The current issue and full text archive of this journal is available at

www.emeraldinsight.com/2040-8749.htm

Financial
Financial reporting quality and reporting quality
corporate investment efficiency:
Chinese experience
197
Qingyuan Li
School of Economics and Management, Wuhan University, Received 3 January 2010
Wuhan, People’s Republic of China, and Revised 5 February 2010
Accepted 1 March 2010
Tielin Wang
Accounting Department, Guangdong University of Finance,
Guangzhou, People’s Republic of China

Abstract
Purpose – The purpose of this paper is to study the relationship between financial reporting quality
and investment efficiency in China.
Design/methodology/approach – By analyzing institutional background and hypotheses
development, the paper selected listed firms in China to be the study samples. On the base of that,
the relationship between financial reporting quality and investment efficiency of the samples were
discussed.
Findings – Consistent with this claim, the paper finds proxies for financial reporting quality, namely
self-constructed composite measures, are negatively associated with both under- and overinvestment
of the listed corporations; of which the effects of accrual quality and earnings smoothness on under-
and overinvestment are most significant.
Research limitations/implications – Overall, this paper has implications for research examining
the determinants of investment efficiency and the economic consequences of enhanced financial
reporting.
Practical implications – This paper seeks to develop Chinese economic infrastructure into an
economically efficient system of public financial reporting and disclosure in order to improve
accounting information’s role of allocating capital.
Originality/value – The conclusion of this paper might be the first empirical evidence to support
prior research that financial reporting quality is positively related to investment efficiency for large,
US publicly traded firms, thus the findings extend to public firms in emerging markets.
Keywords Financial reporting, Corporate investments, China
Paper type Research paper

1. Introduction
One objective of financial reporting information is to facilitate the efficient allocation of
capital in the economy. An important aspect of this role is to improve firms’ investment
decisions. Specifically, theory suggests that improved financial transparency has the
potential to alleviate both over- and underinvestment problems and recent studies Nankai Business Review
support this prediction. Several recent empirical papers support the existence of such a International
Vol. 1 No. 2, 2010
relation (Biddle and Hilary, 2006; Hope and Thomas, 2008; McNichols and Stubben, 2008; pp. 197-213
q Emerald Group Publishing Limited
2040-8749
Qingyuan Li acknowledges the financial support of National Social Science Fund (No. 70702017). DOI 10.1108/20408741011052591
NBRI Biddle et al., 2009; Francis et al., 2009). This evidence, however, has been mostly limited
1,2 to large, publicly traded firms in the USA. It is not obvious that the findings
documented in prior studies extend to different settings. In this study, we extend the
literature by examining the relation between financial reporting quality and investment
efficiency for a sample of public firms in emerging markets. This study provides
evidence of both.
198 Zeng and Lu (2003) mainly focused on the study of relationships between our public
corporate financial reporting quality and capital cost. They mentioned little empirical
evidence about how accounting information quality affects corporate actual investment
decisions. As an integral part of financial contracts, financial accounting information
affects investment efficiency through monitoring and costs of financing. Reliable
financial information can provide a less biased performance measure, which helps to
reward managers for making good investment decisions and punish them for bad
decisions (Bushman and Smith, 2001). Reduced information asymmetry by high-quality
information disclosure will lower costs of financing, reduce market inefficiency and
facilitate financing especially for long-term high-return projects (Levine, 1997). My main
hypothesis predicts that high-financial reporting quality is negatively associated with
both under- and overinvestment of our listed corporation.
We study the relation between financial reporting quality and investment efficiency
on a sample of 2,319 firm-year observations during the sample period of 2004-2006 in
China. The analysis shows the proxies for financial reporting quality are negatively
associated with both firm under- and overinvestment. Although our results suggest that
firms with higher financial reporting quality are associated with more efficient
investment, one cannot conclude from this paper that increasing financial reporting
quality would necessarily translate into higher investor welfare. Enhanced financial
reporting may improve investment efficiency by reducing information asymmetry.
However, firms must weigh this benefit against the costs, which include such
proprietary cost, political cost and tunnelling cost of controlling shareholder. Further, it
may even be impossible for some firms to increase financial reporting quality given the
limitations imposed by Chinese generally accepted accounting principles. Nonetheless,
this paper contributes to literature on the economic consequences of enhanced financial
reporting by showing that financial reporting quality can be associated with more
efficient investment.
The next section reviews-related research and develops our hypotheses. Section 3
describes our data and our measures of accounting quality and investment efficiency.
Section 4 presents our empirical tests and results. Section 4.4 contains several
robustness tests. Section 5 concludes.

