Financial Misconduct Spillover: Sanctioned Institutional Ownership and Aggressive Financial Reporting

Abstract

This study examines the role of financial misconduct of institutional investors on the aggressive financial reporting practices of investee firms. Using the Securities and Exchange Commission’s Registered Investment Advisers’ reported violations to identify sanctioned institutional investors, we find that firms held by these institutions are more likely to engage in aggressive financial reporting practices. Our results support the non-monitoring channel: the lack of monitoring by sanctioned institutional investors creates the right environment for firms to engage in aggressive financial reporting. The results continue to hold after implementing various statistical tests to address potential endogeneity issues (i.e., propensity-score matched methodology, entropy balancing approach, two-stage least squares regression, and regression discontinuity analysis) and alternative measures for aggressive financial reporting practices. Finally, we demonstrate that both sanctioned institutional investors and management of investee firms benefit from the aggressive financial reporting behavior.

Keywords: institutional investors, sanctioned investors, financial misconduct, aggressive financial reporting, earnings quality