Financial Reporting Quality: Red Flags and Accounting Warning Signs

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Financial Reporting Quality and Investment Efficiency
Rodrigo S. Verdi The Wharton School University of Pennsylvania 1303 Steinberg Hall-Dietrich Hall Philadelphia, PA 19104 Email: Phone: (215) 898-7783

This paper studies the relation between financial reporting quality and investment efficiency on a sample of 49,543 firm-year observations between 1980 and 2003. Financial reporting quality has been posited to improve investment efficiency, but there has been little empirical evidence supporting this claim to date. Consistent with this claim, I find that proxies for financial reporting quality are negatively associated with both firm underinvestment and overinvestment. Further, financial reporting quality is more strongly associated with underinvestment for firms facing financing constraints and with overinvestment for firms with large cash balances, which suggests that financial reporting quality mitigates information asymmetries arising from adverse selection problems and agency conflicts. 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.

Current Version: February 14, 2006

_____________________________________________ I thank members of my dissertation committee: John Core, Gary Gorton, Christian Leuz, Scott Richardson, and Catherine Schrand (Chair) for their guidance on this paper. I appreciate comments from Patrick Beatty, Jennifer Blouin, Brian Bushee, Gavin Cassar, Francesca Franco, Wayne Guay, Luzi Hail, Bob Holthausen, Rick Lambert, Frank Moers, Jeffrey Ng, Tjomme Rusticus, Irem Tuna, Ro Verrecchia, Missaka Warusawitharana, Sarah Zechman, Zili Zhuang, and seminar participants at the Wharton School. I also gratefully acknowledge the financial support from the Wharton School and from the Deloitte Foundation. Any errors are my own.

Financial Reporting Quality and Investment Efficiency
1. Introduction This paper studies the relation between financial reporting quality and investment efficiency. Recent papers (e.g., Healy and Palepu, 2001; Bushman and Smith, 2001; Lambert, Leuz, and Verrecchia, 2005) suggest that enhanced financial reporting can have important economic implications such as increased investment efficiency. However, despite solid theoretical support for such a relation, there is little empirical evidence supporting these claims. I hypothesize that financial reporting quality can improve investment efficiency by reducing information asymmetry in two ways: (1) it reduces the information asymmetry between the firm and investors and thus lowers the firm’s cost of raising funds; and (2) it reduces information asymmetry between investors and the manager and thus lowers the shareholders’ cost of monitoring managers and improves project selection. The two key constructs in the analysis are investment efficiency and financial reporting quality. I conceptually define a firm as investing efficiently if it undertakes all and only projects with positive net present value (NPV) under the scenario of no market frictions such as adverse selection or agency costs. Thus inefficient investment includes passing up investment opportunities that would have positive NPV in the absence of adverse selection (underinvestment). Likewise, inefficient investment includes

undertaking projects with negative NPV (overinvestment). I measure investment efficiency as deviations from expected investment using a parsimonious investment model which predicts expected investment as a function of growth opportunities (Tobin, 1982). Thus, both underinvestment (negative deviations from expected investment) and


overinvestment (positive deviations from expected investment) are considered inefficient investment. I conceptually...
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