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IJAIM
27,4 The influence of financial
reporting quality and audit quality
on investment efficiency
600 Evidence from Pakistan
Received 31 August 2018 Faisal Shahzad
Revised 10 December 2018
Accepted 15 January 2019
Department of Management Sciences, COMSATS University Islamabad,
Attock, Pakistan
Ijaz Ur Rehman
College of Business Administration, Al Falah University, Dubai, UAE, and
Waqas Hanif, Ghazanfar Ali Asim and Mushahid Hussain Baig
Department of Management Sciences, COMSATS University Islamabad,
Attock, Pakistan

Abstract
Purpose – This study aims to empirically investigate the effect of financial reporting quality (FRQ) and
audit quality (AQ) on the investment efficiency (IE) for the firms listed on the Pakistan Stock Exchange
during the period 2007-2014.
Design/methodology – The authors use pooled ordinary least squares (OLS) regression which cluster at
the firm and year level to test the hypotheses. For sensitivity check, the authors also account for reverse
causality and cross-sectional dependence by using the GMM and FGLS regression methods. Furthermore, the
authors built their theoretical arguments based on alignment hypothesis of the agency theory and resource-
based view of the firm.
Findings – The findings suggest that higher FRQ and AQ are associated with higher IE. The results for
these particular estimates are robust when tested using alternative estimation techniques. Overall, the
outcomes of this study are in line with the arguments presented by the alignment hypothesis of the agency
theory and resource-based view of the firm.
Practical implications – This study is fruitful for policymakers’ and investors. This study finds that the
audit done by the Big 4 also reduces the information gap and, thus, reduces the moral hazard and adverse
selection problems, thereby enhancing the IE.
Originality – The authors extend the debate on determinates of IE and highlight two monitoring
mechanisms: FRQ and AQ. The authors further extend the literature on the economic consequences of AQ in
terms of IE, as proposed by Francis (2011). For the first time, this study investigates the impact of AQ on IE in
a setting where minority shareholder risk of exploitation is high relative to other markets in Asia.
Keywords Emerging markets, Investment efficiency, Financial reporting quality, Audit quality
Paper type Research paper

