Foreign institutional investment horizon and earnings management: Evidence from around the world

This paper investigates whether and how the investment horizon relates to foreign institutional monitoring in constraining the self-interested managerial use of earnings management for a sample of firms from 29 countries. We find that equity ownership by long-term foreign institutional investors, irrespective of the strength of institutional controls in their home countries, is associated with lesser earnings management. Accounting for the significance of information asymmetry in earnings management and the ability of long-term foreign institutional investors to mitigate the information disadvantage associated with cross-border equity investments, we find that the constraining effect is stronger in firms with weaker information environments. Finally, using multiple proxies for the country- and firm-level agency, we find that monitoring by long-term, rather than short-term, foreign institutional investors is significantly effective in limiting earnings management in environments of severe agency conflicts. Overall, our findings draw attention to the heterogeneity in the monitoring role played by foreign institutional investors in influencing the financial reporting quality.     

Institutional investors and earnings management associated with controlling shareholders' promises: Evidence from the split share structure reform in China

We examine the effectiveness of institutional investors in constraining aggressive earnings management induced by strong contractual incentives. To this end we focus on the consequences of earnings-related promises (covenants) negotiated between corporate controlling shareholders and minority shareholders during China’s split-share structure reform, wherein failure to achieve profit benchmarks had the potential to transfer significant wealth from controlling to minority shareholders. Our initial analysis provides evidence that profit-promised firm-years are, on average, associated with income-increasing earnings management, and that this association is stronger for: (i) firm-years in which the profit-promise was satisfied, and (ii) firm-years in which proxies for the level of unmanaged earnings suggest that earnings management was needed to satisfy the promise. However, such benchmark-beating behavior is weaker for firms with higher levels of institutional ownership. Further analysis documents that the exit threat of institutional shareholders can discipline earnings management associated with profit promises. We also show that the effect of institutional shareholders in reducing earnings management associated with profit promises is greater for domestic mutual funds and for privately controlled firms. Interestingly, our evidence suggests that institutional investors only play an effective monitoring role over earnings management when their incentives are strongly aligned with those of other minority owners. In other cases, our evidence suggests that these investors may exacerbate the level of earnings management.     

Institutional ownership stability and real earnings management

We examine the relationship between institutional ownership stability and real earnings management. Our findings indicate that firms held by more stable institutional owners experience lower real activities manipulation by limiting overproduction. We further examine how the stability in the shareholdings of pressure-sensitive and insensitive institutional investors affect target firms’ use of real earnings management, respectively. Unlike pressure-sensitive institutional investors, the stability in the share ownership of pressure-insensitive institutional investors (i.e., investment advisors, pension funds and endowments) mitigates target firms’ use of real earnings management. Overall, our results are consistent with the view that institutional investors presence acts as a monitor on target firms’ use of real earnings manipulation activities.     

Capital market pressure,real earnings management,and institutional ownership stability - Evidence from Poland

This study investigates whether and how institutional ownership stability influences real earnings management. We find that institutional investors holding stable equity stakes play an important monitoring role in reducing real earnings management by managers pressured by capital market forces to “meet or beat” earnings targets. We also document no relationship between institutional ownership stability and real earnings management in companies with entrenched managers protected from capital market pressure by a dual-class ownership structure. Our findings of the negative association between real earnings management and institutional ownership stability also indicate that firms with more stable ownership are engaged in lesser sales manipulation and overproduction. In addition, we reveal that pressureresistant institutions (pension funds and mutual funds) that reduce real earnings management are an essential part of the external governance mechanism in an emerging economy.     

