A review of Biddle, G. C. and G. Hilary, 2006, “Accounting Quality and Firm-level Capital Investment,” The Accounting Review 81 (5), 963-982.
I. Research question and its importance
This article investigates (1) the association between accounting quality and firm investment efficiency (i.e., cash flow sensitivity) and (2) the moderating effect of state-level financing characteristic. While prior work primarily focuses on the association between accounting quality and state-level financial market characteristic (e.g., ask-bid spread), this article narrows down the unit of analysis into firm-level. Moreover, it allows accounting quality to reduce cash flow sensitivity due to either lack or excess of cash, complementing and extending the literature on capital investment. Since its publication fourteen years ago, this article has been cited by 1195 according to Google Scholar.
II. Method and findings
The independent variable, accounting quality, was measured by an index composed of four dimensions (cf. Bhattacharya et al. (2003) and Bushman et al. (2004)). The dependent variable was measured by investment to cash flow sensitivity. State-level observations across 34 countries were in accordance to Bhattacharya et al. (2003). Firm-level data was retrieved from US and Japan given their difference in financing. OLS was employed for state-level specification with several robustness checks; panel specifications (i.e., OLS and Logit) were employed for firm-level analysis. The estimation was based on ten-year rolling windows. Key institutional features (e.g., legal origin, shareholder rights, and CIFAR) were controlled when regressing accounting quality. The authors found support that higher accounting quality is associated with higher investment efficiency (i.e., lower cash flow sensitivity) both across countries and within countries.
III. Future research
This article opened avenues for extensions. Perhaps the most important question to ask is whether this relation is causal. Namely, whether accounting quality leads to investment efficiency or vice versa. Shock-based research design may offer a more credible inference. For example, one might compare the lagged adoptions of state-level policy pertaining to accounting quality, and establish a causality based on comparison of treatment group (i.e., firms in adopted state) and control group (i.e., identical firms in state that did not adopt the policy). A further extension might examine various firm-level outcomes of capital investment, such as innovation. A recent paper by Wang, Y., Stuart, T., & Li, J. (forthcoming) published in Administrative Science Quarterly under the title of “Fraud and innovation “examines the causality where lower accounting quality leads to less investment in innovation, based on data from Chinese state-owned enterprises.