1. Introduction
International Journal of
Accounting & Information A fundamental question in the finance field is “What determines investment decisions at the
Management
Vol. 27 No. 4, 2019
firm level?” Under perfect market assumption, an investment decision is a function of
pp. 600-614
© Emerald Publishing Limited
1834-7649
DOI 10.1108/IJAIM-08-2018-0097 JEL classification – G31, M42
investment opportunity (Modigliani and Miller, 1958), which means that a company should Audit quality
invest when there is an investment opportunity. Biddle et al. (2009) assert that investment is on investment
based on the previous year’s growth in sales. Basically, if there is a growth in the previous
year’s sales, then a company should further invest in the current year in either capital or
efficiency
non-capital expenditures. Also, when the company’s management invests in positive net
present value (NPV) projects, they would avoid investment in negative NPV projects. This
phenomenon is referred to as investment efficiency (IE) (Jensen and Meckling, 1976).
However, this circumstance does not always hold in the real world or it holds partially, as 601
management may either invest in negative NPV projects (overinvestment) or avoid
investing in positive NPV projects (underinvestment) (Lei et al., 2014).
Prior literature uses financial reporting quality (FRQ) as a main monitoring mechanism
on the company management (Biddle et al., 2009; Chung et al., 2013; Gomraiz and Sánchez
Ballesta, 2013), which curbs the opportunistic behavior of the management and, hence,
eliminates the possibility of adverse selection and moral hazard. Therefore, our first aim is
to investigate the economic consequences of higher FRQ. In addition, we also examine the
impact of audit quality (AQ) on IE. As AQ is a widely debatable topic in the accounting and
finance literature, of particular interest is the role of Arthur Anderson in the Enron failure in
2001, which raises a number of questions on the monitoring efficiency of AQ by the Big 4
accounting firms (Hakim and Omri, 2010; Crockett and Ali, 2015). As little consideration has
been paid to the economic significance of AQ, more investigation is needed in this area
(Francis, 2011). In fact, prior studies suggest that higher AQ results in higher analyst
forecast accuracy (Wu and Wilson, 2015), lower cost of capital (El Ghoul et al., 2016) and
lower stock price crash risk (Robin and Zhang, 2014).
Two attributes of FRQ have served as proxies of FRQ in earlier research: first,
accounting-based earnings characteristics like accruals quality, income smoothing and
earnings persistence; and second, market-based attributes like value relevance and
conservatism. This study uses an accounting-based earning attribute, accruals quality, as a
proxy of FRQ. Accruals quality is the magnitude of abnormal accruals, which is measured
in this research (Kasznik, 1999; McNichols and Stubben, 2008). This motivates to examine
the relation of FRQ with investment efficiency for Pakistan, as accrual quality is extensively
tested for other countries. Accrual quality has been extensively applied in prior research to
find out the relation of FRQ with investment efficiency (Biddle et al., 2009; McNichols and
Stubben; Gomraiz and Sánchez Ballesta, 2013). As such, it is easier to compare the results of
the present research with prior investigations.
We make various contributions to the corporate finance literature. Firstly, we expand the
debate on determinates of IE and highlight two monitoring mechanisms: FRQ and AQ in
Pakistan. Second, we extend the literature on the economic consequences of AQ in terms of
IE, as proposed by Francis (2011). For the first time, this study investigates the impact of
AQ on IE in Pakistan. A number of reasons have prompted this research which attempts to
explain the impact of FRQ and AQ on IE in Pakistan – an emerging economy. First,
increased focus of regulatory bodies on improvement in information disclosure, thereby
protecting the investors and minority shareholders had led to the introduction and
implementation of Code of Corporate Governance in 2002 (Ashraf and Ghani, 2005) and
mandatory compliance of IFRS in 2006 (Rehman and Shahzad, 2014). These are fairly recent
developments that have elicited our interest in gauging the impact of both FRQ and AQ on
IE. Secondly, most of the previous research regarding economic outcomes of FRQ and AQ
had been conducted in developed economies, which are characterized by the presence of
very vibrant and vigilant stock markets (Biddle and Hilary, (2006); McNichols and Stubben,
2008; Biddle et al., 2009; Gomraiz and Sánchez Ballesta, 2013; Das and Pandit, 2010).
IJAIM However, weak institutional framework, poor implementation of regulations and judicial
27,4 efficiency, which is below the average of both common law and civil law countries in
Pakistan (Porta et al., 1999), make it interesting to examine whether FRQ and AQ serve as
monitoring means that possibly lead to mitigating the asymmetric information and agency
problems by reducing the over- and under-investment problems. Our work is closely related
to that of Lu and Sapra (2009) and Das and Pandit (2010). However, Lu and Sapra (2009)
602 used an analytical approach to test the impact of AQ on IE, whereas we leverage on
empirical approach to do the same. The research of Das and Pandit (2010) observes the
association between AQ and IE by using the ratio of audit fee to total fee reported a positive
impact of higher AQ on IE, and that it is amplified in case of firms with higher business risk
and cash surplus. We, however, used presence of Big 4 audit as a proxy for AQ and
concluded that a positive impact of AQ on IE is not contingent upon presence of cash
surplus and higher business risk.
We find strong evidence to suggest that FRQ and AQ enhance IE. These findings are in
line with the view that FRQ and AQ are an efficient monitoring mechanism which limits the
opportunistic behavior of management. Our study also accounts for endogeneity by using
the generalized method of moments (GMM). For robustness, we use alternative estimation
techniques, such as the feasible generalized least square regression (FGLS). Our study has
significant implications for both investors and regulators as it provides a theoretical
framework for studying the efficiency of the two monitoring mechanisms: FRQ and AQ.
The paper is structured as follows. Section 2 explains the theoretical rationale for
studying the relationship of FRQ and AQ with IE. Section 3 presents the methodological
framework to examine the hypotheses developed in the earlier section. Section 4 discusses
the results. At last, Section 5 concludes and provides recommendations for future research.

