Financial Reporting Quality Impact on Firms' Capital Structure.

Purpose: Past literature on capital structure has demonstrated that firms' financing decisions play a crucial role in their performance and longevity. Accordingly, researchers have often addressed this subject to understand why firms opt for either debt or equity financing. Most research suggests that capital structure is predominantly determined by two elements: the firms' internal and external characteristics. In this study, we investigate the possible impact, that has been frequently neglected, the quality of financial information. Since financial reports are the principal basis for most financial decisions, their quality and information can influence capital structure choices. Some managers have been known to resort to earnings management practices during times of financial hardship, to conceal difficulties and mask their financial situation for stakeholders. Such practices compromise the quality of financial information, possibly hindering financial decisions. Therefore, this study aims to investigate the potential impact of financial reporting quality on firms' capital structure. Methodology: To our research, we assembled a sample of non-financial firms listed on the main stock exchanges of Portugal, Italy, Greece, and Spain; this is, the PSI, the FTSE/MIB, the FTSE/ATHEX, and the IBEX 35. After removing financial firms and those with insufficient data, our final sample compiled observations from 414 companies over the period between 2013 and 2022. All the data regarding the observed companies was obtained from the Orbis database, with further data on macroeconomic variables being sourced from Eurostat. To obtain our findings, we use an unbalanced panel data methodology on our sample and estimated the regressions using both fixed effects and Ordinary Least Squares (OLS) models. Capital structure is measured through six different proxies: the total debt ratio, the short-term debt ratio, and the long-term debt ratio based on both accounting and market values. We apply all these measures to gain a more comprehensive understanding of the capital structure and its influencing factors. To assess the quality of financial reporting, we employed four measures, namely, accruals quality (that measures the lack of earnings management - misreporting to hide the real financial situation of the firm), smoothness (hiding fluctuations in earnings), timeliness (measures if earnings are timelier recognized), and accounting conservatism (related with the recognition of bad news in earnings earlier than good news). Prior research has predominantly focused on accruals quality, with smoothness and accounting conservatism being acknowledged to a lesser extent. However, as far as we are aware, the effect of timeliness on debt was not study till now. Our goal is to enhance the understanding of the relationship between financial reporting quality and capital structure, by using various proxies that address different aspects of reporting quality. Finally, to ensure consistency and accuracy among the findings, firm-specific and macroeconomic variables were incorporated into the empirical models. The firm-specific factors, included to mitigate the differences between the analyzed companies, consist of age, size, assets' collateral value, profitability, and market-to-book value. To decrease macroeconomic disparities, we added inflation and gross domestic product (GDP) per capita to the empirical model. Besides the global analysis, our research also investigates two sub-samples to understand the differences between firms that were under the influence of Troika policies and those that were not. Results: Our primary research revealed mixed findings, as three variables of financial reporting quality exhibited a positive impact on debt (accruals quality, smoothness and conservatism), whereas the remaining measure had an adverse effect (timeliness). According to our results, financial information quality as a positive and a negative impact on debt. Resorting to earnings management practices, which reduce accruals quality, to smoothness, or accounting conservatism practices results in a decline in financial reporting quality, subsequently leading to decreased indebtedness. In contrast, engaging in timeliness practices also results in a reduction of financial reporting quality; however, in this case it is prone to increase debt. Our additional analysis investigated the effect of financial reporting quality on debt in companies that were impacted by Troika policies compared to those that were not. While our main findings were upheld for companies not subject to Troika's intervention, the Portuguese and Greek companies, impacted by Troika policies, exhibited significant differences in their results. First, neither discretionary accruals nor smoothness yielded any statistical significance in explaining capital structure. Subsequently, we found that timeliness has a negative impact on Portuguese and Greek companies' debt. Therefore, accounting conservatism is the only variable that provides a consistent outcome throughout all analyses. Moreover, our data indicates that both firm-specific and macroeconomic control variables demonstrate substantial statistical relevance when explaining capital structure, despite not all variables being relevant. Furthermore, the control variables seem to combine elements of both the pecking order and trade-off theories, as demonstrated by the conflicting results, suggesting that neither of these theories completely clarify the models. These observations also apply when analyzing the subsamples. Therefore, it is necessary to consider both approaches to fully comprehend the findings. Research limitations: Despite aiming for listed companies to comprehend the capital structure at an accounting and market-based level, it is important to note that listed companies tend to only make up a small portion of the total market and are, as a result, not a representative sample of all companies in the countries reviewed. Therefore, further research could investigate a wider sample compiling listed and non-listed companies to gain a deeper understanding of how multiple capital structures are affected by financial reporting quality. Our study was also limited to four stock exchanges from developed countries with similar financial environments, which restricts the possibility of generalizing our findings to companies from other countries with distinct macroeconomic backgrounds. Further investigation could tackle this limitation to obtain a more detailed understanding of the potential impact of the macroeconomic context on this relationship between debt and financial reporting quality. Lastly, we only applied four financial reporting quality measures, three already used in previous research, and one new, but more measures can be explored. Therefore, our findings on reporting quality are restricted to the variables that were applied in our empirical model. A more thorough investigation, encompassing additional or even all the variables of financial information quality, may produce more complete findings regarding its influence on capital structure. Originality: This study makes a significant contribution to the existing literature. First, it examines additional determinants of the capital structure ratio, as financial reporting quality proxies are frequently overlooked, as well as the impact of the proxy timeliness which has not previously been addressed. Second, it enhances the understanding of financial reporting quality and its importance by demonstrating its impact on other financial aspects of the company. Third, it extends the scope of previous research by investigating four economies that are often neglected. Lastly, it improves our understanding on how reformative measures impact companies. Therefore, this study aims to provide generalizable conclusions that can be applied to other samples and generate informative insights for the stakeholders of the examined firms. [ABSTRACT FROM AUTHOR]