内部控制与异质机构持股的治理效应

本文实证检验了不同内部控制水平下,异质机构持股在抑制管理层盈余操纵方面的公司治理效应。研究发现,相比外地或短期机构持股,本地或长期机构持股更有助于提升应计质量和降低盈余噪音;当公司存在实质性内部控制缺陷时,本地或长期机构持股在抑制管理层盈余操纵方面的治理效应显著降低;相比国有控股,异质机构持股治理效应的发挥在非国有控股公司中受内部控制的影响更大;当公司存在财务报告实质性内控缺陷时,异质机构持股发挥的治理效应明显更弱。这些结果表明,异质机构持股治理效应的发挥离不开公司内部控制机制,二者之间是互补而非替代关系,这种互补关系主要由财务报告内部控制缺陷驱动。本研究有助于深化理解异质机构持股影响公司治理的具体作用机理,为实务界和监管机构改善公司治理、加强投资者保护提供经验参考。     

Institutional investor type,earnings management and benchmark beaters

This paper classifies institutional investors into transient or long-term by their investment horizons to examine the association between institutional investor type and firms’ discretionary earnings management strategies in two mutually exclusive settings – firms that (do not) use accruals to meet/beat earnings targets. The results support the view that long-term institutional investors constrain accruals management among firms that manage earnings to meet/beat earnings benchmarks. This suggests long-term institutional investors can mitigate aggressive earnings management among these firms. Transient institutional ownership is not systematically associated with aggressive earnings management and is evident only among firms that manage earnings to meet/beat their earnings benchmarks. This indicates transient institution-associated managerial myopia may not be as prevalent as posited by critics. This study highlights the importance of explicitly considering the type of institutional investor and the specific setting when investigating the association between institutional ownership and corporate earnings management.     

The effect of relative performance evaluation on earnings management: a game-theoretic approach

Because investors and creditors often compare the financial statements of similar or competing firms when deciding how to allocate their funds, it is likely that a firm's financial well-being depends on how well it performs relative to its rivals. In this paper, we consider the problem of earnings management as a non-cooperative game among several firms, in which each firm seeks a comparison advantage through its financial statement numbers. Our model indicates that firms may exaggerate their earnings in a world driven by multi-firm-comparisons simply because they expect other firms to do so. Thus, very little may be needed for earnings management to emerge in the Nash equilibrium. Our results hold under the following conditions. First, investors and creditors are not able to unravel the earnings management, thus ensuring that some information asymmetry remains. Second, investors and creditors make inter-firm comparisons when assessing firm value. Third, firms care about their own fundamental value as well as the market's perception about firm value. We also show that the equilibrium amount of earnings management depends on the characteristics of the earnings management technique itself and on the proportion of stockholders who are long-term investors in the firm.     

Institutional Investor Protection Pressures versus Firm Incentives in the Disclosure of Integrated Reporting

Corporate disclosures aim to decrease the expectation gap between investors, decrease the advantage of informed investors and consequently reduce information asymmetry. However, the existence of higher numbers of companies’ reports makes the decision making of firms’ stakeholders difficult. To avoid these problems, companies have started to disclose integrated reports. Previous studies have observed that this voluntary corporate disclosure is a consequence of large firms’ incentives associated with preventing abnormal earnings. In this paper, we examine whether these internal factors have a lower/higher impact than institutional contracting pressures. Our results are evidence that firms’ incentives are the main determinants of the voluntary disclosure of integrated reports, and we observe that there is a substitutive role between institutional country pressures and firms’ transparency decisions. However, the contracting environment plays a complementary role when firms suffer from lower asymmetry problems.     

Do mutual funds have information advantage? Evidence from seasoned equity offerings in China

By integrating the literature on institutional investors with that on seasoned equity offerings (SEOs), this paper investigates the role played by mutual funds around SEO announcements in China. To the extent that shareholdings already held by mutual funds in a firm prior to the firm's SEO issuance represent funds' information advantage, our first finding suggests a positive association between such information advantage and funds' decision to participate in certain SEOs. Second, we find that certain SEO firms that have attracted fund participation at issuance outperform peer firms without fund involvement when performance is proxied for by accounting-based measures. Collectively, our findings are consistent with the notion that mutual funds have an information advantage over other types of investors, and such an advantage would allow them to be able to invest in the “right” SEOs.     

