1. Introduction Information asymmetry between managers and outside capital suppliers can affect how ﬁrms ﬁnance capital investments. A growing body of evidence indicates that better accounting quality can reduce information asymmetry costs and reduce ﬁnancing constraints. Consistent with this possibility, Biddle and Hilary (2006) document that higher accounting quality reduces the sensitivity of ﬁrms’ investment to their internally generated cash ﬂows. Verdi (2006) and Biddle, Hillary, and Verdi (2009) ﬁnd that accounting quality is positively correlated with investment for ﬁrms prone to underinvest and is negatively correlated with investment for ﬁrms prone to overinvest. The importance of accounting quality on investment inefﬁciency may be mitigated when outside capital suppliers have private information or can directly monitor managers. By accessing private information and controlling managerial actions, outside capital suppliers can directly affect a ﬁrm’s investments, reducing the importance of accounting quality. Consistent with this idea, Biddle and Hilary (2006) compare the inﬂuence of accounting quality on investment efﬁciency across countries. They ﬁnd that accounting quality inﬂuences investment efﬁciency in the United States, but not in Japan. They suggest that one potential explanation for this cross-country difference is the mix of debt and equity in the capital structures of U.S. versus Japanese ﬁrms. We extend this research by examining how different sources of ﬁnancing affect the importance of accounting quality on ﬁrms’ investment–cash ﬂow sensitivity. Directly testing how different sources of ﬁnancing inﬂuence the * Accepted by Shivaram Rajgopal. Beatty thanks Deloitte & Touche for ﬁnancial support. We thank Jennifer Altamuro, Ron Dye, Ben Lansford, Tom Lys, Waleed Muhana, Rick Johnston, Shail Pandit, Joe Piotroski, Shyam Sunder, Rick Young, Helen Zhang, and seminar participants at Stanford University, Northwestern University, and Ohio State University.
Contemporary Accounting Research Vol. 27 No. 1 (Spring 2010) pp. 17–47 Ó CAAA doi:10.1111/j.1911-3846.2010.01000.x
Contemporary Accounting Research
effect of accounting quality on the investment–cash ﬂow sensitivity is challenging because a comparison of ﬁrms that recently obtained debt ﬁnancing to those that did not could be affected by their ability to obtain ﬁnancing. To alleviate this problem, we restrict our sample to ﬁrms that have all recently obtained debt ﬁnancing and exploit the differences in access to private information and monitoring that exist across the public debt to private lending continuum as suggested by Diamond 1991.1 We acknowledge that the sensitivity of investment to internal cash ﬂows may be lower immediately after obtaining debt ﬁnancing. However, this possibility would bias against rejecting our hypotheses. Speciﬁcally, we identify a sample of 1,163 ﬁrms on the Securities Datacorp (SDC) database that have recently raised capital through the issuance of either public debt or syndicated bank debt. We restrict our sample to ﬁrms that have recently obtained debt ﬁnancing to hold constant the ﬁrm characteristics associated with borrowing. However, within the sample of ﬁrms that have recently obtained debt ﬁnancing, there are likely to be signiﬁcant differences in the capital provider’s access to private information and the constraints they place on managerial actions. Diamond’s (1991) theory implies that public debt holders have less access to private information and are thus less effective in monitoring borrowers than banks. Based on these arguments, we predict that accounting quality should have a larger inﬂuence on ﬁrms’ investment–cash ﬂow sensitivity for ﬁrms with public debt...