Determinants of Financial Reporting Quality in The Public Sector

The International Journal of Accounting
Vol. 54, No. 3 (2019) 1950009 (35 pages)

°
c Board of Trustees, Vernon K. Zimmerman Center, University of Illinois
DOI: 10.1142/S1094406019500094
Determinants of Financial Reporting Quality

in the Public Sector: Evidence from Indonesia
Fuad Rakhman*
Department of Accounting
Gadjah Mada University, Yogyakarta, Indonesia
Singgih Wijayana
Department of Accounting
Gadjah Mada University, Yogyakarta, Indonesia
Published 23 September 2019
Most studies addressing the issue of financial reporting quality (FRQ) focus on
corporations. This study investigates the determinants of FRQ in the public sector.
We use the type of audit opinion as a proxy for reporting quality, with an un-
qualified opinion representing the best reporting quality while a disclaimer of
opinion represents the worst quality. Using manually collected data from 3018 fi-
nancial reports of local governments in Indonesia from 2008 to 2014, we find that a
high proportion of capital expenditures in the total budget is associated with low
FRQ. Further, we find that larger and wealthier local governments are associated
with higher FRQ. Finally, we find that local governments under more experienced
mayors have higher reporting quality. Our results are robust to different measures of
FRQ. This study contributes to the reporting quality literature by providing em-
pirical evidence on the determinants of FRQ in the public sector, which has been
relatively underexplored. We conclude that certain characteristics of local govern-
ments and of mayors are associated with the types of audit opinion and that
financial incentives accelerate the improvement of reporting quality.
Keywords: Financial reporting quality; public sector; local government; capital

expenditures.
*Addressfor correspondence: Fuad Rakhman, Department of Accounting, Faculty of Eco-

nomics and Business, Gadjah Mada University, Yogyakarta 55281, Indonesia, Email:
frakhman@ugm.ac.id
1950009-1
F. Rakhman & S. Wijayana
1. Introduction
Financial reporting quality (FRQ) is a central issue in accounting and
governance literatures. Extant studies on this issue have mainly focused on
corporations (Dechow et al., 2010; Lo, 2008) or on non-profit non-govern-
mental organizations (Hofmann & McSwain, 2013). In the corporate setting,
FRQ is affected by top managements’ characteristics (Francis et al., 2008;
Habib & Hossain, 2013; Huang et al., 2012; Jiang et al., 2013; Rakhman,
2009) and the effectiveness of audit committees and boards of directors
(Badolato et al., 2014; Klein, 2002; Krishnan & Visvanathan, 2008;
McDaniel et al., 2002; Vafeas, 2005). Other studies find that firm-specific
factors such as audit quality (Stanley & DeZoort, 2007), capital structure,
and business settings (Rahman et al., 2010), employee quality (Call et al.,
2017), company reputation (Cao et al., 2012), and reporting incentives
(Christensen et al., 2015) have a significant impact on the quality of financial
reporting. Institutional factors such as investor protection, culture, and
financial reporting standards/regulations also affect FRQ (Barth et al., 2008;
Wijayana & Gray, 2019; Houqe et al., 2012; Nabar & Boonlert-U-Thai, 2007).
In the non-profit non-governmental sector, financial disclosure manage-
ment1 to improve performance measures is affected by donation markets and
contracting motivations (e.g., Bhattacharya & Tinkelman, 2009; Jones &
Roberts, 2006; Keating et al., 2008) and political costs, regulatory, and tax
motivations (Ballantine et al., 2007; Eldenburg et al., 2011; Krishnan &
Yetman, 2011). However, little is known about factors affecting FRQ in the
context of governmental (public sector) institutions. As the reporting
environments differ significantly, the determinants of reporting quality in
the governmental setting are likely to be different from those in the corpo-
rate or non-governmental setting.
This study examines the determinants of FRQ of local governments in
Indonesia. Investigating the determinants of FRQ in the context of local
governments in Indonesia is interesting for the following reasons. First,
Indonesia is an example of a young, yet one of the largest democracies,
promoting fiscal decentralization and public sector reforms. Since 2004,
nearly 500 local governments in Indonesia have been required by the Law
No. 17 on State Finance issued in 2003 to prepare and submit annual
1
Prior studies for non-profit organizations use more general term such as \financial disclosure
management" or \disclosure management" rather than \earnings management" to describe
the opportunistic behavior of managers in financial reporting, which affect stakeholders’
perceptions of unit performance because the organizations do not focus on earnings or profits
(Hofmann & McSwain, 2013).
1950009-2
Determinants of Financial Reporting Quality in the Public Sector
financial reports, which are then audited by the Supreme Audit Board (i.e.,
Badan Pemerika Keuangan (BPK)). The requirement for all governmental
institutions to prepare annual reports is a key move toward promoting ac-
countability and transparency. Although such a requirement may be nec-
essary, good accountability and transparency alone are insufficient unless
the country addresses the issue of FRQ. Yet, empirical studies on factors
affecting FRQ in the public sectors, especially in Indonesia, remain scarce.
Second, in a country such as Indonesia, which is still marred with corruption
at all levels of government, improving accountability and transparency
through the local governments’ FRQ potentially strengthens preventative
measures against corruption involving government officials. Corruption still
poses a serious challenge to public management reforms in the country
(McLeod & Harun, 2014), and needs to be addressed comprehensively.
Furthermore, the strong efforts of the Indonesian central government to
push for better accountability and financial reporting practices among local
government make Indonesia an interesting setting to conduct research into
governmental FRQ.
Prior research suggests that governmental audits reduce the level of fu-
ture corruption (Avis et al., 2016). Liu and Lin (2012) state that a lower
number of audit irregularities is associated with a lower level of corruption.
In addition, higher transparency is associated with a lower corruption level
(e.g., Casades us de Mingo & Cerrillo-i-Martínez, 2018; Williams, 2015).
Even though it is not always the case, it is expected that fewer audit ir-
regularities and a clean opinion on financial reports are associated with a
lower probability of corruption. This argument is supported by the theo-
retical framework on accountability and transparency in governmental
management (Greiling & Spraul, 2010; Hofmann & McSwain, 2013). In the
context of this study, a clean opinion on financial reports enhances the
accountability of public sector entities and can be seen as increasing trans-
parency in governmental financial statements. Lowering financial disclosure
management2 results in improvements in public accounting practices, which
are crucial for obtaining high-quality information on budgetary stability
(e.g., Beckett-Camarata, 2009) and governmental financial sustainability
(e.g., Chen et al., 2016).
2
Financial disclosure management or simply disclosure management is the term that has been
used by prior studies to analogously refer to earnings management in the corporate setting.
An audit, as part of principle’s monitoring mechanisms, can limit financial disclosure man-
agement practices in the public sector (Greiling & Spraul, 2010).
1950009-3
In the first hypothesis, we expect that the greater the proportion of the
budget spent on capital expenditures, the lower the quality of financial
reporting. Due to higher complexity, less transparency, and the possibility of
corruption in the implementation of capital programs, local governments
with a higher proportion of capital expenditures in their budgets are likely to
have relatively poor reporting quality. In the second hypotheses, we expect
that FRQ would be affected by the characteristics of a local government such
as the size, the level of financial independence, whether the local government
is in a metropolitan area (kota), and whether they are situated on the island
of Java. In the third hypothesis, we develop an argument that the quality of
financial reporting in a local government is affected by the characteristics of
its mayors, such as their level of experience and age. A multinomial logistic
regression model was employed to test the hypotheses, with the type of audit
opinion as the dependent variable. Robustness tests were conducted using
the number of pages of annual reports and the extent of audit findings and
auditors’ recommendations as dependent variables. The data to test the
hypotheses were manually collected from 3018 financial reports of local
governments in Indonesia from 2008 to 2014.
We find that local governments’ FRQ is negatively associated with the
proportion of capital expenditures in their budgets. The implementation of
capital budgets, which generates long-term assets, is relatively more com-
plex and requires long administrative processes and extensive documenta-
tions. The Supreme Audit Board finds that most audit findings and
qualifications are related to the treatment of long-term assets (BPK, 2013).3
Further, capital expenditures through government procurements usually
involve large amounts of funds and are notorious for being a source of cor-
ruption (Neu et al., 2015; Sargiacomo et al., 2015).4 This creates account-
ability and transparency issues and apparently reduces the quality of
financial reports issued by the local governments.
We further find that the quality of local governments’ financial reports is
affected by the size of the governments, where larger-sized institutions are
associated with higher reporting quality. We document that FRQ is
3
The qualification includes, among others, gaps between assertion and evidence (e.g.,
recording assets that are not present when being audited), the assets are present but are
utilized by third parties without any legal agreement, or having lands without proper legal
certificates, etc.
4
Many governmental leaders, including some former cabinet ministers, in Indonesia have
faced corruption charges or have been sent to jail for corruption involving programs related to
procurement and infrastructure development.
1950009-4
significantly better when the local government has a higher level of financial
independence. In summary, it seems that the characteristics of a local gov-
ernment are a major determinant of FRQ. From the supply side, larger-sized
local government and those with higher financial independence (e.g., better
financial, IT, and human resources) do produce financial reports of higher
quality. From the demand side, citizens of local governments with such
characteristics are usually more likely to be involved in making decision,
more politically active, and more capable of processing information, leading
to a higher demand for higher reporting quality. Consequently, their fi-
nancial reports are more likely to receive a cleaner opinion from the Supreme
Audit Board. Finally, local governments under the control of more experi-
enced mayors are more likely to receive a better opinion on their financial
reports. These results are consistent with studies in the corporate setting
where the experience of chief executives is associated with higher reporting
quality (Francis et al., 2008; Jiang et al., 2013).
The study adds to the literature on reporting quality, which has so far
mainly focused on corporations and on non-governmental institutions. This
study shows that the characteristics of local governments are associated with
the types of audit opinion. Unlike corporations, where the majority of
financial reports receive a clean or an unqualified opinion (Shaw, 2007), the
types of audit opinion vary across local governments’ financial reports. This
study contributes to the literature by shedding light on the factors
explaining the variations in the quality of the local governments’ financial
reports, as proxied by the type of audit opinion. The study also presents
an important contribution to the literature by showing that financial
incentives are associated with the local governments’ FRQ. In the unique
setting caused by financial incentives introduced by the Indonesian central
government in 2010, we provide empirical evidence that financial incentives
increase the probability of receiving an unqualified opinion over time. This
empirical evidence indicates that financial incentives have succeeded in
promoting better FRQ and in motivating local governments to continuously
improve the quality of financial reporting. There is limited evidence in the
literature in the area of local government examining the impact of central
government financial incentives on the quality of financial reporting over
time. The research findings can potentially provide guidance to policy
makers on how to improve reporting quality and thus increase the propor-
tion of local governments receiving a clean audit opinion on their financial
reports. They will also potentially benefit the central government,
1950009-5
considering that financial incentives have succeeded in motivating local

