Research Paper

No. 1436

The Role of Institutional Investors in Corporate Governance: An Empirical Investigation* Shivram Rajgopal College of Business Administration Department of Accounting The University of Iowa Mohan Venkatachalam Graduate School of Business Stanford University

The Role of Institutional Investors in Corporate Governance: An Empirical Investigation*

Shivram Rajgopai College ofBusiness Administration Department of Accounting The University of Iowa Iowa City, IA 52242 Tel: (319) 335-1810, Fax: (319) 335-1956 E-mail: rajgopal@blue.weeg.uiowa.edu and Mohan Venkatachalam Graduate School of Business Stanford University Stanford, CA 94305 Tel: (415) 725-9461, Fax: (415) 725-0468 E-mail: vmohan@gsb.stanford.edu

April 1997

The paper has benefited from comments provided by Holly Ashbaugh, Ramji Balakrishnan, Tom Carroll, Maureen McNichols, Karen Nelson and K.R.Subramanyam. All correspondence should be addressed to Mohan Venkatachalam at the, above address.

ABSTRACT

Institutional investors, who now own a significant portion ofequity in U.S. firms, are often described as transient and myopic owners with no incentives to involve themselves in governance. We examine the validity of this assertion by examining whether institutional owners curb managerial discretion by constraining earnings manipulation. Specifically, we investigate the relation between institutional ownership and discretionary accounting behavior, as measured by discretionary accruals. Our findings are consistent with institutional monitoring and inconsistent with institutional investors encouraging myopic management behavior. We also perform triangulatory tests that examine the capital market pricing implications of managerial discretion, across different levels of institutional ownership. Results from additional analyses further strengthen our earlier findings. Overall, we find evidence inconsistent with allegations that institutions, due to their transient disposition or otherwise, do not monitor the firms they invest in.

Introduction Institutional investors collectively hold a substantial portion of equity capital in the United States. Consequently, the role of such investors in corporate governance has been the subject of popular debate in recent years. Prior research (e.g., Schleifer and Vishny, 1986; Watts, 1988) and anecdotal evidence suggest that institutions can potentially play an active role in monitoring and disciplining managerial discretion. However, critics (e.g., Bhide, 1993) argue that institutional involvement in corporate governance is bound to be passive either because of~ theirfragmented ortransient ownership. Transient institutional owners may trade-offcontrol for liquidity (see also Coffee, 1991). Also, institutions are characterized as myopic investors who focus excessively on current earnings rather than long-term earnings in determining stock prices (Jacobs, 1991; Porter, 1992). Such a short-termfocus is likely to deter institutional investors from incurring costs of monitoring managers and governing the firm. In this study, we provide empirical evidence on the controversial role ofinstitutions in corporate governance by investigating i) the relation between institutional ownership and managers discretionary behaviorin manipulating accounting earnings, and ii) the pricing implications of such managerial discretion. The involvement ofinstitutions in corporate governance has a direct bearing on the agency costs resulting from the separation ofownership and control. Agency costs arise from divergence ofinterests between managers and shareholders (Berle and Means, 1932; Jensen and Meckling, 1976). Such costs are increased by the presence of diffuse outside shareholders who may not have adequate incentives to monitor management. Financial reports play an important role in restricting opportunistic behaviorby managers and reducing attendant agency costs. For example, compensation contracts often include financial measures ofperformance (e.g., accounting earnings) as a determinant of managerial remuneration. However, managers have considerable discretion in determining accounting numbers ex post by exploiting the latitude that generally accepted accounting principles (GAAP) provide in choosing accounting policies. Such

