Managerial investment and changes in GAAP: An internal consequence of external reporting

This paper investigates whether mandatory changes in Generally Accepted Accounting Principles (GAAP) affect investment in physical capital and research and development. Using a sample containing forty-nine changes in GAAP, I find evidence that changes in accounting rules affect investment decisions. I then examine two mechanisms through which changes in GAAP affect investment. First, I show that the process of complying with certain mandatory changes in financial reporting alters managers' information sets and consequently changes the quality of their investment decisions. Second, I show that firms with financial covenants likely to be affected by changes in GAAP invest more (less) when the change in GAAP increases (decreases) covenant slack. This paper contributes to the literature on the real effects of accounting by showing that accounting rules affect investment decisions and by documenting specific mechanisms through which the relation manifests.