Taking a long view: Investor trading horizon and earnings management strategy

• Published date: 01 March 2022
• Author: Yeejin Jang,Kyung Yun (Kailey) Lee
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/irfi.12340

ORIGINAL ARTICLE

Taking a long view: Investor trading horizon

and earnings management strategy

Yeejin Jang

1

| Kyung Yun (Kailey) Lee

2

1

University of New South Wales, Kensington,

New South Wales, Australia

2

Hankuk University of Foreign Studies, Seoul,

South Korea

Correspondence

Kyung Yun (Kailey) Lee, Hankuk University of

Foreign Studies, Seoul, South Korea.

Email: kylee@hufs.ac.kr

Abstract

This paper studies how the investment horizon of institutional

investors affects firms' earnings management strategy in terms

of trade-off decisions between accrual management and oper-

ational adjustment. We find that when overall earnings man-

agement motives are held fixed, firms in which long-term

investors hold large stakes are more likely to manage earnings

by adjusting operational decisions than by manipulating

accruals. The preference for real earnings management is

more pronounced when long-term investors face performance

pressures and when they have a strong influence on man-

agers. We further document that real earnings management

helps smooth earnings, and the future adverse consequences

of operational adjustment are relatively less severe for firms

with a greater proportion of long-term investors than for

those with more short-term investors. Our findings are robust

to the endogenous choice of ownership structure. Overall, the

evidence suggests that firms choose earnings management

methods to meet the earnings expectations of institutional

investors, who have different earnings target windows.

KEYWORDS

accrual-based earnings management, earnings management,

institutional investors, investor horizon, real earnings

management

JEL CLASSIFICATION

M41; G23; G30; G31

Received: 7 February 2019 Revised: 10 November 2020 Accepted: 3 December 2020

DOI: 10.1111/irfi.12340

© 2020 International Review of Finance Ltd. 2020

36 International Review of Finance. 2022;22:36–71.wileyonlinelibrary.com/journal/irfi

“There is a constant tension between the short-term and long-term objectives of the firm.”

—from a survey of CFOs by Graham, Harvey, and Rajgopal (2005)

Firms make decisions on how to report earnings in financial statements, and sometimes they trade short-term

profits for long-term value or vice versa. Managers often indicate that the main goal of earnings management is to

meet or exceed the earnings expectations of existing and potential investors in financial markets (see the survey of

401 CFOs by Graham et al., 2005. Both practitioners and academic researchers argue that not all institutional inves-

tors are perceived as being the same. In particular, institutional investors differ in their trading horizons for various

reasons (e.g., types of funds or tax purposes), and their investments may have different windows for achieving their

target returns.

1

Consequently, managers might consider whether to meet the long-term or short-term expectations

of their existing investors, and such considerations affect earnings management choices. In this paper, we study the

effect of institutional investors' trading horizons on firms' earnings management strategy.

The focus of this study is on the trade-off decisions between real earnings management (REM) and accrual-

based earnings management (AEM), holding constant the level of overall earnings management incentives. We also

explore the implications of earnings management strategy. It is well-documented that long-term investors play a role

as efficient monitors by strengthening governance (Chen, Harford, & Li, 2007; Gaspar, Massa, & Matos, 2005;

Harford, Kecskés, & Mansi, 2018). Therefore, ownership by long-term investors should decrease the level of overall

earnings manipulation.

2

Although the common goal of earnings management is to avoid accounting losses and

increase reported earnings, we expect that investor horizon would further impact how firms manipulate earnings.

While a large number of accounting studies focus primarily on AEM (Dechow & Skinner, 2000; Healy &

Wahlen, 1999), recent studies document that in practice, many firms manage earnings by adjusting operating

decisions as long as actual sacrifices are not too substantial (Cohen & Zarowin, 2010; Kothari, Mizik, &

Roychowdhury, 2016; Zang, 2012). They find that AEM and REM act as substitutes; furthermore, the relevant costs

and benefits of each alternative, such as the probability of being scrutinized by auditors and regulators, can explain

firms' choice of earnings management strategy.

From the following distinct differences between REM and AEM, we derive predictions of the effect of

shareholders' trading horizon on the relative use of two strategies. First, managing earnings via accounting proce-

dures tends to be executed in the short period between the fiscal year end and the financial report filing date. In con-

trast, managing earnings by adjusting actual operations can be planned in advance and executed over a longer

period. Second, while managers face uncertainty regarding whether AEM will be allowed by auditors, changing oper-

ational decisions is largely under managers' control. Last, both types of earnings management methods are costly,

leading to future negative consequences, but they entail different types of risks. AEM is subject to future scrutiny by

regulators and auditors, and outside investors can recognize accruals as a sign of poor corporate governance.

3

In

addition, it is difficult to manage earnings through accruals in consecutive years because of the reverting nature of

AEM. On the other hand, REM involves changing the firm's actual operations in the current period, potentially

destroying future cash flows. However, compared to AEM, it can be used more flexibly to smooth earnings to

accommodate certain types of long-term investors.