discretion allows managers to opportunistically manage earnings to: the detriment of shareholder wealth. Since institutional investors hold a substantial stake in the firm, they may have economic incentives to monitor and engage in governing the firm. Through active corporate governance institutional investors may reduce agency costs by mitigating accounting-related incentive conflicts. Therefore, we hypothesize that if institutions engage in monitoring then managers will have reduced incentives to engage in earnings manipulation fortheir own personal benefit. We empirically estimate discretionary managerial behaviorby examining accrual adjustments (Jones, 1991; Dechow, Sloan, and Sweeney, 1995; Warfield, Wild and Wild, 1995). A negative relationship between the level ofinstitutional ownership and the magnitude of discretionary accruals is consistent with institutional monitoring of managers. Institutional investors may lack incentives to monitor the firm because they are often characterized as transient owners (Porter, 1992). That is, institutional investors may be reluctant to incur costs to govern the firm because they are often held accountable based on their quarterly performance and the benefits .ofmonitoring may not accrue in the short-term. As Porter (1992) notes: Perhaps the most basic weakness in the American system is transient ownership, in which institutional agents are drawn to current earnings, unwilling to invest in understanding the fundamental prospects ofcompanies, and unable and unwilling to work with companies to build long-term earning power. Hence, institutional owners may not commit to becoming more informed about the firms future prospects through active governance. This is purported to influence managers to focus excessively on short-termprofits (see Dertotizos, Lester and Solow, 1988; Jacobs, 1991). Consequently, we hypothesize that short-terminstitutional owners may encourage myopic management behavior. We test this hypothesis by examining the relationship between the level ofinstitutional ownership and the likelihood ofmanagers using income-increasing discretionary accruals. 1 Results indicate that the level of institutional ownership is negatively related to the magnitude of discretionary accruals after controlling for other determinants ofmanagerial 2

discretion. This finding is consistent with institutional investors monitoring managers and thus constraining them from engaging in accrual manipulation. In addition, our test results do not suggest that institutional owners induce myopic management behavior~Specifically, in examining whether institutional owners influence managers in choosing income-increasing accruals, we detect no significant positive relationship between the level ofinstitutional ownership and the probability that managers choose income-increasing discretionary accruals. Next, we triangulate our results by performing two additional tests. First, we examine the influence ofinstitutional monitoring on the pricing implications of discretionary accruals. Prior research (Hoithausen, 1990; Healy, and Palepu, 1993) posits that accounting discretion enables managers to communicate theirprivate information about future cash flows ofthe firm. The need for communication arises naturally in the presence of information asymmetry between managers and shareholders. Subramanyam (1996) provides evidence consistent with managers signaling their private information about future earnings through discretionary accruals (see also Hunt, Moyer and Shevlin, 1997; Collins and DeAngelo, 1990). Specifically, he finds a positive relation between discretionary accruals and stock returns. Governance by long-term institutional owners potentially reduces the level of information asymmetry between managers and investors (see Jacobs, 1991; Porter, 1992). As a consequence, the .incentives formanagers to communicate private information through discretionary accounting choices is reduced. Drawing on this perspective, we posit that managers incentives to use discretionary accruals to communicate private information will likely diminish with greater institutional ownership. Thus, we hypothesize that the positive relation between discretionary accruals and stock returns will decline with the level ofinstitutional ownership. Second, we examine whethermarket participants of firms with high institutional holdings place more emphasis on short-term results (e.g., current earnings) relative to long term performance. Steins (1989) theoretical model shows that rational managers have incentives to behave myopically, i.e., inflate current earnings, when managers have superior information about future firm performance than outside investors. Information asymmetries about future earnings 3

potential cause investors to place more weight on currentearnings and as such, provide opportunities for managers to accentuate current earnings. Non-transient institutional owners, perhaps on account of active involvement in governing the firm, can potentially reduce information asymmetries and hence, mitigate myopic management behavior. Therefore, we examine whetherinformation asymmetries about future firm performance, which create incentives for managerial myopia, are lower when institutional ownership is high. Specifically, we use a test proposed by Kothari and Sloan (1992) and empirically assess whether stock prices of firms with high institutional ownership reflect more information contained in future earnings than stock prices offirms with low institutional ownership. Results frOm additional tests suggest that the pricing effects of discretionary accruals documented in prior research diminishes with the level of institutional ownership. This result is consistent with reduced information asymmetry, perhaps due to monitoring and governance by institutional investors. Furth~r, we observe that forfirms with high institi4ional ownership a greater portion of information in current-period earnings is already incorporated in the stock prices of prior periods. This finding implies a reduction in information asymmetry as an outcome of institutional involvement. Taken together, ourresearch results provide no support forthe allegations that institutional owners, because of their transient ownership, lack incentives to govern the firm. This study makes several contributions to extant literature. First, this study contributes to understanding the implications ofthe changing ownership structure for corporate governance. In particular, we provide evidence that institutional owners appear to play the role of corporate monitors rather than as myopic owners thereby constraining (not persuading) managers from engaging in discretionary behavior. Prior research that examines the role of institutional monitoring explores the link between institutional ownership and corporate performance (McConnell and Servaes, 1990; Chaganti and Damanpour, 1991). These papers conduct indirect tests of institutional monitoring because they assume that increased monitoring reduces agency costs ofmanagerial discretion and as such, results in improved firm performance. Our study 4

