The Effect of Private Information

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The Effect of Private Information and Monitoring on the Role of Accounting Quality in Investment Decisions* ANNE BEATTY, The Ohio State University W. SCOTT LIAO, University of Toronto JOSEPH WEBER, Massachusetts Institute of Technology

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

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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...
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