Skip to main content
SpringerLink
Log in

Earnings quality and investment efficiency: the role of the institutional settings

  • Original Research
  • Published:
Review of Quantitative Finance and Accounting Aims and scope Submit manuscript

Abstract

The current study examines the association between earnings quality (EQ) and investment efficiency (IE) using the conditional effect of legal origin. Further, we assess the influence of the institutional ownership (IOW) on the relationship between EQ and IE within different legal environments, using a sample of 22,446 firm-year observations from the US, the UK, Germany and Japan over the period of 2001–2018. In general, the results provide cross-country evidence that a higher EQ enhances IE. Further, the results indicate that higher EQ can mitigate overinvestment and underinvestment problems by ensuring that firms move toward their optimal level of investment. In addition, the findings reveal that a country’s legal environment affects IE with EQ having a stronger association with IE in common law countries as compared to code law economies. In terms of the conditional role of IOW, the findings illustrate that the effect of IOW on the relationship between EQ and IE varies within different legal origins. The results are robust to alternative measures for the main variables examined. This study provides policy implications for investors, managers, regulators, and theorists about the role of the institutional settings on the relation between certain properties of EQ and IE.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

Notes

  1. Throughout the present study, the terms Earnings Quality (EQ), enhanced financial reporting, enhanced disclosures, and high-quality financial reporting are used interchangeably to refer to the precision with which financial reporting conveys information about firms’ operations.

  2. Verdi (2006. p. 2) defines EQ as “the precision with which financial reporting conveys information about the firm’s operations, in particular its expected cash flows, in order to inform equity investors”. In addition, FASB (1978) have indicated that “financial reporting should provide information that is useful to present and potential investors and creditors, and other users, in making rational investment, credit, and similar decisions” (para, 34) and “…provide information to help present and potential investors in assessing the amounts, timing, and uncertainty of prospective cash receipts…” (See Statement of Financial Accounting Concepts No. 1. para. 37).

  3. Palepu et al. (2019) observed that many countries in mainland Europe have been moving towards a model whereby investors’ rights are becoming more prominent and stock exchanges are growing in importance. In particular, Germany has weakened creditor rights during the period covered by this study (Gonzalez 2020). However, the work of La Porta et al. from the late 1990s and the early 2000s placed Germany within the Civil Law tradition. The current study believes that the situation has not dramatically changed since there has not been a fundamental shift in the legal system of the country. In addition, we note that in terms of the ratio of Market Capitalization to GDP, Germany is still very different from the US and the UK with a figure of 54.3% in 2019 compared to 107% for the UK and 164.8% for the USA (CEIC data). Further, the number of listed companies in Germany in 2020 (over 450) is much smaller than the number in the UK (over 1800) and the USA (over 4500) (source, World Bank, 2020). We also note that the ratio of bank credit to the private non-financial sector expressed as percent of GDP is very different as between Germany and the USA (79% vs. 51%) although the percentage for the UK is higher than that of Germany at 86.8% (World Bank, 2020). Further, Noerr (2015) highlights that while creditor rights have been weakened in Germany relative to the protection that was available, creditors now have “an improved possibility to participate in the creditors’ committee”; as a result, they are more willing to support the restructuring of distressed firms. Finally, the current study finds out that while the German gearing ratio ranged between 25 and 49 times over the period of the current study, the UK and US gearing ratio ranged between 22 and 37 times over the same period. In addition, as a civil law country, Japan has a credit-based system and concentrated ownership as well as more emphasis on stakeholders as the primary beneficiary of corporate activities (Yonekura et al. 2012).

  4. Entrepreneurs are better informed than savers and have incentives to overvalue their businesses, leading to information problems and thus savers may encounter difficulties in distinguishing between firms with good and bad business investment opportunities. Consequently, investors would value all firms at an average level; as a result, the capital market may undervalue some firms with good investment ideas. These firms may withdraw from the capital market (Paul and Krishna 2001).

  5. An IE can be measured as deviations from an expected level of investment using a parsimonious investment model which predicts expected investment as a function of growth opportunities (Tobin 1982). Thus, overinvestment arises when management invests in negative NPV projects (He and Kyaw 2018), while underinvestment (negative deviations from predicted investment) refers to the passing up of investment in projects with a positive NPV (Verdi 2006; Biddle et al. 2009).

  6. The study used the number of analysts following the firm and bid-ask spreads as proxies for the information environment, where low level of analyst following and high bid-ask spreads indicated a poor information environment and vice versa.