governments to achieve better reporting quality.
The remainder of the paper is organized as follows. Section 2 discusses the
institutional settings. Section 3 describes the theoretical background and
hypotheses development. Section 4 outlines the methodology. Section 5
discusses the results, and finally Section 6 concludes the paper.
2. Institutional Setting
Indonesia has three levels of government: A central government, 34 pro-
vincial, and approximately 500 local governments. From 2005, as part of the
move toward decentralization and democratization, provincial and local
governmental leaders (i.e., governors and mayors) in Indonesia were elected
directly by the people.5 This process empowered local governments with
more political and fiscal autonomy. This shift in governing power was pre-
ceded by reforms in the public sector in which each local government has
been required by Law No. 17 issued in 2003 to prepare annual financial
reports as a way of promoting accountability. The financial reports must
contain a budget realization report, a balance sheet, a statement of cash
flows, and notes to the financial statements for the fiscal year, which ends on
December 31. Especially for those local governments that lack staff with the
proper financial expertise, the central government provides assistance
and consultancy during the preparation of financial reports through
the Financial and Developmental Oversight Body (i.e., BPKP) per local
governments’ request.
Similar to corporate financial reports, the financial reports of the local
governments are signed by the chief executives (i.e., mayors) prior to their
submission to the Supreme Audit Board. The local governments have until
March 31 of the following fiscal year to submit their financial reports. Then,
the Supreme Audit Board performs an audit on the financial reports and
issues an audit opinion for each report. On top of the audit opinion, the audit
board delivers an assessment report on the internal control effectiveness and
a number of audit findings and recommendations for improvements that
require follow-up actions by the local governments within 60 days.
In contrast to the corporate setting where publicly listed firms are audited
by public accounting firms (both Big 4 and non-Big 4), the Supreme Audit
Board (BPK) is the designated institution to audit the financial reports
5
The governors’ and mayors’ direct elections in 2005 were preceded by the first and historic
presidential election in 2004.
1950009-6
prepared by all governmental offices including those of local governments.

The Board consists of nine members that are selected by the People’s House
of Representatives. With over 6000 employees, the Board has a branch in
each of Indonesia’s 34 provinces. The branch offices perform audits on the
financial reports of all local governments in the respective provinces. Prior to
2006, members of the Board were selected by the President. However, fol-
lowing the constitutional amendment in 2006, the members of the Board
were selected by the People’s House of Representatives to warrant greater
Board independence from the influence of the government.
According to the Local Government Act No. 32 in 2003, the local gov-
ernments’ financial reports are required to be prepared in accordance with
the government’s accounting standards.6 These accounting standards were
developed by the Governmental Accounting Standards Committee consist-
ing of governmental officials, professionals, and accounting academics, and
were enacted under a government rule signed by the President. The com-
mittee regularly reviews and makes improvements to the accounting stan-
dards, including the move toward accruals-based accounting, which all
governmental institutions were required to be using by the 2015 fiscal year.
The accounting practices among local governments are generally not as
advanced as those among corporations where most companies receive a clean
opinion from their auditors on their financial reports (Shaw, 2007). During
the 2008 to 2014 sample period, the vast majority of financial reports of the
local governments received less than an unqualified opinion.7 The low pro-
portion of financial reports receiving a clean opinion, especially in the early
years of the practices, is surely of concern to the central government. To
promote higher quality reporting, the central government has created poli-
cies, which include financial incentives designed to motivate local govern-
ments to improve the quality of their financial reports, the timeliness of their
submissions, and other performance measures such as the quality of public
services. A report by the Supreme Audit Board suggested that the quality of
financial reporting has steadily improved year-on-year, as indicated by the
6
Traditionally, Indonesia’s government institutions used the cash basis for financial reporting.
However, the central government issued Rule No. 71 in 2010, requiring the use of an accruals
basis by fiscal year 2015 at the latest.
7
See Table 1 under the analysis section. To accelerate the improvement of financial reporting
practices among local governments and to boost the proportion of local governments’ reports
receiving a clean opinion, the central government provides a monetary incentive of at least
3 billion rupiahs (or around US$ 222,000, US$1 ¼ Rp13,500) for every local government that
submits the report on time and receives an unqualified opinion on the reports. Local
governments with satisfactory performance receive more.
1950009-7
increasing proportion of local governments obtaining a clean opinion on their

financial reports from only 2.9% in 2008 to 58% in 2015 (BPK, 2016).
The national medium-term developmental plans for 2010–2014 explicitly
mention that all local governments should receive an unqualified opinion on
their financial reports by the fiscal year 2014. However, the Supreme Audit
Board reported that in 2014, only 44.60% of local governments received an
unqualified opinion on their reports (BPK, 2015).8 Even though the current
reporting quality is significantly better than in 2004 (i.e., the first year that
financial report submissions were required), it is still a far cry from the
national target. This raises the following questions: What factors hinder
local governments from receiving a clean opinion on their financial reports?
What factors explain the variations in the quality of local governments’
financial reports?
3. Theoretical Background and Hypotheses Development

