The Effect of Private Information and Monitoring on the Role of Accounting Quality in Investment Decisions

We investigate how private information and monitoring affects both the sensitivity of investment to internally generated cash flows and the role of accounting quality in reducing this sensitivity. We expect financing frictions to be lower when debt is obtained from banks with private information and when banks place direct restrictions on investments. We also argue that access to private information and direct restrictions on investments are likely to affect the extent to which accounting quality reduces financing frictions. The results of our empirical analysis suggest that for financially constrained firms, banks’ access to private information reduces the investment-cash flow sensitivity, and the presence of this private information decreases the value of accounting quality. We further find that, for both financially constrained and unconstrained firms, covenants directly restricting capital expenditures also mitigate the negative effects of information asymmetry on investment spending. In addition, the importance of accounting quality is eliminated in the presence of covenants that directly restrict capital expenditures. Our results suggest that when information asymmetry problems are likely to be the largest, accounting quality is most important. However, if outside suppliers of capital use contractual restrictions on investment, or have access to private information, then accounting quality is less important. We also provide evidence that banks’ access to private information reduces the cash flow sensitivity of cash and mitigates the importance of accounting quality in reducing this sensitivity. This additional evidence suggests that our investment-cash flow sensitivity results are not driven by mismeasurement of the investment opportunity set.