Institutional Investors on Boards and Audit Committees and Their Effects on Financial Reporting Quality

• Published date: 01 July 2014
• Date: 01 July 2014
• Author: María Consuelo Pucheta‐Martínez,Emma García‐Meca
• DOI: http://doi.org/10.1111/corg.12070

Institutional Investors on Boards and Audit

Committees and Their Effects on Financial

Reporting Quality

María Consuelo Pucheta-Martínez* and Emma García-Meca

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines how the presence of representatives of institutional investors as directors on

boards or on audit committees enhances financial reporting quality, reducing the probability that the firm receives qualified

audit reports. We focus on directors who maintain business relations with the firm on whose board or committee they sit

(pressure-sensitive directors). We also investigate the specific role of bank directors and examine their effects on financial

reporting quality when they act as shareholders and directors.

Research Findings/Insights: Our results suggest that institutional directors are effective monitors, which leads to higher

quality financial reporting and, therefore, a lower likelihood that the firm receives a qualified audit report. Consistent with

the relevant role of business relations with the firm, we find that directors appointed to both boards and audit committees

by pressure-sensitive investors have a larger effect on financial reporting quality as it is more likely that the auditor issues

an unqualified audit opinion. Nevertheless, when analyzed separately, only savings bank representatives on the board

increase financial reporting quality.

Theoretical/Academic Implications: The results confirm that board characteristics have an important influence on financial

reporting quality, in line with the views that have been expressed by several international bodies. The findings also suggest

that both researchers and policy makers should no longer consider institutional investors as a whole, given than directors

appointed by different types of institutional investors havevarious implications on financial reporting quality, measured by

the type of audit opinion.

Practitioner/Policy Implications: This study makes its core contribution by empirically showing that directors appointed

by different types of institutional investors have diverse implications on financial reporting quality. This evidence can be

potentially helpful in providing a basis for regulatory actions, namely those aiming to influence the structure of the board

of directors. The resultshave important implications for supervisors and regulators,who will benefit from an understanding

of how the presence of directors on boards of savings and commercial banks in nonfinancial firms affects financial reporting

quality in a bank-based system.

Keywords: Corporate Governance, Audit Committee, Board of Directors, Institutional Investors, Financial Reporting

Quality

INTRODUCTION

The recent persistence of accounting scandals has led

to serious reconsideration of the workings of boards

and audit committees. Research has shown that board char-

acteristics may affect the quality of the board’s supervision

of the financial reporting process (e.g., Beasley, 1996; Xie,

Davidson, & DaDalt, 2003), and extant research on this issue

has focused on board composition, specifically on the pres-

ence of independent directors (Klein, 2002; Peasnell, Pope, &

Young, 2005). However, other board members have received

scant attention in the literature, including directors

appointed by institutional investors.

Institutional investors are among the most important con-

trolling shareholders in continental Europe, where the prin-

cipal agency conflict focuses on the expropriation of

*Address for correspondence: María Consuelo Pucheta-Martínez, Departamento de

Finanzas y Contabilidad, Universidad Jaume I, Campus del Riu Sec, s/n, 46012-

Castellón-, Spain. Tel:34 964 38 7141; E-mail: pucheta@uji.es

347

Corporate Governance: An International Review, 2014, 22(4): 347–363

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12070

minority shareholders’ wealth by controlling shareholders.

In civil law countries the importance of institutional inves-

tors as supervisors compensates for the weaknesses of inves-

tor protection laws (Faccio & Lang, 2002). The specific

agency problems in European continental countries have led

to large blockholders, especially institutional investors,

becoming directors. Thus, directors appointed by institu-

tional investors (hereafter: institutional directors) have a

significant influence on European continental boards,

accounting for 40 percent of directorships in Spanish firms,

compared to 2 percent in British firms (Heidrick & Struggles,

2011). In this context, unlike in the Anglo-Saxon environ-

ment, institutional investors who are also board members

can exercise control over the firm as part of the internal

decision-making process (e.g., Weinstein & Yafeh, 1998).

These directors act as representatives of core shareholders in

monitoring management and ensuring thatthe firm operates

in their best interests.

Whereas recent studies have shown the prevalence of

large institutional shareholdings around the world, research

on the influence of institutional investors as directors is still

scarce. In addition, whether the role of non-independent

non-executive directors (also known as grey directors) is

more like that of inside directors or outside directors

remains ambiguous in the corporate governance literature

(Hsu & Wu, 2010). Research shows that institutional direc-

tors have an important influence on leverage (Booth & Deli,

1999; García-Meca, López-Iturriaga, & Tejerina, 2013), firm

value (Kumar & Singh, 2012), and earnings management

(García Osma & Gill-de-Albornoz Noguer, 2007).