3.1. Theoretical background
The purpose of this study was to examine whether variations in the FRQ of
Indonesian local governments are affected by the budget composition, the
characteristics of the local governments, and the characteristics of the
mayors. This study uses a framework of financial disclosure management,
analogous to earnings management in the private sector (Greiling & Spraul,
2010; Hofmann & McSwain, 2013), to predict how these factors can explain
the variations in the quality of financial reporting among Indonesian local
governments. In particular, financial disclosure management is driven by
information asymmetry, agency problems, contracting, governance, and
regulations. This creates demands for accounting information which may be
opportunistically managed by the institution’s managers (i.e., mayors).
Givoly et al. (2010) proposed two theories explaining the variations in the
quality of financial reporting: the demand hypothesis and the opportunistic
behavior hypothesis. The demand for reporting quality from the users of
financial reports increases the reporting quality (Ball & Shivakumar, 2008)
while the opportunistic behavior of managers reduces the quality. In the
context of governmental reporting, the opportunistic behavior could mani-
fest itself in the form of revenue underestimation and expense overestimation
in the budgets (Anessi-Pessina & Sicilia, 2015), as well as strategic
8
The remaining half of the local governments’ reports in 2014 received a qualified (45.64%),
an adverse (0.77%), and a disclaimer of opinion (3.77%).
1950009-8
management of debt levels by local governments during election cycles

(Bastida et al., 2013) or during slow economic growth (Chen et al., 2016).
There are several sources of demand for the quality of local governments’
financial reports. One source of demand for reporting quality, apparently, is
the central government, whose interest is to make sure that local govern-
ments use the funds for their intended purposes and report them in com-
pliance with the existing rules and standards. The central government even
provides monetary incentives for local governments whose financial reports
receive at least a qualified opinion from the Audit Board and submit their
budgets on time. Further, local governments in Indonesia are allowed to take
loans from banks, or foreign loans through the Ministry of Finance, as al-
ternative sources of financing. Most local governments have a certain
amount of debt on their balance sheets. The presence of external borrowings
creates a demand for quality reporting by the creditors, and by the Ministry
of Finance in the cases where foreign loans are obtained.
There is a substantial incentive among Indonesian governmental leaders
to obtain an unqualified opinion on their local governments’ financial reports
from the Supreme Audit Board. The incentives are mainly related to the
institutions’ reputations. As the information concerning the audit opinion on
local governments’ annual financial reports is publicly available, receiving
anything less than a clean audit opinion on financial reports is to some extent
perceived as an embarrassment to the top officials of the reporting entities.
Furthermore, many governmental leaders are concerned that if they receive
a poor audit opinion and significant audit findings from the Supreme Audit
Board, the audit findings might be used by NGOs or the Attorney General’s
office to look for possible state losses, which could be used to raise corruption
charges against the government’s leaders.9
Earnings management, which is common among for-profit entities, is
not relevant in a governmental (public sector) setting.10 Nonetheless, the
primary roles of accounting information as used for stewardship and
valuation in a corporate environment are applicable in the non-profit sector
(Beyer et al., 2010; Hofmann & McSwain, 2013) or the public sector
9
Initially, the audited financial reports of all government offices were available on the website
of the Supreme Audit Board. However, the decision to publish the reports online was later
repealed following the objection of many governmental leaders. The leaders claimed that
some parties have (ab) used unfavorable audit findings mentioned in the reports against the
reporting entities.
10
This is because a mayor’s performance is usually evaluated based on an array of perfor-
mance indicators, such as economic growth, the quality of public services, and the devel-
opment of public facilities, and not on the amount of the government’s surplus.
1950009-9
(Greiling & Spraul, 2010). Mayors, as governmental managers, are likely to

have more information about the organizations’ financial condition and
program service expenses than outsiders. This information asymmetry11
creates a demand for financial reporting and an opportunity for financial
disclosure management, which is similar to earnings management in the
corporate setting (Hofmann & McSwain, 2013).
Prior studies suggest that information asymmetry is greater in nonprofits
than in corporations because donors (capital providers) have limited
knowledge of the need or the preferences of the beneficiaries (Hofmann &
McSwain, 2013; Kitching, 2009). In the context of the public sector, no
direct link exists between sources of funding (tax revenues or provincial/
central government) and the beneficiaries of the government’s goods and
services. For example, a local government, as an agent, receives funding
from the central government to provide free goods or services, but then they
require payments from the beneficiary (i.e., the public/society). An agent
who has privileged information about a public service creates information
asymmetry. In addition, governmental managers (i.e., the mayors) are
chosen by political parties and therefore their acts tend to be in the interest
of the political parties rather than of the society, reducing the goods and
services benefits received by the society. Accordingly, this asymmetry cre-
ates opportunities to misrepresent financial conditions through financial
disclosure management (Greiling & Spraul, 2010; Hofmann & McSwain,
2013).
3.2. Hypotheses development

The considerable theory and the amount of empirical evidence from the
corporate and non-profit non-governmental literatures, especially on the
quality of financial reporting literature, provide a justification for this study
to examine the determinants of FRQ in the public sector. By referring to the
existing literature on FRQ in a corporate setting, this study examines the
impacts of the budget composition, the characteristics of the local govern-
ments, and the characteristics of the mayors on the variations in FRQ
among Indonesian local governments. The details of these discussions are
presented as follows.
11
For publicly listed firms, information asymmetry here refers to the asymmetry between the
management and investors, known as the agency problem, first noted by Jensen and Meckling
(1976) and the asymmetry between investors, first noted by Akerlof (1970), also known as the
lemon problem. Financial reporting plays an important role in mitigating both types of
information asymmetry (Frankel & Li, 2004; Healy & Palepu, 2001; Lev, 1988).
1950009-10
3.2.1. Capital expenditures and FRQ

Capital projects promote the growth of local governments, which would to
some extent support the financial reporting infrastructure and the IT sys-
tems and thus improve FRQ. However, the majority of the literature sup-
ports a negative association between capital expenditures and FRQ based on
at least two arguments. First, government contracts are usually associated
with less transparency and a lack of efficiency in their monitoring in com-
parison to their private counterparts (Berrios, 2006; Evenett & Hoekman,
2005). Moreover, capital expenditures usually involve construction and
procurement where corruption and bribery frequently occur (Neu et al.,
2015; Sikka & Lehman, 2015). On average, governments across the world
spend a total of $9.5 trillion annually through public procurements, of which
$2 trillion disappears from the procurement budgets (Kuhn & Sherman,
2014). The presence of corruption (which unfortunately is still common
among Indonesian local governments) complicates the process of account-
ability and hinders transparency during the preparation of financial reports.
Second, investing in capital projects generally involves a complex process
(Warren & Jack, 2018) and is inherently risky. Failure to strictly follow the
administrative guidelines would result in audit findings which may then be
classified as irregularities. Additionally, capital projects generate long-term
assets, which is one of the most common audit problems in governmental
institutions (Rivenbark, 2000). This includes long-term assets that have
been disposed of but still appear on the asset list, purchases of new assets
that are not recorded on the asset list, and long-term assets that are not
valued properly on the balance sheet. In fact, the Indonesian Supreme Audit
Board found that most qualifications and findings in audits were associated
with how local governments deal with long-term assets (BPK, 2013).
Based on the above literature and arguments, it is expected that local
governments with a higher proportion of capital expenditures in their budget
would be associated with greater complexity, lower transparency and poor
accountability, reducing the FRQ. The first hypothesis is stated as follows:
H1 : The greater the proportion of the budget spent on capital expenditures,

the lower the quality of financial reporting.
3.2.2. Local governments’ characteristics and FRQ