departs from this stream of research by directly testing the effect of institutional owners on managements discretionary behavior, as defined by discretionary accruals.2 Second, we provide evidence that institutional owners do not induce myopic management behavior, i.e., they mitigate managers tendencies to artificially inflate short-term earnings. This study shows that institutional owners are a potential force in mitigating earnings manipulation through accruals management. Research on the influence of institutional investors in inducing myopic management behavior typically examines the relation between institutional ownership and R&D spending (e.g., Graves, 1988; Hansen and Hill, 1991; Bushee, 1997). We argue that if institutional owners are obsessed with current earnings, managers have incentives to take both economic decisions (not restricted to R&D investments) and accounting decisions in managing earnings. Hence, in contrast to these studies, we first provide evidence on the institutional influence on managers discretionary accounting choices that affect accounting earnings. Subsequently, we provide evidence that the stock prices of firms with high institutional ownership are less sensitive to current earnings relati-ve to future earnings. This also provides indirect evidence on the institutional influence on earnings management that results from both accrual decisions and investment decisions. Third, we contribute to the literature on the pricing of discretionary accruals in two ways (e.g., Wahlen, 1994; Ahmed, 1996; Beaver and Engel, 1996; Subramanyam, 1996). One, we provide evidence that the implications ofearnings management for stock prices depend on the ownership structure, in particular, the level of institutional ownership. Two, recent research by Guay, Kothari, and Watts (1996) and Dechow, Sabino and Sloan (1997) casts doubt on the validity of extant discretionary accrual models that estimate discretionary accruals as a measure of earnings management.3 They argue that the accrual models measure discretionary accruals with considerable measurement error. Ifpricing of discretionary accruals is an artifact of measurement error, then it is unlikely to observe a systematic relation between returns and discretionary accruals across different levels of institutional ownership. Hence, the results ofthis

study increases the confidence that the pricing ofdiscretionary accruals is not merely a manifestation of measurement error. Finally, we show that a firms information environment affects the managers discretionary behavior. Recent research by Bartov and Bodnar (1996) and Richardson (1997) suggests that the greater the information asymmetry, the more likely the firm is to manipulate accruals and earnings. We add to this research by documenting that investor heterogeneity affects the information asymmetry and hence, constrains management behavior. The rest ofthe paper is organized as follows: Section 2 provides evidence on the role of institutions as corporate monitors. Section 3 provides evidence on the role ofinstitutional investors in influencing myopic management behavior. The pricing implications of discretionary management behavior is examined in Section 4. The studys conclusions are presented in Section 5. The role of institutions as corporate monitors Institutions control assets worth $6 trillion, which is more than the GNP ofthe United States and account for nearly 20% of all financial assets and 45% of all outstanding equities. One-third of the 1000 largest companies had more than 60% institutional ownership (see Brancato (1991). The increasing ownership in the hands of institutional investors has directed attention to their controversial role in disciplining and monitoring managers. The debate Anecdotal evidence suggests a significant increase in institutional investors demanding greater accountability from management. Institutions proposed more than 120 proxy resolutions in 1990, up from 70 resolutions in 1989 and 28 in 1988 (Taylor, 1990). Institutional activism4 has taken the form of proxy contests to bring about fundamental changes in implementing confidential voting, changing the composition of boards, and executive compensation. Institutional owners have often required firms to include more outside board members and even

