Good quality financial reporting has been shown to improve capital investment efficiency, but this finding to date has been incomplete. While reporting quality is related to general improvement, it has not been clear whether it reduces over-investment or under-investment, or both.

Gary Biddle, Gilles Hilary and Rodrigo Verdi investigate and find higher quality financial reporting does indeed offer benefits in both circumstances, depending on a firm's situation. Firms more likely to over-invest are cash rich and unlevered, while those more prone to under-invest are cash constrained and highly levered.

The authors base their results on an examination of 34,791 firm-year observations in the US from 1993-2005. Financial reporting quality was gauged by looking at two measures of accruals quality, a separate measure of financial disclosure transparency, and a combination of the three.

"Financial reporting conveys information about the firm's operations, in particular expected cash flows that inform equity investors," they say. "We find that higher quality reporting is associated with both lower over-investment and lower under-investment."

For example, while the mean investment across all firm-years was 14.14 per cent, this was reduced by between 4.4 per cent and 7.3 per cent on a relative basis for firms that were prone to over-investing if their accruals quality measures were one standard deviation higher than the norm.

Firms prone to under-investment saw investment increase by 1.9 per cent to 5 per cent for a one standard deviation increase in their accruals quality measures.

The findings apply even when tested against corporate governance variables to show that financial reporting quality rather than other factors are the reason for improved investment efficiency.

The authors also look at whether macro-economic forces might be skewing the results, but they find firms with higher financial reporting quality are less affected by macro-economic shocks. They are also less likely to deviate from their predicted level of investment.

"The results are consistent with the argument that financial reporting quality facilitates investment for constrained firms and curbs investment for firms more likely to over-invest," the authors say.

"Overall, the findings are consistent with the idea that financial reporting quality serves a role in mitigating information frictions that ultimately hamper investment efficiency."