Fund ownership and stock price informativeness of Chinese listed firms

We examine the impact of mutual fund ownership on stock price informativeness in China. Existing evidence shows that stock price informativeness is low in China, and attributes this to firms’ lack of disclosure incentives under the weak investor protection institutional environment. Mutual funds are more sophisticated and influential than individual investors to monitor firms, and thus serve as an external governance mechanism to improve corporate transparency. However, the impact of mutual funds in China can also be moderated by state ownership of listed firms, which reduces firms’ dependence on outside investors for capital. Indeed, we find that mutual fund ownership is positively related to share price informativeness, but this effect is less pronounced among state-controlled firms. The main policy implication from our findings is that mutual funds contribute to the corporate information environment of emerging economies but further privatization of listed firms would be needed to realize greater benefit.     

When does comparability better enhance relevance? Policy implications from empirical evidence

This study investigates the user-specific contexts under which comparability better enhances relevance of accounting information. We first confirm the intuition in the FASB’s (2010) current conceptual framework by documenting that the short-window earnings response coefficient (ERC) is positively associated with the pre-determined level of comparability. Using the cross-sectional variation in the positive relation between ERC and comparability, we show that the link between ERC and comparability is more pronounced for firms with higher investor sophistication and lower information asymmetry among investors. We further support our predictions using analysts’ earnings forecast revisions and various alternative measures of earnings informativeness. In sum, our paper shows that comparability improves information users’ ability to identify similarities and differences across different firms to a greater extent when investor base is more sophisticated and private information is less prevalent. These results suggest that standard setters, regulators, and practitioners should devote more attention to the role of comparability in firms whose investors are less sophisticated and information environment is more opaque.     

Predicting earnings in a poor information environment

Financial intermediaries, such as analysts, play an important role in providing information to investors. However, a large segment of the market (about 39% of CRSP firms between 1992 and 2009) is not served by financial analysts, leaving investors in a poor information environment. In this paper, we examine whether other publicly available information signals, such as insider trades, institutional holdings, and firms’ stock repurchases, can be used to predict information about earnings for these firms. We find that CFOs’ trading decisions are associated with new information contained in the annual earnings reports for firms with no or scant analyst coverage. In contrast, for firms with multiple analyst coverage, insider trading decisions are not predictive of new information in earnings reports. Our results suggest that some public information signals, such as insider trades, can be used to alleviate the poor information environment faced by investors. However, the market may not have fully priced the information contained in these signals.     

Do institutional investors reinforce or reduce agency problems? Earnings management and the post-IPO performance

This study investigates the dual roles of institutional investors in earnings management during initial public offerings (IPOs). Research suggests that institutional investors play a monitoring role in the corporate governance of firms by mitigating earnings management to reduce agency problems. However, institutional investors have incentives to opportunistically maximize their wealth by manipulating earnings when firms engage in IPOs. Results suggest that institutional investors facilitate accrual-based earnings management before IPOs but restrain earnings management after their issuance. We also find that firms with high institutional ownership experience superior post-IPO stock returns and operating performance, thereby suggesting that the capital market positively prices the monitoring function of institutional investors after IPOs, and the performance of these firms is improved. Our results are robust to controlling the endogeneity problem of institutional investors and further identifying active institutional investors.     

Ethnic board diversity,earnings quality and institutional investors: evidence from Malaysian corporate boards

Motivated by calls to examine the issue of board diversity in emerging economies, this study explores the association between ethnic board diversity and earnings quality; and the moderating effect of institutional investors’ ownership. In a sample of Malaysian firms, we find that boards with higher ethnic diversity are associated with higher earnings quality. Consequently, our findings suggest that institutional investors prefer boards to be ethnically diverse. Consistent with geographical proximity theory, this effect is primarily driven by domestic institutional investors. Finally, we find that political connection attenuates the association between ethnic board diversity and higher earnings quality.     

Making honest men of them: Institutional investors,financial reporting,and the appointment of female directors to all-male boards

In this paper, we theorize that dedicated institutional investors are more likely than transient institutional investors to appoint female directors to investee firms with all-male boards, particularly those with high opacity. We conjecture that dedicated investors appoint female directors as a governance mechanism to improve the financial reporting quality of these investee firms. Specifically, we find that through the appointment of female directors, dedicated institutional investors trigger the release of stockpiled negative accounting information, thereby increasing the likelihood of a stock price crash risk. We also show that dedicated investors, through the appointment of female directors, improve investee firms' corporate disclosure environment by decreasing earnings management. Finally, we find that through continued service on investee firms' boards, female directors reduce the future likelihood of a stock price crash.     