2. Theoretical framework and related literature

2.1 Financial reporting quality and investment efficiency
It has been observed that management invests even when the marginal benefit is less than
the marginal cost in inefficient projects (Stein, 2003; Biddle et al., 2009; Gomraiz and Sánchez
Ballesta, 2013). According to the financial theory, this phenomenon happens due to market
imperfection and uncertainty (Jensen and Meckling, 1976). Uncertainty leads to information
asymmetry between managers and capital suppliers. Asymmetric information has two
forms. One is adverse selection, which arises when a potential shareholder perceives that
existing management have more access to information and would use this informational
advantage to pursue personal goals or provide benefits to existing shareholders. Therefore,
potential shareholders feel reluctant to invest (Myers and Majluf, 1984; Walker, 2013). The
second form of asymmetric information is moral hazard, a problem that arises when
shareholders are not able to check the actions of management, as to whether they are putting
money in a safe basket or investing in risky projects (Myers and Majluf, 1984; Walker, 2013).
Previous studies find the association between FRQ and asymmetric information
(Bushman and Smith, 2001; Healy and Palepu, 2001). The study of Liou and Yang (2008)
finds that sensing the fake reporting in advance can efficiently improve the accuracy rate of
business failure predictions, and through true financial reporting, investors draw accurate
picture of firm performance. According to these studies, FRQ acts as a monitoring
mechanism for shareholders. It also provides the supplier with information regarding the
capital. If these reports provide a true representation of the company, they can mitigate the
asymmetric information problem, and managers cannot sell their shares at higher prices nor
will they get extra money to finance projects with negative NPV (Verdi, 2006; Biddle et al.,
2009; Chen et al., 2011; Gomraiz and Sánchez Ballesta, 2013). Hence, quality accounting
information reduces the problem of overinvestment and underinvestment by overcoming the Audit quality
moral hazard problem, as higher FRQ would allow principals to sign efficient contracts with on investment
agents and effective monitoring at lower cost would be facilitated. Therefore, management
would not be involved in empire building activities or passing up investment with positive
efficiency
NPV. Hence, we predict that higher FRQ reduces the agency cost and curbs the opportunistic
behavior of mangers, as it does not permit the pursuit of personal goals of over- and under-
investment at the cost of the shareholders. Therefore, we hypothesize as follows:
603
H1. FRQ is positively linked with IE.

2.2 Audit quality and investment efficiency

The financial theory expounds that investment in inefficient projects may occur due to
market imperfections (Jensen and Meckling, 1976), which lead to information asymmetry
between mangers and capital suppliers. Asymmetric information has two forms. First,
adverse selection can arise when potential shareholders perceive that existing management
have more access to information. Hence, managers would use this informational advantage
to pursue personal goals or recompense existing shareholders. Therefore, potential
shareholders feel reluctant to invest (Myers and Majluf, 1984; Walker, 2013). Second, moral
hazard is a problem that can develop when shareholders are not able to check the actions of
management, as to whether managers are putting money in a safe basket or investing in
risky projects (Myers and Majluf, 1984; Walker, 2013).
The resource-based view of the firm posits that it is access to the unique resources that
allows companies to get a competitive advantage and translate it into performance. Several
scholars identified the unique key resources in the Big 4 accounting firms (i.e. organizational
culture, professional development opportunities, auditor risk assessment expertise) which
enable them to perform high-quality audit (Kinney et al., 2004; Christensen et al., 2016). In
addition, the strong reputation of the Big 4 firms urges them to conduct audit with high
integrity and, hence, acts as an efficient monitoring tool (DeAngelo, 1981; Astami et al.,
2017). Further, their large customer base allows the Big 4 to keep audit independent, which
allows them to be less dependent on the client fees. Therefore, the Big 4 accounting firms
provide better AQ when compared to their non-Big 4 competitors (Hung Chan and Wu, 2011;
Ball et al., 2012).
Previous literature reported many positive economic consequences of higher auditor
quality. For example, various scholars found that when AQ increases then two main
advantages get highlighted: firstly, investors receive information advantage in which
investors receive appropriate accounting information; in other words, higher auditor quality
reduced the information asymmetry. Secondly, when AQ increases, this means monitoring
activities within firm increase, which reduce the opportunistic behavior of manager and,
hence, firm performance increases (Khurana and Raman, 2004; Kim et al., 2011; Dedman and
Kausar, 2012; Luypaert and Van Caneghem, 2014). Furthermore, AQ is associated with
lower stock price crash risk (Lim et al., 2016), higher analyst forecasts accuracy (Behn et al.,
2008), lower tax aggressiveness (Kanagaretnam et al., 2016), lower cost of equity and debt
(Houqe et al., 2017; Wang et al., 2017), higher firm performance (Shahzad et al., 2017a, 2017b)
and lower discretionary accruals (Rusmin et al., 2014) and played a vital role in reducing
agency problem-related issues in emerging economies (Khan et al., 2016).
Hence, this efficient monitoring tool further curbs the opportunistic behavior of the
management and mitigates the conflict of interest between the principal and the agent. It
does so by mitigating the two anomalies, adverse selection and moral hazard, both of which
arise due to the asymmetric information (Biddle et al., 2009; Hail and Leuz, 2009).
IJAIM Furthermore, higher AQ is reduced the risk premium demanded by the investors, and the
27,4 firm is able to get extra money, which ultimately reduce the issues of underinvestment
(Baker and Al-Thuneibat, 2011). Hence, we predict that higher AQ will produce positive
outcomes and enhance the IE at the firm level. Therefore, we hypothesize that firms with
higher AQ have higher IE when compared to firms with lower AQ.

