Which Types of Institutional Investors Constrain Abnormal Accruals?

• DOI: http://doi.org/10.1111/corg.12044
• Published date: 01 January 2014
• Author: Mingzhu Wang
• Date: 01 January 2014

Which Types of Institutional Investors

Constrain Abnormal Accruals?

Mingzhu Wang*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study analyses which type of institutional investors constrains accruals management using

a sample of UK listed f‌irms in the period of 1997–2010.

Research Findings/Results: Empirical results show that block-holding levels, investment strategies, and investment dura-

tions inf‌luence institutional investors’ role in constraining accruals management of the investee f‌irms. Institutional investors

with 10–20 percent ownership, adopting an active investment strategy, and having moderate investment duration signif‌i-

cantly decrease the probability of income-inf‌lating abnormal accruals but increase the probability of income-def‌lating

abnormal accruals. In addition, these three aspects have a signif‌icant joint impact on accruals management. Even after

considering the interaction among the three aspects of institutional investors, 10–20 percent block-holding and moderate

investment duration remain as signif‌icant driving forces on the constraint of accruals management by institutional inves-

tors. Further tests are conducted for sub-sample periods of 2001–2005 and 2007–2009. Institutional investors with an active

investment strategy and moderate investment duration are better motivated to constrain accruals management of UK f‌irms

during 2001–2005 when there were vigorous regulatory changes in corporate governance. Institutional investors with a

passive investment strategy and short investment duration encouraged accruals management during the recent f‌inancial

crisis (2007–2009).

Theoretic/Academic Implications: The f‌indings of the paper provide some much needed clarity to the mixed evidence in

the extant literature on the role of institutional investors in constraining accruals management. Block-shareholding level,

investment strategies, and the actual investment duration are valid dimensions to ref‌lect their heterogeneous incentives in

monitoring managerial discretions in accruals management. Institutional investors are a complex group of diverse types of

f‌inancial institutions and would be more appropriately analyzed with multiple dimensions in future research on their

monitoring of managerial discretion.

Practitioner/Policy Implications: This study underpins the concern of UK policymakers over the short-term investment

orientation of institutional investment by showing that institutional investors with less than one year investment duration

signif‌icantly encourage accruals manipulations. Policymakers may pay attention to the three aspects, as identif‌ied in the

present paper, of institutional investors in terms of enhancing shareholder engagement with their investee f‌irms.

Keywords: Corporate Governance, Abnormal Accruals, Institutional Ownership, Directors’ Ownership and Board

Composition

INTRODUCTION

Institutional investors are now a majority component of

equity markets in many Anglo-American countries.

Equity ownership by institutional investors in the UK is

perhaps one of the highest in the world (Ferreira & Matos,

2007). It is generally thought thatthe presence of institutional

investors may cause a change in the behavior of the investee

f‌irms through their monitoring activities (Gillan & Starks,

2003). Prior research has examined the role of institutional

investors in corporate governance by searching for evidence

of their effects on stock prices (Jiambalvo, Rajgopal, &

Venkatachalam, 2002), f‌irm prof‌itability (Brous& Kini, 1994),

and executive compensation (Almazan, Hartzell, & Starks,

2008). There is also a wide debate on the role of institutional

investors in monitoring managers’ discretion in accounting

manipulation. Institutionalmonitoring may be a supplemen-

tary mechanism to the public f‌irms’ internal control of the

*Address for correspondence: Mingzhu Wang, Department of Management, King’s

College London, 150 Stamford Street, London SE19NH, UK. Tel: 20-7848-3628; Fax:

20-7848-4639; E-mail: mingzhu.wang@kcl.ac.uk

43

Corporate Governance: An International Review, 2014, 22(1): 43–67

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12044

qualityof f‌inancial reporting. Policymakers try to regulate the

f‌inancial reporting of public f‌irms. For instance, the UK Cor-

porate Governance Code1and a series of guidance notes

published by the FinancialReporting Council (FRC) intend to

assist listed f‌irms address specif‌ic aspects of governance and

accountability, including internal control in the f‌inancial

reporting process. Despite all the regulatory efforts in

enhancing the quality of f‌inancial reporting, managers of

listed f‌irms still have discretion in manipulating accounting

accrualsbecause of information asymmetry and agency prob-

lems between managersand shareholders. The present paper

explores which types of institutional investors effectively

curtail managerial discretion in accruals manipulation and

when they become effective in monitoring accruals manage-

ment after their initial investments.

Accountingaccruals contain signif‌icant explanatorypower

for future cash f‌lows (Al-Attar& Hussain, 2004). The compo-

nents of accrualswhich are not in line with the expectation for

cash f‌lows have been termed “abnormal accruals” in previ-

ous literature (Dechow & Dichev, 2002). Managers may

manipulate accrualsopportunistically and thereby adversely

affect the qualityof reported earnings and reduce their ability

to convey information on future cash f‌lows (Chung, Firth, &

Kim, 2002; Gul, Chen, & Tsui, 2003). Accruals management

undermines investors’ conf‌idence in f‌inancial information

and in the worst case scenario maylead to corporate failures.