  7. For example, minority shareholders may be reluctant to exercise their rights to monitor managers, because any monitoring costs may be greater than the likely benefit which may accrue; this results in a “free rider” problem among investors (Jensen and Meckling 1976). By contrast, Stiglitz (1985) suggested that concentrated ownership is more likely to be associated with greater control over managerial effort because such monitoring activities are likely to curtail management deviations from the maximization of shareholder wealth.

  8. The global financial crisis of 2008 has pressurized legislators and supervisory authorities worldwide to find ways to improve investor protection. In 2013, Germany implemented the Alternative Investment Fund Managers (AIFM) Directive, aiming at providing more protection to the interests of investors (Hoffmann and Paetzmann 2018).

  9. Wang et al. (2014) examined the association between EQ, ownership concentration and IE in China between 2008 and 2012. The study reported that enhanced EQ was negatively associated with levels of both underinvestment and overinvestment. Further, the results showed that EQ was more strongly associated with overinvestment for firms with low levels of ownership concentration.

  10. These were selected because they were the “largest” two common-law and civil-law countries (based on the aggregate rankings of a number measures) from the data presented in La Porta et al. (1998). For example, the US had the biggest GNP per capita (in US$) among common-law countries while the UK was ranked fourth. Japan and Germany were the two largest code-law countries based on GNP per capita (in US$). When countries were ranked by the average market capitalisation of listed firms, the US and the UK were ranked first and second among the common-law countries. From the civil law countries, Japan was raked first and Germany third (just behind France). We decided not to include data for French companies in our analysis because “differences between the French and other legal families are statistically significant” for a number of measures (La Porta et al. 1998, p. 1148). Arguably, the inclusion of data for French companies might have sharpened the differences uncovered between common-law and code-law countries.

  11. Overinvestment represents positive residuals from the IE model, while underinvestment represents absolute value of the negative residuals from the IE.

  12. Previous research used Clogg et al.’s (1995) model to examine whether differences between coefficients are significant. Accordingly, the current study uses this model and finds (un-tabulated) that coefficients (reported in Table 8) of Germany and Japan are statistically different from that of the UK and the US confirming the study conclusion about the effect of the legal origin.

  13. The IOW variable was also individually included while examining the results of Tables 10 and 11 and the results remain consistent (un-tabulated).

  14. Results are not tabulated but available upon request.

  15. Results are not tabulated but available upon request.

  16. The results are not tabulated but available based on request.

References

  • Abel A (1983) Optimal investment under uncertainty. Am Econ Rev 73(1):228–233

    Google Scholar 

  • Aghion P, Van Reenen J, Zingales L (2013) Innovation and institutional ownership. Am Econ Rev 103(1):277–304

    Google Scholar 

  • Ascioglu A, Hegde SP, Krishnan GV, McDermott JB (2012) Earnings management and market liquidity. Rev Quant Financ Acc 38(2):257–274

    Google Scholar 

  • Baker TA, Lopez TJ, Reitenga AL, Ruch GW (2019) The influence of CEO and CFO power on accruals and real earnings management. Rev Quant Financ Acc 52(1):325–345

    Google Scholar 

  • Ball R (2006) International Financial Reporting Standards (IFRS): pros and cons for investors. Account Bus Res 36(sup1):5–27

    Google Scholar 

  • Ball R, Kothari SP, Robin AR (2000) The effect of international institutional factors on properties of accounting earnings. J Account Econ 29(1):1–51

    Google Scholar 

  • Beck T, Demirguc-Kunt A (2006) Small and medium-size enterprises: access to finance as a growth constraint. J Bank Finance 30(11):2931–2943

    Google Scholar 

  • Bharath ST, Sunder J, Sunder SV (2008) Accounting quality and debt contracting. Account Rev 83:1–28

    Google Scholar 

  • Biddle G, Hilary G (2006) Accounting quality and firm-level capital investment. Account Rev 81(5):963–982

    Google Scholar 

  • Biddle GC, Hilary G, Verdi RS (2009) How does financial reporting quality relate to investment efficiency? J Account Econ 48(2–3):112–131

    Google Scholar 

  • Boonlert-U-Thai K, Meek GK, Nabar S (2006) Earnings attributes and investor-protection: international evidence. Int J Account 41(4):327–357

    Google Scholar 

  • Bushee BJ (1998) The influence of institutional investors on myopic R&D investment behaviour. Account Rev 73(3):305–333

    Google Scholar 

  • Bushman R, Piotroski D (2006) Financial reporting incentives for conservative accounting: the influence of legal and political institutions. J Account Econ 42:107–148

  • Cahan SF, Emanuel D, Sun J (2009) The effect of earnings quality and country-level institutions on the value relevance of earnings. Rev Quant Financ Acc 33(4):371

