Earnings Quality and Investment Efficiency: Evidence from Eastern Europe

Issue: 4/2017

Daryush Rasadi

National Research University Higher School of Economics (NRU HSE), Faculty of Economic Sciences, Department of Finance, 26 Shabolovka St. Building 3, 119049 Moscow, Russia; daryush.rasadi@gmail.com

Victoria Cherkasova

National Research University Higher School of Economics (NRU HSE), Faculty of Economic Sciences, Department of Finance, 26 Shabolovka St. Building 3, 119049 Moscow, Russia; vcher-kasova@hse.ru (corresponding author)

This study explores the firm-level relationship between earnings quality and investment efficiency. Higher quality of reported results has the capacity to positively impact the efficiency of company’s investment levels by over- and underinvestment reduction. The research is carried out on the sample of 7546 companies from Eastern Europe for the period 2010-2015. Eastern European countries have a unique institutional and business environment that is relevant to the purpose of this paper. We divide the sample into 2 fundamentally different economic sectors – industrial and retail – and test the significance of each factor in the main relationship. We also examine the factor of the firm’s ownership form by comparing earnings quality with investment efficiency values between public and private companies. Our main results show that a higher earnings quality mitigates both overinvestment and underinvestment issues. The relationship between earnings quality and underinvestment turns out to be stronger in the industrial sector. As for the comparison of public and private firms, public companies on average demonstrate a higher earnings quality and lower overinvestment issues.

DOI: 10.1515/revecp-2017-0023
JEL: G32, G31
Keywords: underinvestment, overinvestment, investment efficiency, financial reporting quality, Earnings quality

Abel, A. B. (1983). Optimal investment under uncertainty. American Economic Review, 73(1), 228–233.

Allee, K. D., and Yohn, T. L. (2009). The demand for financial statements in an unregulated environment: An examination of the production and use of financial statements by privately held small businesses. Accounting Review, 84(1), 1–25. https://doi.org/10.2308/accr.2009.84.1.1

Ball, R., Kothari, S. P., and Robin, A. (2000). The effect of international institutional factors on properties of accounting earnings. Journal of Accounting and Economics, 29(1), 1–51. https://doi.org/10.1016/S0165-4101(00)00012-4

Basu, S. (1997). The conservatism principle and the asymetric timeliness of earnings. Journal of Accounting and Economics, 24(1), 3–37. https://doi.org/10.1016/S0165-4101(97)00014-1

Biddle, G. C., and Hilary, G. (2006). Accounting quality and firm-level capital investment. Accounting Review, 81(5), 963–982. https://doi.org/10.2308/accr.2006.81.5.963

Biddle, G. C., Hilary, G., and Verdi, R. S. (2009). How does financial reporting quality relate to investment efficiency? Journal of Accounting and Economics, 48(2–3), 112–131. https://doi.org/10.1016/j.jacceco.2009.09.001

Bushman, R. M., and Smith, A. J. (2001). Financial accounting information and corporate governance. Journal of Accounting and Economics, 32(1–3), 237–333. https://doi.org/10.1016/S0165-4101(01)00027-1

Chen, F., Hope, O. K., Li, Q., and Wang, X. (2011). Financial reporting quality and investment efficiency of private firms in emerging markets. Accounting Review, 86(4), 1255–1288. https://doi.org/10.2308/accr-10040

Cherkasova, V., and Zakharova, E. (2016). Suboptimal investments and M&A deals in emerging capital markets. Economic Annals, 61(208), 93–120. https://doi.org/10.2298/EKA1608093C

Collins, D. W., Kothari, S. P., Shanken, J., and Sloan, R. G. (1994). Lack of timeliness and noise as explanations for the low contemporaneuos return-earnings association. Journal of Accounting and Economics, 18(3), 289–324. https://doi.org/10.1016/0165-4101(94)90024-8

Cutillas Gomariz, M. F., and Sánchez Ballesta, J. P. (2014). Financial reporting quality, debt maturity and investment efficiency. Journal of Banking and Finance, 40(1), 494–506. https://doi.org/10.1016/j.jbankfin.2013.07.013

Dayanandan, A., Donker, H., Ivanof, M., and Karahan, G. (2016). IFRS and accounting quality: legal origin, regional, and disclosure impacts. International Journal of Accounting and Information Management, 24(3), 296–316. https://doi.org/10.1108/IJAIM-11-2015-0075

