The impact of institutional investor type on corporate earnings management

This thesis examines the relation between institutional investor type (specifically, transient and long-term oriented institutional investors) and the discretionary earnings management strategies of their portfolio firms. By focusing on accruals management, it extends current understanding of the relation between institutional investor type and earnings management beyond (a) earnings management through real investment decisions and (b) only firms with research and development activities (Bushee, 1998). The association between transient (long-term oriented) institutional investors and portfolio firms' accruals management is first examined without reference to portfolio firms' specific earnings targets. Then, the association is investigated conditional upon portfolio firms' non-discretionary earnings relative to earnings targets. Transient institutional investors' investments in portfolio firms are transitory and fluctuate over a short period of time (Bushee, 1998; Porter, 1992). These investors create incentives for portfolio firm managers to adopt aggressive earnings management strategies to avoid earnings disappointment, or to take a bath when earnings disappointment is unavoidable. In contrast, long-term oriented institutional investors invest for the long-term prospects of their portfolio firms rather than focus on the current earnings performance of portfolio firms (Bushee, 1998; Shleifer and Vishny, 1997). They actively participate in monitoring their portfolio firms and their presence is argued to constrain and limit portfolio firm managers' earnings management discretion (Rajgopal and Venkatachalam, 1998; Shleifer and Vishny, 1997). Using a sample of US institutional investors and US portfolio firms, the results support the arguments that transient institutional ownership is associated with both larger income increasing and larger income decreasing discretionary accruals. This is consistent with transient institutional ownership encouragement of managerial myopia (Bushee, 1998). However, evidence supporting the managerial myopic effects of transient institutional investors is stronger when total institutional ownership is predominantly transient. There is insufficient evidence to suggest that transient institutional investors encourage "big bath" strategies, and only very limited evidence of an association between transient institutional ownership and portfolio firms' income smoothing strategies. Consistent with long-term oriented institutional investors constraining portfolio firm managers' accruals discretion, long-term oriented institutional ownership is found to be associated with smaller income increasing and smaller income decreasing discretionary accruals. The constraining effects of long-term oriented institutional investors remain evident among portfolio firms that have exercised their accrual discretion to meet their earnings targets. For firms that fail to meet their earnings targets, long-term oriented institutional ownership is negatively associated with discretionary accruals. That is, inconsistent with their long-term orientation, longterm oriented institutional investors appear to encourage "reverse" myopic accrual management behaviour among portfolio firms. There is no evidence supporting arguments that long-term oriented institutional investors create incentives for portfolio firms to adopt income smoothing strategies. These results highlight the importance of examining different types of institutional ownership separately when investigating the effects of institutional ownership on firms' earnings management. The study also provides evidence indicating alternative effects of institutional ownership types on firms' discretionary accruals, conditional upon the position of firms' non-discretionary earnings relative to their earnings targets. The overall results provide evidence indicating the complexities of institutional ownership type effects on portfolio firms' accrual management strategies. The insights provided in this thesis are valuable to academic researchers, analysts, investors and regulators who seek an understanding of the influences and implications of institutional investor type on corporate financial reporting.