H2. Firms with higher AQ have higher performance when compared to firms with
604
lower AQ.

3. Research methodology
3.1 Data
All publicly listed companies (excluding finance stocks) listed on the Pakistan Stock
Exchange over the period 2007-2014 are included in the sample. However, only data of total
190 companies are selected as a sample that is based on availability. Hence, sample size is
1,520 firm/year observations. The choice of timeframe for the study is driven by a series of
changes in the accounting standards that took place in 2006 when Pakistan switched from
GAAP to IFRS (Rehman and Shahzad, 2014). According to Ma et al. (2015), choosing post-
reformed standards data as the starting point for the study increases the accuracy of the
research findings. Banker Thomson data stream is used to extract the information.
3.1.1. Dependent variables. IE is a dependent numerical variable in the study. Following
the previous research (Gomraiz and Sánchez Ballesta, 2013; Shahzad et al., 2018), this study
follows Biddle et al. (2009) to measure IE. The measure of IE is computed as a deviation from
the optimal investment level by regressing the previous year’s sales growth over the total
investment. In equation (1), the error term represents the deviation from the expected
investment level. A positive residual represents investment in negative NPV projects
(overinvestment), whereas a negative residual represents firms that do not invest in positive
NPV projects (underinvestment). Furthermore, the absolute of residuals is considered and
multiplied by –1. Higher values represent greater IE and vice versa:

Ii;t ¼ ai;t þ b 1 SGi;t1 þ « i;t (1)

Total investment (Ii,t) is the sum of capital and non-capital expenditure, whereas sales
growth (SG) is the difference between sales of the company in year t – 2 and t – 1.
3.1.2. Independent variables. The study has two independent variables: FRQ and AQ.
Consistent with the previous studies, FRQ is calculated using the Kasznik (1999) model.
This model has been extensively used in the accounting field to measure FRQ (Gomraiz and
Sánchez Ballesta, 2013). Kasznik (1999) argued that excluding cash flows from the operation
of Jones’ model would increase the estimation error. Given that the change in cash flow from
operations is negatively correlated with accruals, Kasznik (1999), therefore, included a
change in cash flows from the operations in the model of Jones (1991). The following
equation is used to compute FRQ:

TAi;t ¼ ai:t þ b 1 Dsalesi:t þ b 2 PPEi:t þ b 3 DCFOi;t þ « i;t (2)

where, TAi,t represents total accruals; DSalesi,t is the change in sales from year t to t – 1.
PPEi,t is the property plant and equipment. DCFOi,t is the change in cash flows from
operations from year t to t – 1 and ἑit represents the error term. We obtained the absolute
values of residuals and multiplied them by –1 to compute FRQ. Higher value of residuals
indicates higher FRQ. The second variable, AQ is as a dummy variable and is coded 1 if the Audit quality
company audit is done by the Big 4 accounting firm; otherwise, it is coded 0 (Yang, 2010; on investment
Cascino et al., 2010; Achleitner et al., 2014; El Ghoul et al., 2016). efficiency
3.1.2.1 Robustness check. For robustness check, present study is also considering
discretionary revenue as a proxy of FRQ. McNichols and Stubben (2008) argue that
discretionary revenue has more predictive power than discretionary accruals for three
reasons. First, the degree of measurement error embedded in discretionary revenue is quite 605
low as compared to that embedded in discretionary accruals. Second, accruals such as
depreciation have a closer link with investments. Third, product demand is a function of
revenue; thus, discretionary revenue is linked with investment. It means higher demand of
the product is increased the sales revenue. Finally, to meet or beat analysis forecasts,
accountants most often manipulate sales revenues. Therefore, to enhance the predictive
power of testing, discretionary revenue along with discretionary accruals as a proxy of FRQ,
the model outlined (equation (3)) would regress changes in accounts receivable on changes in
sales after being deflated by lagged total assets:

DARi;t ¼ ai;t þ b 1 DSRi;t þ « i;t (3)

