Financing and Investment Efficiency, Information Quality, and Accounting Biases

Abstract:     
In this paper, we investigate the effect of accounting biases on firms' financing decisions and the role of accounting biases in endogenous information quality. We find that with information asymmetry, distorted financing decisions may induce distorted investment decisions in equilibrium. We show that in industries with generally low-profit prospects, a downward-biased accounting system performs better than a neutral accounting system, and a more downward bias helps mitigate both investment and financing inefficiency; while for industries with generally high-profit prospects, an upward-biased accounting system is better than a neutral accounting system, and a more upward bias helps improve financing efficiency. In addition, we find that a downward accounting bias has a more pronounced effect on improving overall efficiency by discouraging investment distortions through its impact on financing decisions when investment friction is severe. Moreover, a more downward-biased accounting system motivates good firms to exert more effort to improve the information quality.

Number of Pages in PDF File: 45

Keywords: conservatism, capital structure, information quality

JEL Classification: G31, G32, M41

working papers series