    Google Scholar 

  • Callen JL, Segal D (2004) Do accruals drive firm-level stock returns? A variance decomposition analysis. J Account Res 42:527–560

    Google Scholar 

  • Cao Y, Dong Y, Lu Y, Ma D (2018) Does institutional ownership improve firm investment efficiency? Emerg Mark Finance Trade 56:2772–2792

    Google Scholar 

  • Cascino S, Pugliese A, Mussolino D, Sansone C (2010) The influence of family ownership on the quality of accounting information. Fam Bus Rev 23(3):246–265

    Google Scholar 

  • Chan-Lee JH, Ahn S (2001) Informational quality of financial systems and economic development: an indicators approach for East Asia. Asian Development Bank Institute Working Paper, 20

  • Chen F, Hope O-K, Li Q, Xin W (2011) Financial reporting quality and investment efficiency of private firms in emerging markets. Account Rev 86(4):1255–1288

    Google Scholar 

  • Chen R, El Ghoul S, Guedhami O, Wang H (2017) Do state and foreign ownership affect investment efficiency? Evidence from privatizations. J Corp Finan 42:408–421

    Google Scholar 

  • Childs PD, Mauer DC, Ott SH (2005) Interactions of corporate financing and investment decisions: the effects of agency conflicts. J Financ Econ 76:667–690

    Google Scholar 

  • Cho M (1998) Ownership structure, investment, and the corporate value: an empirical analysis. J Financ Econ 47(1):103–121

    Google Scholar 

  • Chung R, Firth M, Kim JB (2002) Institutional monitoring and opportunistic earnings management. J Corp Finan 8(1):29–48

    Google Scholar 

  • Chung CY, Liu C, Wang K, Zykaj BB (2015) Institutional monitoring: evidence from the F-score. J Bus Financ Acc 42(7–8):885–914

    Google Scholar 

  • Clogg CC, Petkova E, Haritou A (1995) Statistical methods for comparing regression coefficients between models. Am J Sociol 100(5):1261–1293

    Google Scholar 

  • Crane AD, Michenaud S, Weston JP (2016) The effect of institutional ownership on payout policy: evidence from index thresholds. Rev Financ Stud 29(6):1377–1408

    Google Scholar 

  • Daske H, Gebhardt G, McLeay S (2006) The distribution of earnings relative to targets in the European Union. Account Bus Res 36(3):137–167

    Google Scholar 

  • Dechow PM, Dichev LD (2002) The quality of accruals and earnings: the role of accrual estimation errors. Account Rev 77:35–59

    Google Scholar 

  • Doidge C, Karolyi A, Stulz R (2007) Why do countries matter so much for corporate governance? J Financ Econ 86(1):1–39

    Google Scholar 

  • Dou Y, Hope O, Thomas WB, Zou Y (2018) Blockholder exit threats and financial reporting quality. Contemp Account Res 35(2):1004–1028

    Google Scholar 

  • Elshandidy T, Fraser I, Hussainey K (2015) What drives mandatory and voluntary risk reporting variations across Germany, UK, and US? Br Account Rev 47(4):376–394

    Google Scholar 

  • FASB (1978) Statement of Financial Accounting Concepts No. 1. Objectives of Financial Reporting by Business Enterprises. Norwalk, FASB

  • Ferreira MA, Matos P (2008) The colors of investors’ money: the role of institutional investors around the world. J Financ Econ 88(3):499–533

    Google Scholar 

  • Fields TD, Lys TZ, Vincent L (2001) Empirical research on accounting choice. J Account Econ 31(1–3):255–307

    Google Scholar 

  • Francis J, LaFond R, Olsson P, Schipper K (2005) The market pricing of accruals quality. J Account Econ 39(2):295–327

    Google Scholar 

  • Globerman S, Shapiro D (2003) Governance infrastructure and US foreign direct investment. J Int Bus Stud 34(1):19–39

    Google Scholar 

  • Gomariz C, Fuensanta M, Ballesta S, Pedro J (2014) Financial reporting quality, debt maturity and investment efficiency. J Bank Finance 40(C):494–506

  • González F (2020) Creditor rights, financial health, and corporate investment efficiency. North Am J Econ Finance 51:100873

  • Hadlock CJ (1998) Ownership, liquidity, and investment. Rand J Econ 29(3):487–508

    Google Scholar 

  • Hartzell JC, Starks LT (2003) Institutional investors and executive compensation. J Financ 58(6):2351–2374

    Google Scholar 

  • Haw I, Hu B, Hwang L, Wu W (2004) Ultimate ownership, income management, and legal and extra-legal institutions. J Account Res 42(2):423–462

