The power of oversight: institutional investors as moderators of the earnings quality-information asymmetry nexus in Europe

• Date: 06 November 2024
• Pages: 68-103
• DOI: https://doi.org/10.1108/IJAIM-01-2024-0029
• Published date: 06 November 2024
• Subject Matter: Accounting & finance,Accounting/accountancy,Accounting methods/systems
• Author: Yasser Eliwa,Jim Haslam,Santhosh Abraham,Ahmed Saleh

The power of oversight: institutional

investors as moderators of the

earnings quality-information

asymmetry nexus in Europe

Yasser Eliwa

College of Interdisciplinary Studies, Zayed University, Abu Dhabi, UAE and

Loughborough Business School,

Loughborough University, Loughborough,UK

Jim Haslam

Durham University Business School, Durham, UK and School of Business,

The University of Jordan, Amman, Jordan

Santhosh Abraham

McAfee School of Business, Union University, Jackson, Tennessee, USA, and

Ahmed Saleh

Brunel Business School, Brunel University London, London, UK and

Faculty of Commerce, Mansoura University, Mansoura, Egypt

Abstract

Purpose –While there is some evidence of a relationship between earnings quality and information

asymmetry, thereis limited evidence on the moderating role of institutional investors inthis relationship. To

f‌ill this gap, this study aims to examine how institutionalownership affects the relationship between earnings

quality and informationasymmetry, with a focus on the impact of differentinvestment horizons.

Design/methodology/approach –This study uses a sample of listed European f‌irms from 2000 to 2022.

Earnings quality is measured using the McNichols (2002) modif‌ication of the Dechow and Dichev (2002)

model. The analysis examines the moderating effect of institutional ownership on the relationship between

earningsquality and information asymmetry.

Findings –This study f‌inds that the relationship between earnings quality and information asymmetry is

more pronounced in f‌irms with a higher percentage of institutional ownership. This study f‌inds that the

monitoring role of long-term institutional investors is more effective than that of short-term institutional

investors. This study also f‌inds that the inf‌luence of institutional investors is more signif‌icant in f‌irms with

incentivesto engage in earnings management.

Practical implications –The f‌indings provide evidence suggesting that institutional investors are an

important class of investors in terms of exercising an effective monitoring role to mitigate information

asymmetry and demand higher earnings qualityfrom their investee f‌irms. These f‌indings are informative for

many f‌inancialreporting participants, including investors, analysts,regulators and managers.

The authorsare grateful for comments of the EAAAnnual Congress and the BAFAAnnual Conference.

Any remainingerrors are the authors’own.

Conf‌lict of interest:The authors declare that theyhave no conf‌lict of interest.

IJAIM

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Received24 January 2024

Revised3 A ugust2024

14 October2024

Accepted14October2024

InternationalJournal of

Accounting& Information

Management

Vol.33 No. 1, 2025

pp. 68-103

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-01-2024-0029

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

Originality/value –This study extends the existing research examining the relationship between earnings

quality andinformation asymmetry (e.g. Aff‌leck-Graveset al., 2002; Ascioglu et al., 2012; Bhattacharya et al.,

2013; Jayaraman, 2008; Liu and Elayan,2015) by examining the moderating effect of institutional ownership

on this relationship. It further contributes to the literature by distinguishing between long- and short-term

institutional investorsand their respective monitoring roles. In addition, this studybroadens the geographical

scope of the research by using cross-country data from European f‌irms, providing evidence that country-

specif‌ic factorsdo not uniformly affect the relationship between earningsquality and information asymmetry.

Keywords Earnings quality, Information asymmetry,Institutional investors, Investment horizon, Europe

Paper type Research paper

1. Introduction

This study aimsto investigate the effect of institutional ownershipon the relationship between

earnings quality and information asymmetry. Earnings quality is widely recognised as a

crucial measure of f‌inancial reporting quality, inf‌luencing capital market resource allocation

(Li Eng and Lin, 2013;Lim etal.,2015;Dayanandan et al.,2016;Song, 2016). High earnings

quality provides reliable f‌inancial information that helps investors make informed decisions,

thus promoting eff‌icient market functioning (Francis et al.,2006;Bhattacharya et al.,2013;

Eliwa et al.,2016;Isidro and Dias, 2017;Deng et al.,2017;Eliwa et al.,2019). Information

asymmetry, on the other hand, is a critical factor in assessing the presence of private insider

information among investors, potentially leading to adverse selection in stock markets

(Easley et al.,2002;Iatridis, 2011;Tartaroglu and Imhof, 2017).The presence of information

asymmetrycan distort asset prices andhinder the eff‌icient allocationof capital.

Theoretical models posit that high quality accounting information reduces information

asymmetry among market participants, thereby enhancing asset allocation eff‌iciency (e.g.

Diamond and Verrecchia, 1991;Easley and O'hara, 2004;Lambert et al.,2012). This

relationship is empirically supported by studies showing a negative association between

earnings quality and information asymmetry (e.g. Aff‌leck-Graves et al.,2002;Jayaraman,

2008;Ascioglu et al.,2012;Bhattacharya et al.,2013;Liu and Elayan, 2015). By providing

accurate and timely f‌inancial information, high-quality earnings help mitigate the adverse

effectsof asymmetric information, therebyfostering investor conf‌idenceand market stability.

