CHAPTER 2 – THEORETICAL BASIS AND LITERATURE REVIEW

2.1 Theoretical Basis

1. Agency Theory
This study uses the Agency Theory approach proposed by Jensesn & Meckling
(1976). They state that the agency concept is the relationship between management and
shareholders agreed upon on the employment contract. These relationships often create
problems between contract holders because each of them has their own interests and
goals. Management as a company manager has an interest in improving his individual
performance while shareholder has an interest in improving company performance. This
very difference of interest is the one that causes agency conflict.
To this date, agency theory has undergone modifications in such ways, but that it
did not abandon its original concept. According to Appah et al., (2013), capital owners no
longer run their own business; they require management experts to create a modern
company model. According to research conducted by Glover, and Prawitt (2014),
management acts as an agent to shareholders (principal) and fulfils stewardship functions
through the management of company assets. Agents consist of several professionals who
are contracted by the owner to work optimally in fulfilling the interests of the owners.
They also must be accountable for all actions related to the management of the company
to the owner.

2. Information Asymmetry
Management as the party assigned to manage the company certainly has its hands
on information about the company internal than the owner of the company. Therefore,
management is obliged to convey information about the company in a transparent,
accurate and relevant manner through the disclosure of accounting information contained
in financial statements. The imbalance between information obtained by management and
shareholders is a condition called information asymmetry.
According to Jogiyanto and Hartono (2007), information asymmetry is a
condition where some investors have information that is not owned by others; making
that investors have the advantage of information about the actual economic conditions
that occur within the company. In addition, according to Suwarjono (2014), information
asymmetry is a condition in which management as a company manager controls
 information better than an investor or creditor. Moreover, according to Hanafi et al.,
(2012), information asymmetry is closely related to signaling theory, where asymmetry
occurs when interested parties in the company do not have the same information about
the prospects and risks of the company, while certain parties have better information than
the other parties.
Information asymmetry occurs because the management as the company manager
has more information than the owners and shareholders. Assuming that management acts
for its own sake, the existing information asymmetry will increasingly encourage
management to hide information that is considered important. This condition leads to
investment inefficiencies that commonly occur due errors in strategic made and decisions
taken. The better quality of financial reporting is expected to reduce information
asymmetry, so that it can improve investment efficiency.
Research conducted by Scott (2009) states that information asymmetry is divided
into two categories, namely:
1. Adverse Selection
Information asymmetry occurs because internal companies which involve
management and other parties have more information than those about the company's
financial condition and future prospects. This leads management to prioritize their
personal benefits and neglecting shareholders’, making the shareholders deemed at
disadvantage.
2. Moral Hazard
Information asymmetry results from the separation of the corporate structure
between internal control and company ownership, this makes shareholders, investors, and
creditors cannot effectively take optimal measurements of quality and management
responsibilities. This condition causes management to have the opportunity to deviate
from responsibility and do things that can harm the company. Company profit is one of
tools used as a measurement of management performance; this can encourage
management to manipulate profit reports to increase compensation or the reputation of
management itself.

3. Indicators of Information Asymmetry

 Information asymmetry can be measured using the bid-ask spread. Bid-Ask
Spread is the difference from the bid and the ask price. According to Wasilah (2005),
information asymmetry can be estimated using three approaches, they are as follow:
1. Based on the Forecast Analyst
The variable used in this measurement is the accuracy of the analysis in making
earnings per share (EPS) predictions that can be used as a measurement of information
asymmetry.
The problem that often occurs in this measurement is the attitude of over-reacting
to positive information and the attitude of under-reacting to negative information. In
addition, this forecast analysis is actually more related to the analysis of fluctuations level
and earnings rather than the analysis of the risks faced by the company.
2. Based on Investment Opportunities
It can be said that companies with high growth rates have a better ability to
predict cash flows in the coming period. Some proxies that are widely used are the ratio
of market value to book value from equity, market to book value of assets, and price
earnings ratio. The reasons for using these ratios are as follow:
1. The ratio of market to book value of equity and assets, in addition to
reflecting the performance of the company, also reflects the growth
potential of the company with the assets it currently has.
2. Price earnings ratio reflects the risk of earnings growth faced by the
company.
3. Based on Microstructure Market Theory
The broad concern of this theory is how prices and volumes of trade can be
formed. To see the two factors, the bid-ask spread which states that there is a component
spread that contributes to the loss experienced by the dealer (company) when making
transactions with information traders (transaction information) can be used. Bid-ask
spread is the price difference where the trade (stock trader) is willing to purchase a stock
at highest price with the lowest selling price where the trader is willing to sell the stock. It
is in line with Jogiyanto (2010) that states the indicators used to measure information
asymmetry variables can be seen from the difference between the lowest purchase price
proposed by the buyer and the highest selling price requested by the seller.
4. Bid-Ask Spread Theory
Bid - Ask Spread occurs when an investor wants to purchase or sell a stock or
other securities in the capital market. This broker or dealer is the one ready to sell to
investors for the Ask price if the investor wants to buy a security. If an investor already
has a security and wants to sell it, then this broker or dealer will buy securities at a Bid
price. The difference between the Bid price and the Ask price is called the Spread. In
other words, Bid-Ask Spread is the difference between the highest purchase price for the
broker or dealer willing to buy a stock and the selling price at which the broker or dealer
is willing to sell the stock.
In the capital market mechanism, market participants also face agency problems.
Market participants interact with each other in the capital market to fulfill the goal of
purchasing or selling securities, so the activities they do are influenced by information
received either directly (public reports) or indirectly (insider trading). Dealers or market
makers have limited thinking power towards perception of the future and face losses
when dealing with informed traders. This is what causes adverse selection that
encourages dealers to cover losses from informed traders by increasing their spread to
liquid traders. According to Komalasari (2011), information asymmetry that occurs
between informed dealers and traders is reflected in the spread the dealers specified.