DARi,t is the change in account receivable from year t to t – 1, DSalesi,t is the change in sales
revenue, and ἑ it represents residuals. Here, the error term is the measure of FRQ. The
present study takes the absolute value of residuals obtained in equation (3) and
afterward multiplied it by –1; the present study computed measure of FRQ. Higher
value of residuals indicates higher FRQ. At last, the present study also uses the
aggregate value of these above two measures of FRQ to eliminate the biasness in each
measure.
3.1.2.2 Control variables. Following the previous literature, we also account for the
control variables which may affect the relationship between FRQ and IE[1]. The control
variables may strongly impact the targeted results when testing the relative association
between dependent and independent variables. The control variables included in this study
are Company size, Leverage, Firm age, Presence of loss, Standard deviation of cash flows
from operations to sales, Degree of solvency, Cash flows from operations and Tangibility.
All control variables used in the study are numerical. The descriptions of all variables are
reported in Table I.

3.2 Estimation technique

We investigate H1 and H2 by applying three estimation approaches: pooled ordinary least
squares (OLS), GMM and FGLS.

3.3 Econometric model

The relationship of FRQi,t and AQi,t with IE (IEi,t) is estimated by the following
equation (4) suggested by Biddle et al. (2009) to test H1 and H2. However, the present
study extends the Biddle model and adds AQ as an explanatory variable. Here, the
relationship of FRQ and AQ with IE is examined by the coefficient estimates on FRQi,t
and AQi,t. The predicted sign on coefficient estimates on FRQi,t and AQi,t is positive. It
means FRQ and AQ eliminates the adverse selection and moral hazard problem and,
hence, enhances the IE of the firm. Equation (4) represents the empirical specification of
this relationship:
IJAIM Variable Label Description
27,4
Dependent variables
Investment Efficiency IE The residual value of the investment model (Biddle et al., 2009)
multiplied by –1
Independent variables
606 Financial reporting FRQ Absolute residuals’ values of Kasznik’s (1999) model. Absolute
quality residuals’ values of McNichols and Stubben (2008) model
Audit quality AQ Coded “1” if audit is done by the Big 4 accounting firm; otherwise,
coded “0”
Control variables
Company size CS Natural logarithm of total assets
Firm age FA The natural log of the year number when a firm started its business
Leverage LEV Ratio of total debt to total assets
Cash flows from CA The ratio of cash flows from operations divided by the average of
operations to total assets total assets
Tangibility TANG The tangible fixed assets divided by the total assets
Presence of losses POL Coded 1 if income before tax and extraordinary items is negative;
otherwise = 0
Degree of solvency ZSCR Z= 0.012Y þ 0.014 T þ 0.033 U þ 0.006S þ 0.999G Y = working
capital/total asset; T = retained earnings/total asset; U = earnings
before interest and tax/total asset, S = market value of equity/book
value of total debt. G = sales/total asset
Table I Standard deviation of SCS Standard deviation of cash flow from operation to sales
Description of cash flow from operation
variables to sales

IEi;t ¼ b 1 i;t þ b 2 FRQi;t þ b 3 AQi;t þ b 4 FAi;t þ b 5 SCSi;t þ b 6 CSi;t þ b 7 POLi;t

X
þ b 8 ZSCRi;t þ b 9 CAi;t þ b 10 TANGi;t þ b 11 LEVi;t þ b j INDUDUM
X
þ b n YEARDUMþ« i;t (4)

IEi,t represents IE of the firm, –ἑi,t is the error term, b is the coefficient of the equation,
subscripts i and t represent firm and fiscal year (where t = 1,2,3, . . ., 10), respectively,
whereas FRQi,t is the absolute value of the residuals, estimated by the model suggested by
Kasznik (1999) and McNichols and Stubben (2008). AQi,t is a dummy variable which is
coded “1” if audit is done by the Big 4 accounting firm; otherwise, coded “0.” Among other
explanatory variables, we include the presence of loss (POLi,t) which is coded as “1” if
income before tax and extraordinary items is negative, and “0” otherwise. SCSi,t is the
standard deviation of cash flows from operations to sales (t – 2 to t), ZSCRi,t is the degree of
solvency which is measured by Altman Z-score, and CAi,t is the ratio of cash flows from
operations divided by the average total assets, TANGi,t is the ratio of tangible fixed assets
divided by total assets.