Since long-term investors will not quickly exit their positions, they have a greater influence on managers'

decisions than short-term investors do, and they might want to resolve any uncertainty on earnings performance in

advance and to smooth out their earnings over long periods of time. Therefore, if REM takes longer planning and

execution over the fiscal year than does AEM, we expect that the presence of long-term investors is positively asso-

ciated with the choice of REM over AEM. Furthermore, long-term investors would like to avoid any potential risk of

regulatory scrutiny on accrual management, which can lead to a substantial drop in stock prices.

4

Since this might

occur a few years in the future from the time of the accounting manipulation to boost earnings, accrual management

would be more costly from the perspective of long-term investors than from that of short-term investors. On the

other hand, if making a suboptimal operational decision harms future cash flows more than manipulating accounting

JANG AND LEE 37

numbers, we expect that firms with long-term investors will prefer AEM to REM. To what extent shareholders'

trading horizon affects firms' trade-off decisions between the two earnings management methods is thus an

empirical question.

We use a sample of firm-year panel data of 6,988 U.S. firms that were traded on the NYSE, NASDAQ, or AMEX

from 1988 to 2014 and find evidence that the investor horizon affects firms' earnings management strategy. Using

the quarterly holdings information from 13F filings from 1987 to 2014, we follow previous studies (Gaspar

et al., 2005) to estimate the trading horizon. We calculate the value-weighted average of the turnover ratios of the

institutional investors that held a specific firm over four quarters. Next, we follow conventional methods of estimat-

ing discretionary accruals to measure AEM (Jones, 1991), and we employ three REM measures, following

Roychowdhury (2006): abnormal cash flows, abnormal discretionary expenses, and abnormal production costs.

The goal of this paper is to examine the effect of investor horizon on managers' relative use of AEM and REM,

holding the incentive to manage earnings constant. Thus, it is important to consider the first-order effect of investor

horizon on the aggregate level of earnings management. To do so, we focus on a sample of firms that are likely to

manage reported earnings, regardless of which of the two methods that they use. Specifically, we estimate a two-

stage model, as in Cohen and Zarowin (2010), to control for firms' incentive to manage earnings in the first step.

Conditional on firms engaging in active earnings management, in the second stage, we estimate whether investor

horizon is associated with firms' preference for adjusting operational decisions over manipulating accounting figures.

Our main finding is that firms with a longer investor horizon prefer adjusting real operations over manipulating

short-term accruals when firms intensively manage earnings. Compared to firms held by short-term investors, firms

primarily held by long-term investors have lower abnormal accruals. In contrast, firms with long-term investors are

more likely to engage in REM than those with short-term investors. Specifically, investor horizon is positively

associated with lower abnormal discretionary expenses and higher abnormal production costs.

5

One of the empirical challenges in our analysis is that the investor horizon and firms' earnings management strat-

egy can be endogenous. It is possible that institutional investors with a long trading horizon prefer to buy and hold

firms with specific unobservable characteristics, which can also affect the firms' earnings management strategy

simultaneously. To establish the causal effect of investor horizon on earnings management strategy, we exploit inclu-

sion in the Russell 2000 index as an instrumental variable to measure plausibly exogenous changes in investors' trad-

ing horizon. Since Russell 2000 index stocks temporarily attract short-term trading funds, especially in the year when

they are added to the index, we find that inclusion in the index negatively predicts investor horizon, consistent with

Cremers et al. (2020). Our specification instruments investor horizon using the Russell 2000 index inclusion event

years and estimates two-stage least squares (2SLS) regressions.

6

After addressing this endogeneity problem, we

confirm that our main finding remains robust.

We further develop our analysis to explore the two underlying channels through which long-term investors

pressure firms to manage earnings through REM. First, we expect that long-term investors who experience perfor-

mance pressures and face high market uncertainty should have strong incentives to influence firms' earnings man-

agement strategy (the incentive channel). We find evidence supporting this incentive channel. Firms held by long-

term investors are more likely to boost earnings through REM, especially when long-term investors experienced low

fund flows in the previous year. Our analysis further documents that long-term investors are more likely to pressure

managers into REM when market uncertainty, measured by the volatility index (VIX), is high.

Second, we look at the ability of long-term investors to influence firms' earnings management strategy (the influ-

ence channel). We expect the effect of the investor horizon on earnings management strategy to be more pro-

nounced if long-term investors have the ability to put more pressure on firms' managers. We observe that long-term

investors are more able to influence smaller firms' operational decisions. Often, larger firms are considered to have

more numerous investor interests and greater analyst and media coverage (Bhushan, 1989; O'Brien &

Bhushan, 1990; Piotroski & Roulstone, 2004; Shores, 1990). Thus, it is costlier for long-term investors to influence

the earnings management strategy of larger firms that receive intense market attention. In addition, we find that the

likelihood of the use of REM over AEM is higher when long-term investors hold a greater percentage of ownership

38 JANG AND LEE