Improvements in Investment Efficiency Prior to a Mandated Accounting Change: Evidence from ASC 842

Abstract

Prior literature on the relationship between financial reporting and investment efficiency generally overlooks the connection between firms’ financial and managerial reporting systems. As a result, it is difficult to determine whether increases in the quality of firms’ internal information environments (IIQ) and/or external information environments (EIQ) explain improvements in investment efficiency following financial reporting changes. Leveraging the transition period to the new lease standard (ASC 842), we use a difference-in-differences design and find firms that materially change their internal controls due to ASC 842 (treatment firms) significantly improve their investment efficiency in the final year of the transition period. Attributing our findings to changes in IIQ, falsification tests generally fail to find evidence of contemporaneous improvements in treatment firms’ EIQ. Further, we fail to find evidence the improvements are driven by reductions in information asymmetry between external capital providers and firm insiders. Additional channel analyses suggest the increases in IIQ for treatment firms predominately alleviate moral hazard risk between central and divisional managers within the firm, leading to a reduction in empire-building. Our findings extend the literature on the relationship between financial reporting and investment efficiency. They also contribute to the literature on the consequences of ASC 842 by answering the FASB’s call for evidence on how ASC 842 affects firms’ asset utilization.

Keywords: investment efficiency, internal information quality, ASC 842, leases, internal moral hazard, internal adverse selection, information uncertainty

JEL Classification: M41, G31, D83