Financial Reporting Quality and Intangible Investments

Abstract

This paper presents theory and empirical evidence that greater financial reporting quality can incentivize myopic investments. Our model shows that greater financial reporting quality increases investor response to earnings and, in turn, the importance of earnings for the manager, elevating her incentive to invest myopically to improve earnings. Using the setting of Big N auditors' acquisitions of non-Big Ns, which increased investor response to earnings for the acquired client firms, we find evidence supporting myopic investments. Specifically, the acquired clients decrease intangible investments, particularly when (i) the increase in investor response to earnings is larger and (ii) the horizon of shareholders is shorter. The investment decrease is inefficient, as evidenced by reduced profitability, fewer exploratory innovations, and other measures.

Keywords: Financial reporting quality; Earnings response coefficient; Measurements; Myopia; Intangible investments; Patents; Real effects; Innovations