 684 samples for Jakarta, 99 samples for East Java, 54 samples for West Java, and 9 samples for East Kalimantan. This research only examines the effect of corruption on earnings quality separately for Jakarta and East Java. East Kalimantan cannot be examined separately since the corruption case in this province is 0. Number of samples for West java and East Kalimantan do not provide enough variance of the variables. The results for earnings persistence and corruption are shown in Table 12, while the results for earnings value relevance, predictability, and corruption are shown in Table 13. Based on Table 12, in the regression model of ROA tþ1 , the interaction variable between the current return on assets and corruption (ROA t COR) for group of samples in Jakarta has a coefficient value of −159,092.2910 with a t-statistic of −4.8373 (significant in 0.01). In the regression model of ROA tþ1,tþ3 ,the interaction variable between the current return on assets and corruption (ROA t x COR) for group of samples in Jakarta has a coefficient value of −138,891.6000 with a t-statistic of −5.8373 (significant at 0.01). This indicates that the results in Table 12 are consistent with the main result in Table 4, where corruption reduces current earnings persistence in the next year and the average earnings of the next three years. In the regression model of ROA tþ1 , the interaction variable between the current return on assets and corruption (ROA t COR) for group of samples in East Java has a coefficient value of −80,787.3100 with Table 10. Earnings persistence and corruption (under heteroscedasticity condition). Dependent Var ROA tþ1 ROA tþ1,tþ3 Independent Var Coeff t-Stat Coeff t-Stat ROA t 0.5657 7.0114 0.5392 9.1439 ROA t x COR 2125725.9000 22.8981 2251440.8000 22.5068 COR −5887.4870 −0.8636 3648.2880 0.5715 SIZE 0.0037 0.3737 0.0054 0.6162 SALES 0.0037 1.85310.0028 1.7154 EARN −0.2125 −2.1941 −0.2332 −2.6444 OCF 0.0591 0.7094 0.0587 0.8581 FCF −0.0069 −12.6448 −0.0022 −13.4010 AG 0.0679 1.0278 0.0084 1.9252 CEO 0.0021 1.1001 0.0021 0.9418 CFO −0.0012 −0.9879 −0.0022 −0.3465 Constant −0.0678 −0.0448 Adjusted R-squared 0.2386 0.2704 F-statistic 30.4348 36.0879 Significant in 0.01, significant in 0.05. Table 11. Earnings value relevance and predictability and corruption (under heteroscedasticity condition). Independent Var Coeff t-Stat E t-1 0.2899 1.8993 E t 0.3836 1.9125 E tþ1,tþ3 0.0067 0.0784 R tþ1,tþ3 0.0740 2.3572 E t-1 x COR −1620091.0000 −2.1655 E t x COR 295324.5000 20.1906 E tþ1,tþ3 x COR 2601796.6000 22.1440 COR 152556.6000 1.0369 SIZE −0.0218 −0.8205 SALES 0.1549 1.3360 EARN −4.2834 −1.5761 OCF −0.5915 −0.4116 FCF −0.0592 9.2994 AG 0.0027 0.0370 CEO 0.0020 0.5379 CFO 0.0031 0.5908 Constant 0.4142 Adjusted R-squared 0.2157 F-statistic 17.6002 Significant in 0.01, significant in 0.05, significant in 0.10. 14 E. A. SUDARYONO ET AL. a t-statistic of −1.0872 (insignificant). In the regression model of ROA tþ1,tþ3 , the interaction variable between the current return on assets and corruption (ROA t x COR) for group of samples in East Java has a coefficient value of −72,717.1200 with a t-statistic of −1.0526 (insignificant). There is no effect of corruption on earnings persistence for group of samples in East Java. In general, the effect of corruption on earnings persistence occurs more in Jakarta than East Java where Jakarta has more corruption level than East Java. The results in Table 13 show that the interaction between the current earnings price ratio and corruption (E t COR) for group of samples in Jakarta has a coefficient value of −216,374.1000 with a t-statistic of −2.0324 (significant at 0.05). This finding indicates that corruption reduces the relevance of earnings values for group of samples in Jakarta. The interaction between the total earnings price ratio in the next three years and corruption (E tþ1,tþ3 x COR) for state-owned firms has a coefficient value of −87,372.1000, with a t-statistic of −2.4211 (significant at 0.05). This finding indicates that corruption reduces the earnings predictability for group of samples in Jakarta. Table 9 also shows that the interaction between the current earnings price ratio and corruption (E t  COR) for group of samples in East Java has a coefficient value of −98,762.7610 with a t-statistic of −1.0133 (insignificant). This finding indicates that corruption has no effect on the relevance of earnings values for group of samples in East Java. The interaction between the total earnings price ratio in the next three years and corruption (E tþ1,tþ3 x COR) for private-owned firms has a coefficient value of −7,326.1000, with a t-statistic of −0.7632 (insignificant). This finding indicates that corruption has no Table 13. Earnings value relevance and predictability and corruption for each province. Group of sample Jakarta (N ¼684) East Java (N ¼99) Independent Var Coeff t-Stat Coeff t-Stat E t-1 0.5433 2.5877 0.3242 2.3333 E t 0.6544 8.9837 0.9837 4.3453 E tþ1,tþ3 0.1244 4.8732 0.8723 4.3253 R tþ1,tþ3 0.0435 4.8726 0.0873 2.0121 E t-1 x COR −251678.1000 −2.0324 −87262.1200 −1.0022 E t x COR 2216374.1000 22.0324 298762.7610 21.0133 E tþ1,tþ3 x COR 287372.1000 22.4211 27362.1000 20.7632 COR 34224.1000 0.7873 65522.1000 0.6322 SIZE −0.0787 −1.0817 −0.0876 −1.8722 SALES 0.9837 0.6726 0.9827 0.8727 EARN −4.6372 −3.8726 −3.0252 −4.2344 OCF 0.7872 0.8722 0.7621 0.3422 FCF −0.0982 −1.7777−0.0873 −1.9811 AG 0.1817 1.0342 0.8722 1.0862 CEO 0.0012 1.0623 0.0076 0.2651 CFO 0.0014 0.0873 0.0032 0.6532 Constant 1.9873 1.7222 Adjusted R-squared 0.1689 0.1111 F-statistic 14.8761 13.7636 Significant in 0.01, significant in 0.05, significant in 0.10. Table 12. Earnings persistence and corruption for each province. Group of sample Jakarta (N ¼684) East Java (N ¼99) Dependent Var ROA tþ1 ROA tþ1,tþ3 ROA tþ1,tþ3 ROA tþ1,tþ3 Independent Var Coeff t-Stat Coeff t-Stat Coeff t-Stat Coeff t-Stat ROA t 0.6859 11.9832 0.2367 11.8739 0.6765 12.2574 0.6422 14.3124 ROA t x COR 2159092.2910 24.8373 2138891.6000 25.8373 280787.3100 21.0872 272717.1200 21.0526 COR −7892.1090 −0.3624 7523.321 0.6272 1181.1100 1.0111 1761.6610 1.0001 SIZE 0.0074 1.7962 0.0021 1.0991 0.0012 0.3243 0.0013 0.7657 SALES 0.0013 0.5467 0.0056 0.8222 0.0001 0.0744 0.0001 0.0785 EARN −0.0983 −4.7683 −0.2721 −5.4561 −0.2345 −1.0123 −0.5262 −1.0547 OCF 0.3287 0.9827 0.0937 0.2526 0.0234 0.6363 0.0561 0.8654 FCF −0.0094 −0.8736 −0.0009 −1.0527 −0.0011 −1.0001 −0.0010 −1.1002 AG 0.0082 0.9998 0.0087 1.0410 0.0064 0.3456 0.0056 0.7453 CEO 0.0012 1.1998 0.0090 0.7326 0.0012 0.2345 0.0013 0.4774 CFO −0.0008 −0.3456 −0.0061 −0.0527 −0.0044 −0.6333 −0.0045 −0.9654 Constant −0.0872 −0.0990 −0.0345 −0.0562 Adjusted R-squared 0.3998 0.3991 0.1511 0.1621 F-statistic 28.9882 28.1414 11.1414 12.0191 Significant in 0.01, significant in 0.05. COGENT ECONOMICS & FINANCE 15 effect on earnings predictability for group of samples in East Java. In general, the effect of corruption on earnings value relevance and predictability occurs more for group of samples in Jakarta than East Java where Jakarta has more corruption level than East Java. 6.7. Discussion The first result shows that the interaction between corruption and current earnings negatively affects future earnings. It indicates H1, that state corruption reduces earnings persistence. A corruption culture promotes weaker monitoring and controlling functions, leading to a higher risk of business uncertainty. A higher risk of business uncertainty causes firms to fail to mitigate uncertain business conditions and unpredictable events. The risk of business uncertainty leads to lower persistence and sustainability of earnings. This result was consistent with that reported by Xu et al. (2019) who find that local corruption reduces the earnings quality of persistence. The second result shows that the interaction between corruption and current earnings does not affect stock return. It indicates H2, that state corruption reduces earnings value relevance and that it is rejected. However, the role of corruption culture in reducing earnings value relevance occurs when corruption cases at the national level are involved. This result indicates that stock market participants use earnings information to make decisions based on the national level of corruption. The arguments that explain this finding are as follows: First, earnings value relevance explains the direct relationship between earnings and stock market responses;(S. Ahmed, 2015) second, stock market responses in Indonesia are affected by the joint factors of micro- and macro-economic variables (Yusfiarto, 2020). Thus, corruption at the local