The Impact of Institutional Stock Ownership on a Firm's Earnings Management Practice: An Empirical Investigation

This study examines whether institutional investor shareholdings inhibit firm managers from engaging in earnings management practice. It investigates the empirical association between discretion/flexibility available to managers in managing abnormal non-cash working capital accruals and institutional stock ownership for a sample of 386 New York Stock Exchange firms over a period of 8 years, from 1991 through 1998. The differential institutional influence on the level of accrual management of firms having different information environment, S&P 500 versus non S&P 500, is also examined to see whether the difference in information environment of these two sets of firms has any effect on this empirical relationship.By performing various multivariate statistical analyses, I find significant evidence that institutional stockholders reduce management flexibility in generating abnormal accounting accruals. Further, concentrated institutional shareholdings in some cases are found to diminish managerial propensity to manage abnormal accruals. A separate analysis for the S&P 500 and the non S&P 500 firms reveals that institutional monitoring effect on accrual management is different for these two sets of firms. I observe that institutions do not have mitigating influence in the S&P 500 firms but have significant mitigating effects on accrual management level in the non S&P 500 firms.The study makes two-fold contributions to the existing earnings management literature. First, it is generally assumed in prior studies that firms have uniform abilities to generate abnormal accruals to manage earnings. This study provides evidence that managements ability to manage earnings is not constant across firms but varies according to the level and concentration of institutional stock ownership. Institutional investors are found to improve the quality of corporate governance in financial reporting in cases where other important governance factors exist. Consequently, this study also extends prior research that examined the effects of other influential governance factors such as external audit, independence of boards or audit committees on the level of accrual management. Second, I develop a unique and powerful accrual model, which represents an improvement over the traditional models typically used in previous research and provides more robustness to the tests of earnings management.