The Effect of Shareholder-Initiated Corporate Governance on Accrual-Based and Real Earnings Management

Shareholder activism is an important source of corporate governance. Using a dynamic regression discontinuity design on shareholder proposals that pass or fail by a small margin of votes in shareholder meetings, we analyze the effect of shareholder-initiated corporate governance on earnings management. We find that both accrual-based and real earnings management diminish after shareholder proposals are passed. However, when we focus on proposals to improve auditor independence or to approve clawback provisions (i.e., proposals targeted at firms' financial reporting), we find that accrual-based earnings management decreases while real earnings management increases, suggesting a substitution effect. Consistent with one of these proposals' objectives, dealing with weakness in financial reporting due to “entrenched” auditors, we find that the substitution effect is stronger for firms with entrenched auditors. The substitution effect is also stronger when a firm has less analyst coverage and lower institutional investor ownership, suggesting a shift to potentially more costly real earnings management when there is weaker external monitoring. Overall, our paper contributes to the literature on shareholder activism by demonstrating that shareholder-initiated corporate governance can affect earnings management and that the effect can vary depending on the nature of the activism