by Dr Marwin Mönkemeyer, Research Associate at the Cambridge Centre for Finance, University of Cambridge Judge Business School
Ever since Berle and Means’ (1932) seminal work on the separation of ownership and control in modern firms, scholars have debated about the potential conflict of interests between managers and shareholders. According to the agency theory, this separation incentivises managers to select and apply accounting estimates and techniques that increase their own managerial wealth. But because such opportunistic earnings management occurs to the detriment of the firms’ other stakeholders, auditors, regulators, and investors have their own motivation to detect and mitigate these self-serving managerial practices.
It is a common notion in the field of corporate governance that institutional investors can reduce the agency problem between managers and shareholders by monitoring managers’ actions (Jensen and Meckling (1976); Shleifer and Vishny (1986); Hartzell and Starks (2003)). Studies have put forward two main arguments supporting institutional investors’ comparative advantage in monitoring over individual (retail) investors. First, sophisticated institutions have professional research, traders, and portfolio managers that guide their decisions, allowing them to detect earnings management already in the first place. Second, because they are powerful and equipped with the right incentives to engage in monitoring, they can utilise their privileged access to information and effectively constrain opportunistic managerial behaviour (Balsam et al. (2002); Ayers et al. (2011); Kang et al. (2018)).
Acknowledging institutional investors’ superior monitoring abilities, studies typically use the level of institutional ownership or the heterogeneity among different types of institutional investors to explain the quality of financial reporting (Bushee (1998); Tsang et al. (2019); Ramalingegowda et al. (2021)). Despite a growing body of research, the literature so far has neglected the role of the network created by institutional investors holding stakes in the same firms. However, the structure of such network is likely to affect the dynamics of information dissemination between institutions as well as an investor’s influence and power in interacting with firm management. As a result, networks increase monitoring effectiveness. Central as compared to peripheral institutions are likely to obtain more timely and superior information necessary to constrain opportunistic managerial behaviour. Moreover, due to their higher number of connections in the network, central institutions can effectively discipline managers by pursuing other investors to vote into the same direction (Bajo et al. (2020))
Given the above arguments, we propose shareholder centrality as a major determinant with an explanatory power that is incremental to traditional proxies for institutional monitoring. To provide empirical evidence on the relation between institutional investor centrality and earnings management, we use a comprehensive sample of 6,870 U.S. firms over the 1990–2019 period.
Our analyses reveal four key findings:
- First, we find that the presence of central institutional shareholders is associated with lower levels of earnings management. This evidence is robust to the use of alternative earnings management proxies and network centrality measures. This effect is also economically relevant. Recognising the potentially endogenous nature of the relation, we implement two identification strategies, which seem to suggest a causal relationship.
- Second, turning to firms that have particular incentives to manipulate earnings (so-called suspect firms), we find that shareholder centrality plays an even more important role in limiting earnings management in such firms.
- Third, we substantiate that information advantages obtained through institutional investor networks effectively drive reductions in earnings management. To this aim, we rerun our main analysis using measures of centrality among heterogeneous investor types. In line with an information-based explanation, we observe stronger reductions in earnings management in the presence of “monitoring institutions”, ie institutions that are most likely to use information to monitor management such as independent or long-term investors.
- Finally, we examine the effect of network centrality on shareholder proposal outcomes to shed light on the role of power and reputation through which institutional investor networks affect earnings management. We find that shareholder proposals filed by central institutions are less likely to be omitted from proxy statements and more likely to be withdrawn or put to a vote. The results indicate that central institutions use their negotiation power to engage in governance via voice.
Overall, our results emphasise the role of the institutional shareholdings network as a corporate governance mechanism that influences accounting quality and shed light on how investors obtain valuable information for monitoring. The findings have implications for academics and practitioners alike. For academics, our results reveal how institutions obtain information through network centrality. Future studies on reporting quality should thus incorporate network-based proxies to avoid model misspecification. For practitioners, our work highlights a novel determinant of institutional investor monitoring and, more specifically, the quality of financial reporting.
References
Ayers, B., S. Ramalingegowda, and P. Yeung, 2011, “Hometown advantage: The effects of monitoring institution location on financial reporting discretion”, Journal of Accounting and Economics 52, 41–61.
Bajo, E., E. Croci, and N. Marinelli, 2020, “Institutional investor networks and firm value”, Journal of Business Research 112, 65–80.
Balsam, S., E. Bartov, and C. Marquardt, 2002, “Accruals management, investor sophistication, and equity valuation: Evidence from 10–Q filings”, Journal of Accounting Research 40, 987–1012.
Berle, A., and G. Means, 1932, The Modern Corporation and Private Property (Mac-Millan, New York, New York).
Bushee, B., 1998, “The influence of institutional investors on myopic R&D investment behavior”, The Accounting Review 73, 305–333.
Hartzell, J., and L. Starks, 2003, “Institutional investors and executive compensation”, Journal of Finance 58, 2351–2374.
Jensen, M., and W. Meckling, 1976, “Theory of the firm: Managerial behavior, agency costs and ownership structure”, Journal of Financial Economics 3, 305–360.
Kang, J., J. Luo, and H. Na, 2018, “Are institutional investors with multiple blockholdings effective monitors?” Journal of Financial Economics 128, 576–602.
Ramalingegowda, S., S. Utke, and Y. Yu, 2021, “Common institutional ownership and earnings management”, Contemporary Accounting Research 38, 208–241.
Shleifer, A., and R. Vishny, 1986, “Large shareholders and corporate control”, Journal of Political Economy 94, 461–488.
Tsang, A., F. Xie, and X. Xin, 2019, “Foreign institutional investors and corporate voluntary disclosure around the world”, The Accounting Review 94, 319–348.