Characteristics of Institutional Investors and Discretionary Accruals

Abstract

This paper examines the differential effects of institutional non-blockholders (NONB) and active institutional blockholders (ACTB) on earnings management behavior, as measured by discretional accruals. We propose that NONB stimulates and ACTB mitigates earnings management. We believe that institutional investors do not always work as monitors as suggested by some previous literature. Hence, we propose that institutional non-blockholders are more interested in short-run performance than are institutional blockholders and that this interest creates pressure on management to deliver high earnings. Moreover, we believe that active institutional blockholders exercise their monitoring power more than passive institutional blockholders. Accordingly, we propose that institutional blockholders who are willing to challenge management are active monitors and will reduce the likelihood of earnings management.

We also propose that the hypothesized influence of NONB and ACTB on earnings management behavior is affected by earnings pressure (i.e. the gap between target earnings and pre-managed earnings). In particular, we believe that the stimulating effect of NONB on earnings management may not manifest when the stimulating effect of earnings pressures is already strong and the mitigating effect of ACTB may manifest only when the stimulating effect of earnings pressure is there. We group our sample into three earnings pressure conditions: pressure to increase earnings, neutral pressure and pressure to decrease earnings. Consistent with our expectations, we find that NONB stimulates earnings management, but only when earnings pressure is not strong and that ACTB mitigates earnings management, but only when there is pressure to increase earnings.

Our study's contributions to the literature are twofold: 1) we show that the characteristics of institutional investors should be considered when examining the relationship between institutional investors and earnings management; 2) we show that the direction and level of earnings pressure should be considered when evaluating the relationship between institutional investors and earnings management.

Keywords: earnings management, institutional investors, corporate governance and discretionary accruals

JEL Classification: G34, M41