    Google Scholar 

  • Hayashi F (1982) Tobin’s marginal q and average q: a neoclassical interpretation. Econometrica 50(1):213–224

    Google Scholar 

  • He W, Kyaw NA (2018) Ownership structure and investment decisions of Chinese SOEs. Res Int Bus Financ 43:48–57

    Google Scholar 

  • He W, Ng L, Zaiats N, Zhang B (2017) Dividend policy and earnings management across countries. J Corp Finan 42:267–286

    Google Scholar 

  • Hoffmann B, Paetzmann K (2018) Investor protection, valuation methods and the German alternative funds industry. J Risk Finance 19:174–189

    Google Scholar 

  • Hope OK, Thomas WB, Vyas D (2011) Financial credibility, ownership, and financing constraints in private firms. J Int Bus Stud 42(7):935–957

    Google Scholar 

  • Hope O., Thomas WB, Vyas D (2013) Financial reporting quality of U.S. private and public firms. Account Rev 88(5): 1715–1742

  • Hubbard RG (1998) Capital-market imperfections and investment. J Econ Literat 36(1):193–225

    Google Scholar 

  • Jensen MC (1986) Agency costs of free cash flow, corporate finance, and takeovers. Am Econ Rev 76(2):323–329

    Google Scholar 

  • Jensen MC, Meckling WH (1976) Theory of the firm: managerial behaviour, agency costs and ownership structure. J Financ Econ 3(4):305–360

    Google Scholar 

  • Jones J (1991) Earnings management during import relief investigations. J Account Res 29(2):193–228

    Google Scholar 

  • Kasznik R (1999) On the association between voluntary disclosure and earnings management. J Account Res 37(1):57–81

    Google Scholar 

  • Kim I, Miller S, Wan H, Wang B (2016) Drivers behind the monitoring effectiveness of global institutional investors: evidence from earnings management. J Corp Finan 40:24–46

    Google Scholar 

  • Kothari SP, Leone AJ, Wasley CE (2005) Performance matched discretionary accrual measures. J Account Econ 39(1):163–197

    Google Scholar 

  • La Porta R, Lopez-de-Silanes F, Shleifer A, Vishny RW (2000) Agency problems and dividend policies around the world. J Financ 55(1):1–33

    Google Scholar 

  • La Porta R, Lopez-de-Silanes F, Shleifer A, Vishny R (2002) Investor protection and corporate valuation. J Financ 57(3):1147–1170

    Google Scholar 

  • La Porta R, Lopez-de-Silanes F, Shleifer A, Vishny R (1998) The quality of government. NBER Working Paper, 6727

  • Lambert R, Leuz C, Verrecchia RE (2007) Accounting information, disclosure, and the cost of capital. J Account Res 45(2):385–420

  • Lara JMG, Osma BG, Penalva F (2016) Accounting conservatism and firm investment efficiency. J Account Econ 61(1):221–238

    Google Scholar 

  • Lemma TT, Negash M, Mlilo M, Lulseged A (2018) Institutional ownership, product market competition, and earnings management: some evidence from international data. J Bus Res 90:151–163

    Google Scholar 

  • Leuz C, Nanda D, Wysocki P (2003) Earnings management and investor protection: an international comparison. J Financ Econ 69:505–527

    Google Scholar 

  • Lin C-J, Wang T, Chao-Jung P (2016) Financial reporting quality and investment decisions for family firms. Asia Pac J Manag 33:499–532. https://doi.org/10.1007/s10490-015-9438-8

    Article  Google Scholar 

  • Liu Y, Miletkov MK, Wei Z, Yang T (2015) Board independence and firm performance in China. J Corp Finan 30:223–244

    Google Scholar 

  • McConnell JJ, Servaes H (1990) Additional evidence on equity ownership and corporate value. J Financ Econ 27(2):595–612

    Google Scholar 

  • McNichols MF, Stubben SR (2008) Does Earnings Management Affect Firms’ Investment Decisions? Account Rev 83(6):1571–1603

    Google Scholar 

  • Modigliani F, Miller MH (1958) The cost of capital, corporate finance and the theory of investment. Am Econ Rev 48(3):261–297

    Google Scholar 

  • Morck R, Shleifer A, Vishny RW (1988) Management ownership and market valuation: an empirical analysis. J Financ Econ 20:293–315

    Google Scholar 

  • Myers SC (1977) Determinants of corporate borrowing. J Financ Econ 5(2):147–175