and national levels can explain earnings value relevance more than corruption at the local level alone. Investors assess that local and national corruption levels can promote lower controlling and monitoring functions and higher asymmetry information, which leads to lower earnings value relevance. This result is consistent with those of Ujan and Mukhlasin (2019) and Lin et al. (2007) They find that lower controlling and monitoring functions and higher asymmetry information have a negative effect on earnings value relevance. The third result shows that the interaction between corruption and future earnings negatively affects stock returns. It indicates H3, that state corruption reduces earnings predictability. Earnings predictability indicates that future earnings are reflected in current stock returns. As corruption lowers reputation, higher earnings manipulation, lower controlling and monitoring functions, higher asymmetry information, and lower managerial quality, earnings cannot be reflected in the current stock return and cannot be used to predict future performance. This result is consistent with those of Suh and Fernando (2013), Fanani and Merbaka (2020), and Simamora (2021) who find that lower controlling and monitoring functions, higher information asymmetry, and lower managerial quality lead to lower earnings predictability. Regarding earnings persistence, corruption has a greater effect on the relationship between current earnings and earnings three years ahead than one year ahead because the coefficient of interaction between corruption and current earnings has a larger absolute coefficient value on earnings three years ahead (251440.8000) than one year ahead (125725.9000), as shown in Table 4. This finding indicates that corruption explains why firms have a lower ability to maintain persistent earnings further ahead. The argument that explains this finding is that earnings persistence is important in measuring the ability to generate recurring earnings in the future (Fatma & Hidayat, 2019). Since earnings value relevance and predictability are in the same regression model, this study compares whether corruption has a greater effect on earnings value relevance or earnings predictability. Based on the results in Table 5, the corruption effect occurs more in earnings predictability than earnings value relevance. This indicates that earnings value relevance is difficult for investors in emerging markets to have institutional deficiencies such as disclosure inadequacy; in some cases, poor accounting standards, audit quality has generally been perceived as low, and investors are too naive and irrational to accounting information (Aharony et al., 2000; C. J. P. Chen et al., 2001; Graham & King, 2000). On the other hand, economic predictability is more important in emerging markets because it provides information on future stability (Rehman et al., 2022). This study finds that corruption reduces earnings quality. This is consistent with previous studies, which (Y. Chen et al., 2020; Lei & Wang, 2019; Lourenc¸o et al., 2018; A. H. Nguyen & Duong, 2020; Picur, 2004; H. Xu et al., 2019) find that corruption has a negative effect on earnings quality attributes. Some 16 E. A. SUDARYONO ET AL. arguments explain why corruption reduces the quality of earnings. First, higher corruption captures lower regulation implementation and law enforcement, leading managers to be less concerned about the litigation risk of earnings manipulation. Second, the secret illegal movement characteristic causes corruption to provide higher information asymmetry, leading to lower information quality. Third, since managers tend to have lower quality when surrounded by a politically corrupt culture, lower-quality managers fail to maintain earnings quality. The result implies the literature. This research confirms the concept of social capital, in which corrupt behavior becomes societal norms and values and is absorbed by firms to corrupt managers. Corrupted managers promote fraud and lawbreaking, which leads managers to report lower-quality earnings. Firms that absorb corrupted societal norms and values have a lower capability to monitor and control the financial reporting process, which leads to lower earnings quality. Therefore, it is important to achieve higher earnings