suggested specific candidates (TheNew York Times, 1988; Wall Street Journal, 1992; and Washington Post, 1992). In some instances, institutional investors have asked for a special institutional investor seat on the board to safeguard their interests. In other cases, institutions periodically review the operating and financial results of the company through the formation of shareholder advisory committees. For example, the California Public Employees Retirement System (CALPERS), widely regarded as a leader in shareholder activism, allocates substantial capital to police the performance of firms that is part of their pension funds. Prior work by Shleifer and Vishny (1986) suggests that institutions seek to protect their significant stake in the firm by active monitoring. Furthermore, the growth of index funds, where the sale of shares is ruled out as a response to poor stock performance, has encouraged institutions to follow buy and hold strategies. Buy and hold strategies may motivate institutions to take a greater interest in corporate governance. Coffee (1991) argues that exercising voice in corporate governance is less costly because ofthe significant ownership of equity by institutions and the resulting increased capacity forcollective action. More recently, Smith (1996) provides evidence that shareholder activism, for the most part, results in modified governance structure which, in turn, results in a significant increase in shareholder value. In the past, institutions would just sell (exit) the stock of companies that were mismanaged. However, selling large blocks of stock has become more expensive since such large sales usually entail substantial discounts. One other plausible reason forthe growth in activism could be the limitations oftraditional corporate governance mechanisms such as the board of directors and the market for corporate control in aligning the interests of managers and investors (Parthiban, Hill and Gimeno, 1996). In contrast, critics (e.g., Bhide, 1993) argue that institutional involvement in corporate governance is diffused, anns length and passive. Institutions try to avoid closer access to management to avoid being labeled insiders. Pension regulators discourage pension managers from being appointed to governing boards to prevent collusion between unscrupulous fiduciary bodies and company managements. Further, institutions labeled as insiders (those who own 7

more than 10% of a companys stock, serve on its board or receive any confidential information) are subject to insider trading rules that jeopardize the liquidity of their hOldings. Therefore, a model akin to the Japanese keiretsu framework ofclose communication between large stockholders arid management may not be practical in the U.S. context (see Maug, 1995). The tendency of institutions to diversify their holdings leads to potential coordination failures as various institutions need to cooperate to collectively exercise control over the management. Institutions do not often sit on directors boards. Hence, they may not have any direct influence on management behavior (Porter, 1992). In addition, it is claimed that institutional shareholders do not have the necessary expertise with the day to day affairs of the business to effectively monitor management (Taylor, 1990). The liquid stock market may also allow institutional investors to sell out quickly in times of a crisis rather than attempt to resolve the problems faced by the firm. Fund managers are sometimes forced to rebalance their portfolios frequently since they are often evaluated on a quarterly basis. As a result, they may have little time to actively involve themselves in corporate governance.
/

Hypothesis It is evident that a case can be made for both active monitoring and a passive hands-off policy by institutional shareholders. Whether institutional investors, on average, monitor corporate managers is obviously an empirical issue. We discriminate between the two competing positions by examining managers behavior in manipulating disclosed earnings numbers. Specifically, we use a measure that has been extensively used in prior research to determine managers discretion in adjusting reported accounting numbers, viz., the magnitude of discretionary accruals (see for e.g., Warfield et al., 1995; Richardson, 1996). Opportunistic management of accounting earnings arise from accounting-based contractual restrictions and the latitude in the accounting choices allowed under GAAP (Watts and Zimmerman, 1986,1990). Consistent with this notion, evidence from prior research suggests that managers have incentives to manipulate earnings for opportunistic reasons (Healy, 1985; DeAngelo, 1988; Jones, 1991).

Institutional monitoring may prevent managers from taking actions detrimental to shareholder value, thereby reducing agency costs arising from separation of ownership and control. We posit that if institutional investors are actively involved in corporate governance, then managers incentives to manipulate accruals for private gains are attenuated. Therefore, if institutional investors act as corporate monitors, we should observe a negative relation between the level ofinstitutional ownership and the magnitude Of discretionary accruals. Alternatively, the presence of passive institutional investors will not restrict managers self-interested behavior to exploit accounting techniques and aggressively determine accruals. This yields our first testable hypothesis (in null form): Hi: Ceteris paribus, the magnitude ofdiscretionary accruals is not relatedto the level of institutional ownership.

