The Effect of Shareholder Rights and Insider Ownership on Earnings Management

Abstract

This paper examines whether shareholder rights, which enable shareholders to replace managers, can constrain earnings management and whether this effect is conditional on the level of insider ownership. Using the comprehensive shareholder rights measure constructed by Gompers, Ishii, and Metrick (2003), we find that firms with stronger shareholder rights are associated with less income-increasing discretionary accruals, suggesting that stronger shareholder rights deter managers from reporting aggressive earnings. More importantly, we investigate whether this association is conditional on the level of insider ownership. If insider ownership introduces managerial entrenchment, managers with higher ownership would be insulated from shareholder discipline. Consistent with this entrenchment theory, we find that the association between shareholder rights and earnings management becomes insignificant in the presence of higher levels of insider ownership. Shareholder rights are negatively associated with earnings management only when insider ownership is low. Our results indicate that the disciplinary effect of shareholder rights can be attenuated by high levels of insider ownership.

Keywords: earnings management, shareholder rights, insider ownership