Financial reporting quality and capital structure: Do financial constraints matter?

Purpose Understanding the determinants of capital structure decisions is essential to enhancing the firm's financial sustainability. The objective of the present study is to examine the influence of financial reporting quality (FRQ) on the decision of a firm's capital structure. Furthermore, the moderating impact of financial constraints (FC) is investigated in this relationship. Design/methodology/approach The study's sample consists of 165 non-financial Pakistan Stock Exchange-listed companies from 2010 to 2023. The sample companies' capital structure is calculated by the ratio of total debt to total debt plus the market value of equity. FRQ is calculated using Jones' (1991) accrual-based model and Dechow et al.'s (1995) accrual quality-based model, while financial constraints are evaluated using the KZ Index. To meet the study's objectives, we used a random effect model (REM) based on the Hausman test. Furthermore, the system-generalized approach of the moment estimation technique is employed to assess the robustness of the findings. Findings In support of the agency theory and pecking order theory, the results indicate that firms with greater FRQ minimize information asymmetry and agency cost, lowering the cost of equity and therefore negatively correlated with financial leverage in the capital structure. Furthermore, the results demonstrate that financial constraints enhance the negative relationship between FRQ and capital structure. Research limitations/implications The findings have serious consequences for emerging markets where governments want to increase market openness. In emerging markets with a lack of clear information, high agency costs, and a higher perceived risk, an acceptable FRQ is critical for boosting transparency and lowering agency expenses, which enhances a firm's stability. Practical implications The study's findings provide policymakers, business managers, regulators and investors with a better knowledge of how a firm's FRQ affects capital structure in Pakistani firms, as well as the significance of financial constraints in this relationship. Originality/value To the best of the authors' knowledge, this is the first study in an emerging market that empirically investigates the impact of FRQ on capital structure while studying the moderating role of financial constraints.