The impact of financial reporting quality on debt maturity: the case of private firms

We examine whether the debt maturity structure of privately held firms is associated with the quality of their earnings numbers. We argue that earnings numbers that are better able to predict future cash flows lower information asymmetry between privately held firms and their creditors, improving privately held firms’ access to long-term debt. Furthermore, we examine whether the relationship between privately held firms’ earnings quality and their debt maturity differs between small and medium-sized enterprises (SMEs) and larger privately held firms. Using detailed financial statement information from a sample of privately held Belgian firms, we find that earnings quality is positively associated with the likelihood of having long-term debt and with the proportion of long-term debt in total debt. Further, we report evidence that these associations are more pronounced for SMEs than for larger privately held firms, which is consistent with smaller firms entailing more fundamental risk for creditors.     

The informativeness of brokerage reports: Privately-circulated versus publicly-disseminated news

Using the brokerage analyst reports released from 2014 to 2019, this paper examines the effects of the information role of brokerage firms and the information transmission role of the media on investor trading activity in the Taiwan stock market. Trading activity in the market can be categorized by investor types, including retail investors and institutional investors (foreign institutions, mutual funds, and broker dealers). This paper reviews the “buy the rumor, sell the news” trading strategy, which refers to institutional investors acting as early-informed traders and exhibiting short-term profit-taking characteristics. Notably, mutual funds have the best informational advantage among institutional investors, whose trading activities are significantly and positively related to the abnormal returns around the release of brokerage reports. On the other hand, retail investors may follow the trading activity of institutional investors without making a significant profit. The empirical findings are robust to include several firm and market characteristics. Overall, the empirical results provide in-depth insights into the regulation of brokerage analyst report disclosures.     

The incidence of earnings management on information asymmetry in an uncertain environment: Some Canadian evidence

In this study, we investigate the association between earnings management and information asymmetry considering environmental uncertainty. Results show that a complex and dynamic environment weakens the relationship between discretionary accruals and information asymmetry measured as share price volatility and bid-ask spread. More specifically, the positive relationship between earnings management and information asymmetry is weakened for diversified firms, those intensively investing in R&D, and those facing high sales volatility. This highlights the difficulty for investors to assess earnings management in an uncertain environment. Finally, in such a context, discretionary accruals are more likely to be detected by investors for firms cross-listed on a U.S. stock exchange, a more liquid and transparent stock market compared with the Canadian stock market.     

Informed trading before positive vs. negative earnings surprises

This paper investigates whether institutional investors trade profitably around the announcements of positive or negative earnings surprises. Using Korean data over the period of 2001–2010, we find that information asymmetry is larger before negative earnings surprises (earnings shock) among investors and that the trading volume decreases only before earnings shock announcements due to the severe information asymmetry. We also find that institutions sell their stocks prior to earnings shock announcements whereas individual and foreign investors do not anticipate bad news. Finally, we find that institutional trade imbalance is positively related to the post-announcement abnormal returns of negative events. This study complements and extends prior literature on informed trading around earnings announcements by documenting evidence that domestic institutions exploit their superior information around particularly earnings shock announcements.     

External financing and earnings management: Evidence from international data

Corporate financing conditions in the external capital market are significantly affected by information asymmetry, while internal financing is not. Given that earnings information influences market perceptions regarding firms’ quality, firms relying on external financing should have incentives to manage earnings to improve their financing conditions. This study investigates the effect of corporate external financing behavior on earnings management. Using a sample comprising 75,790 observations of 12,874 firms in 43 countries, we find that accrual-based and real earnings management are positively associated with firms’ reliance on external financing. This positive relationship holds especially true for firms that rely on equity rather than debt financing. We argue that reliance on external financing (especially equity financing), which is subject to problems arising from information asymmetry, generates a motive for earnings management.