Hometown Advantage: The Effects of Monitoring Institution Location on Financial Reporting Discretion
51 Pages Posted: 11 Apr 2010 Last revised: 1 Feb 2011
Date Written: January 31, 2011
We examine the impact of institutional ownership on financial reporting discretion, focusing on whether the impact varies with institutions’ cost of acquiring monitoring information. We posit that geographic distance between the firm and a monitoring institutional investor impacts the institution’s cost of acquiring monitoring information and predict that corporate managers are less likely to use financial reporting discretion in the presence of local monitoring institutions (our proxy for monitors with low information costs) than distant monitoring institutions. We base our expectation on prior research that suggests that information asymmetry between the firm and stakeholders is a necessary condition for managers to engage in opportunistic reporting discretion and prior findings that institutional investors located in proximity to the firm are more informed than other institutional investors located far away. We find a negative association between the magnitude of abnormal accruals and local monitoring institutional ownership and that this association is more negative than the association between abnormal accruals and distant monitoring institutional ownership. We also find that the impact of monitoring institutions on financial reporting discretion varies with the costs and benefits of financial reporting discretion. Specifically, when the costs of opportunistic financial reporting discretion are particularly high for outside shareholders monitoring the firm (e.g., high growth firms, firms engaging in takeovers, financial statement frauds), corporate managers are less likely to use financial reporting discretion in the presence of local monitoring institutions than distant monitoring institutions. In contrast, we find that the presence of local monitoring institutions does not deter financial reporting discretion when such discretion has clear benefits to shareholders (e.g., signaling private information around stock splits).
Keywords: Reporting discretion, Institutional investors, Geographic location, Corporate governance, Earnings management
JEL Classification: M41, G2, G34
Suggested Citation: Suggested Citation