Prior studies, especially in the corporate setting, provide competing evi-
dence on the association between size and reporting quality. On the one
hand, large entities usually have more current assets and thus have more
1950009-11
room for managing earnings since they receive more pressure to meet or beat
analysts’ expectations (Baber et al., 2011; Barton & Simko, 2002). Conse-
quently, they do not report earnings accurately (Myers et al., 2007; Shu &
Chiang, 2014) and thus lower the quality of financial reporting (Lo, 2008).
Relative to small firms, the top management in large firms has more power
and may override the internal control systems to manipulate earnings. Large
firms also have greater bargaining power in negotiations with auditors
(Luippold et al., 2015; Nelson et al., 2002). Finally, attempts at earnings
management at large firms tend to be ignored by auditors (Nelson et al.,
2002). On the other hand, prior studies suggest that large entities tend to
engage in less earnings management because a large number of investors and
analysts monitor larger entities more closely (Kim et al., 2017). Larger en-
tities have more competent internal auditors and more sophisticated internal
control systems. Large firms are likely to have better corporate governance
mechanisms, leading to improved quality of financial reporting (Cohen et al.,
2004; Klein, 2002).
In the context of governmental institutions, the association between
government size and reporting quality also remains unclear. Liu and Lin
(2012) found that larger provincial governments are associated with more
irregularities and corruption. Similarly, Avis et al. (2016) documented that
irregularities discovered in the audit were more common in municipalities of
greater sizes. However, larger entities generally receive more intense over-
sight by stakeholders (e.g., the central government and the media), and
greater political pressure from various parties for better information dis-
closure. In addition, they have better resources and accounting information
systems, thereby larger municipalities are more likely to comply with ac-
counting regulations (Christiaens, 1999) and are less likely to experience
audit delays (Cohen & Leventis, 2013). Other studies have documented that
size is associated with improved reporting quality. Larger municipalities and
non-profit institutions are associated with greater transparency toward their
stakeholders (Behn et al., 2010; Gordon et al., 2002; Guillamon et al., 2011)
are less likely to misreport (Gross & Neely, 2014), and are more likely to
provide voluntary online reporting of financial information (García &
García-García, 2010). Based on the above arguments, we propose the fol-
lowing hypothesis:
H2a : Larger local governments are more likely to have higher FRQ.
The revenues of a local government usually come from two sources: rev-
enues generated locally and revenues transferred from higher (provincial or
1950009-12
central) governments. Local governments with higher financial indepen-

dence are considered wealthier because they generate their revenues more
from local sources, instead of from intergovernmental transfers. Wealthier
local governments have greater resources to utilize information technology
or hire consultants to support the accounting systems, increasing the
likelihood of generating financial reports of higher quality. Tavares and
da Cruz (2017) found that local governments with more revenues generated
locally tend to be more transparent. Further, the society has greater
incentives to monitor the local governments when more of the revenues
come from local tax money. Geys et al. (2010) found that voter involve-
ment improves local government performance only when financial inde-
pendence is high.
Further, in relatively less wealthy local governments where revenues are
mainly generated from higher governments, the funding might be provided
in an amount and time that may differ from local governments’ preferences.
The amounts may be lower than what the local governments propose or
expect and the availability of the funding is not always on time. Such issues
then create uncertainty about the timing of programs or activities, resulting
in more complexity in financial reporting. In many cases, local governments
are forced to delay programs or activities until close to the end of fiscal year
and consequently, they have a very limited time to spend the money and
then prepare the financial report. These problems may lead to lower FRQ for
local governments. We propose the following hypothesis:
H2b : Wealthier local governments are associated with higher reporting quality.
The expectation that metropolitan areas will have better FRQ is based on
two arguments: the supply side and the demand side. From the supply side,
metropolitan areas are relatively more developed and are usually more
attractive to talented people than relatively remote districts. Consequently,
human capital tends to accumulate more quickly in the metropolitan areas
(Berry & Glaeser, 2005; Glaeser & Resseger, 2010). Those with better
accounting and financial expertise desiring to work for local governments
are more likely to prefer institutions in more developed areas than those
in smaller and remote areas for reasons such as better quality of life, better
facilities and infrastructure, a higher salary and career prospects, and
more job opportunities. From the demand side, with relatively more edu-
cation, citizens of metropolitan areas are more likely to be involved in
decision making in their local governments (Yang & Callahan, 2005).
1950009-13
Due to their higher socioeconomic status, they are also more politically
active (Rosenstone & Hansen, 1993). Therefore, it is expected that people in
metropolitan areas will monitor the affairs of their local governments more
effectively and are more likely to demand for better FRQ. Based on the
above argument, we propose the following hypothesis:
H2c : Local governments in metropolitan areas (kota) are more likely to have
higher FRQ.
We predict that local governments situated on the island of Java have rel-
atively higher financial reporting due to the following arguments. First, the
capital city of Jakarta is located on the island of Java. Due to their proximity
to the capital city, local governments situated in Java have better access to
supporting resources and financial monitoring by the central government is
expected to be more effective, resulting in better financial reporting prac-
tices. Second, the size of Java is only 6% of the total land in the country, but
it is home to around 60% of the total population. With this greater popu-
lation size, the number of people who care about government’s transparency
and accountability is also greater in Java. Sol (2013) reported that local
governments with greater jurisdictions have better transparency. Similarly,
Jorge et al. (2011) found that a large population size is associated with higher
fiscal transparency.
Moreover, local governments in Java generally have relatively better
facilities, infrastructure, and education systems. This is because highly ed-
ucated and talented people tend to choose to work and stay in Java. With
such an environment, it is easier for local governments in Java to hire people
with more expertise or provide good training for their staff. Consequently,
they are more likely to have higher FRQ. Thus, we propose the following
hypothesis:
H2d : Local governments situated in Java are more likely to have higher FRQ.
3.2.3. Mayors’ characteristics and FRQ

The literature on corporate settings suggests that a firm’s FRQ is affected by
the characteristics of its top executives. Matsunaga and Yeung (2008) found
that CEO experience improves reporting and disclosure quality. Aier et al.
(2005) found that CFOs with greater experience were associated with a
lower probability of financial restatement. It is expected that mayors with
greater experience (i.e., those who have served longer as mayors) are more
capable of delivering financial reports of higher quality. Extant studies have
1950009-14
also reported that a CEO’s age is associated with higher reporting quality
(Huang et al., 2012). In the context of local governments, mayors are usually
not involved directly in the preparation of financial reports. However, more
experienced mayors are likely to have greater awareness of the importance of
high-quality financial reports. When mayors signal their strong concerns
about the quality of financial reports, the subordinates (e.g., the treasurer)
will be more likely to \go the extra mile" to make sure that the financial
reports are prepared in accordance with the standards and rules. Based on
the above arguments, we propose the following hypotheses:
H3a : A mayor’s experience is associated with higher FRQ.
H3b : A mayor’s age is associated with higher FRQ.
4. Methodology
4.1. Data and sample
This study uses a sample of 3018 financial reports issued by local govern-
ments in Indonesia from 2008 to 2014. All financial data were manually
collected from the financial reports of local governments compiled by the
Supreme Audit Board of Indonesia. We use the type of audit opinion issued
by the Supreme Audit Board as the proxy for FRQ. There are four types of
audit opinions and they are ranked based on the cleanliness of the financial
report as follows: unqualified, qualified, adverse, and a disclaimer of opinion.
We formed an ordinal scale in which an unqualified opinion represents higher
reporting quality relative to a qualified opinion; a qualified opinion is better
than an adverse opinion; and an adverse opinion is better than a disclaimer
of opinion. We assign a score (one to four) to each of the four types of
opinion, where a higher score indicates higher reporting quality. The re-
gression model to examine the determinants of the quality of financial
reporting is as follows:
FRQ it ¼ 0 þ 1 CAPEXit þ 2 SIZEit þ 3 FINDEPit þ 4 METROi
þ 5 JAVAi þ 6 EXPit þ 7 AGEit þ 8 REALit þ 9 Incentives þ e;
ð1Þ
where
FRQit is a value set to 1 if the financial report received a disclaimer of
opinion, 2 for an adverse opinion, 3 for a qualified opinion, and 4
for an unqualified opinion.
1950009-15
CAPEXit is the capital expenditure ratio as measured by the amount of