quality. Higher earnings quality leads to lower information asymmetry and helps firms to gain easier access to funding resources from creditors and investors (Scott, 2014). Higher earnings quality can also reduce the costs of conflicts between firms and stakeholders (Scott, 2014). Higher earnings quality can also improve a firm’s value (Dewi & Devie, 2017), financial performance (Dewi & Devie, 2017; Huynh, 2018), and reputation (Huynh, 2018). The benefits of easier funding resources (Scott, 2014), conflict reduction (Scott, 2014), firm value (Dewi & Devie, 2017), financial performance (Dewi & Devie, 2017; Huynh, 2018), and reputation (Huynh, 2018) can maintain organizational stability, including financial stability (Siekelova, 2021). If firms have lower earnings quality, they will have difficulty accessing funding and incur more costs of conflict. This can disturb a firm’s stability. This research also confirms agency theory where corruption enhance the agency conflict between managers and owners. The corruption characteristics of low law and regulation enforcement (ineffective governance) and high hidden transactions (information asymmetry) are absorbed by managers (in the context of social capital). In internal condition, the corruption characteristics increase agency conflict between managers and owners and lead managers to report low quality earnings information. This result implies literature, especially to capture the concept of social capital and agency theory comprehensively to explain the relationship between corruption and earnings quality. This result also implies business practice, especially to improve effective governance for firms that are headquartered in high corruption level region. This study further substantiates the principles outlined in agency theory, wherein instances of corruption exacerbate the agency conflict existing between managerial entities and company proprietors. The identifiable traits of corruption, notably stemming from lax law enforcement and regulatory oversight (reflecting ineffective governance), coupled with a prevalence of clandestine transactions (evidencing information asymmetry), are typically assumed by managerial agents within the framework of social capital dynamics. Within this internal milieu, these corruption-related attributes contribute to an escalation in the agency conflict between managerial agents and company owners, consequently prompting managers to furnish financial reports characterized by diminished quality. This outcome underscores the significance of scholarly literature in comprehensively elucidating the interplay between corruption and the quality of reported earnings, particularly in integrating notions of social capital and agency theory. Furthermore, this finding bears significant implications for business practices, notably emphasizing the imperative of enhancing governance mechanisms within firms operating in regions characterized by elevated levels of corruption. 7. Summary and conclusion The primary objective of this study is to assess the impact of corruption on earnings quality, encompassing elements such as earnings persistence, earnings value relevance, and earnings predictability within the context of Indonesia. Broadly, corruption diminishes both earnings persistence and predictability. Moreover, corruption specifically reduces earnings value relevance when instances of corruption are associated with both local and national levels. The findings suggest that corruption fosters diminished controlling and monitoring functions, heightened information asymmetry, and a decline in managerial quality, all contributing to a reduction in earnings quality. The implications of the results suggest that firms, particularly those headquartered in regions with elevated corruption levels, should enhance their controlling and monitoring functions to alleviate increased information asymmetry and enhance overall earnings quality. Furthermore, COGENT ECONOMICS & FINANCE 17 the findings suggest a need for improved anti-corruption initiatives by regulators in Indonesia, particularly spearheaded by entities such as the Corruption Eradication Committee (Komite Pemberantasan Korupsi), to curb corrupt practices within government offices and prevent the proliferation of a corrupt culture into business