5. Investation
Investment is closely related to finance and economics. Investment is a form of
asset with an expectation to gain profits in the future. Todaro (2000) said that investment
has an important role in running the country's economy, because it can increase business
capital, enlarge production capacity, expand employment opportunities, and create new
jobs. Sukirno and Sadono (2010) clearly state that investment is the company's strategy to
carry out capital expenditure which aims to increase the ability to produce goods and
services in order to increase company profits.

6. Investation Efficiency
Based on the neo-classical view, investment will affect the value of the company
if the marginal investment is lower than the benefits (benefits) Abel (1983) in Biddle et
al. (2009). In investing, investment returns can only be obtained if the company invests in
 a project that has a positive net present value. This will increase the value of the company
and provide returns for investors as capital providers.
Investment profits will not work well if in the company there exists an
information asymmetry between management and capital owners. With the information
asymmetry, companies tend to experience investment deviations. Investment deviations
occur when companies over-invest their capital in unprofitable projects. Cehng et al.
(2010) in his study said that differences of opinion due to information asymmetry
resulted in inefficient investment.
The best investment is as efficient as possible. Gomariz et al. (2014) said that
investment efficiency is an investment that is in accordance with company expectations
and targets. If the investment carried out exceeds the optimal limit, it is called over-
investment. Conversely, if the company does not reach investment expectations, it is
called under-investment.

2.2 Literature Review

There were several researchers who have conducted research related to the quality of
financial reporting on investment effectiveness. Biddle et al., (2009) in his research entitled
"How Does Financial Reporting Quality Relative to Investment Efficiency" provided evidence
that the higher the quality of financial reporting will reduce investment inefficiency (over-
investment and under-investment). Sampling in this study used company data from 1993 - 2005
and selected 34,791 companies. The result of this research was that higher financial reporting
quality will increase investment efficiency. The listed Mining Company of the Indonesia Stock
Exchange, which was accessed on the official website of the Indonesia Stock Exchange
(www.idx.co.id), was used as the location of this research. The object of this research was the
effect of financial reporting quality on investment efficiency with information asymmetry as an
intervening variable in manufacturing companies listed on the Stock Exchange in 2014 - 2017.
Mohammadi (2014) conducted a research entitled "The Relationship between Financial
Reporting Quality and Investment Efficiency in Tehran Stock Exchange" with a study of 93
companies in Tehran Stock Market in 2009 - 2012. The researcher concluded that financial
reporting quality had significant positive effect on investment effectiveness. The size of the
company and the opportunity to develop had a significant influence on investment effectiveness.
This means that the higher the quality of financial reporting, the higher the investment
effectiveness of a company.
There was also a research conducted by Aulia and Siregar (2018) entitled "Financial
Reporting Quality, Debt Maturity, and Chief Executive Officer of Career Concerns on
Investment Efficiency". This research used observations of 689 non-financial companies in
2012-2015. The result of this research was that financial reporting quality had no effect on
investment effectiveness. This was because over-investment was not affected by the quality of
financial statements. Debt Maturity had a significant negative effect on investment effectiveness.
Whereas, CEO Carrer Concern had no influence on under-investment, yet it had a positive
influence on over-investment.
In addition, there was a research conducted by Nurcholisah (2016) regarding "The Effects
of Financial Reporting Quality on Information Asymmetry and Its Impacts on Investment
Efficiency". This research used data from 22 pension fund companies in Indonesia in the 2012
period. The result of this research said that financial reporting quality did not affect information
asymmetry and information asymmetry did not affect the effectiveness of information.
Lastly, Ma (2012) conducted a research regarding "Financial Reporting Quality and
Information Asymmetry: Evidence from the Chinese Stock Market". This research focused on
domestic and foreign investors. The result of this research was that the quality of financial
statements must be well presented in order to reduce information asymmetry that will attract
investors which were interested in investing.