Abstract

A fundamental question in accounting is whether and to what extent

financial reporting facilitates the allocation of capital to the right
investment projects. Over the last two decades, a large and growing
body of literature has contributed to our understanding of whether and
why financial reporting affects investment decision-making. We review
the empirical literature on this topic, provide a framework to organize
this literature, and highlight opportunities for future research.

Introduction
We review the empirical literature investigating the influence of
financial reporting and disclosure on corporate investment decisions.
A fundamental question in accounting is whether and to what extent
financial reporting facilitates the allocation of capital to the right
investment projects. In a frictionless world, such as that modeled by
Modigliani and Miller (1958), every project with a positive net present
value (NPV) is funded as it arises, and negative NPV projects are not
funded. In practice, a variety of frictions prevent this perfect outcome,
with perhaps the most widely-discussed one being frictions arising
from information asymmetries (Hubbard, 1998, Stein, 2003). Over the
last two decades, a large and growing body of literature has
contributed to our understanding of whether and why financial
reporting affects investment. Such research efforts have also
uncovered unforeseen and perhaps unintended consequences of
financial reporting. Our objective in this review is to synthesize this
growing stream of empirical archival research in a unified framework
and to highlight opportunities for future research.1

Much of the early literature on the “economic consequences” of

financial reporting suggests that financial reporting affects stock prices
and contracts (e.g., Ball and Brown, 1968, Beaver, 1968, Watts and
Zimmerman, 1986), with implications for firm value. Initial efforts to
establish a link between financial accounting and firm value focus on
testing whether financial reporting transparency lowers the cost of
capital (Healy and Palepu, 2001, Verrecchia, 2001, Beyer et al., 2010)
and/or improves contracting efficiency (Bushman and Smith, 2001,
Lambert, 2001, Armstrong et al., 2010). While this prior work has
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examined the role of accounting in reducing information asymmetry

and in designing efficient contracts, it has not examined the direct
effect of accounting on the firm's investment decisions. Thus, an
unanswered question from this stream of work is whether financial
reporting affects managers' investment decisions, and consequently
firm value. Capturing this sentiment, Bushman and Smith (2001) state
“accounting information potentially enhances the investment decisions
and productivity of firms … we suggest future research that directly
examines the effects of financial accounting information on economic
performance.”
Most of the literature inspired by Bushman and Smith's (2001) call for
research focuses on corporate investment decisions such as capital
expenditures, mergers and acquisitions (M&A), and research and
development (R&D). The focus on investment reflects the notion that
investment decisions are a primary means through which firms create
value for their investors and stakeholders. In fact, in the frictionless
Modigliani-Miller world, investment is the only factor affecting firm
value. Guided by the progress in the literature, we restrict the scope of
our review to studies examining corporate investment and, for the
most part, refrain from discussing the evidence relating financial
reporting to other drivers of firm value such as financing decisions
(e.g., capital issuance, payout policy). For the purposes of our
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discussion, a firm is considered to be investing efficiently if it invests in

every project with a positive NPV as such projects become available
(i.e., in a timely manner) and does not invest in projects with negative
NPV (e.g., Jorgenson, 1963, Hayashi, 1982).
Several attributes of the accounting system are purported to influence
investment decisions and they can be broadly classified into two non-
mutually exclusive groups: (i) attributes capturing the amount and
precision of the information disclosed, and (ii) attributes capturing the
nature and extent of disclosure related to a transaction or economic
event. Examples of financial reporting attributes related to the
precision of accounting information include earnings quality proxies,
changes in accounting standards, voluntary disclosures, etc.
Examples of attributes related to the nature and extent of disclosure
include the frequency of financial reporting, which economic
transactions are measured and which are not measured, how they are
measured and aggregated, etc. (Kanodia and Sapra, 2016). 4

Why might financial reporting affect investment choices and hence

investment efficiency? As we describe in Fig. 1, we organize the
literature into two broad categories. The first category (discussed in
Section 2) involves the role of financial reporting in a world
with agency frictions arising from information asymmetry. The key
feature in Section 2 is that accounting information either helps reduce
information asymmetry and consequently improves investment
efficiency, or provides agents with an incentive to undertake
potentially inefficient investment to meet financial reporting
benchmarks. The second category (discussed in Section 3) abstracts
from agency issues and information asymmetry among agents, and
instead focuses on learning effects arising from the presence of
uncertainty about investment opportunities. The key feature in Section
3 is that accounting information (reported by the firm or disclosed by
peer firms) affects managers' information set and thereby alters their
investment choices. 5,6

