Can Institutional Investors Restrain Earnings Management Activities in Weak Investor Protection Countries.Pdf
Can institutional investors restrain earnings management activities in weak investor protection countries? The role of foreign and domestic institutional investors
UGUR LEL*
This draft: February 2013
Abstract This paper investigates the role that institutional investors play in restraining earnings management activities of firms under varying investor protection environments. Distinguishing between foreign and domestic institutional ownership in a sample of about 190,000 firm-year observations from 75 countries over the 1999 to 2012 period, we find that foreign institutional ownership is associated with lower earnings management. This effect is present almost exclusively for independent foreign institutional investors and for firms in weak investor protection countries. A similar effect of independent foreign investors is documented for firms with greater growth opportunities and capital expenditures, especially in countries with weak investor protection. We also find some evidence that domestic institutional investments are associated with higher (lower) earnings management when investor protection is weak (strong). These results are robust to controlling for unobserved firm heterogeneity, factors that can influence institutional investors’ decision to invest in the firm, and alternative earning management measures. Overall, our results suggest that independent foreign institutional investors provide an effective cross-border governance mechanism in curbing earnings management activities of firms in absence of strong legal protection, thereby helping reduce the governance disparity across countries.
Keywords: corporate governance, earnings management, foreign and domestic institutional investors, investor protection, management incentives, monitoring. JEL Classifications: G23, G34, M41
* Pamplin College of Business, Virginia Tech. We would like to thank Bowe Hansen for helpful comments. All errors are our sole responsibility.
Electronic copy
UGUR LEL*
This draft: February 2013
Abstract This paper investigates the role that institutional investors play in restraining earnings management activities of firms under varying investor protection environments. Distinguishing between foreign and domestic institutional ownership in a sample of about 190,000 firm-year observations from 75 countries over the 1999 to 2012 period, we find that foreign institutional ownership is associated with lower earnings management. This effect is present almost exclusively for independent foreign institutional investors and for firms in weak investor protection countries. A similar effect of independent foreign investors is documented for firms with greater growth opportunities and capital expenditures, especially in countries with weak investor protection. We also find some evidence that domestic institutional investments are associated with higher (lower) earnings management when investor protection is weak (strong). These results are robust to controlling for unobserved firm heterogeneity, factors that can influence institutional investors’ decision to invest in the firm, and alternative earning management measures. Overall, our results suggest that independent foreign institutional investors provide an effective cross-border governance mechanism in curbing earnings management activities of firms in absence of strong legal protection, thereby helping reduce the governance disparity across countries.
Keywords: corporate governance, earnings management, foreign and domestic institutional investors, investor protection, management incentives, monitoring. JEL Classifications: G23, G34, M41
* Pamplin College of Business, Virginia Tech. We would like to thank Bowe Hansen for helpful comments. All errors are our sole responsibility.
Electronic copy