4. Results and discussion

4.1 Descriptive statistics
We begin the analysis by reporting key summary statistics of key variables presented in
Table II. The results in the Table II suggest that the mean scores of IE and FRQ are –0.201
and –0.069, respectively, which are generally in line with Gomraiz and Sánchez Ballesta, (2013).
In the control variables, only leverage appears to have a high mean score that suggests Audit quality
that companies in the Pakistan capital have more debt financing. According to the on investment
findings presented in Table III below, out of the 190 firms included in the sample, 67
per cent publicly listed companies are audited by Big 4, while 23 per cent firms get
efficiency
audited by non-Big 4.
Table IV below reports the results of the Pearson’s correlation matrix. The correlation
between FRQ and IE is positive and significant. Further, there is significant positive
correlation between AQ and IE. This supports the proposition that FRQ and AQ enhance IE. 607
In addition, Table IV highlights a significant degree of correlation of other variables with IE.
However, the observed correlation between independent variables is not more than 0.5;
therefore, the estimates survive the problem of multicollinearity.

Variable Mean SD Minimum Maximum

Full sample (N = 190 firms)

IE –0.201 0.611 –9.56 0
FRQ –0.069 0.068 –0.59 0
Firm age (FA) 1.216 0.179 0.095 1.617
Leverage (LEV) 29.60 23.53 0 100
Company size (CS) 1.393 0.537 –4.605 2.240
Cash flows from operation to total assets (CA) 0.070 0.152 –0.84 1.43
Tangibility (TANG) 0.532 0.684 0 10.2
Degree of solvency (ZSCR) 0.345 2.42 0 42.38 Table II
Standard deviation of cash flows from operations to sales (SCS) 5.228 1.823 –2.302 8.794 Descriptive statistics

Table III
Percentage of audit
Categories No. of companies across eight years Proportion in total sample (%)
by Big 4 and non-Big
Big 4 1,018 67 4 firms in the firms
Non-Big 4 502 23 listed at the Pakistan
Total 1,520 100 Stock Exchange

IE FRQ LEV CS ZSCR TANG CA FA SCS AQ

IE 1
FRQ 0.004*** 1
LEV 0.013*** 0.033*** 1
CS –0.013** –0.037*** –0.164 1
ZSCR 0.009*** 0.011*** –0.007 0.099 1
Tang –0.000*** 0.068*** 0.309 –0.07** –0.00 1
CA 0.015 –0.028*** –0.027** 0.044 –0.02 –0.00 1
FA 0.054 0.003 –0.083 0.180** 0.00 0.018 –0.008** 1
SCS –0.003 0.005 0.053** –0.03 –0.01** 0.060 0.051*** 0.0110*** 1
AQ 0.008*** 0.056 –0.119 0.202** 0.609** 0.030 –0.029 0.123 –0.01 1

Notes: *Represents significance at 1 per cent; **represents significance at 5 per cent; ***represents Table IV
significance at 10 per cent Correlation matrix
IJAIM 4.2 Regression analysis
27,4 We estimate equation (4) using the pooled OLS regression method to test H1 and H2. Model
1 in Table V reports the estimation of equation (4) and takes into account the effect of the
control variables. Column 1 of Table V reports the results for regression of investment
efficiency on FRQ and AQ by considering the effect of control variables as well. The results
suggest the positive and significant relation of FRQ with IE. These results support H1 that
608 higher FRQ acts as a monitoring mechanism and enhances the IE of the firm. These results
lead to the conclusion that higher FRQ and AQ is associated with higher IE. As indicated by
Porta et al. (1999), Pakistan is a country with weak institutional framework and poor
implementation of regulation. The statistical results, however, point to the fact that in spite
of the foregone facts, the introduction of Code of Corporate Governance in 2002 and
imposition of mandatory compliance of IFRS in 2006 onward have had a considerable
impact on improvement of FRQ and AQ as monitoring mechanisms. This, in turn, has
resulted into improvement in IE of the firms. The results show that higher FRQ mitigates
the problems of over- and under-investment by reducing the information gap between
managers and capital suppliers that provides advantage to the company management to
play with the excess money. This asymmetric information gives rise to “moral hazard” and
“adverse selection” problems. Potential shareholders are likely to purchase shares at a
higher price due to this misleading information. It enables opportunistic managers to misuse
excess money and invest in unproductive projects.