2. Background and hypotheses development

In perfect capital market, marginal Tobin q is the only motivating factor of corporate
investment policy. However, the correlation between firm investment and cash flow is
always defined as capital market friction, such as evidences of financing constraints
(Fazzari et al., 1988). More and more literatures show that stock price is affected not only
by corporate basic information but also by market abitrage fads and fashions which
make this kind of noise reducing the power of stock price automatically to guide optimal
investment (Shleifer and Vishny, 1997). In the real world, there are taxes and transaction
costs and other factors, making the market could not run perfectly. As Stein (2003) points
out, firms often face inadequate investment, or the risk of excessive investment, which Financial
potentially affect the firm investment efficiency, but the most common and important reporting quality
factors that affect the firm investment efficiency may come from information
asymmetry and agency problem. The literature suggests that financial reporting and
disclosure has the potential to mitigate both under- and overinvestment problems, and
hence increases overall investment efficiency. There are several mechanisms through
which financial reporting can play such a role. First, high-quality accounting 199
information can reduce information asymmetry between investors, improve the capital
market liquidity. Thereby it can reduce cost of financing due to adverse selection, and
also facilitate financing of long-term and high-yield investment projects, while
accounting information will also reduce information asymmetry between management
and the shareholders, reducing the probability that investors inferred firms issuing
securities as poor type, leading capital suppliers to assess current prices of firms
correctly, and thus reduce financing costs. So, high-quality accounting information will
reduce financing costs caused by shareholders’ adverse selection and thus directly
increase investment efficiency. Second, the accounting information is not only often
directly used for the design of executive compensation contracts, but also an important
source of information channel that is used by shareholders supervising managers, which
greatly help to mitigate the firms agency problem between the shareholders and
managers. Finally, as the important sources of firms’ heterogeneous information,
accounting information can help to play stock market’s supervising role and thus
contribute to reduce agency problems between shareholders and managers, increasing
shareholders’ supervising capacities, improving their project selection and reducing
financing costs, thereby increasing investment efficiency.
Based on sample of US listed firms from 1967 to 2000, Wang (2003) uses Wurgler
(2000) model and Richardson (2006) model to measure the investment efficiency of firms
and finds that the relation between industry and firm-level investment efficiency and
quality of accounting information is significant positive, without making a distinction
between under- and overinvestment. Based on US listed firm data from 1993 to 1997,
Durnev et al. (2004) use Tobin’s marginal q ratio to measure the efficiency of investment
and find the proximity of marginal q to its optimal level and the magnitude of
firm-specific return variation to be highly positively correlated across industries. Based
on listed corporation for the time period 1990-2003 in nine European countries, Risberg
(2006) uses marginal Tobin’s q ratio to measure investment efficiency and find that gain
timeliness is convex related to investment efficiency while loss timeliness is concave
related to investment efficiency. Based on the sample including 34 countries that had
ever been studied by Bhattacharya et al. (2003), Biddle and Hilary (2006) aggregate four
accounting quality measures, such as earnings aggressiveness, loss avoidance, earnings
smoothing and timeliness into a summary proxy for financial reporting quality. They
find that accounting quality is negatively related with investment-cash flow sensitivity
both across and within countries and this relation is stronger in economies where
financing is largely provided through arm’s length transactions. Based on the sample
including 34,791 firm-year observations from 1993 to 2005, Biddle et al. (2009) find that a
conditional negative (positive) association between financial reporting quality and
investment for firms operating in settings more prone to overinvestment
(underinvestment).
NBRI Since capital market was built in 1991, Chinese Government has strived to improve
1,2 its accounting standard and has attained qualitative convergence with international
financial reporting standards in 2006. Additionally, China’s economy has become more
and more market-orientated while other financial infrastructure has been gradually
improved. These have made market system, regulation and investors change very
much, thus the role of financial reporting quality improve corporate capital allocation
200 efficiency will become more and more important. Based on the sample of listed
companies, which can conduct seasoned equity offerings in Shenzhen stock market,
Zeng and Lu (2003) find there is a negative relationship between disclosure quality and
marginal cost of equity capital controlling b, size, B/M, leverage and asset turnover,
which means that disclosure quality will influence the cost of equity capital in Chinese
stock market while earnings smoothness and total disclosure quality are the main
influence factors on the cost of equity capital. Based on the discussion above that
financial reporting affects both adverse selection and agency conflicts, I predict an
average negative relation between financial reporting quality and both under- and
overinvestment:
H1. Financial reporting quality is negatively associated with underinvestment.
H2. Financial reporting quality is negatively associated with overinvestment.

3. Sample and measurement of main variables

3.1 Data source
We obtain our sample of publicly listed Chinese firms available in the China Security
Market and Accounting Research dataset. The starting point of our sample is dictated
by accounting standards and in particular by the accounting standard for business
enterprises: cash flow statements that became operative from January 1998. Since it is
only feasible to calculate accruals using cash flow statements in the first year, we use a
sample during 1998-2006. Sample selection is as follows:
.
because the demarcation between operating, investing and financing activities is
ambiguous for these firms, we exclude observations of such firms;
. based on the A-M industry first classification method of standard industrial
classification of listed firms stipulated by China Securities Regulatory
Commission (CSRC) in 2001, at least 20 industry-year observations are
required because of data requirement[1];
.
data omission is removed; and
.
data that cannot be accurately obtained due to reorganization of assets, control
right changing but making main business of firms changed is removed.

Finally, to mitigate the influence of outliers, we winsorize all variables at the 1 and 99
percent levels.

3.2 Proxy for investment efficiency

The two key constructs in the analysis are investment efficiency and financial reporting
quality, and we investigate how earnings quality in the current year affects next year’s
investment efficiency. Conceptually, investment efficiency refers to firms undertaking
all and only projects with positive net present value. Consistent with prior research
(Biddle et al., 2009), we measure investment efficiency as deviations from expected Financial
investment using a model that predicts investment as a function of growth
opportunities. Thus, both underinvestment (negative deviations from expected
reporting quality
investment) and overinvestment (positive deviations from expected investment) are
considered inefficient investments.
In many empirical studies, proxies for investment efficiency include average Tobin’s
q ratio, cost of capital as well as cost of capital rate divided by return of investment, but 201
recently increasingly widely used proxy for firm-specific investment efficiency include
the marginal Tobin’s q model, Wurgler (2000) model and Richardson (2006) model.
Although Richardson (2006) model has been questioned by Bergstresser (2006), this
model can also directly measure firm-specific firm-year investment efficiency, and this
use of cross-sectional data regression can avoid the survivors bias caused by marginal
Tobin’s q model and Wurgler (2000) model. Recently, scholars began to increasingly use
Richardson (2006) model to study the effect of accounting information, compensation
contracts and governance mechanism on the investment decisions and capital allocation
efficiency, thus we follow Richardson (2006) model to calculate the under- and
overinvestment of Chinese listed firms. Estimation model is as follows:
X
Invi;t ¼ g0 þ g1 Growi;t21 þ fj Control j;i;t21 þ y i;t ð1Þ

