• Policy Uncertainty, Financial Reporting Quality, and Investment Efficiency

Abstract

Purpose – This paper examines the association between policy uncertainty and investment efficiency and whether this association varies with financial reporting quality.

Design/methodology/approach – We use the monthly-updated economic policy uncertainty index (EPU) developed by Baker, Bloom, and Davis (2015) to proxy for policy uncertainty. We estimate the modified version of Biddle, Hilary, and Verdi’s (2009) model to capture the optimal level of investment. Finally, we estimate the modified cross-sectional Jones model (1991) and the Stubben's (2010) model to construct proxies for financial reporting quality.

Findings – W document a positive association between the aggregate level of uncertainty and investment efficiency. In addition, we find that this association is stronger for firms with lower financial reporting quality than for firms with higher financial reporting quality, suggesting that firms with lower financial reporting quality are more sensitive to the political environment.

Research limitations/implications – While we conduct a battery of robustness tests, our proxies for policy uncertainty, investment efficiency, and financial reporting quality may still have measurement errors.

Practical implications/Social implications – Our findings have important implications to the government. As companies with better reporting quality are less sensitive to the changes in the political environment, regulators should promote measures to enhance firms’ financial reporting quality.

Originality/value – We extend prior studies investigating the association between policy uncertainty and firms’ investment by exploring an alternative perspective—investment efficiency and provide direct evidence to suggest that firms with better financial quality are less sensitive to macro-conditions. This message is not directly documented in prior accounting literature and is relevant to the capital market participants.

Keywords – Policy Uncertainty, Investment Efficiency, Financial Reporting Quality