Influence or Preference? A New Look at Institutional Ownership and Earnings Management

Abstract

Prior literature finds that earnings management is negatively correlated with institutional ownership. The question is whether institutional investors drive down earnings management of the firms they invest in, or they choose firms with lower earnings management. In this paper, we use the regression discontinuity design around Russell 1000 and 2000 indexes reconstruction to obtain an exogenous variation in institutional ownership. We find that institutional investors do not drive down earnings management after they become shareholders. Instead, institutions choose firms with lower earnings management level when they make investment decisions. To further support the preference hypothesis, we add measures of institution preference in the panel regression and find that the negative relation between institutional ownership and earnings management disappears.

Keywords: Corporate Governance, Institutional Ownership, Earnings Management, Institutional Preference

JEL Classification: G23, G38, M41