In model (1), we define Invi,t as net change sum of fixed assets, long-term investment and
intangible assets and scaled by average total assets for firm i in year t; Growi,t2 1 is
annual revenue growth rate for firm i in year t 2 1; Controlj,i,t2 1 is control variables,
specifically including financial leverage (Levi,t2 1), measured as liabilities divided by
total assets for firm i in year t 2 1; listed age (Age i,t2 1), measured as the log of the age for
firm i in year t 2 1; cash ratio (Cashi,t2 1), measured as the ratio of cash plus short-term
investments to average assets in year t 2 1; the log of lagged total assets (Sizei,t2 1),
annual stock returns (Reti,t2 1), measured as buy-and-hold annual stock returns from
May in year t 2 1 to April in year t, adjusted by the value-weighted annual market
returns; lag items (Invi,t2 1).
We estimate the investment model cross-sectionally with at least 20 observations in
each industry by year. The sample consists of 3,600 firm-year observations with
available data to estimate equation (1) from 2004 to 2006. To mitigate the influence of
outliers, we winsorize all variables at the 1 and 99 percent levels. We then classify firms
into two groups based on the residuals of equation (1) (i.e. the deviations from the
predicted investment levels). To ease exposition, we multiply the underinvestment
variable by 21 so that a higher value suggests a more severe underinvestment.
Additionally, we also perform empirical analysis to investigate the residuals from the
investment model as firm-specific investment efficiency measure. Optimal investment
means future growing cash flows and better economic performance. We partition all the
firms with available estimates into three groups based on the absolute residuals to
investigate their future market and accounting performance. If firms have minimum
absolute volume of residual investment, then they are considered to have higher
efficiency of investment, otherwise are considered to have lower efficiency of
investment. The median and mean test showed that the equity returns in the next two
years and the earnings before interest and tax of the groups having minimum absolute
value of residual investment are more significant than the groups having maximum
absolute value of residual investment, which means the lower the absolute value of
NBRI residual investment of company the more easily to achieve optimal capital allocation.
1,2 The firms’ future value and business performance are corresponding better. These
analyses support some rationality of adopting Richardson (2006) model to estimate
firm-specific efficiency of China.

