Financial Reporting Quality, Capital Allocation Efficiency, and Financing Structure: An International Study

Abstract

I examine the relation between financial reporting quality and capital allocation efficiency across twenty-three countries. Previous literature points out that outside shareholders reduce information asymmetry by requiring extensive financial reporting, while insiders, such as banks, more frequently use private communication channels. I hypothesize that high quality financial reporting improves capital allocation decisions, but its usefulness increases (declines) with equity (bank) financing. I find that a country's legal, political and economical infrastructure improves the country's capital allocation efficiency. Financial reporting quality beyond the level associated with a country's infrastructure improves capital allocation efficiency for industries more dependent on equity financing. My findings are consistent with a heterogeneous demand for financial accounting information. Outside shareholders are more dependent on financial reporting to reduce information asymmetry than are banks. Adopting better financial reporting standards will be more beneficial to industries dependent on equity financing.

Keywords: international accounting, capital allocation efficiency, financing structure