Column 1 Column 2 Column 3

Pooled OLS GMM model FGLS model

Independent variables
FRQ 0.13*** (3.90) 0.198** (3.13) 0.080* (1.72)
AQ 0.12*** (4.97) 0.558** (2.01) 0.077*** (5.66)
Control variables
FA 0.06* (1.61) 0.108 (1.22) 0.001 (0.58)
SCS –0.001*** (–7.74) 0.118 (1.28) 0.009* (2.75)
CS –0.008* (–1.66) –0.871* (–1.96) 0.004 (0.24)
POL –0.14* (–1.67) 0.056* (1.67) 0.002 (0.12)
ZSCR 0.002*** (3.53) 0.001 (0.16) 0.004 (0.73)
CA –0.09* (–1.79) –0.931 (–0.75) 0.059** (2.55)
TANG –0.02* (–1.65) –0.147 (–1.04) 0.923*** (2.83)
LEV 0.001* (1.67) 0.341* (1.87) 0.032** (2.81)
Constant –0.39*** (–4.81) 0.127 (0.06) 0.174*** (7.70)
Industry dummy Yes Yes Yes
Year dummy Yes Yes Yes
N 1,520 1,520 1,520
R2 0.35
F-statistic (p > F) 9.352***
Pesaran test 234.98**
Wald test 397.45***
Wooldridge test 456.89**
LM test 3.57
Hansen test 156.77
Table V AR(2) 7.51
Regressions of IE, Notes: We measure AQ as a categorical variable and regress it on IE, considering the control variables. *,
AQ and FR: Kasznik ** and *** represent the level of significance at 10, 5 and 1 per cent, respectively. T-statistics are presented
(1999) model in parentheses
On the other side, lack of monitoring subsequent to investment in a company made by new Audit quality
shareholders also provides an opportunity to management to further their personal agenda either on investment
through over- or under-investment. Several scholars (Linck et al., 2013; Gomraiz and Sánchez
Ballesta, 2013; Cheng et al., 2013; Di Meo, 2014) find that these asymmetric information gaps can
efficiency
be reduced through higher FRQ, as higher FRQ brings shareholders and management to a
uniform level in the context of company information. Therefore, it is difficult for managers to sell
securities at a higher price. On the contrary, managers with positive NPV projects get an
opportunity to sell shares at a lower price. Therefore, higher FRQ eliminates the adverse selection 609
problem. In addition, it also enables shareholders to monitor the actions of top management, and
hence, reduces moral hazard problem because it counters the furthering of personal agenda of a
manager resulting in lesser conflict between manager and capital supplier. Therefore, higher
FRQ reduces the manager’s propensity to over- and under-invest.
In addition, our results suggest that higher AQ is also associated with better IE as the
coefficient of AQ is positive (AQ = 0.12***) and significant at 1 per cent level. These results
support H2. The rationale behind this finding lies in the resource-based view of the firm
which states that access to unique resources provides a competitive edge for the business.
Similarly, we argue that unique resources of the Big 4, such as a strong organizational
culture and large customer base, enable these firms to remain independent and adopt
integrity in performing the audit review. Further, reputational risks and litigation concerns
faced by the Big 4 once again emphasize the need for superior AQ (Ball et al., 2012;
Christensen et al., 2016).
Hence, these factors act as an efficient monitoring mechanism which mitigates the two
anomalies, adverse selection and moral hazard, both of which arise in the context of
asymmetric information (Biddle et al., 2009; Hail and Leuz, 2009). The resulting better-
quality audit by the Big 4 generates positive economic consequences and leads to greater IE.
For the robustness check, we re-estimated equation (4) using the McNichols and Stubben
(2008) model. The results are reported in Table VI. The results confirm the robustness of
Kasznik (1999) with increased power size of the coefficients.

4.3 Robustness check

We also conducted the analysis by using alternative estimation techniques to examine the
relation of IE with FRQ and AQ. The choice of estimation technique is based on several
diagnostic tests. For example, Table V reports the LM test outcome, which indicates the
choice of pooled OLS model.
For robustness, we estimate equation (4) with other estimation techniques. We use
the system GMM to examine H1 and H2. The results of the Wald and Wooldridge
diagnostic tests in Table V above point to the presence of heteroscedasticity and
autocorrelation. In addition, several empirical studies which examine the relation
between FRQ and IE highlight the issue of reverse causality (Di Meo, 2014). Therefore,
we use the system GMM to capture the issue of heteroscedasticity, autocorrelation and
endogeneity in equation (4). Model 2 in Table V above reports the system GMM
estimation, and the results are consistent with pooled OLS estimation. Overall, these
results support H1 and H2. The results of Hansen test in Table V above confirm the
validity of instrument which is used for system GMM estimation. Further, AR(2) shows
that there is no second-order serial correlation. In addition, we also use the Pesaran test
to examine the cross-sectional dependence within the error terms of companies. The
Pesaran result in Table V point to the cross-sectional dependence. Therefore, the
outcomes of pooled OLS and GMM become rather controversial. Hence, for robustness,
we also estimate equation (3) with FGLS to test H1 and H2. Columns 2 and 3 in Table V
IJAIM Column 1 Column 2 Column 3
27,4 Pooled OLS GMM model FGLS model