3.3 Proxies for financial reporting quality

202 There is no one universally agreed upon measure of financial reporting quality
(Dechow et al., 2010), but no figures could be as attractive as earnings noticed by
investors. Although earning attributes include accruals quality, persistence,
predictability, value relevance, timeliness, conservatism and smoothness, there are
not adequate time-series data, it is difficult to build all of the above-mentioned measures
about financial information quality of listed firms because Chinese capital market has
not been long established and accounting standards have been changed several times.
Therefore, combining with existing accounting data of Chinese listed firms, we
aggregate three accounting quality measures, such as accrual quality, accounting
conservatism and smoothness into a summary proxy for financial reporting quality in
order to mitigate the measurement errors and extreme value caused by individual
indicators measuring the quality of accounting information.
3.3.1 Accrual quality.
1. Dechow and Dichev (2002) model. Recently, Francis et al. (2005) and Biddle et al.
(2009) often make use of Dechow and Dichev (2002), and McNichols (2002) model to
measure earnings quality, whose main idea is that accruals are estimates of future cash
flows, and earnings will be more representative of future cash flows when there is
lower estimation error embedded in the accruals process. That is to say, regardless
of management’s intentions, accruals estimation error affects the accrual quality.
As Dechow and Dichev (2002) model has a better model meaning, and this calculated
accrual quality and cost of capital are most relevant (Francis et al., 2004), so we use
Dechow and Dichev (2002) model to estimate the accrual quality. The model is a
regression of working capital accruals on lagged, current and future cash flows plus the
change in revenue and PPE. All variables are scaled by average total assets:
DWCi;t ¼ a0 þ a1 CFOi;t21 þ a2 CFOi;t þ a3 CFOi;tþ1 þ 1 ð2Þ
where DWCi,t is measured as the change in non-cash current assets minus the change in
current liabilities, minus depreciation and amortization expense for firm i at year t,
scaled by lagged total assets; CFOi,t2 1, CFOi,t, CFOi,tþ 1 is measured as operating cash
flows for firm i at year t 2 1, t, t þ 1, respectively, scaled by lagged total assets.
2. Ball and Shivakumar (2005) model. While Dechow and Dichev (2002) and
McNichols (2002) are widely proxied for accrual quality, but these models assume that
the accrual profit is linear estimates of future cash flows while considering accrual
profits can mitigate the role of estimated noise, but it did not take into account the second
role that accruals is also a timely recognition of economic gains and losses. Therefore,
combinated with asymmetric timeliness of loss recognition, Ball and Shivakumar (2005)
presented a cash flow and accruals of piecewise linear estimation model, so we use this
model to estimate accrual quality under the condition of timeliness of loss recognition,
thus defining accrual quality from the another side:
ACCi;t ¼ a0 þ a1 DCFOi;t þ a2 CFOi;t þ a3 DCFOi;t *CFOi;t þ 1i;t ð3Þ
where DWCi,t is measured as the change in non-cash current assets minus the change in Financial
current liabilities, minus depreciation and amortization expense for firm i at year t,
scaled by lagged total assets; CFOi,t is measured as operating cash flows for firm i at year
reporting quality
t, scaled by lagged total assets. DCFOi,t is dummy variable, and when CFOi,t is negative,
DCFOi,t is defined as one, otherwise zero. According to Ball and Shivakumar’s (2005)
findings, a2 is negative and a3 is significantly negative too.
Following Francis et al. (2005), I estimate the model in equations (1) and (2) 203
cross-sectionally for each industry in a given year. Accrqi,t and Naccrqi,t at year t is the
negative standard deviation of the firm-level residuals from equations (1) and (2) during
the years t 2 4 to t so that these variables become increasing in financial reporting
quality. As discussed in Dechow and Dichev (2002) and McNichols (2002), the estimation
of Accrqi,t captures the absolute variation in the residuals of equation (1) rather than the
variation relative to a benchmark. One concern with this approach is that Accrqi,t may be
capturing some underlying degree of volatility in the firm. Thus, I follow the suggestion
in McNichols (2002) and create a relative measure of accruals quality. In particular, we
measure Accrqr i;t as the ratio of the standard deviation of the residuals from equation (2)
during the years t 2 4 to t to the standard deviation of total accruals during the years
t 2 4 to t multiplied by negative one. This measure captures the relative variance of the
estimation errors in accruals compared to the total variance, mitigating the concern that
the proxies for financial reporting quality are associated with investment efficiency
because of the spurious effect of firm uncertainty.
3.3.2 Accounting conservatism. The most important feature of financial reporting is
to recognize economic losses or bad news related with conservatism. Timeliness of
accounting recognition of economic losses may constrain overinvestment even in the
absence of debt contracts if managers are penalized for reporting losses, for example, by
adverse reputation effects, adverse compensation effects, increased threat of dismissal
by the board, or increased threat of takeover (Ball, 2001; Ball and Shivakumar, 2005).
Because the time-series data of Chinese listed firms is limited, it is difficult for us to
measure firm-specific accounting conservatism when we use Basu (1997) model and Ball
and Shivakumar (2005) model. In general, accounting conservatism affect accounting
earnings through accrual, then accumulation of accruals in a certain period can reflect
firm-specific conservatism better, implying accumulation of discretionary accruals in a
certain period can measure firm-specific conservatism (Qiang, 2003). Given that the total
accounting accruals may also reflect economic characteristics of firms unrelated with
conservatism such as the firms growth (Givoly and Hayn, 2001). Additionally compared
to other models, it is more fit to estimate nondiscretionary accruals by Jones (1991) model
estimated cross-sectionally for each industry in a given year for Chinese public firms
(Xia, 2003). So, we use Jones (1991) model estimated cross-sectionally for each industry in
a given year to obtain average discretionary accruals in order to measure accounting
conservatism:
TACCi;t 1 DRevi;t PPEi;t
¼ a1 þ a2 þ a3 þ 1i;t ð4Þ
Asset i;t21 Asset i;t21 Asset i;t21 Asset i;t21
where TACCi,t is measured as a line item before net operating profit minus cash flows for
firm i at year t, scaled by lagged total assets; Asseti,t2 1 is measured as lagged total
assets; DRevi,t is measured as the annual change in sales revenues scaled by lagged total
assets. PPEi,t is property, plant and equipment for firm i at year t 2 1, scaled by lagged
NBRI total assets. Taking into account effectiveness of Chinese securities markets and
consistency of proxies for financial reporting quality in time, accounting conservatism
1,2 (ACi,t) is measured as the model (4)’s negative mean of regression residual during the
years t 2 4 to t, then the greater ACi,t is, the higher accounting conservatism is, the
higher of financial reporting quality of listed firms correspondingly[2].
3.3.3 Earnings smoothing. If accounting earnings are artificially smooth, then they
204 fail to depict the true swings in underlying firm performance, thus decreasing the
informativeness of reported earnings and, hence, reducing earnings opacity. Earnings
smoothness is the correlation coefficient between firms accruals change and cash flow
changes in the corresponding year, and mismatch between accrual and cash flows is
common phenomenon of Chinese listed firms. If direction of those two changes are
inconsistent, and absolute value of this correlation coefficiency is large, then it is most
likely that our listed firms have smoothed earnings by difference between the two
change (Bhattacharya et al., 2003). Thus, a higher degree of earnings smoothness means
that firm managers are more likely to provide investors with the illusion of stable
performance so as to deliberately hide fluctuations of operational performance, thus
increasing information asymmetry, reducing financial reporting quality. Following
Francis et al. (2004), as well as consistence among various proxies, earning smoothness
(ESi,t) is defined as negative standard deviation of operating earnings divided by
standard deviation of cash flow from operations for firm i at year t, and the higher ESi,t is,
which means lower earnings smoothness, the higher quality of accounting information
accordingly. Earnings smoothness formula is as follows:
s ðProfi;t Þ
ES i;t ¼ ð5Þ
s ðCFOi;t Þ
where s(Profi,t) is standard deviation of operating earnings during the years t 2 4 to t,
s(CFOi,t) is standard deviation of cash flow from operations during the years t 2 4 to t.
3.3.4 Financial reporting quality index. In order to maximize the information content
of the sample and tradeoff between above proxies for financial reporting quality,
following Francis et al. (2004), we use simply weighted percentile assignment
methodology. Financial reporting quality is defined as FQ, and the larger FQ is, the
higher financial reporting quality is. In particular, five proxies, such as Accrqi,t, will be
sorted by size and given values in their ascending percentile orders and then aggregate
those 5 percent into a composite index, namely:
½DðAccrq i;t Þ þ DðAccrqri;t Þ þ DðACi;t Þ þ DðNaccrqi;t Þ þ DðESi;t Þ

