The Effect of Bank Debt and Equity Financing on the Relation between Investment and Financial Reporting Quality

Abstract

This paper studies how the difference in the demand for accounting information from shareholders and banks affects the relation between financial reporting quality and corporate investment decisions. Ineffective monitoring and capital rationing by shareholders and banks due to information asymmetry may result in a lack of management’s investment responses to changes in growth opportunities. This paper, based upon analysis across twenty-seven countries, shows that financial reporting can reduce these problems and thus increase management's investment sensitivity to changes in growth opportunities. The increase, however, depends on the effectiveness of financial reporting in reducing information asymmetry. Outside shareholders rely on extensive financial reporting to reduce information asymmetry, while bank loan officers use private communication and monitoring channels as their primary information source. Consistent with this argument, I find that industries dependent on equity financing voluntarily disclose more information to satisfy the needs of shareholders, whereas the usefulness of financial reporting in improving investment sensitivity decreases with the level of bank debt financing.