activities; however, it is essential to acknowledge the limitations of this research. First, the study focuses on explaining corruption culture in the region where firms are headquartered, assuming that the corruption culture within firms is absorbed from the local context. Organizational culture within firms has not been directly examined. Second, the research does not distinguish between firms involved in corruption cases or those that have associations with corrupt government offices and those that do not. Third, this study does not compare earnings quality in firms not involved in corruption cases in different regions to assess the potential absorption of local corruption culture into these firms. Suggestions for future research include an in-depth examination of the corruption culture at the firm level, a focused analysis of firms engaged in corruption cases to accurately capture the corruption culture affecting earnings quality, and an assessment of firms not involved in corruption cases to determine the potential absorption of the local corruption culture as part of their organizational culture. Authors’contributions Eko Arief Sudaryono contributes to do the conception and design, analysis and interpretation of the data, the drafting of the paper, revising it critically for intellectual content, and the final approval of the version to be published. Wahyu Widarjo contributes to do the conception and design, analysis and interpretation of the data, revising it critically for intellectual content, and the final approval of the version to be published. Agung Nur Probohudono contributes to do the conception and design, analysis and interpretation of the data, revising it critically for intellectual content, and the final approval of the version to be published. Adhitya Agri Putra contributes to do analysis and interpretation of the data and revising it critically for intellectual content. Frank Aligarh contributes to do analysis and interpretation of the data and revising it critically for intellectual content. All authors agree to be accountable for all aspects of the work. Disclosure statement No potential conflict of interest was reported by the author(s). About the authors Eko Arief Sudaryono is a lecturer in Faculty of Economics and Business, Universitas Sebelas Maret (UNS), Indonesia. Research interests including financial accounting, financial reporting, corporate tax, corporate social responsibility, and corporate governance. Wahyu Widarjo holds a PhD in Accounting from Universitas Sebelas Maret (UNS) in Surakarta and is a Lecturer in the Faculty of Economics and Business at Universitas Sebelas Maret. Agung Nur Probohudono holds a PhD from Curtin University, Australia, and is a Professor in the Faculty of Economics and Business at Universitas Sebelas Maret in Surakarta, Indonesia. Adhitya Agri Putra is a lecturer in Faculty of Economics and Business, Universitas Riau, Indonesia. Currently, he is attending a doctoral program in Faculty of Economics and Business, Universitas Sebelas Maret, Indonesia. Research interests including financial accounting, financial reporting, corporate social responsibility, and corporate governance. Frank Aligarh is an assistant professor at the Universitas Islam Negeri Raden Mas Said Surakarta, Indonesia. The author’s interest research mainly concentrates on Financial Technology, Behavioral Accounting, and Accounting Information Systems. Frank Aligarh is pursuing his PhD at Universitas Sebelas Maret (UNS) Surakarta, Indonesia. ORCID Eko Arief Sudaryono http://orcid.org/0000-0002-9780-8641 Agung Nur Probohudono http://orcid.org/0000-0001-7736-373X Frank Aligarh http://orcid.org/0000-0002-5575-5473 18 E. A. SUDARYONO ET AL. Data availability statement Financial data are accessed from financial reports published on the firms’website or the Indonesian Stock Exchange website (www.idx.co.id). Corruption data were accessed from the corruption level report published on the Indonesian Corruption Eradication Committee website (www.kpk.go.id). References Adler, P. S., & Kwon, S.-W. (2002). Social capital: Prospects for a new concept. Academy of Management Review,27(1), 17–40. https://doi.org/10.5465/amr.2002.5922314 Aharony, J., Lee, C.-W. J., & Wong, T. J. (2000). 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