Earnings quality, investment decisions, and financial constraint.

Autorde Carvalho, Flavio Leonel

1 Introduction

In order to inhibit earnings management, in 2002, the United States approved the Sarbanes-Oxley Act, which aimed to reinforce the importance of adopting corporate governance practices (Chan, Chou, Lin, & Liu, 2016) and therefore provide greater reliability of reported financial information. Based on this initiative, legislators from different countries have sought ways to encourage the adoption of corporate governance practices (Sorensen & Miller, 2017) that, in turn, can be understood as a set of mechanisms by which investors seek to ensure return on investment (Shleifer & Vishny, 1997).

However, Lopes (2001) stated that the adoption of sophisticated and costly governance practices is needed when the accounting information system does not fulfill its role as an asymmetry reducer. Additionally, for Bushman, Chen, Engel, and Smith (2004), the adoption of a complex corporate governance structure derives from low-quality accounting. Given the above, it is possible to notice the existence of an intrinsic relationship between agency problems, attempts to reduce asymmetries, and the quality of financial reporting.

Quality accounting information is understood as the information relevant for decision-making, i.e., information that generates benefits that are greater than their costs, that are relevant and reliable, and that allow comparability between entities (Hendriksen & Breda, 1999). Moreover, the quality of earnings has been used as a proxy to specify financial reporting quality, given that profit is a firm performance measurement that is often cited, analyzed, and discussed in the literature and in the financial community (Dechow & Dichev, 2002; McNichols, 2002; Niu, 2006).

Apart from involving subjective aspects, profits are calculated and disclosed by managers and are therefore subject to influences by the various firm interests. According to Hribar, Melessa, Small, and Wilde (2017), the managers' beliefs about a company's future results are associated with accruals estimation errors. The subjective aspects inherent to the accrual basis of accounting, as well as the recognition decisions involving income or expenses and gains or losses, enable the manipulation of financial figures in favor of managers' objectives. The inherent subjectivity of the accounting recognition process is reflected in accounting adjustments, called accruals, consisting of the difference between the recognition of an economic event in firm results (accrual basis) and its actual impact on cash (Dechow & Dichev, 2002; Dechow, Ge, & Schrand, 2010).

Earnings should show the performance of a firm as accurately as possible. Thus, it is possible to assume, according to Carvalho, Kalatzis, and Albuquerque (2014), that the quality of accounting information can play an important role in decision-making. More accurate information allows for the better monitoring of managers' activities. As a consequence, this fidelity is expected to facilitate the process of controlling investment decisions.

An investment decision basically consists of the process of accepting or rejecting a particular investment project. Thus, it can be noted that, from a theoretical point of view, the decision is simple: projects for which the return is greater than the opportunity cost must be accepted, while others must be rejected. In real life, this process is not so easy, since the decision to accept or reject a project can be influenced by agents' interests in the decision-making process. Thus, accepting economically unviable projects or rejecting economically attractive projects can occur when the outcome of such deliberations offers benefits to decision makers, even when it causes losses to shareholders. In countries with weak law enforcement and low-quality financial information--which are common features of developing countries--the asymmetry problem and discretionary decisions taken by managers become even more relevant. However, few studies have focused on investigating this assumption (Verdi, 2006).

Considering that earnings quality can reduce the asymmetry of information and that information asymmetry can enable inefficient investment decisions, the following question arises: does the quality of financial information influence the efficiency of investment decisions?

Another important aspect of investment decisions is the availability of external resources for investment. Firms for which access to debt can reduce investment opportunities can be considered financially constrained companies. In this situation, a company's investments will depend on the generation of internal cash. Thus, many studies have investigated the use of investment-cash flow sensitivity as a proxy for financial constraint. Firms for which investments are sensitive to internal cash flow are financially constrained.

However, the option of internally generated resources is not necessarily attributable to difficult access to external sources of capital; it could also be due to the decision makers' interests in avoiding publishing data that may increase the monitoring and control of their management. For Myers (1984) and Myers and Majluf (1984), there would be a hierarchy of preferences among the various sources of resources, and decision makers may prefer to use internal resources in investments because it would require a lower level of information reporting. Thus, the relationship between cash flow and investments may also be associated with the conflicts of interest present in the management process and the interest in maintaining the asymmetry of information between managers and investors (shareholders or creditors). In addition, an improvement in the transparency of financial information or the adoption of governance mechanisms would facilitate access to credit, provide lower funding costs, and enable the reduction of financial constraint problems (Botosan, 1997; Dechow et al., 2010; Francis, LaFond, Olsson, & Schipper, 2005), and it is possible to suppose a negative relationship between low earnings quality and investment-cash flow sensitivity. Thus, one also wonders: does earnings quality affect investment-cash flow sensitivity?

It is therefore noted that the accounting flexibility derived from the accrual basis coupled with the divergent interests involved in a firm's management may stimulate discretionary behaviors (Kim, 2016) and thus influence investment decisions and investment-cash flow sensitivity. Based on the research problem, this study aims to investigate whether the quality of financial information influences the efficiency of corporate investment decisions in seven countries in Latin America--Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Moreover, it aims to investigate whether earnings quality has an effect on investment-cash flow sensitivity.

This research investigates how the quality of financial information and the level of financial constraint impact a firm's investment decisions. We expect to verify the relationship between financial information and the efficiency of investment decisions. Moreover, we expect to analyze the theoretical assumption that investments for the group of companies classified as "firms with excess investment" have a negative relation with the quality of accounting information. Thus, as the accounting information quality improves, the volume of investments for companies investing in excess will decrease. In turn, we expect to test a theoretical hypothesis that the investments of firms investing in an inefficient way, that is, investing less than necessary (underinvesting), demonstrate a positive relation with the proxy for earnings quality. In addition, we expect the quality of financial information to affect investment-cash flow sensitivity. The theoretical basis for this last expectation is the argument that financially constrained firms that report information with quality and transparency will reduce the asymmetry of information between managers and creditors and could facilitate the acquisition of external resources. Additionally, the literature points out that a reduction in information asymmetry can impact the hierarchy of preferences for capital sources, since the maintenance of informational advantages, when using internal resources, will be minimized. Another contribution is the use of the Generalized Method of Moments (GMM) as a statistical tool for the estimation of significant investment variables, since it is uncommon to use this technique in this kind of study, especially when the relationship between investment decisions, earnings quality, and financial constraints is analyzed.

The study is structured in four sections, including this contextualization. The second section presents a brief theoretical framework discussing the determinants of corporate investments, the determinants of the quality of financial reporting, and the relationship between financial information quality, investment efficiency, and financial constraint. The third section presents the methodology employed. The fourth section analyzes the results and the main implications of the study, as well as their relationship with existing studies. Finally, we present considerations regarding the results obtained.

2 Review of the Literature

According to Branco (2006), from the perspective of agency theory, the main reason for reporting financial information is to alleviate the problem of information asymmetry by increasing shareholders', creditors', and others' access to information about a company. As access to information increases, the privileged position held by managers in relation to private information decreases. The author states that accounting is also away to control managers' activities, as their behaviors change depending on the content of the disclosed information. Therefore, financial accounting plays an important role in facilitating the creation and fulfillment of contracts.

Given this background, studies have...

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