FQi;t ¼ ð6Þ
5
where D(Accrqi,t) and D(Accrqri,t) are defined as accrual quality percentage using model
(2), respectively; D(Naccrqi,t) is defined as accrual quality percentage using model (2);
D(ACi,t) and D(ESi,t) are defined as accounting conservatism and earnings smoothness
percentage using models (4) and (5), respectively. Following Francis et al. (2005),
I estimate Dechow and Dichev (2002) model, Ball and Shivakumar (2005) model and
Jones (1991) model cross-sectionally for each industry with at least 20 observations in a
given year based on the A-M industry classification method of “guidance on the industry
category of listed companies” issued by the CSRC in 2001 and manufacturing industry is
classified as second level. Because of the above data requirement, it includes 7,351
firm-year data from 1998 to 2005.
4. Research design and results Financial
4.1 Basic empirical model
According to Durnev et al. (2004), Xin et al. (2006) and Biddle et al. (2009), we selected
reporting quality
executives compensation, managing costs, volatility of operating cash flow,
diversification, price synchronicity and degree of product market competition and
industry and year as the control variable. Additionally in order to avoid potential
simultaneity bias between dependent variables and explanatory variables, so 205
explanatory variables is lagged one period. Regression model is as follows:
Overinvi;t orUnderinvi;t ¼a0 þ a1 FQ i;t21 þ a2 Vfo i;t21 þ a3 State i;t21 þ a 4 Payi;t21
þ a 5 Mfe i;t21 þ a 6 Reg i;t21 þ a 7 Diveri;t21 þ a 8 Dmsn i;t21 ð7Þ
X X
þ a9 Dsyn i;t21 þ g0 Industry þ l0 Year þ 1i;t
where dependent variable is underinvestment (Underinv), or overinvestment (Overinv);
FQ is proxied for financial reporting quality; Vfo standard deviation of cash flow from
operations during the years t 2 4 to t; Pay is measured as the logarithm of executive
compensation; Mfe is measured as managing costs, deflated beginning total assets; Reg is
a dummy variable whether the company belongs to regulated industry, if an industry
belongs to “energy, raw materials, infrastructure”, then value of this industry is set as 1,
otherwise 0; State is a dummy variable whether the company is state-owned, if a company
is controlled by state, then value of this company is set as 1, otherwise 0. Syn is measured
as Ln½R 2 =ð1 2 R 2 Þ
, where R 2 is the coefficient of determination from the estimation of
the capital asset pricing model model, which means the larger the Syn, the lesser is the
amount of firm-specific information incorporated into share prices. Msn is measured as:
h P i
ðS i;t 2 S i;t21 Þ 2 ð1=nÞ j¼nj¼1 ðS i;t 2 S i;t21 Þ
;
S i;t
where S is measured as firm sales, which means the larger the Msn, the higher is the
extent of product market competition (Lyandres, 2006). Diver is the dummy variable
whether the company is a diversified business, if the ratio of one industry’s sales to total
sales in specific firm is more than 90 percent, then Diver in this firm is defined as 1,
otherwise 0. Industry is measured as industry dummy variable, whose industry is based
on the A-M industry classification method of “guidance on the industry category of listed
companies” issued by the CSRC in 2001 and manufacturing industry is classified as
second level. To mitigate the influence of outliers, we winsorize all variables at the 1 and
99 percent levels. In particular, in order to mitigate and extreme values of Msn and Syn,
Dmsn and Dsyn are defined to 1 when each of its annual three-fifths of points above the
median, respectively, and otherwise 0.