the capital expenditure budget divided by the total budget of
local government i in year t.
SIZEit is the natural log of the total assets of local government i in
year t.
FINDEPit is the financial independency ratio as measured by the locally
generated revenues divided by the total revenues of local gov-
ernment i in year t.
METROi is a dummy variable set to 1 if the local government is a city
(kota), and zero if it is a regency (kabupaten).12
JAVAi is a dummy variable set to 1 if the local government i is situated
in Java, and zero otherwise.
EXPit is a proxy for the mayor’s experience measured as the number of
years the mayor has held the position.
AGEit is the age of the mayor of local government i in year t.
REALit is a proxy for managerial effectiveness and is the budget reali-
zation ratio as measured by the actual spending divided by the
total budget of local government i at year t.
Incentives is a dummy variable set to 1 if the observation comes from 2010
to 2014 when the central government provides financial incen-
tives, and zero otherwise.
e is the error term.
The model also controls for the level of budget realization (REAL) as higher
expenditures, especially nearing the end of year, are associated with lower
quality projects (Liebman & Mahoney, 2017) and might increase the
likelihood of audit findings by the Supreme Audit Board, potentially re-
ducing FRQ. Prior studies incorporate the gender of executives as a control
variable that is expected to have an effect on reporting quality (Araujo &
Tejedo-Romero, 2016; Barua et al., 2010; Tavares & da Cruz, 2017).
However, in this study, we do not include this variable due to a variability
issue as less than 4% of the sample population comprised of female mayors.
4.2. Measures of FRQ

There is no one single measure of FRQ that is accepted by all researchers
(Dechow et al., 2010). Most studies in this area use the accruals management
12
Each province in Indonesia has cities and regencies. Cities are generally more developed,
more highly populated, and with more educated populations than regencies.
1950009-16
approach to measure financial reporting and earnings quality (Hope et al.,

2013). In the public sector, accruals quality has been employed to measure
earnings quality of Australian local governments (e.g., Pinnuck & Potter,
2009) and English NHS hospital Trust (e.g., Ballantine et al., 2008), or in
other non-profit non-governmental organizations (Hofmann & McSwain,
2013). Real earnings management has also been employed in the corporate
setting (Huang & Sun, 2017) and in non-profit non-governmental settings
(e.g., Eldenburg et al., 2011). However, such measures are not applicable in
the context of government reporting in Indonesia, as most governmental
institutions, including local governments, still used a cash basis rather than
an accruals basis during the period of this study.13 Other studies use
restatements as an indicator of poor FRQ (Aier et al., 2005; Cao et al., 2012;
Stanley & DeZoort, 2007). Studies have found that municipalities bear
higher costs of debt following restatement disclosures (Baber et al., 2013)
and information delays (Edmonds et al., 2017). (Johnson et al., 2012) used
financial reporting deficiency scores as a proxy for local governments’ FRQ.
Our study uses the types of audit opinion issued by the Supreme Audit
Board as a proxy for FRQ. Audit opinion types are ranked based on the
cleanliness of the financial reports as follows: (1) disclaimer, (2) adverse, (3)
qualified, and (4) unqualified opinion where higher scores signify higher
quality.14 These types of audit opinion are used as a measure of reporting
quality for the following reasons. First, contrary to corporations where
auditing work across various companies is performed by diverse accounting
firms, in the Indonesian governmental setting, financial report audits of all
local governments are performed exclusively by the same accounting office
(i.e., the Supreme Audit Board). Thus, the audit policies applied and
the level of audit quality associated with the audits of local governments’
financial reports are expected to be relatively standardized where a certain
type of audit opinion means the same thing across all the local governments
in the country. Thus, an unqualified opinion on a financial report of a local
government is more likely to bear the same meaning as an unqualified
opinion on a financial report of another local government.
Second, contrary to the audit practices among corporations, where
auditors receive audit fees from their clients, the Supreme Audit Board does
13
The use of accruals basis for governmental financial reporting is not required until 2015.
14
According to Law No. 15 issued in 2004, audit opinions on financial reports are issued by
the Audit Board based on its review of four aspects: compliance with the governmental
accounting standards, adequacy of disclosures, internal control effectiveness, and compliance
with laws and regulations.
1950009-17
not take any audit fees from the local governments. In the absence of audit
fees, the auditors of the Supreme Audit Board are expected to be relatively
more independent from their clients’ pressure to issue a clean opinion.
Auditors are not reluctant to issue a less than clean opinion on a financial
report when they believe the report does not deserve a clean opinion. Finally,
the Supreme Audit Board is protected by law from being terminated as the
auditor for the local governments when the auditees are not satisfied with
the audit opinion issued by the board. This \permanent audit contract"
should allow the auditors to freely assert an objective opinion on the fi-
nancial reports. Based on the arguments above, we believe that the types of
audit opinions are a valid and less noisy measure of FRQ in the context of
governmental institutions in Indonesia.
5. Analyses and Discussions

5.1. Distribution of audit opinion
Table 1 presents the summary of the types of audit opinions on local gov-
ernments’ financial reports by year from 2008 to 2014 as reported by the
Supreme Audit Board in 2015 (BPK, 2015). Overall, only a small portion
(17%) of the 3394 financial reports audited by the Supreme Audit Board
received an unqualified or a clean opinion. The majority of the financial
reports received a qualified opinion (62%). A small proportion of the reports
received an adverse opinion (4%), while the rest received a disclaimer of
opinion (17%). The table suggests that the quality of the financial reports
improved year-on-year. The most visible improvements were associated with
changes in the proportion of unqualified and adverse opinions. As shown by
the table, those receiving an unqualified opinion rose from only 2.9% in 2008
to 44.6% in 2014. The proportion of reports with an adverse opinion decreased
from 6.6% in 2008 to 0.8% in 2014, and those with a disclaimer of opinion
decreased from 24.3% in 2008 to 6.5% in 2014. There was a significant jump in
the proportion of financial reports receiving an unqualified opinion from
28.3% in 2013 to 44.6% in 2014. This was likely due to the government’s last
push to get closer to the target stated in the medium-term national devel-
opment plan of 2010–2014, which stated that by the end of 2014, all local
governments should receive a clean opinion on their financial reports.
5.2. The role of ¯nancial incentives

In 2010, the central government introduced a new policy to provide financial
incentives to local governments to promote better accountability and
1950009-18
Table 1. Distribution of Audit Opinion Types by Year
Overall 2008 2009 2010 2011 2012 2013 2014
Opinion No. (%) No. (%) No. (%) No. (%) No. (%) No. (%) No. (%) No. (%)
Unqualified 579 17.0 13 2.9 14 3.0 28 5.7 57 11.5 103 21.0 139 28.3 225 44.6
Qualified 2103 62.0 299 66.2 306 65.0 319 65.2 330 66.5 308 62.9 298 60.7 243 48.1
Adverse 136 4.0 30 6.6 45 9.5 26 5.3 13 2.6 6 1.2 12 2.4 4 0.8
Disclaimer 576 17.0 110 24.3 106 22.5 116 23.7 96 19.4 73 14.9 42 8.6 33 6.5
1950009-19
Total 3394 100 452 100 471 100 489 100 496 100 490 100 491 100 505 100
Source: The Supreme Audit Board (BPK, 2015).

