Abstract

This article systematically reviews 94 accounting and finance studies that address the real effects of financial reporting. Whereas the effects of financial reporting on capital suppliers’ decisions traditionally have received much attention, recent research has generated important new insights into the feedback effects of financial reporting on the reporting firms’ real activities (e.g., investments or allocation and use of resources). We identify the consequences of financial reporting for (1) the reporting firm, (2) its peer firms, and (3) the input and output markets. We also highlight the effects of firms’ internal controls over financial reporting and consider how accounting and auditing regulations influence and contribute to real effects. The studies we review are consistent in their findings that high-quality financial reporting is positively associated with the efficiency of the reporting firm’s resource allocation. Many studies also suggest a positive association between high-quality financial reporting and an efficient allocation of resources in the real sector, which can also benefit other market participants like consumers or employees. The article concludes with an outlook on fruitful research opportunities.

Introduction

Most accounting research focuses on the capital market effects of financial reporting. Financial reporting informs investors, creditors, and the public about firms’ activities, net assets, financial position, and results of operations. It thus decreases information frictions when firms need to fund (new) projects and activities. A large portion of the literature on the effects of financial reporting addresses efficiency problems in the capital market by investigating the decisions taken by capital suppliers (e.g., Ball and Sadka, 2015, Ball et al., 2009, Botosan, 2006, Dye and Sridhar, 2002, Verrecchia, 2001). However, the relevance of financial reporting for the real sector, which includes firms’ decisions on investments and the production and consumption of goods and services, has received considerably less attention. Nevertheless, a small but fast-growing strand of the accounting and finance literature investigates the effects of financial reporting on the real sector. These effects are also referred to as real effects.

Most real effects studies investigate the economic effects of financial reporting on the investments and operations of the reporting firm (e.g., Biddle et al., 2009, García Lara et al., 2016, Kanodia and Sapra, 2016, McNichols and Stubben, 2008). An increasing number of studies also address the effects of a firm’s financial reporting on its peer firms. Examples of such studies are Badertscher et al., 2013, Beatty et al., 2013, Durnev and Mangen, 2009, and Li (2016), who find that misreporting can distort the peer firms’ investment and operational efficiency. The reason is that the peers seem to rely on misleading economic prospects. In contrast, peer firms might benefit from learning about market uncertainties from another firm’s financial report (Badertscher et al., 2013, Bernard et al., 2020, Durnev and Mangen, 2020). Finally, a few studies investigate the real effects of finanical reporting for the aggregate input or output market. These studies are consistent in their finding that financial reporting can facilitate the efficient allocation of resources across firms, for example, by reducing differences in productivity within an industry (Breuer, 2021, Francis et al., 2009, Hann et al., 2020). However, there is scarce research on the real consequences of financial reporting for other market participants in the input or output market. Yet real effects for consumers can exist in the output market, if, for example, firms change their pricing policies (Li, 2016, Sadka, 2006) or differentiate their products (Bernard et al., 2020) in response to their competitors’ financial reports. Furthermore, in the labor input market, financial reporting relates to firms’ labor investment efficiency (Choi, 2021, Jung et al., 2014, Kedia and Philippon, 2009), and this ultimately has implications for employees.

Conclusion

This review article summarizes 94 studies on the role of financial reporting for the real sector, focusing on (1) the reporting firm, (2) its peer firms, and (3) the input and output market. First, we find that most of the studies investigate real effects for the reporting firm. The findings of these studies suggest that high-quality financial reporting is positively associated with firms’ investments and operations efficiency. The reporting of (in)efficient internal controls can be interpreted as a moderating factor in firms’ efficiency in real decisions. Second, an increasing number of studies investigate the real effects of financial reporting for the reporting firm’s peers. These studies suggest that high-quality financial reporting can improve the efficiency of peer firms’ real decisions through learning. Low-quality reporting, on the other hand, can be misleading and result in inefficient real decisions by peer firms. Third, we find that only a few studies focus on the real consequences of financial reporting at the aggregate level. The findings suggest a positive association between industry- or country-level measures of financial reporting quality and the efficient allocation of resources across firms (e.g., by increasing product market competition). However, the economic implications of financial reporting for other market participants (e.g., consumers or employees) remain insufficiently explored. For example, consumers might benefit from an increase in product market competition resulting from high-quality financial reporting. Moreover, financial reporting quality positively relates to firms’ labor investment efficiency, which can affect employees. Finally, we observe that an increasing number of studies investigate the real effects of accounting and auditing regulations. These studies suggest that financial reporting regulations addressing the needs of capital market participants can have unintended economic consequences for firms and other market participants in the real sector.