Accounting Quality, Investment Efficiency, and the Country-Level Strength of Institutional Enforcement

Abstract

This study examines the extent to which the effect of firm-level accounting quality on corporate investment efficiency differs across jurisdictions with differential strength of institutional and regulatory enforcement. Institutional enforcement is expected to mitigate adverse selection and moral hazard concerns which drive inefficient investment, in the same way as firm-specific financial reporting quality has been shown to do by previous research within the single-country setting. Using a sample of mandatory IFRS adopters from 25 countries, findings first indicate a significantly negative association between accounting quality and both over- and under-investment, which strongly holds regardless of the institutional characteristics of a country. However, this negative association becomes more pronounced when the level of institutional enforcement is weaker and less effective in a country, consistent with firm-specific reporting quality increasing importance as country-level regulatory enforcement worsens. This evidence indicates that when the effectiveness of institutional enforcement in a country does not successfully alleviate information asymmetries, and help facilitate the efficient monitoring of corporate insiders by capital providers, there is greater need for firm-specific accounting quality to perform this function in order to promote efficient investing.