performance based on the cleanliness of financial reports and the timeliness

of their budget submissions and some other criteria.15 The financial incen-
tives were designed, among other things, to accelerate the improvement in
FRQ. Previously, the cleanliness of financial reports had been one of the
criteria in the evaluation of local governments’ performance by the central
government. In 2010, the central government went a little further by tying it
to financial incentives. The amount of the incentives varies depending on the
comprehensiveness of the achievement, ranging from hundreds of thousands
to tens of millions USD for each local government. The amount of incentives
received by individual achievers also increased from year-to-year. For ex-
ample, initially, each local government that obtained at least a qualified
opinion and submitted the budget on time would receive a minimum of
3 billion rupiahs (over US$200,000). In 2015, those meeting these minimum
requirements would receive 7.5 billion rupiahs (or nearly US$600,000).
Prior to the introduction of financial incentives, the proportion of finan-
cial reports receiving an unqualified opinion was only 3% or below from 2006
through 2009. However, following the introduction of the incentives, the
proportion of unqualified opinion increased significantly and continuously
from nearly 3% in 2009 to 5.7% (in 2010), 11.5% (in 2011), 21.0% (in 2012),
28.3% (in 2013) and 44.6% (in 2014), consecutively (see Table 1). In 2015,
the proportion of financial reports receiving an unqualified opinion reached
58% or the majority for the first time (BPK, 2016). The significant increase
in the quality of financial reporting nationwide and the number of local
governments receiving the incentives was reflected in the persistent annual
increase in the total amount of incentives from 1.38 trillion rupiahs in 2011 to
8.5 trillion rupiahs in 2018, or more than six fold in a span of seven years
(Haryanto, 2017). This significant increase in the proportion of financial
reports receiving a clean opinion following the introduction of financial
incentives is also documented in our regression analysis. The central gov-
ernment issued additional requirements in 2017, such as the requirement
that local governments have to obtain an unqualified opinion (previously,
the requirement was at least a qualified opinion) on the reports and to
implement e-procurement to be eligible for the incentives.
15
The criteria for the incentives include the audit opinion, timeliness of financial statement
and local budget submissions and other criteria including efforts to increase locally generated
revenues, increases in human development index, economic growth, and efforts to address
poverty and unemployment.
1950009-20
5.3. Descriptive statistics

After eliminating observations with missing information, this study uses
3018 local government-years as the sample. Table 2 presents the descriptive
statistics of the independent variables. On average, local governments al-
locate 26% of their budget to capital projects. The average local government
has total assets of 2.217 trillion rupiahs (equivalent to US$164 million,
US$1 ¼ Rp13; 500). Further, 19.5% of the observations were from local
governments situated in metropolitan areas (kota). Around 26.5% of the
financial reports were issued by local governments situated on Java Island,
while the other 73.5% were issued by those on the other islands. The table
shows that mayors had been in office for 4.76 years on average. The average
(median) age of the mayors was 51.67 years (52 years). The average budget
realization during the seven-year period in the sample was 89.3% while the
average proportion of locally generated revenues was 7.4% (the rest of the
revenues came either from the central or the provincial government).
Table 3 presents the correlation coefficients among the variables used in
this study. The figures below the diagonal display Pearson’s correlations,
while those above the diagonal display Spearman’s rank correlations. FRQ is
correlated significantly and negatively with CAPEX, and positively with
SIZE, FINDEP, METRO, JAVA, and EXP. The table shows that there is
Table 2. Descriptive Statistics
Variables N Mean Min Q1 Med Q3 Max Std. Dev.
CAPEX 3018 0.260 0.050 0.188 0.243 0.319 0.630 0.099

SIZE (trillion) 3018 2.217 0.002 1.075 1.593 2.441 38.606 2.686
FINDEP 3018 0.074 0.000 0.033 0.054 0.091 0.790 0.070
METRO 3018 0.195 0 0 0 0 1 0.396
JAVA 3018 0.265 0 0 0 1 1 0.442
EXP 3018 4.758 1 2 4 7 10 2.819
AGE (years) 3018 51.666 25 47 52 57 78 8.084
REAL 3018 0.893 0.450 0.866 0.906 0.935 1.060 0.063
Notes: CAPEX: The capital expenditure ratio as measured by the amount of the capital
expenditures budget divided by the total budget of local government i in year t. SIZE:
Natural log of the total assets of local government i in year t. FINDEP: The financial
independency ratio as measured by the proportion of locally generated revenues out of total
revenues. METRO : A dummy variable set to 1 if the local government is in a metropolitan
area (city), and zero otherwise. JAVA: A dummy variable set to 1 if the local government i is
situated in Java, and zero otherwise. EXP : A proxy for the mayor’s experience measured as
the number of years the mayor has held the position. GNDR: A dummy variable set to 1 if
the mayor of local government i in year t is a male, and zero if a female. AGE: The age of the
mayor of local government i in year t. REALit : The budget realization ratio as measured by
the actual spending divided by the total budget of local government i at year t.
1950009-21
Table 3. Correlation Matrix
Variables FRQ CAPEX SIZE FINDEP METRO JAVA EXP AGE REAL
FRQ ¡0.188 0.320 0.380 0.140 0.168 0.110 0.075 0.38

CAPEX ¡0.240 ¡0.211 ¡0.395 ¡0.096 ¡0.468 0.012 0.016 0.395
SIZE 0.299 ¡0.153 0.549 0.058 0.394 0.110 0.092 0.042
FINDEP 0.285 ¡0.217 0.493 0.361 0.551 0.091 0.11 0.033
METRO 0.133 ¡0.106 0.078 0.333 0.057 0.014 0.051 0.076
JAVA 0.191 ¡0.430 0.342 0.457 0.057 0.037 0.006 0.107
EXP 0.111 0.014 0.147 0.060 0.008 0.045 0.241 0.024
AGE 0.070 0.027 0.095 0.065 0.047 0.001 0.240 0.030
REAL 0.093 ¡0.418 0.037 ¡0.074 ¡0.059 0.131 0.028 0.037
Notes: The figures above the diagonal are Spearman’s rank correlations while those below the
diagonal are Pearson’s correlations. The numbers in bold show a significant correlation at 1%
level.CAPEX: The capital expenditure ratio as measured by the amount of the capital ex-
penditure budget divided by the total budget of local government i in year t. SIZE: Natural
log of the total assets of local government i in year t. FINDEP: The financial independency
ratio as measured by the proportion of locally generated revenues out of total revenues.
METRO: A dummy variable set to 1 if the local government is in a metropolitan area (city),
and zero otherwise. JAVA: A dummy variable set to 1 if the local government i is situated in
Java, and zero otherwise. EXP: A proxy for the mayor’s experience and is measured as the
number of years the mayor has held the position. AGE: The age of the mayor of local
government i in year t. REALit : The budget realization ratio as measured by the actual
spending divided by the total budget of local government i at year t.
no serious multicollinearity problem among the independent variables. The

largest correlation seems to be between FINDEP and JAVA (r ¼ 0:551),
indicating that local governments in Java have a relatively higher level of
financial independence. Further, local governments situated in Java allocate
relatively lower percentages of their budgets toward CAPEX (r ¼ 0:468).
This is consistent with the Indonesian government’s commitment to consider
development in local governments outside Java as a top priority, through a
program called \accelerated development in disadvantaged regions," intro-
duced in 2008. The program would push more CAPEX to local governments
situated outside the island of Java.
5.4. Multinomial logistic regression results

Table 4 presents the coefficients and the t-values of the multinomial logistic
regression analyses.
The results suggest that comparing the qualified opinion versus unqual-
ified opinion, CAPEX seems to marginally increase the probability of re-
ceiving an unqualified opinion (t ¼ 1:85). However, we find that the
1950009-22
Table 4. Results of the Multinomial Regression Analysis
Unqualified versus Unqualified versus Unqualified versus

Qualified Adverse Disclaimer
Expected Signs Parameter Parameter Parameter
Intercept ? 9.518*** 2.158 13.733***