    Google Scholar 

  • Noerr (2015) Insolvency study 2015: German insolvency law is headed in the right direction, retrieved from https://www.noerr.com/en/newsroom/PressReleases/insolvency-study-2015-german-insolvency-law-is-headed-in-the-right-direction.aspx. 15 December 2016

  • Palepu K, Healy P, Peak E (2019) Business analysis and valuation, IFRS. Cengage Learning, London

    Google Scholar 

  • Paul HM, Krishna P (2001) Information asymmetry, corporate disclosure, and the capital markets: a review of the empirical disclosure literature. J Account Econ 31(1–3):405–440

    Google Scholar 

  • Pound J (1988) Proxy contests and the efficiency of shareholder oversight. J Financ Econ 20:237–265

    Google Scholar 

  • Rad SS, Ebrahimi ZE, Mohd-Saleh N, Jaffar R (2016) Financial information quality and investment efficiency: evidence from Malaysia. Asian Acad Manag J Account Finance 12(1):129–151

    Google Scholar 

  • Rahman A, Yammeesri J, Perera H (2010) Financial reporting quality in international settings: a comparative study of the USA, Japan, Thailand, France and Germany. Int J Account 45(1):1–34

    Google Scholar 

  • Rajan RG, Zingales L (1998) Financial dependence and growth. Am Econ Rev 88(3):559–586

    Google Scholar 

  • Rajgopal S, Shevlin T (2002) Empirical evidence on the relation between stock option compensation and risk taking. J Account Econ 33(2):145–171

    Google Scholar 

  • Reese WA Jr, Weisbach MS (2002) Protection of minority shareholder interests, cross-listings in the United States, and subsequent equity offerings. J Financ Econ 66(1):65–104

    Google Scholar 

  • Shen J, Firth M, Poon WPH (2016) Credit expansion, corporate finance and overinvestment: recent evidence from China. Pac Basin Financ J 39:16–27

    Google Scholar 

  • Shleifer A, Vishny RW (1997) A survey of corporate governance. J Finance 52(2):737–783

    Google Scholar 

  • Stiglitz JE (1985) Credit markets and the control of capital. J Money Credit Bank 17(2):133–152

    Google Scholar 

  • Sun J, Ding L, Guo JM, Li Y (2016) Ownership, capital structure and financing decision: evidence from the UK. Br Account Rev 48(4):448–463

    Google Scholar 

  • Tobin T (1982) Money and finance in the macroeconomic process. J Money Credit Bank 14(2):171–204

    Google Scholar 

  • Velury U, Jenkins DS (2006) Institutional ownership and the quality of earnings. J Bus Res 59:1043–1051

    Google Scholar 

  • Verdi RS (2006) Financial reporting quality and investment efficiency. Available online at SSRN: https://ssrn.com/abstract=930922 or https://doi.org/10.2139/ssrn.930922. Accessed on 20 Mar 2018

  • Wang D (2006) Founding family ownership and earnings quality. J Account Res 44(3):619–656

    Google Scholar 

  • Wang F, Zhu Z, Hoffmire J (2014) Financial reporting quality, ownership concentration, and investment efficiency: evidence from China. Bio Technol Indian J 10:9872–9881

    Google Scholar 

  • Ward C, Yin C, Zeng Y (2020) Motivated monitoring by institutional investors and firm investment efficiency. Eur Financ Manag 26:348–385

    Google Scholar 

  • Yonekura A, Gallhofer S, Haslam J (2012) Accounting disclosure, corporate governance and the battle for markets: the case of trade negotiations between Japan and the U.S. Crit Perspect Account 23(4–5):312–331

  • Yoshikawa H (1980) On the “q” theory of investment. Am Econ Rev 70(4):739–743

    Google Scholar 

  • Zhong L, Chourou L, Yang N (2017) On the association between strategic institutional ownership and earnings quality: does investor protection strength matter? J Account Public Policy 36(6):429–450

    Google Scholar 

Download references

Author information

Authors and Affiliations

  1. College of Business Administration, Gulf University for Science and Technology, Hawally, Kuwait

    Yasean A. Tahat

  2. Business School, University of Dundee, Dundee, UK

    Ahmed H. Ahmed & David Power

Authors
  1. Yasean A. Tahat
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Ahmed H. Ahmed
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. David Power
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Yasean A. Tahat.

Additional information

Publisher's Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Tahat, Y.A., Ahmed, A.H. & Power, D. Earnings quality and investment efficiency: the role of the institutional settings. Rev Quant Finan Acc 58, 1277–1306 (2022). https://doi.org/10.1007/s11156-021-01024-w

Download citation

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11156-021-01024-w

Keywords

JEL Classification

Search

Navigation