Institutional Ownership and Audit Quality: Evidence from Russell Index Reconstitutions

Abstract

This paper investigates the monitoring effect of institutional investors on portfolio firms’ audit quality. We identify an exogenous discontinuity in institutional ownership around the Russell index threshold to overcome the endogeniety concerns. We find that an exogenous increase in a firm’s institutional ownership significantly increases the readability of its 10-K forms. Furthermore, we show that higher ownership enhances the firm’s auditor committee effectiveness, induces the firm to appoint tough auditors, and increases its quality of internal controls. In addition, auditors perceive the reduction in agency costs and audit risk caused by the changed institutional ownership, and hence charge lower audit fees.

Keywords: Institutional Ownership, Indexing,Readability, Audit Quality, Audit Risk

JEL Classification: G23; G34; G14; M40; M42