Independent variables
FRQ 0.23*** (2.80) 0.213** (2.19) 0.091* (1.92)
AQ 0.10*** (3.16) 0.458** (2.21) 0.017*** (4.67)
610 Control variables
FA 0.05* (1.67) 0.208 (1.32) 0.011 (0.61)
SCS –0.901*** (–8.71) 0.107 (1.37) 0.012* (2.45)
CS –0.007* (–1.68) –0.801* (–1.86) 0.004 (0.14)
POL –0.23* (–1.77) 0.026* (1.77) 0.003 (0.13)
ZSCR 0.012*** (2.63) 0.001 (0.16) 0.004 (0.13)
CA –0.09* (–1.69) –0.924 (–0.55) 0.023** (3.11)
TANG –0.12* (–1.69) –0.120 (–1.24) 0.923*** (3.83)
LEV 0.091* (1.87) 0.211* (1.91) 0.011** (3.81)
Constant –0.10*** (–3.01) 0.134 (0.12) 0.132*** (3.12)
Industry dummy Yes Yes Yes
Year dummy Yes Yes Yes
N 1,520 1,520 1,520
R2 0.39
F-statistic (p > F) 10.213***
Pesaran test 134.92**
Wald test 267.32***
Wooldridge test 157.32**
LM test 2.57
Table VI Hansen test 134.67
Regressions of IE, AR(2) 2.51
AQ and FRQ: Notes: We measure AQ as a categorical variable and regress it on IE, considering control variables. *, ** and
McNichols and *** represent the level of significance at 10, 5 and 1 per cent, respectively. T-statistics are presented in
Stubben (2008) model parentheses

show the results of estimation of equation (4) with GMM and FGLS, respectively. The
findings based on the FGLS support H1 and H2.

5. Conclusion and implications

We empirically examine the impact of FRQ and AQ on firm-level IE over the period of 2007-2014
of firms listed on the Pakistan Stock Exchange. Using panel data estimation techniques, our
findings suggest that higher FRQ is associated with higher investment efficiency. The results
show that higher FRQ mitigates the problem of over- and under-investment, as the information
gap between managers and capital suppliers provides advantage to the company management to
play with the excess money. Furthermore, audit done by the Big 4 firms also reduces the
information gap, thus enhances the firm-level IE. Our findings yield few important implications
in the context governance mechanism. First, it establishes a link between two important
corporate governance mechanisms with the IE in the institutional settings where minority
shareholder risk of exploitation is high relative to other markets in the region. Second, our results
call for regulatory measures for increased disclosure level by both periodic and continuous
financial reporting. In addition, regulators may exercise regulatory enforcement by making it
mandatory for the listed firm in Pakistan to conduct audit through Big 4 firms. Such measures
will assist firms to potentially advance a firm’s capital investment decisions and provide
opportunity to outside investors and minority shareholders to view and assess the value of the
firm through higher level of IE. Our study is subject to some caveats, thus leaves few avenues Audit quality
open to future research. First, this paper used only IE as an economic consequence of AQ and on investment
FRQ. Future research may address other economic consequences (like cost of debt, credit risk,
etc.). Second, it would be interesting for future research to observe the influence of family control
efficiency
on the linkage of FRQ and IE, keeping the institutional context.

Note 611
1. Gomraiz and Sánchez Ballesta (2013), Baik et al. (2010), Biddle et al. (2009), Biddle and Hilary
(2006).

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Further reading
Francis, J., LaFond, R., Olsson, P.M. and Schipper, K. (2004), “Costs of equity and earnings attributes”,
The Accounting Review, Vol. 79 No. 4, pp. 967-1010.

Corresponding author
Faisal Shahzad can be contacted at: faisalnoorshah85@gmail.com

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