Within an agency framework, accounting information can affect

investment decisions by influencing information asymmetry between
managers and shareholders (and between other stakeholders of a
firm, for example, shareholders and debtholders) in two ways. First,
financial reporting can improve investment decisions by reducing
information asymmetry between managers and investors, as well as
among investors, which can affect adverse selection costs and
consequently the cost of raising external capital. Second, accounting
information can affect investment decisions by altering moral hazard
costs arising from agency conflicts among various stakeholders in the
firm. A notable observation that emerges from our review is that
financial reporting can simultaneously improve investment efficiency
by reducing moral hazard costs and reduce investment efficiency by
providing managers incentives to make myopic investment decisions.
Within the learning channel, our review highlights two ways through
which managers (and shareholders) can learn new information about
their investment opportunity set. First, accounting information
disclosed by peer firms can help reduce uncertainty about growth
opportunities available to related firms, particularly when a firm is
affected by common demand and supply conditions with the disclosing
peer firms. Second, in the presence of information acquisition and
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processing costs, disclosure requirements and financial reporting

regulation (e.g., internal control testing) can induce firms to collect and
process additional information that affect managers' information sets
and thus their investment decisions.
Much of the literature we review can be characterized as relying on
one or more of the four channels in Fig. 1. However, our review also
identifies two streams of literature that have received considerable
attention in economics and finance, but have not received as much
attention in accounting. In particular, accounting information can
influence investment decisions when managers or stakeholders have
behavioral biases, and when firms are connected through networks
created by the use of common agents (auditors, board members,
etc.). We discuss these streams of work in Section 4.
In the remainder of this section, we highlight six insights that emerge
from our review (we provide ideas to address the issues in the later
sections). First, the literature documenting that financial reporting
can improve investment efficiency has evolved somewhat
independently from the literature showing that financial reporting can
induce myopia and reduce investment efficiency (e.g., when a firm
cuts R&D to meet financial reporting goals). As a result, although the
evidence in these literatures is closely related, they do not provide a
cohesive picture of the economic consequences of financial reporting
that incorporates both its positive and negative effects on investment
decisions. More research is necessary to reconcile these two streams
of the literature.
Second, in addition to having both beneficial and distortionary
investment effects at the firm-level, financial reporting also generates
significant externalities. As a result, it is difficult to estimate the
aggregate effect of financial reporting on investment decisions that
accounts for (i) the firm-specific positive and negative effects (as
discussed in the first point above) as well as (ii) the positive and
negative spillover effects on non-disclosing firms. As an illustration,
consider the case of increased reporting frequency. On the one hand,
Fu et al. (2012) document that an increase in reporting frequency can
be beneficial for a firm because it reduces the firm's cost of capital. On
the other hand, Kraft et al. (2018) find that increases in reporting
frequency can be detrimental to shareholders of the firm because it
leads managers to reduce investment by exacerbating myopic
incentives. Further, Kajüter et al. (2018) find that increases in
reporting frequency is net costly for small firms (due to compliance
costs), but that increased reporting frequency by larger firms has
spillover benefits for smaller firms exempt from the reporting
requirements. Collectively, these studies provide important evidence
on several pieces of a large and multidimensional issue that involves
both firm-level effects and spillover effects on peer firms. All these
different pieces of evidence are relevant for the question of whether
an increase in reporting frequency is desirable from a regulator's
perspective, and for discerning the net impact of financial reporting on
aggregate investment. A concerted effort by researchers to estimate
and discuss the economic magnitudes of the effects of financial
reporting on investment will help answer these questions.
Third, there is an opportunity to enhance our understanding of the
sources of variation in financial reporting quality aimed at influencing
investment decisions in the presence of agency frictions. In adverse
selection settings, managers and (current) shareholders typically have
aligned interests, and an increase in reporting quality is a natural
outcome as long as the expected benefits of increasing transparency
exceed the expected costs. In contrast, in situations involving moral
hazard, managers and shareholders typically have incentives that are
not perfectly aligned, and joint control over reporting and investment
choices poses a more complicated problem. Managers can
conceivably exploit their discretion to issue low-quality reports as well
as engage in inefficient investments as mutually reinforcing strategies
that allow them to pursue their own private interests as opposed to
shareholders'. In this context, it is crucial to understand when
managers have the incentive and the opportunity to engage in such
behavior. Further, mechanisms such as regulation, governance and
litigation that discipline managers' reporting choices are likely to have
significant spillover effects on investment decisions. Understanding
how managers exercise their joint control over reporting and
investment, and how they can commit to higher reporting quality in a
way that facilitates more efficient investments remains a fertile area of
research.
Fourth, while our framework identifies separate channels through
which financial reporting may affect investment, the findings in most
studies are consistent with multiple mechanisms. For example, an
observed increase in investment after an increase in financial
reporting transparency may be the result of the increased
transparency reducing adverse selection costs, and hence the cost of
capital, thus expanding the firm's investment opportunities. However,
such a finding is also consistent with the increase in transparency
allowing shareholders to incentivize managers to undertake new
investment projects, that is, a mitigation of moral hazard. Studies
identifying and isolating specific mechanisms through which
accounting information affects investment decisions will help further
our understanding of when and how accounting information might be
most valuable. In addition, such studies will also help us compare the
role of accounting with other “curative mechanisms” that help resolve
agency frictions.
Fifth, most of the literature concentrates on the classic agency frictions
arising from manager-shareholder conflicts. However, there exist
several related topics that have received less attention and present an
opportunity for future research. For example, financial reporting
information can improve investment efficiency by reducing conflicts of
interests between shareholders and debtholders, by alleviating agency
issues within multi-segment organizations, as well as conflicts of
interest between shareholders and a broader stakeholder group that
includes customers, employees, etc. Similarly, there exists relatively
less research on the “learning” channel in which financial reporting
information improves the manager's information set about future
investment opportunities (see also a discussion of our review by
Ferracuti and Stubben (2019)). There is also little evidence on
whether information processing frictions (e.g., limited attention or
bounded rationality) as well as behavioral biases (e.g., loss aversion,
fixation on salient metrics, miscalibration) lead to an association
between financial reporting and investment choices. In addition, recent
technological advances and the availability of big data and
sophisticated data analytic tools can influence internal and external
reporting decisions which can ultimately influence investment via
agency costs, managerial learning or behavioral biases, and thus offer
promising opportunities for both empirical and analytical research. As
such, several research opportunities remain and we highlight them
throughout the review.
Last, a criticism of this literature is that investment efficiency is not
observable and researchers often use many imperfect proxies, each
with its own limitations. Specifically, a large literature in economics
and finance discusses the significant inferential challenges that arise
due to measurement error in proxies for growth opportunities,
conflicting evidence regarding the validity of proxies for financing
constraint, and misspecification in the empirical investment model
based on q theory. In addition, as discussed in Dechow et al. (2010),
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financial reporting quality is also an elusive construct without a one-