Dechow, P., Ge, W., and Schrand, C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50(2–3), 344–401. https://doi.org/10.1016/j.jacceco.2010.09.001

Dechow, P. M., and Dichev, I. D. (2002). The quality of accruals and earnings: The role of accrual estimation errors. Accounting Review, 77(SUPPL.), 35–59. https://doi.org/10.2308/accr.2002.77.s-1.61

Dechow, P. M., Sloan, R. G., and Sweeney, A. P. (1995). Detecting Earnings Management. The Accounting Review, 70(2), 193–225. https://doi.org/10.2307/248303

Fazzari, S. M., Hubbard, G. R., and Petersen, B. C. (2000). Investment-Cash Flow Sensitivities Are Useful: A Comment on Kaplan and Zingales. Quarterly Journal of Economics, 115(2), 695–705. https://doi.org/10.1162/003355300554773

Francis, J., Schipper, K., and Vincent, L. (2005). Earnings and dividend informativeness when cash flow rights are separated from voting rights. Journal of Accounting and Economics, 39(2), 329–360. https://doi.org/10.1016/j.jacceco.2005.01.001

Fusheng, W., Zhibiao, Z., and John, H. (2015). Financial Reporting Quality, Free Cash Flow, and Investment Efficiency. SHS Web of Conferences, 27.

Gugler, K., Ivanova, N., and Zechner, J. (2014). Ownership and control in Central and Eastern Europe. Journal of Corporate Finance, 26, 145–163. https://doi.org/10.1016/j.jcorpfin.2014.03.001

Hayashi, F. (1982). Tobin’s Marginal q and Average q: A Neoclassical Interpretation. Econometrica, 50(1), 213–224. https://doi.org/10.2307/1912538

Healy, P., and Palepu, K. (2001). Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclostire literature. Journal of Accounting and Economics, 31(1-3), 405–440. https://doi.org/10.1016/S0165-4101(01)00018-0

Jones, J. J. (1991). Earnings Management During Import Relief Investigations. Journal of Accounting Research, 29(2), 193–228. https://doi.org/10.2307/2491047

Klapper, L. F., Sarria-Allende, V., and Sulla, V. (2002). Small- and Medium-Size Enterprise Financing in Eastern Europe. World Bank Policy Research Working Paper, (2933). https://doi.org/10.1596/1813-9450-2933

Kothari, S. P., Leone, A. J., and Wasley, C. E. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39(1), 163–197. https://doi.org/10.1016/j.jacceco.2004.11.002

La Rocca, M., Cariola, A. and La Rocca, T. (2007). Overinvestment and underinvestment problems: determining factors, consequences and solutions. Corporate Ownership and Control, 5(1), 79-95. https://doi.org/10.22495/cocv5i1p7

McNichols, M. (2002). Discussion of ‘‘The quality of accruals and earnings: The role of accrual estimation errors’’. Accounting Review, 77(s-1), 61–69. https://doi.org/10.2308/accr.2002.77.s-1.61

McNichols, M. F., and Stubben, S. R. (2008). Does earnings management affect firms’ investment decisions? Accounting Review, 83(6), 1571–1603. https://doi.org/10.2308/accr.2008.83.6.1571

Md. Shamimul, H., Normah, O., and Syed Zabid, H. (2015). Corporate attributes and market capitalization. Evidence from Bangladesh. Aestimatio, 11, 92–105. https://doi.org/10.5605/IEB.11.4

Myers, C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5(2), 147–175. https://doi.org/10.1016/0304-405X(77)90015-0

Myers, S. C., and Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), 187–221. https://doi.org/10.1016/0304-405X(84)90023-0

Ohlson, J. A. (2014). Accruals: An overview. China Journal of Accounting Research, 7(2), 65–80. https://doi.org/10.1016/j.cjar.2014.03.003

Petersen, M. A. (2009). Estimating standard errors in finance panel data sets: Comparing approaches. Review of Financial Studies, 22(1), 435–480. https://doi.org/10.1093/rfs/hhn053

Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? Accounting Review, 71(3), 289–315. https://doi.org/10.2307/248290

Tobin, J. (1969). A General Equilibrium Approach To Monetary Theory. Journal of Money, Credit & Banking (Ohio State University Press), 1(1), 15–29. https://doi.org/10.2307/1991374