After several f‌inancial scandals, including Enron,Xerox, and

WorldCom, there has been an international trend to imple-

ment effective corporate governance mechanisms to con-

strain managers’ incentives in accrual manipulations.

Some recent research has focused on the role of institu-

tional investors in constraining accruals managements

but with mixed evidence. Rajgopal, Venkatachalam, and

Jiambalvo (2002), Chung et al. (2002), Mitra and Cready

(2005) and Jiraporn and Gleason (2007) suggest that institu-

tional investors mitigate earnings management behavior.

Others (Beasley, 1996; Peasnell, Pope, & Young, 2000, 2005;

Siregar & Utama, 2008) f‌ind no evidence. The mixed evi-

dence is attributed to the fact that heterogeneous institu-

tional investors have been treated as a homogeneous group

in previous studies. For instance, taking heterogeneity into

consideration, Hsu and Koh (2005) and Koh (2007) f‌ind insti-

tutional investors with low portfolio turnovers constrain

accruals management among f‌irms manipulating earnings

to beat benchmarks. However, there is still room for further

research to clarify heterogeneity of institutional investors’

impact on accruals management. Further research in the area

of ownership identity may provide more insights into the

relationship between ownership structure and accruals

quality (García-Meca & Sánchez-Ballesta, 2009). For both

intuitive and empirical reasons, three aspects of institutional

investors are used in the present paper – block-holding

levels, investment strategies, and investment durations.

Empirical results show that the bargaining power of institu-

tional investors in constraining the managerial use of abnor-

mal accruals is determined by these three aspects

individually and collectively.

While most evidence in the literature that is related to the

present study is from the US, the UK provides an interesting

country context for further research on institutionalinvestors

and accrualsmanagement. These twoAnglo-American coun-

tries are different in the following three aspects. First, the

legal framework with regard to f‌inancial reporting signif‌i-

cantly differs. In the UK, it startswith common law f‌iduciary

duties owed by directors and then adds specif‌ic duties in

company law, for example on directors to prepare f‌inancial

statements thatgive a true and fair view (Rushton, 2005). The

London Stock Exchange (LSE) Listing Rules impose further

requirements for public f‌irms, including the obligation to

report on compliance with the Combined Code. In the US,

company lawexists only at state level but not atfederal level.

The securities regulation is the only available guidance for

listed f‌irms’ f‌inancial reporting at federal level. Second, the

nature and extent of earnings management are different. For

example, revaluation of non-current assets has been banned

in US since 1933 but is still permitted in UK (Companies Act,

2006, 85 4.31; FRS15 [Accounting Standards Board, 1999];

SSAP19 [Accounting Standards Board, 1981]). However, the

extent to which US managers manage earnings is signif‌i-

cantly higher than that by their counterparts in the UK

(Brown & Higgins, 2001). Third, different from the manda-

tory nature of the US corporate governance system, the UK

system is described as “shareholder-led” and shareholders

have the independence of deciding which monitoring

approaches are necessary to protect their interests (Tafara,

2007).2Unlike their US counterparts,institutional investors in

the UK do show engagement with the f‌irm management and

regularly meet with the boards and top management to

discuss strategies, governance issues, and f‌inancial perfor-

mance (Aguilera,Williams, Conley,& Rupp, 2006; Williams &

Conley,2005). Many f‌inancial institutions in the UK now have

built up substantialdedicated teams of corporate governance

experts, who often meet with the managers or boards of the

portfolio companies (Hendry, Sanderson, Barker, & Roberts,

2007). Despite the interesting institutional setting in the UK,

only Peasnell et al. (2000, 2005) have conducted studies to

board monitoring and earnings managementin the UK with

a fairly small and somewhat dated sample (1993–1996). They

treatinstitutional investors as a homogeneous group and f‌ind

no signif‌icant association between the institutional owner-

ship and earnings management.

Using a panel data of FTSE All Share constituent f‌irms

listed on the LSE in the period 1997–2010, the present paper

aims to provide a closer look at the association of abnormal

accruals with institutional investors categorized according

to their block-holding level, investment strategy, and invest-

ment duration. It makes three contributions to understand-

ing about the role of different types of institutional investors

on accruals management.

The f‌irst contribution is to clarify the ambiguity in the

literature on the monitoring role of institutional investors in

constraining managerial discretion. For example, it is com-

monly accepted that institutional investors with a certain

level of block-holding have more incentives in monitoring

managerial discretion.However, it is unclear in the literature

which level of block-holding triggers institutional investors

to constrain accruals management despite the assumption

thatshareholders with 5 percent ownership level or above are

likely to be effective monitors. Findings in the present paper

indicate that an ownership threshold of 10 percent triggers

institutional investors to monitor the managerial use of

income-inf‌lating accruals.3Institutional investors holding 20

44 CORPORATE GOVERNANCE

Volume 22 Number 1 January 2014 © 2013 John Wiley & Sons Ltd