Financial reporting quality and corporate innovation

• Date: 01 July 2018
• Author: KoEun Park
• Published date: 01 July 2018
• DOI: http://doi.org/10.1111/jbfa.12317

DOI: 10.1111/jbfa.12317

Financial reporting quality and corporate

innovation

KoEun Park

Universityof Massachusetts Boston, MA, USA

Correspondence

KoEunPark, Department of Accounting and

Finance,College of Management, University

ofMassachusetts Boston, 100 Morrissey Blvd.,

Boston,MA 02125, United States.

Email: KoEun.Park@umb.edu

Abstract

This paper examines the relationship of financial reporting to corpo-

rate innovation. Given the importance of a high-quality information

system and coordination to innovation, I predict a positive associa-

tion between financial reporting quality and future innovation. My

empirical evidence is consistent with this prediction. I also find some

evidence that the positive association between financial reporting

quality and innovation is more pronounced for firms with intensive

internal research and development activities and for firms in com-

petitive industries. The main findings are robust to using an instru-

mental variable approach as well as controlling for alternative expla-

nations. I find that firms with high-quality financial reporting trans-

form investment inputs into greater innovation outcomes and firm

value. This study provides additional insight into the role of financial

reporting quality and its relation to the real economy.

KEYWORDS

accruals quality, financial reporting quality, innovation

1INTRODUCTION

“In a period of rapid structuralchange, the only ones who survive are those who innovate and create change” (Drucker,

2008, p. 357). Technologicalinnovation is a key determinant of a firm's and nation's long-term economic growth. What

drives innovation is of great interest to various stakeholders,including investors, managers, employees, suppliers, cus-

tomers and regulators. There is a growing body of research that supports the critical role of highly developed financial

markets in promoting innovation (e.g., Hsu, Tian, & Xu, 2014).Despite information and incentive problems associated

with innovation (e.g., Holmstrom, 1989), the existing literatureprovides little insight into the direct relation between

external financial reporting, which is a keyingredient of well-developed financial markets, and innovation. The goal of

this paper is to shed light on whether and how financial reporting quality,which proxies the quality of the information

system, relates to future innovation.

Corporate investment decisions are among the most important decisions entrusted to managers (e.g., Jackson,

Liu, & Cecchini, 2009). Prior studies suggest that high-quality financial reporting can serve to mitigate market fric-

tions, such as adverse selection and moral hazard, and improve investment efficiency (e.g., Bushman & Smith, 2001;

Healy & Palepu, 2001). For example, high-quality financial reporting can help identify positive net present value

projects by managers and investorsand reduce adverse selection. It can also mitigate moral hazard by facilitating more

J Bus Fin Acc. 2018;45:871–894. wileyonlinelibrary.com/journal/jbfa c

2018 John Wiley & Sons Ltd 871

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efficient contracting and monitoring. Although severalempirical studies have investigated the relation between finan-

cial reporting quality and the quantity of observable investmentinputs (e.g., Biddle & Hilary, 2006), we have incomplete

knowledge of the relation between financial reporting quality and the quality, or outcome, of corporate investments

such as innovation.

While firms engage in different types of investments, it is particularly advantageous to investigatefinancial report-

ing in the context of corporate innovation. Innovation involves a multi-stage, long-term process that is full of uncer-

tainty and with a high probability of failure (e.g., Holmstrom, 1989). These unique features of innovation result in an

opaqueinformation environment. This, in turn, makes it difficult to estimate payoffs from innovative activities. Further-

more, innovation is an interactive process that involves communication and collaboration among various actors and

across various functions (e.g., Ostergaard, Timmermans, & Kristinsson, 2011). Environmental uncertainty surrounding

corporate innovation requires a dynamically efficient system of information exchangeand coordination.

The focus of this study is to explore whether information system quality, particularly external financial report-

ing quality, is associated with corporate innovation. I argue that higher-quality financial reporting is associated with

greater future innovation. Higher-quality financial reporting is associated with better internal reporting (e.g., Dichev,

Graham, Harvey, & Rajgopal, 2013; Gong, Li, & Xie, 2009), which helps investment decision makers identify value-

enhancing opportunities with fewer errors (e.g., Bushman & Smith, 2001). Furthermore, technological intensiveness

requires teamwork (e.g., Chang, Fu, Low,& Zhang, 2015; Siegel & Hambrick, 2005). Better internal reporting, which is

associated with a better overallinformation system, is particularly important to facilitating collaboration in innovation

efforts. A high-quality information system can reduce disagreement on expected payoffs among innovation decision

makers, enhance communication, and decrease bargaining and decision costs. This, in turn, is associated with greater

effectiveness in implementing or adjusting innovation plans.

I define financial reporting quality as the precision with which financial reporting conveys information about the

firm's fundamentals that are meant to capture the value-generating process of the firm, especially cash flows (e.g.,

Bhattacharya, Ecker, Olsson, & Schipper, 2012; Biddle, Hilary, & Verdi, 2009). Following prior studies (e.g.,Aboody,

Hughes, & Liu, 2005; Francis, LaFond,Olsson, & Schipper, 2005; Jones, 1991; Perotti & Wagenhofer, 2014), I use two

alternative measures of accruals quality as proxies for financial reporting quality.1Followingprevious studies on the

innovation literature (e.g., Fang, Tian, & Tice, 2014; Hirshleifer, Hsu, & Li, 2013), I measure corporate innovation by

patenting activity that captures how effectively a firm has utilized its innovation inputs. Specifically, I use the num-

ber of patent applications a firm files in a year that are eventually granted and the number of citations subsequently

received by each patent applied for during a given year as main proxiesto assess the success of long-term investment

in innovation (e.g., Aghion, VanReenen, & Zingales, 2013; Cornaggia, Mao, Tian, & Wolfe, 2015; Fang et al., 2014; He &

Tian, 2013; Hirshleifer,Low, & Teoh, 2012; Tian & Wang,2014).

Mybaseline test reveals a positive association between financial reporting quality and future innovation. The results

indicate that firms with higher financial reporting quality exhibit greater innovation success.2Toalleviate potential

endogeneity concerns, I investigate the effect of financial reporting quality on three-year-ahead innovation(e.g., He &

Tian, 2013), include an extensiveset of control variables, use a fixed effects approach (e.g., Hsu et al., 2014), and employ

a two-stage least squares (2SLS) regression model in which financial reporting quality variables are instrumented. I find

consistent results across different identification strategies.

I next explore cross-sectional heterogeneity to examine how the relation between financial reporting quality and

innovation varies across firms. The association between external and internal reporting is likely to be stronger for

firms facing a more uncertain environment (e.g., Gong et al., 2009). Internal research and development (R&D) is an

observable input into corporate innovation.3The longer-term, uncertain nature of internal R&D activities makes the

quality of internal reporting and collaboration particularly crucial to the success of R&D. In addition, intense industry

1Ialso use real activities manipulation measures as alternative proxies for financial reporting quality as robustness tests (Section 4.5.4).

2Since I include R&D expenditures to the set of controls (e.g.,Hirshleifer, Low, & Teoh, 2012), my evidencethus indicates that financial reporting quality is

positivelyassociated with the effectiveness of generating innovation after controlling for the amounts of R&D expenditures.

3Thereare other inputs into corporate innovation. For example, firms may achieve innovation by acquiring an innovative firm (Section 4.5.2).