Building on these studies, our study explores the role of institutional investors –an

inf‌luential group due to their substantial asset management capabilities –in moderating the

relationship between earnings qualityand information asymmetry. Institutional investors are

pivotal in corporate governance because of their signif‌icant shareholdings and enhanced

ability to oversee and inf‌luence managerial decisions (Chung et al., 2002;Bushee and

Goodman, 2007;Tahat et al., 2022). Despite the established importance of institutional

investors in monitoringand inf‌luencing corporate governance, the extent to which they affect

the earnings quality–information asymmetry nexus remains underexplored, especially in a

cross-country context.

The impact of institutional ownership on the earnings quality–information asymmetry

nexus is theoretically ambiguous. On the one hand, active monitoring by institutional

investors can mitigateagency problems. Institutional investors are better equippedthan retail

investors to engage in eff‌icient monitoring since they hold a larger number of shares and

possess superior information-gathering capabilities. Their position leadsto strong incentives

to monitor effectively (e.g. Shleifer and Vishny, 1986), which has been linked to reducing

managerial opportunistic behaviour and improving transparency and quality of accounting

information (Chung et al.,2002;Ajinkya et al., 2005;Cornett et al.,2007;Boone and White,

2015;Khaf‌id and Arief, 2017;Kim et al., 2018). This view aligns with the trading

hypothesis, which posits that institutional trading enhances market liquidity and reduces

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information asymmetry (Ajina et al.,2015). On the other hand, institutional investors could

be myopic and passive in relation to the corporate governance of their investee f‌irms,

prioritising short-term gains over long-term value creation (McConnell and Servaes, 1990).

This is consistent with the adverse selection hypothesis, which is premised on institutional

investors as informed investors with access to private information, resulting in increasing

information asymmetry (Ajinkya et al.,2005;Comerton-Forde and Rydge, 2006;LaFond

and Watts, 2008;Boehmer and Kelley, 2009;Aslan et al., 2011;Ramalingegowda and Yu,

2012;Blume and Keim, 2012).

To address this complexity, our study f‌irst investigates how institutional ownership

inf‌luences the relationship between earnings quality and information asymmetry. Our

analysis reveals that the negative relationship between earnings quality and information

asymmetry is more pronounced in f‌irms with higher institutional ownership. This f‌inding

supports the view that institutional investors engage in more substantive monitoring than

retail investors. Through their substantial shareholdings and close relationships with f‌irms,

institutional investors are better equipped to gather information and monitor management,

thus mitigating adverse selection risks and decreasing information asymmetry. This aligns

with the trading hypothesis, suggesting that the presence of institutional investors enhances

market eff‌iciency by improving transparency and reducing the information gap between

informed and uninformedinvestors.

We further extend our analysis by examining the impact of the investment horizon of

institutional investors on their monitoring effectiveness. Prior studies highlight the

heterogeneity among institutional investors, which plays a crucial role in shaping corporate

governance and inf‌luencing corporate outcomes (Borochin and Yang, 2017;Alvarez et al.,

2018;Harford et al., 2018;Kim et al., 2019;Boubaker et al., 2019;Ghaly et al., 2020;

Cremers et al.,2020;Döringet al., 2021). According to this literature, long-term institutional

investors are associatedwith enhanced governance practices, as they have a vestedinterest in

the long-term success of the f‌irms they invest in. Conversely, short-term institutional

investors may exert pressure on corporate managersto prioritise short-term gains over long-

term value, potentially undermining governance and increasing information asymmetry

(Jones, 1991;Porter,1992;Laverty, 1996;Bushee,2001;Jiang and Anandarajan, 2009).

Building on these insights, our study explores whether the investmen t horizon of

institutional investors signif‌icantly affects the relationship between earnings quality and

information asymmetry. We classify institutional investors into long- and short-term categories

and hypothesise that long-term institutional investors have stronger incentives to promote

robust governance practices. This promotion is expected to manifest in higher earnings quality

and lower information asymmetry. Our empirical f‌indings support this hypothesis,

demonstrating a stronger negative relationship between earnings quality and information

asymmetry in f‌irms with high long-term institutional ownership compared to those with

predominantly short-term institutional investors. These results corroborate the notion that

long-term institutional investors prioritise sustainable corporate governance, thereby

enhancing f‌inancial reporting quality and reducing the potential for in formation asymmetry.

In contrast, short-term institutionalinvestors appear more focused on immediate f‌inancial

performance, which may result in managerial actions that compromise long-term value

creation. This focus can lead to weaker corporate governance, lower earnings quality and

higher information asymmetry, as suggested by previous studies (Porter, 1992;Demirag,

1998). Thus, our study contributesto the ongoing debate on the role of institutional investors

in corporate governanceby highlighting the importance of their investmenthorizon.

Our study makes three keycontributions to the existing body of literature. First, it extends

the existing research examining the relationship between earnings quality and information

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