(5.41) (0.67) (6.41)
CAPEX 1.323* 5.432*** 1.546**
(1.85) (3.93) (2.02)
SIZE þ 0.342*** 0.298* 0.668***
(3.76) (1.72) (5.76)
FINDEP þ 5.479*** 7.569*** 18.202***
(6.12) (2.64) (6.85)
METRO þ 0.345*** 0.355 0.562***
(2.63) (1.14) (2.60)
JAVA þ 0.517*** 0.602 0.213
(3.59) (1.38) (0.80)
EXP þ 0.057*** 0.005 0.122***
(3.01) (0.12) (4.52)
AGE þ 0.005 0.018 0.009
(0.71) (1.29) (1.01)
REAL 2.385** 0.903 4.270***
(2.27) (0.50) (3.36)
Incentives þ 1.955*** 3.043*** 2.219***
(9.58) (10.75) (9.69)
N 2457 661 984
Nagelkerke R 2 0.284
Chi-square 850.497***
Notes: The superscripts *, **, and *** indicate significance at 10%, 5%, and 1% levels,
respectively. The numbers in parentheses are the t-statistics. FRQit : FRQ as measured
by types of audit opinion: 1 ¼ disclaimer, 2 ¼ adverse, 3 ¼ qualified, 4: unqualified.
CAPEX: The capital expenditure ratio as measured by the amount of the capital expenditure
budget divided by the total budget of local government i in year t. SIZE: Natural log of
the total assets of local government i in year t. FINDEP: The financial independency ratio
as measured by the proportion of locally generated revenues out of total revenues. METRO:
A dummy variable set to 1 if the local government is in a metropolitan area (city), and
zero otherwise. JAVA: A dummy variable set to 1 if the local government i is situated in Java,
and zero otherwise. EXP: A proxy for the mayor’s experience and is measured as the
number of years the mayor has held the position. GNDR: A dummy variable set to 1 if the
mayor of local government i in year t is a male, and zero if a female. AGE: The age of
the mayor of local government i in year t. REALit : The budget realization ratio as measured
by the actual spending divided by the total budget of local government i at year t. Incentives:
A dummy variable set to 1 if the observation comes from year 2010 to 2014, and zero
otherwise.
1950009-23
proportion of capital expenditures of local governments reduce the proba-

bility of receiving an unqualified opinion relative to an adverse (t ¼ 3:93)
or to a disclaimer of opinion (t ¼ 2:02). Additional analyses using the
number of pages of financial reports and the extent of audit findings and
auditors’ recommendations as the dependent variables show that CAPEX
reduces FRQ (see Table 5). This is consistent with the view that programs
associated with capital expenditures increase complexity in financial
reporting and result in more audit findings by the auditors (BPK, 2013).
Failure to follow prescribed procedures and to furnish the auditors with
necessary documents to support the assertions in the financial reports ap-
parently affects audit opinion on the financial reports. Furthermore, capital
projects such as infrastructure development and procurement are often
entangled with enormous vested interests, are more susceptible to bribes
(Mauro, 1998), and are inherently less transparent in their implementation
(Evenett & Hoekman, 2005), reducing the quality of financial reporting.
Table 4 further shows that the total assets of local government (SIZE)
increase the probability of receiving an unqualified opinion relative to a
qualified opinion (t ¼ 3:76) to an adverse (t ¼ 1:72) or to a disclaimer of
opinion (t ¼ 5:76). Our finding is consistent with previous studies stating
that larger local governments are associated with greater compliance to
accounting regulations (Christiaens, 1999) and with greater transparency
(Behn et al., 2010). Further, the financial independence (FINDEP) seems to
be a strong discriminating factor between local governments receiving an
unqualified opinion on financial statements and the rest. FINDEP increases
the probability of receiving an unqualified opinion relative to a qualified
(t ¼ 5:47) to an adverse (t ¼ 2:43) or to a disclaimer of opinion (t ¼ 6:71).
This is consistent with previous studies, which showed that financial inde-
pendence of a local government as a proxy for wealth improves transparency
(Tavares & da Cruz, 2017) and public accountability (Geys et al., 2010),
leading to better financial reports.
The results also show that local governments situated in metropolitan
areas (kota) are more likely to receive an unqualified opinion on their fi-
nancial reports. The variable METRO increases the probability of receiving
an unqualified opinion relative to a qualified (t ¼ 2:63) or to a disclaimer of
opinion (t = 2.60). This is consistent with the view that citizens in metro-
politan areas are more involved in their local governments’ decision making
(Yang & Callahan, 2005) and are more active politically (Rosenstone &
Hansen, 1993), increasing the demand for higher FRQ. However, the geo-
graphic location of the local governments (JAVA) provides a mixed result.
1950009-24
It seems that local governments situated in Java are in fact less likely to
receive an unqualified opinion relative to a qualified one (t ¼ 3:59), while the
results are not significant relative to an adverse and a disclaimer of opinion.
However, in the robustness test reported on Table 5, we document results as
expected that local governments in Java are associated with higher FRQ.
We find that local governments are more likely to receive an unqualified
opinion when the mayors have stayed longer in office. Mayors’ experience
(EXP) increases the probability of receiving an unqualified opinion relative
to a qualified opinion (t ¼ 3:01) or to a disclaimer of opinion (t ¼ 4:52). This
is consistent with the view that the experience of top management increases
the quality of reporting (Aier et al., 2005; Matsunaga & Yeung, 2008). The
results further show that budget realization is associated with lower FRQ.
However, we do not find the age of the mayors to be a significant determi-
nant of FRQ. This finding is different from those in the corporate setting
where the age of top executives was found to affect the reporting quality
(Huang et al., 2012). Finally, it was our interest to test whether the financial
incentives introduced in 2010 by the Indonesian central government affect
the quality of financial reporting of local governments. The result suggests
that financial incentives increase the probability of receiving an unqualified
opinion relative to a qualified (t ¼ 9:58) to an adverse (t ¼ 10:75) or to a
disclaimer of opinion (t ¼ 9:69). This can be interpreted that the financial
incentives have succeeded in motivating local governments to continuously
improve the quality of financial reporting.
5.5. Robustness tests

To test the robustness of the multinomial logistic regression results, we
employ two other measures of reporting quality as the dependent variables:
the number of pages of local governments’ financial reports (NUMPG) as a
proxy for more informative disclosures (Hansen et al., 2014) and the extent
of audit findings and recommendations in management letters (AUDFDG)
as a proxy for poor reporting quality (Johnson et al., 2012).16 In the context
of local governments financial reporting in Indonesia, an auditor’s report
consists of three parts: (1) a financial report and its auditor’s opinion, (2)
audit findings and recommendations related to internal control issues, and
16
Our test indicates the type of audit opinion (FRQ) as our original measure of reporting
quality is positively correlated with the number of pages of financial reports (NUMPG)
(r ¼ 0:280, p < 0:001) and is negatively correlated with the extent of audit findings and
recommendations (AUDFDG) (r ¼ 0:281, p < 0:001). NUMPG and AUDFDG are nega-
tively correlated (r ¼ 0:667, p < 0:001).
1950009-25
Table 5. Robustness Tests Using Different Dependent Variables
Dependent Variables
NUMPG AUDFDG
Independent Variables Exp. Signs Parameter Exp. Signs Parameter
Intercept ? 2.920*** ? 0.731***

(13.55) (11.22)
CAPEX 0.253*** þ 0.112***
(2.78) (4.13)
SIZE þ 0.092*** 0.005
(7.90) (1.45)
FINDEP þ 0.847*** 0.155***
(6.46) (3.96)
METRO þ 0.019 0.002
(0.95) (0.336)
JAVA þ 0.260*** 0.086***
(12.84) (14.19)
EXP þ 0.005* 0.001
(1.80) (1.57)
AGE þ 0.002** 0.001
(2.21) (0.75)
REAL 0.359*** þ 0.036
(2.71) (0.91)
Incentives þ 0.307*** 0.010**
(18.06) (1.97)
Observations 2,971 2,971
Adj. R 2 0.294 0.151
F-stat 138.105 59.475
Notes: The superscripts *, **, and *** indicate significance at 10%, 5%, and 1%
levels, respectively. The numbers in parentheses are the t-statistics. NUMPG:
Natural log of the total number of pages of local governments’ financial reports.
AUDFDG: The number of pages of the audit findings and recommendations
divided by the total number of pages of auditors’ reports. CAPEX: The capital
expenditure ratio as measured by the amount of the capital expenditure budget
divided by the total budget of local government i in year t. SIZE: Natural log of
the total assets of local government i in year t. FINDEP: The financial inde-
pendency ratio as measured by the proportion of locally generated revenues out of
total revenues. METRO: A dummy variable set to 1 if the local government is in a
metropolitan area (city), and zero otherwise. JAVA: A dummy variable set to 1 if
the local government i is situated in Java, and zero otherwise. EXP: A proxy for
the mayor’s experience and is measured as the number of years the mayor has
held the position. AGE: The age of the mayor of local government i in year t.
REALit : The budget realization ratio as measured by the actual spending divided
by the total budget of local government i at year t. Incentives: A dummy variable
set to 1 if the observation comes from 2010 to 2014, and zero otherwise.
1950009-26
(3) audit findings and recommendations related to compliance issues. Our