4.2 Empirical results

To investigate H1 and H2, we first present preliminary analysis on the univariate relation
between the measures of investment efficiency and financial reporting quality. The
sample consists of 2,319 firm-year observations and all variables are winsorized at the 1
and 99 percent levels by year. In this sample, there are 1,009 (1,310) firms classified as
overinvesting (underinvesting) firms. The mean (median) value for Overinv is 0.086 (0.054)
and for Underinv is 0.075 (0.047), which means that the proportion of underinvestment
NBRI sample is greater in our sample while on average underinvestment is more serious than
1,2 overinvestment for our listed firms. Among the financial reporting quality proxies, the
mean (median) firm in the sample has an (FQ) of 0.501 (0.506). Panels B and C present
spearman correlations for the variables in Panel A. By construction, Overinv and
Underinv cannot be correlated because each firm-year observation can only be in one
group. Most importantly, In Panel B, Underinv is negatively correlated with FQ
206 (spearman correlation equals 2 0.103); the same is true for Overinv (spearman
correlation equals 20.109). These results present preliminary evidence for the relation
between financial reporting quality and investment efficiency in H1 and H2 (Table I).
As our samples include cross-sectional data and time-series of non-balanced panel
data, and using a continuous five-year data to measure the quality of accounting
information makes little difference within firms, which may result in biased parameter
estimates under fixed firm effect, so we will use ordinary least squares as well as fixed
both industry and year effect to estimate model (7), while making use of Petersen (2009)
methodology to cluster standard errors in two dimensions between firms and years in
order to revise the heteroscedasticity, serial and cross-section correlation often occurred
in panel data, thus our empirical conclusions are more reliable and stable.
Table II reports the regression results for the test of H1 and H2, where the estimated
model is a regression of investment efficiency on financial reporting quality, firm
characteristics and industry (based on “guidance on the industry category of listed
companies” issued by the CSRC) and year fixed effects. As predicted in H1, Underinv is
negatively related to FQ (both coefficients are significant at 5 percent level). The
estimated coefficients are also negative and significant for OverInv, supporting the
prediction in H2. The estimated coefficients suggest that increasing FQ by one standard
deviation is associated with a reduction on Underinv of 1.0 percent (such in Model B) and
on Overinv of 1.08 percent (such in Model B). Given that the mean values for
underinvestment and overinvestment in Table II are 7.50 and 8.60 percent, these changes
have 14.18 and 13.40 percent, suggesting that the economic significance of the effect is
relatively large. In the same time, because simply weighted percentile assignment
methodology is relatively subjective, based on five proxies, such as Accrq i,t, we use
principal components analysis to obtain another composite proxy for financial reporting
quality[3], which the larger this proxy is, the higher financial reporting quality is. The
results in Models C and H show that financial reporting quality is negatively related with
under- and overinvestment. Additionally, we further use percentage of five proxies for
financial reporting quality to regress model (7), respectively. The results in Panel A show
that both accrual quality and earning smoothing are negatively related with under- and
overinvestment, while accounting conservatism is positively related with
underinvestment, which reason is that accounting conservatism may urge
risk-reverse managers to promote overly prudent investment behaviors, and
aggravate underinvestment of these firms. In addition to complementing and
extending prior academic research in different institutional background. In fact, it is a
reasonable conjecture that, compared with publicly traded companies in the USA, our
sample firms face immature market economic environment and is easy to be intervened
by government, so accounting measurement (as well as disclosure) requirements are less
strict than counterparts. Therefore, our sample firms’ choices regarding financial
reporting quality have the potential to be especially important for improving
investment efficiency. Overall, the results in Table II support H1 and H2 that financial
 Panel A. Descriptive statistics
Observations Mean Median STD Minimum Maximum
UnderInv 1,310 0.075 0.047 0.114 0.000 1.296
OverInv 1,009 0.086 0.054 0.101 0.000 0.954
FQ 2,319 0.501 0.506 0.161 0.028 0.847
Mfe 2,319 0.066 0.044 0.156 0.000 4.912
Vfo 2,319 0.065 0.052 0.048 0.004 0.436
Pay 2,319 12.761 12.799 0.880 8.366 15.517
State 2,319 0.616 1.000 0.486 0.000 1.000
Reg 2,319 0.342 0.000 0.475 0.000 1.000
Diver 2,319 0.539 1.000 0.499 0.000 1.000
Dsyn 2,319 0.641 1.000 0.480 0.000 1.000
Dmsn 2,319 0.400 0.000 0.490 0.000 1.000
Panel B. Underinvestment sample (n ¼ 1,310)
UnderInv FQ State Mfe Vfo Pay Reg Diver Dsyn Dmsn
UnderInv 1.000
FQ 2 0.095 * * * 1.000
State 2 0.039 2 0.003 1.000
Mfe 0.227 * * * 2 0.055 * * 2 0.009 1.000
Vfo 0.040 2 0.011 0.027 0.029 1.000
Pay 20.110 * * * 2 0.026 0.124 * * * 2 0.084 * * * 0.057 * * 1.000
Reg 20.065 * * 0.122 * * * 0.006 2 0.042 0.002 2 0.020 1.000
Diver 0.050 * 0.005 0.010 20.028 2 0.015 0.028 2 0.087 * * * 1.000
Dsyn 20.002 20.015 0.085 * * * 0.000 2 0.001 2 0.047 * 0.006 2 0.013 1.000
Dmsn 0.033 0.142 * * * 0.023 0.038 0.024 2 0.027 0.081 * * * 2 0.105 * * * 20.010 1.000
Panel C. Overinvestment sample (n ¼ 1,009)
OverInv FQ State Mfe Vfo Pay Reg Diver Dsyn Dmsn
OverInv 1.000
FQ 20.109 * * * 1.000
State 0.045 0.005 1.000
Mfe 0.062 20.017 0.133 1.000
Vfo 2 0.063 * 0.006 2 0.097 0.036 * * * 1.000
Pay 0.021 * * 2 0.018 2 0.015 0.007 * * * 0.039 1.000
Reg 20.005 0.031 0.061 * * 0.034 * 0.033 0.065 1.000
Diver 20.084 * * * 0.006 0.026 0.011 20.045 2 0.045 0.025 1.000
Dsyn 20.017 2 0.052 * 0.026 * * 2 0.031 2 0.007 0.080 20.066 * * 2 0.060 * 1.000
Dmsn 20.033 0.132 * * * 2 0.042 * 2 0.042 2 0.031 0.057 20.031 0.043 20.019 1.000
Note: Statistical significance level at *10, * *5, and * * *1 percent
Financial

coefficient
Spearman correlation
Descriptive statistics and
reporting quality

207

Table I.
NBRI
1,2

208

Table II.
Financial reporting
quality and investment
efficiency
 Financial
reporting quality

209

Notes: In Panel B, indicators of financial reporting quality are sub-index quantile of financial reporting
quality; T values make use of Petersen (2009) methodology to cluster standard errors in two dimensions
between firms and years (Peterson, 2009) to amend the variance, ***, **, * represent statistical significance
level of 1, 5 and 10 percent Table II.

reporting quality is negatively associated with both under- and overinvestment,

consistent with the argument that high quality of accounting information help to
improve the supervision and contracts, reducing moral hazard and adverse selection
between the contracting parties, thus reducing underinvestment and curb
overinvestment and thus enhance the firms investment efficiency.
As discussed under Section 4.1 the firm’s incentives to make optimal capital
investment decision are likely to be a function of several firm characteristics. I have
included a set of control variables that captures the main firm characteristics such as
executives compensation, managing costs, operating cash flow volatility, share prices
volatility, diversification, price synchronicity and degree of product market competition
in addition to industry and year dummy variables. Executive compensation (Pay) is
basically significant negative correlated with over- and underinvestment. That result
means when the executive compensation cannot have compensation and incentives to
make managers hard work, and this may induce opportunistic behavior of managers,
resulting in insufficient capital investment, which is in line with previous empirical
results (Xin et al., 2006). The regression coefficients of operating cash flow volatility
(Vfo) were basically significantly positive, which means that the greater the volatility of
operating cash flow, the more easily firms invest inefficiently. The higher management
fee (Mfe), the more serious underinvestment is, which reason is that much perquisite
consumption of management reduces disposable investment funds, thus reducing
capital investment of firms; firm diversification (Diver) is significantly positive related
with underinvestment, but significantly negative related with overinvestment, meaning
that internal capital markets of diversified firms likely show inefficient resource
allocation and investment bias in China.

