Ebook Earnings Quality and the Sensitivity of Capital Investment to Accounting Information
Corporate investment is the ultimate driving force of value creation in an economy. Financial information production is crucial for capital allocation efficiency. The accounting system is clearly a source of information for managers to identify and distinguish between good versus bad investment projects. Higher accounting information quality will enhance efficiency by providing useful information that enables managers to identify value creation opportunities with less error (Bushman and Smith (2001)). However, few studies investigate how quality of accounting information affects use of accounting information in firms’ capital investments. This is partially because there is no role for accounting information in the traditional Q theory of investment. Under the efficient market hypothesis and other assumptions, Q theory postulates that Tobin’s Q should be a sufficient statistic for investment (Hayashi (1982)).
Thus any observed association between corporate investment and accounting variables (e.g. cash flows from operations) after controlling for Q, has been interpreted as evidence of capital market frictions (e.g. Fazzari, Hubbard, and Petersen (1988, 2000)). Recently, more studies have begun to recognize that the accounting system provides incremental information about investment opportunities in capital investment decisions (e.g. Morck, Shleifer, and Vishny (1990), Blanchard, Rhee, and Summers (1993), Gilchrist and Himmelberg (1995), Alti (2003), Liu and Qi (2002), Bond et al. (2004), among others). These studies suggest that accounting variables provide information about investment opportunities beyond market information. However, none of them examine the effect of accounting information quality on the use of accounting information in capital investment decisions.
This study seeks to shed light on this issue by investigating the effect of earnings quality on the sensitivity of capital investment to accounting earnings. The study starts from the assumption that firms’ capital investments are sensitive to information about firms’ investment profitability (economic earnings). Managers incorporate multiple sources of information to form expectations about investment profitability. Rational managers place more weight on signals that are more informative about investment profitability. Current economic earnings have predictive power on economic earnings from investment. Accounting earnings are a noisy measure of economic earnings. Thus, the more informative that accounting earnings are about economic earnings, the more investment should be sensitive to accounting earnings. In this paper, I proxy for informativeness of accounting earnings about economic earnings by using the earnings quality measure first proposed by Dechow and Dichev (2002) and modified by McNichols (2002). Schipper and Vincent (2003) argue that Dechow and Dichev’s (2002) earnings quality measure is consistent with the representational faithfulness perspective, i.e. reported earnings correspond or agree with economic earnings. Thus, I predict stronger sensitivity of capital investment to accounting earnings when earnings quality is higher.
To test the hypothesis, I conduct a firm and time fixed-effects regression of firms’ capital investments against lagged Tobin’s Q, contemporaneous operating cash flows, and lagged earnings scaled by total assets. I allow the sensitivity of investment to lagged earnings, Tobin’s Q and contemporaneous operating cash flows to change with earnings quality. I provide strong evidence that firms’ capital investments are more sensitive to accounting earnings when earnings quality is higher. Next, I investigate the effect of earnings quality on the incremental sensitivity of investment to accruals, controlling for sensitivity to lagged operating cash flows. Accruals are the crucial element that make earnings a better measure of performance than cash flows and prior studies show accruals provide incremental information about firms’ economic performance beyond operating cash flows. I then further separate earnings into operating cash flows and accruals. I find that higher earnings quality is associated with higher sensitivity of investments to accruals. To summarize, the evidence is consistent with the conjecture that a higher quality accounting system provides more accurate information about investment profitability for managers to make investment decisions.
This paper considers a number of robustness tests. I find that the positive association between earnings quality and sensitivity of investment to earnings is neither solely driven by measurement errors of earnings due to earnings management, nor by measurement errors of Tobin’s Q. In addition, I find that the positive association between earnings quality and sensitivity of investment to earnings is robust when controlling for information from analysts. I also examine different empirical specifications and the results are qualitatively similar.
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