Given the importance of institutional investors in allocat-

ing capital to corporations and their role in firm governance,

an understanding of how their presence on boards affects

financial reporting quality is undoubtedly needed. Dechow,

Ge, and Schrand (2010) state, “Higher quality earnings

provide more information about the features of a firm’s

financial performance that are relevant to a specific decision

made by a specific decision-maker.” However, accounting

quality is a noisy theoretical construct thatis operationalized

using a range of measures, the validity of which is unknown

relative to the theoretical constructs of interest (Suberi, Hsu,

& Wyatt, 2012).1In line with Bartov, Gul, and Tsui (2000),

Butler, Leone, and Willenborg (2004), Chen, Chen, and Su

(2001), Farihna and Viana (2009), and Pucheta-Martínez and

de Fuentes (2007), among others, we use the audit opinion as

a proxy for accounting quality. According to Farihna and

Viana (2009), whereas the audit opinion is observable, dis-

cretionary accruals (i.e., the proxy for earnings management

generally used in the prior literature) are unobservable and

must be estimated using models that can lead to wrong

conclusions due to specification problems (Dechow,

Richardson, & Tuna, 2003; Dechow, Sloan, & Sweeney, 1995;

McNichols, 2000).

To the extent that directors appointed by institutional

investors monitor management more effectively than inside

directors and have financial training, we hypothesize that

companies with a greater proportion of institutional direc-

tors will be more likely to enhance financial reporting

quality and, therefore, the likelihood that the auditor issues

a qualified auditreport will be lower. This study fills a gap in

the literature as, to the best of our knowledge, we are the

first to examine the influence of directors appointed by insti-

tutional investors on financial reporting quality.

Our analysis follows three steps. First, we study the

impact that directors who represent institutional investors,

both on boards and audit committees, have on financial

reporting quality. In a second step, and according to recent

literature, we assume that institutional investors cannot be

considered as a homogeneous group due to their different

incentives and ability to engage in the corporate governance

(Almazán, Hartzell, & Starks, 2005; Chen, Elder, & Hsieh,

2007; Cornett, Marcus, Saunders, & Tehranian, 2007). We

propose that the type of business relations between firms

and institutional investors is a key issue in describing the

role of institutional directors and,thus, their effects on finan-

cial reporting quality. Accordingly, we make a distinction

between those who maintain business relations with the

firm on whose board they sit and institutional investors

whose business activity is not related to the company in

which they hold a directorship. To our knowledge, no prior

works that focus on the continental Europe context analyze

the relation between institutional directors and financial

reporting quality measured by the audit opinion. Finally, in

a third step, we focus on the specific roleof bank directors on

boards and audit committees and analyze their effects on

financial reporting quality when they act as shareholders

and directors.

We use a sample of Spanish listed firms between 2004 and

2010. Spain is a good paradigm to study the effectiveness of

institutional directors because it has the highest presence of

institutional investors on the boards of large firms among

European countries (Heidrick & Struggles, 2011). Corporate

governance and auditing systems are different between

Spanish and Anglo-Saxon markets (Fernández & Arrondo,

2007). Unlike the Anglo-Saxon capital markets, Spain is char-

acterized by a high ownership concentration and the lack of

liquid capital markets. This explains why the board of direc-

tors – which is marked by the presence of the large

blockholders, especially institutional investors – is the

prevalentmechanism of control in Spain. Finally, Spainoffers

a unique opportunity to analyze the conflicts of interest that

arise when banks have simultaneous roles as shareholders,

creditors, and directors.

Our results suggest that institutional directors are effec-

tive monitors, which results in higher quality financial

reporting and, therefore, a lower probability of a firm receiv-

ing qualified audit reports. Consistent with the relevant role

of business relations with the firm, we find that directors

appointed by pressure-sensitive investors, that is, those who

maintain business relations with the firm on whose board or

audit committee they sit, have a greater effect on financial

reporting quality since the likelihood that the auditor issues

a qualified audit opinion is lower. Nevertheless, when ana-

lyzed separately, commercial banks and savings bank repre-

sentative directors show different attitudes.Specifically, only

savings banks representatives on the board help to enhance

financial reporting quality. This finding may be justified by

the specific composition of these entities, in which the

regional and local governing bodies exercise a decisive

power in firm strategy.2Even though the Spanish Unified

Good Governance Code (2006) highly recommends forming

audit committees of entirely independent and institutional

348 CORPORATE GOVERNANCE

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