robustness test uses the number of pages of financial reports (i.e., part 1 of
the auditor’s report) as a proxy for high reporting quality as it implies an
increased disclosure level and reduced information asymmetry. The average
(median) number of pages of financial reports is 84.8 (74) pages, ranging
from 18 to 492 pages.
Further, this study uses the number of pages of the audit findings and
recommendations (i.e., parts 2 and 3 of the auditor’s report, or commonly
called the management letter) relative to the total number of pages (i.e.,
parts 1, 2, and 3 combined) as a proxy for poor FRQ. More audit findings
and recommendations from auditors imply that a local government’s fi-
nancial report and operations have not been prepared and conducted in
accordance with the respective standards, guidelines, and regulations.
Johnson et al. (2012) reported that a high number of comments in man-
agement letters among local governments are associated with lower FRQ
and with a lower probability of receiving an unqualified opinion. The average
(median) number of pages of audit findings and recommendations, or
management letters, is 174.5 (156) pages, ranging from 19 to 708 pages.
We employ OLS regression analyses to examine whether substituting the
types of audit opinion with NUMPG and AUDFDG as dependent variables
in Eq. (1) would generate similar results to the ones reported in Table 4.
Table 5 presents the regression analyses for our robustness test. The table
shows that CAPEX is associated with a lower disclosure level as indicated
by the lower number of pages of financial reports (t ¼ 2:78) and more
audit findings and recommendations (t ¼ 4:19). This result supports H 1
that CAPEX are associated with poor FRQ. The table further shows that
local government size (t ¼ 7:90), financial independence (t ¼ 6:46) and
being located in Java, where the capital city is located (t ¼ 12:84), are
associated with a greater level of information disclosures. Financial inde-
pendence (t ¼ 3:78) and being located in Java (t ¼ 14:11) are associated
with fewer audit findings and recommendations. These results support H2a ,
H2b , and H2d .
With respect to the characteristics of mayors, this study finds that
mayors’ experience (t ¼ 1:80) and age (t ¼ 2:21) is associated with a higher
level of disclosure. However, the two variables do not seem to be associated
with the extent of audit findings and recommendations. Finally, we find that
the financial incentives systems introduced in 2010 are associated with more
disclosures (t ¼ 18:06) and fewer audit findings and recommendations
(t ¼ 1:89).
1950009-27
6. Conclusions and Limitations

This study investigates the determinants of FRQ in the public sector, with
the local governments in Indonesia as the sample. Based on the framework of
financial disclosure management (Greiling & Spraul, 2010; Hofmann &
McSwain, 2013) and the theories of demand for accounting information,
which may be opportunistically managed by the top management (Givoly et
al., 2010), we examine and find that a high ratio of capital expenditures to
the total budget, smaller local governments, local governments with lower
financial independence, and local governments under less experienced
mayors are associated with lower FRQ. We also confirmed that financial
incentives introduced in 2010 by the central government have to some extent
succeeded in promoting the improvement of FRQ among local governments.
This study has several policy implications. First, the findings suggest that
higher capital expenditures are associated with poor FRQ. Consequently, to
improve the reporting quality at the national level, the central government
should assist local governments with relatively high spending on capital
projects more. Stronger monitoring may help improve transparency and
prevent corruption in local government procurements, which should lead to
better reporting quality. Second, as the less developed regions are associated
with lower reporting quality, the central government might need to provide
local governments in less developed areas better access to employees with
more financial and accounting expertise (i.e., financial expertise redistribu-
tion). There is some evidence that many local governments, especially the
smaller ones, are suffering from a lack of employees with an adequate ac-
counting background (McLeod & Harun, 2014). The lack of capable
accountants working for local governments in preparing their financial
reports potentially reduces the likelihood of receiving a clean opinion on the
reports. The government could provide incentives to motivate accountants
and financial experts to work for smaller-sized local governments and for
those in remote areas.
One limitation of this study is that the audit opinions do not seem to be
normally distributed. However, as this study uses a large sample size, this
issue should not be of a serious concern. Another limitation is that the
inclusion of local governments receiving an adverse and a disclaimer of
opinion on their financial reports might pose data reliability issues. There are
also other potential determinants of the reporting quality including the
number of staffs with an accounting background working for the local gov-
ernments in relevant areas and the financial expertise of the treasurer of the
1950009-28
local government. The rules suggest that only the mayor (not the treasurer)
has to sign the financial reports for the local government, and thus only the
name of the mayor is mentioned in the financial reports. Further studies
could therefore examine the financial expertise of the treasurers as a possible
determinant of reporting quality.
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The International Journal of Accounting

Vol. 54, No. 3 (2019) 1950009 (35 pages)

Determinants of Financial Reporting Quality

Published 23 September 2019

Keywords: Financial reporting quality; public sector; local government; capital

*Addressfor correspondence: Fuad Rakhman, Department of Accounting, Faculty of Eco-

considering that ﬁnancial incentives have succeeded in motivating local

prepared by all governmental oﬃces including those of local governments.

increasing proportion of local governments obtaining a clean opinion on their

3. Theoretical Background and Hypotheses Development

management of debt levels by local governments during election cycles

(Greiling & Spraul, 2010). Mayors, as governmental managers, are likely to

3.2. Hypotheses development

3.2.1. Capital expenditures and FRQ

H1 : The greater the proportion of the budget spent on capital expenditures,

3.2.2. Local governments’ characteristics and FRQ

central) governments. Local governments with higher ﬁnancial indepen-

3.2.3. Mayors’ characteristics and FRQ

CAPEXit is the capital expenditure ratio as measured by the amount of

4.2. Measures of FRQ

approach to measure ﬁnancial reporting and earnings quality (Hope et al.,

5. Analyses and Discussions

5.2. The role of ¯nancial incentives

Overall 2008 2009 2010 2011 2012 2013 2014

Source: The Supreme Audit Board (BPK, 2015).

performance based on the cleanliness of ﬁnancial reports and the timeliness

5.3. Descriptive statistics

Table 2. Descriptive Statistics

Variables N Mean Min Q1 Med Q3 Max Std. Dev.

CAPEX 3018 0.260 0.050 0.188 0.243 0.319 0.630 0.099

Table 3. Correlation Matrix

FRQ ¡0.188 0.320 0.380 0.140 0.168 0.110 0.075 0.38

no serious multicollinearity problem among the independent variables. The

5.4. Multinomial logistic regression results

Table 4. Results of the Multinomial Regression Analysis

Unqualified versus Unqualified versus Unqualified versus

Expected Signs Parameter Parameter Parameter

Intercept ? 9.518*** 2.158 13.733***

proportion of capital expenditures of local governments reduce the proba-

5.5. Robustness tests

Table 5. Robustness Tests Using Diﬀerent Dependent Variables

Independent Variables Exp. Signs Parameter Exp. Signs Parameter

Intercept ? 2.920*** ? 0.731***

(3) audit ﬁndings and recommendations related to compliance issues. Our

6. Conclusions and Limitations

European Accounting Review, 24, 31–61. Available at 10.1080/

Jones, C. L., & Roberts, A. A. (2006). Management of ﬁnancial information in

subjects. Critical Perspectives on Accounting, 28, 62–70. Available at https://

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Intercept ? 9.518* 2.158 13.733*

Intercept ? 2.920* ? 0.731*