size-fits-all proxy that conforms to all research questions. This issue is
further complicated in our setting because the “true” financial
performance of a firm is integrally linked to its investment
opportunities, which makes it challenging for reporting quality proxies
to separate out the measurement of performance from the
true underlying performance of a firm. For example, firms may
disclose more information in footnotes because they are more
transparent (a financial reporting decision) or because they engage in
more transactions (an economic/investment decision). Researchers
have attempted to address these measurement issues by selecting
proxies for financial reporting quality tailored to suit a research
question, and by relying on multiple proxies for efficient investment.
However, more needs to be done to address the measurement
challenges in the literature.

Section snippets
Agency issues arising from information asymmetry
In this section, we review the literature on the effect of financial
reporting on investment decisions in the presence of agency frictions.
The common theme underlying the studies discussed in this section is
that information asymmetry between various parties to the firm gives
rise to investment distortions relative to first best. In such a setting,
financial reporting can improve investment efficiency by reducing
information asymmetry (and consequently agency costs).
Alternatively, financial

Learning issues arising from information uncertainty

This section discusses the theoretical arguments and empirical
evidence examining whether and why financial accounting disclosures
affect investment when the stakeholders of a firm are symmetrically
informed and agency frictions are absent. We step back into a
Modigliani and Miller (1958) world and discuss evidence showing that
financial accounting disclosures can affect investment decisions even
in a frictionless world as long as managers and investors are not fully
informed regarding all

Related topics
This section discusses two research topics that abstract away from
both information asymmetry and uncertainty as the sources of friction
that generate a relation between financial reporting and investment.

Conclusion
Over the last two decades, a large and growing body of literature has
contributed to our understanding of whether and why financial
reporting affects investment decision-making. In this review, we
provide a framework that organizes the literature into the different
channels that connect financial reporting to investment choices. We
articulate two broad scenarios in which financial reporting “matters” for
investment choices: (i) the presence of information asymmetry that
gives rise to agency