High quality financial reporting "an open book" to investors

Accountancy

Rebecca N. Hann ; Heedong Kim ; Wenfeng Wang ; Yue Zheng.

Published in The Accounting Review, May 2020 

In the grand scheme of the economy, the accounting information that individual firms report can have big impacts. Here’s why.
In a fully competitive and efficient market, “good quality” firms would drive the “bad” ones out of market. However, many economic forces keep underdogs in industries alongside top-producers – think the retail dichotomy of Kmart and Walmart. Competition, taxes, regulations and government subsidies are some of the forces that prevent markets from simply weeding out underperforming firm. Information is another source.

Wenfeng Wang and his co-authors for the first time explore how accounting numbers can explain productivity dispersion within an industry. When making investment decisions, investors would like to put their money into productive firms. But productivity is not something that one can easily observe or measure, so outside investors have to use other information signals, like accounting information, to surmise productivity. They also need to know where each firm is in relation to others in the industry to decide where to invest. To allow investors to be able to compare different firms, we require all the firms to follow the same set of accounting standards to prepare their financial statements. 

Bad quality financial statements can reduce investors’ ability to gauge firm productivity. This can make it difficult for investors to make efficient investment decisions. As a result, resources may not always be allocated to more productive firms, and low productivity firms may continue to exist. That’s when we observe large productivity dispersion. Industries with more transparent financial reporting and higher quality financial statements have less productivity dispersion. Those industries are like open books so investors know where to put their money and the market can work as it should.