Financial Reporting Quality and Investment Efficiency

Abstract

This paper studies the relation between financial reporting quality and investment efficiency on a sample of 38,062 firm-year observations between 1980 and 2003. Financial reporting quality has been posited to improve investment efficiency, but to date there has been little empirical evidence to support this claim. Consistent with this claim, I find that proxies for financial reporting quality are negatively associated with both firm underinvestment and overinvestment. The relation between financial reporting quality and underinvestment (overinvestment) is mainly driven by the innate (innate and discretionary) component of reporting quality. Further, financial reporting quality is more strongly associated with overinvestment for firms with large cash balances and dispersed ownership, which suggests that financial reporting quality mitigates information asymmetries arising from agency conflicts. However, I find mixed evidence for the hypothesis that financial reporting quality is more strongly associated with underinvestment for firms facing financing constraints. Finally, the relation between financial reporting quality and investment efficiency is stronger for firms with low quality information environments. Overall, this paper has implications for research examining the determinants of investment efficiency and the economic consequences of enhanced financial reporting.

Keywords: Reporting Quality, Investment Efficiency, Adverse Selection, Agency Problems

JEL Classification: G30, G31, M41, M43