Zero Leverage, Accounting Quality, and Overinvestment

Sally Chung is a Professor of Accountancy. Below is the summary of her recent research.

Based on the static trade-off theory, firms could achieve a higher level of firm value by levering up to a certain point. However, the proportion of firms with zero leverage has steadily increased over time. It has been reported that over 10% of U.S. firms between 1962 and 2009, on average, are debt-free, and those zero-leverage firms tend to pay higher taxes and dividends, issue less equity, and have higher cash balances. It should be noted that zero-leverage capital structure provides a unique setting that has no monitoring from the private or public debt markets but faces pressure from equity markets, enabling us to isolate the effects of debt monitoring, or lack thereof, on financial reporting and investment decisions. In this study, we investigate the causal relation between zero-leverage capital structure and accounting quality, and the joint effect of zero-leverage policy and accounting quality on investment efficiency, specifically overinvestment.

The accounting quality of firms that choose to be debt-free may be low, because they are not monitored by debtors. When firms receive no or negligible pressure for high accounting quality from debt monitors, the information asymmetry between managers and investors is potentially higher for unlevered firms. On the other hand, the users of financial statements might require firms without debt monitors to enhance their accounting quality for the purpose of achieving efficient contracting and monitoring. Thus, zero-leverage firms face greater demands from equity market to provide high quality accounting information. Alternatively, it is possible that a firm chooses or is forced to be debt-free due to its low accounting quality. When a firm’s accounting quality is low, banks and credit agencies must spend more time and effort to verify the reliability of its accounting information. The increased cost of information collection and monitoring may result in higher interest rates or stricter borrowing contracts, causing the firm to reduce its desired level of leverage.

We use a simultaneous-equations approach since the association between zero-leverage policy and accounting quality can be reciprocally causal, and these two policy choices can be endogenous. The proxy for accounting quality is obtained from principal component analysis using three measures of abnormal accruals commonly used in accounting literature. Our methodology enables us to examine (i) whether a firm’s accounting quality drives its zero-leverage policy, and (ii) whether a firm’s zero-leverage capital structure affects its accounting quality. Using the sample firms from 1996 to 2015, we find that zero-leverage firms tend to provide high quality accounting information, while accounting quality does not affect a firm’s choice of adopting a debt-free policy.

Our results suggest that zero-leverage firms provide high quality accounting information to reduce information asymmetry due to lack of debt monitoring. Additionally, we find the mitigating role of accounting quality on investment inefficiency is significantly diminished for unlevered firms. Further analyses indicate that while accounting quality of zero-leverage firms does not reduce overinvestments, for almost-zero-leverage firms, accounting quality is an effective mechanism for reducing overinvestments. The comparison of zero-leverage firms and almost-zero-leverage firms highlights the effect of the presence/absence of debt monitoring as a boundary condition for the importance of accounting information on investment efficiency. This unique setting enables us to isolate the effects of debt monitoring, or lack thereof, on financial reporting and investment decisions. Overall, our results suggest that firms without debt monitoring attempt to lower adverse selection problems through high accounting quality, and that accounting quality may play a substitutive role for debt monitors in the equity market. Moreover, we provide evidence supporting the notion that debt monitors have significant impact on the information role of accounting quality for investment efficiency. That is, the mitigating role of accounting quality on investment efficiency is relevant when debt monitoring is also present.