4.3 Possible endogeneity related to financial reporting quality

One alternative explanation for the results in Table II is that causality goes the other
way. For instance, suppose that poorly performing managers are more likely to invest
NBRI inefficiently and also choose to report low-quality financial information in order to hide
1,2 their bad performance (Leuz et al., 2003). Then one could spuriously find a positive
association between financial reporting quality and investment efficiency. In order to
address this concern, we repeat the analysis using the financial reporting quality proxies
lagged by two periods (the variables in the model are already lagged by one period).
Panel A presents the results of this sensitivity analyses when FQ (columns D and I) are
210 lagged by two periods. Again, all the inferences are unchanged since the estimated
coefficients are statistically negative at conventional levels.

4.4 Sensitivity analysis

In this section, I discuss some robustness tests to the analysis presented in the paper.
First, we study the sensitivity of the results to inclusion of omitted control variables
using firm fixed-effect estimation. The advantage of this approach is that it controls for
all time-invariant unobservable firm characteristics. However, since the estimation of
financial reporting quality (FQ) is done using five years of data, the within-firm variation
is small, which makes the fixed-effect estimation very conservative. Untabulated
analyses show that the results in H1 and H2 are mostly are weaker (coefficients are of the
same sign but in most cases not significant at conventional levels). Second, we
investigate the sensitivity of the results to the use of alternative financial reporting
quality and investment efficiency. That is say, add the year and industry dummy
variables in regression models (1)-(3) to calculate under- and overinvestment and
financial reporting quality metrics, respectively. Third, we use feasible generalized least
squares through random-effect model to correct the heteroscedasticity between groups
and autocorrelation. Finally, we sort firms yearly based on the residuals from equation
(1) into quartiles. Firm-year observations in the bottom quartile (i.e. the most negative
residuals) are classified as underinvesting, observations in the top quartile (i.e. the most
positive residuals) are classified as overinvesting, and observations in the middle two
quartiles are classified as the benchmark group. We estimate a multinomial logit model
that predicts the likelihood that a firm will be in one of the extreme quartiles as opposed
to the middle quartiles. These results show that the above conclusion is still valid.

5. Conclusions
Prior studies suggest that higher financial reporting quality can improve investment
efficiency by reducing information asymmetries that give rise to frictions such as moral
hazard and adverse selection. We test the hypotheses that higher financial reporting
quality can be associated with either lower over- or underinvestment in China.
With China’s emerging and transitional system of background, using Shanghai and
Shenzhen listed firms, we find that high-quality accounting information of listed firms
can higher financial reporting quality can be associated with either lower over- and
underinvestment, of which effects of accrual quality and earnings smoothness on under-
and overinvestment are most significant. Therefore, we should improve and make
perfect of our market infrastructure especially the financial reports of listed firms and
the disclosure system, in order to play a better role of financial reporting quality in
allocation of capital. While our findings suggest that financial reporting quality is
associated with lower over and an opportunity exists to extend our findings in several
ways. First, one could explore the causal link between financial reporting quality and
investment efficiency. Second, one could further explore the link between reporting
quality and either over- or underinvestment, such as corporate governance, tax Financial
incentive, bank financing and some institutional factors. We leave these issues for future reporting quality
research.

Notes
1. Based on the A-M industry classification method of “guidance on the industry category of 211
listed companies” issued by the CSRC and manufacturing industry is classified as second
level, at least 20 industry-year observations are required; then I obtain the final sample of
1,479, a decrease of nearly 36 percent, which will result in even greater sample selection bias.
2. To some extent, the smaller discretionary accruals are, the higher the accounting
conservatism is, but this also means that likelihood and extent of profits to manipulate are
greater (firms hides large profit for some reason), thus discretionary accruals proxied for
accounting conservatism remains to be discussed. In addition, we use modified Jones model to
estimate discretionary accruals of listed firms, the above conclusions do not qualitatively
change.
3. In principal component analysis process, over- and underinvestment in the sample of
2003-2005 years Kaiser-Meyer-Olkin test values (x 2) were 0.564 (3,730.05) and 0.544
(4,820.91). Owing to space limitations, we have not listed the detailed process of principal
component analysis here.

References
Ball, R. (2001), “Infrastructure requirements for an economically efficient system of public
financial reporting and disclosure”, Brookings Wharton Papers on Financial Services,
Brookings Institution Press, Washington, DC, pp. 127-69.
Ball, R. and Shivakumar, L. (2005), “Earnings quality in UK private firms”, Journal of Accounting
and Economics, Vol. 39 No. 1, pp. 83-128.
Basu, S. (1997), “The conservatism principle and the asymmetric timeliness of earnings”, Journal
of Accounting and Economics, Vol. 24, pp. 3-37.
Bergstresser, D.B. (2006), “Discussion of ‘overinvestment of free cash flow’”, Review of
Accounting Studies, Vol. 11, pp. 191-202.
Bhattacharya, U., Daouk, H. and Welker, M. (2003), “The world pricing of earnings opacity”, The
Accounting Review, Vol. 78, pp. 641-78.
Biddle, G. and Hilary, G. (2006), “Accounting quality and firm-level capital investment”,
The Accounting Review, Vol. 81 No. 5, pp. 963-82.
Biddle, G., Hilary, G. and Verdi, R.S. (2009), “How does financial reporting quality relate to
investment efficiency?”, Journal of Accounting and Economics, Vol. 48, pp. 112-31.
Bushman, R. and Smith, A. (2001), “Financial accounting information and corporate
governance”, Journal of Accounting Economics, Vol. 31, pp. 237-333.
Dechow, P. and Dichev, I. (2002), “The quality of accruals and earnings: the role of accrual
estimation errors”, The Accounting Review, Vol. 77, pp. 35-59.
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
(in press).
Durnev, A., Morck, R. and Yeung, B. (2004), “Value-enhancing capital budgeting and
firm-specific stock return variation”, Journal of Finance, Vol. 59, pp. 65-105.
NBRI Fazzari, S.M., Hubbard, R.G. and Petersen, B.C. (1988), “Financial constraints and corporate
investment”, Brookings Papers on Economic Activity: Microeconomics, Vol. 1, pp. 141-95.
1,2
Francis, J., LaFond, R., Olsson, P. and Schipper, K. (2004), “Cost of equity and earnings
attributes”, The Accounting Review, Vol. 79 No. 4, pp. 967-1010.
Francis, J., LaFond, R., Olsson, P. and Schipper, K. (2005), “The market pricing of accruals
quality”, Journal of Accounting and Economics, Vol. 39 No. 2, pp. 295-327.
212 Francis, J.R., Huang, S., Khurana, I.K. and Pereira, R. (2009), “Does corporate transparency
contribute to efficient resource allocation?”, Journal of Accounting Research, Vol. 47,
pp. 943-89.
Givoly, D. and Hayn, C. (2001), “The changing time-series properties of earnings, cash flows and
accruals: has financial accounting become more conservative?”, Journal of Accounting and
Economics, Vol. 29, pp. 287-320.
Hope, O.-K. and Thomas, W.B. (2008), “Managerial empire building and firm disclosure”, Journal
of Accounting Research, Vol. 46, pp. 591-626.
Jones, J. (1991), “Earnings management during import relief investigations”, Journal of
Accounting Research, Vol. 29, pp. 193-228.
Leuz, C., Nanda, D. and Wysocki, P. (2003), “Earnings management and investor protection: an
international comparison”, Journal of Financial Economics, Vol. 69, pp. 505-27.
Levine, R. (1997), “Financial development and economic growth: views and agenda”, Journal of
Economic Literature, Vol. 35, pp. 688-726.
Lyandres, E. (2006), “Capital structure and interaction among firms in output markets-theory and
evidence”, Journal of business, Vol. 79 No. 5, pp. 2381-421.
McNichols, M.F. (2002), “Discussion of the quality of accruals and earnings: the role of accrual
estimation errors”, The Accounting Review, Vol. 77, pp. 61-9.
McNichols, M.F. and Stubben, S.R. (2008), “Does earnings management affect firms’ investment
decisions?”, The Accounting Review, Vol. 83, pp. 1571-603.
Petersen, M. (2009), “Estimating standard errors in finance panel data sets: comparing
approaches”, Review of Financial Studies, Vol. 22, pp. 435-80.
Qiang, X. (2003), “The economic determinants of self-imposed accounting conservatism”,
working paper, State University of New York, Buffalo, NY.
Richardson, S. (2006), “Over-investment of free cash flow”, Review of Accounting Studies, Vol. 11,
pp. 159-89.
Risberg, M. (2006), “Does earnings quality matter for the investment decision?”, working paper,
University of Gøteborg, Göteborg.
Shleifer, A. and Vishny, R.W. (1997), “A survey of corporate governance”, The Journal of
Finance, Vol. 52 No. 2, pp. 737-83.
Stein, J. (2003), “Agency, information and corporate investment”, in Constantinides, G.M.,
Harris, M. and Stulz, R. (Eds), Handbook of the Economics of Finance, Elsevier,
Amsterdam, pp. 111-65.
Wang, X. (2003), “Capital allocation and accounting information properties”, working paper,
Emory University, Druid Hills, GA.
Wurgler, J. (2000), “Financial markets and the allocation of capital”, Journal of Financial
Economics, Vol. 58, pp. 187-214.
Xia, L.J. (2003), “Econometric models of earnings management in China’s stock market applied
research”, China Accounting and Finance Review, Vol. 2, pp. 123-54.
Xin, Q.Q., Lin, B. and Wang, Y.C. (2006), “Government control, manager salaries and capital Financial
investment”, Economic Research, Vol. 8, pp. 110-22.
Zeng, Y. and Lu, Z.F. (2003), “Quality of information disclosure and equity financing costs”,
reporting quality
Economic Research, Vol. 2, pp. 69-79.

Further reading
Ecker, F., Francis, J., Kim, I., Olsson, P. and Schipper, K. (2006), “A returns-based representation 213
of earnings quality”, The Accounting Review, Vol. 81, pp. 749-80.
Healy, P.M. and Palepu, K.G. (2001), “Information asymmetry, corporate disclosure, and the
capital markets: a review of the empirical disclosure literature”, Journal of Accounting and
Economics, Vol. 31, pp. 405-40.

About the authors

Qingyuan Li is an Associate Professor in School of Economics and Management, Wuhan
University with research interests including accounting quality and M&A. Qingyuan Li is the
corresponding author and can be contacted at: qyli@whu.edu.cn
Tielin Wang is an Associate Professor of Accounting Department in Guangdong University
of Finance with research interests including accounting quality and corporate governance.

To purchase reprints of this article please e-mail: reprints@emeraldinsight.com

Or visit our web site for further details: www.emeraldinsight.com/reprints