Research method To test hypothesis 1 we first estimate discretionary accruals using the modified Jones (1991) model. Recent research (Dechow et al., 1995) concludes that the modified Jones (1991) model is powerful in determining earnings management. Specifically, the following model is estimated: ACC~/TA~..i = a ~1/ TA~.i]+ a2~(E~SAL~ MEC~) I TA~_~}+ a3~PPE~ I TA~_1]+p~ (1) 1 where ACC is aggregate accruals, TA is total assets, i~SAL is change in net sales, i~REC is change in net receivables, PPE is gross property, plant and equipment, t and t-1 are time subscripts. Aggregate accruals are defined as inDechow et al. (1995). Equation (1) is estimated using time-series observations for each firm. The residuals (q~) obtained from this estimation process represents the discretionary portion of accruals (DACC) for each of the years. Since hypothesis 1 depends on the extent (magnitude) of accrual adjustments rather than on the direction in which the accrual is managed, we use the absolute amount of discretionary accruals (IDACCI) (see for e.g., Warfield et al., 1995). Specifically, we

relate the magnitude of the discretionary portion to the level of institutional ownership to examine whether the presence of institutional investors have any bearing on managers discretionary accounting choices. We measure the level of institutional ownership in two ways: i) the percent of shares owned by institutional investors (PINST) and ii) the number of institutions owning shares in the firm (NINST). A negative relation between institutional ownership and discretionary accruals would be consistent with shareholder activism i.e., institutional investors monitor managers actions and inhibit manipulation of accruals. Since the benefits of monitoring management are a collective good, the presence of diffuse institutional owners may deter any single institutional shareholder from monitoring, thereby leading to the standard collective action and free-rider problem. However, greater concentration of ownership (i.e., fewer institutional owners holding a large percent of shares outstanding) makes monitoring worthwhile for large institutional shareholders because: a) free riding is less likely, and b) exit (i.e., selling shares) becomes potentially less attractive when compared to monitoring (Rock, 1991). Hence, to control for the potential countervailing effects ofconcentration of institutional ownership we include a variable (CONC) that captures the extent of concentration. Specifically, we measure CONC as the interaction of percentage institutional ownership and the number ofinstitutional owners. Conditioned on the level of institutional ownership as measured by PINST and NINST, a higher CONC is representative of diffuse institutional ownership while a lower CONC is indicative ofconcentrated institutional ownership. It follows then that, if collective action represents a serious threat to institutional monitoring then a positive association between discretionary accruals and CONC is expected. Recognizing that institutional ownership is not the sole determinant of discretionary accounting choices, we include several control variables that have been found in prior research to influence managers incentives to manipulate earnings. In particular, we include managerial ownership, size, leverage, earnings variability and earnings performance as control variables. Prior research by Warfield et al. (1995) suggests that managerial ownership and the magnitude of discretionary accrual adjustments are negatively related (see also Dhaliwal, Salamon, and Smith, 10

1982). They argue that accounting based contractual constraints in firms with low managerial ownership provide managers with incentives to aggressively determine accruals. Therefore, we include the level of managerial ownership (MGR) to control for potential reduction in agency costs when managerial ownership is high. The inclusion of firm size (SIZE) and a proxy for earnings variability (EVAR) is motivated by political cost theory (see Watts and Zimmerman, 1978). According to this theory, managers of (i) large firms which are politically sensitive and (ii) firms that experience high earnings variability are more likely to manipulate accounting numbers. Further, managers of firms that are closer to default on debt covenants are more likely to use accounting discretion (Duke and Hunt, 1990; Press and Weintrop, 1990). Therefore, we include leverage ratio (LEV) to capture the proximity to violating debt covenants. Finally, findings by Dechow et al. (1995) suggest that tests of earnings management may be misspecified when discretionary accruals are correlated with firm performance. Hence, we use the absolute value of current earnings before extraordinary items (IIBEXI) as an earnings performance measure to control for the effects of extreme financial performance on discretionary accruals.5 This leads to the following empirical specification: IDACC:I 1= r~ + y1PINS2~ + 72N1NS71 + y3CONC~, + y4MGR1, +75SIZE,, + 76 EVAR~1+ y~ LEVI, +781 IBEXII~ +V~

(2)

where IDACC I is the absolute value of residuals from estimating firm specific regressions based~ on equation (1), PINST is the percentage of institutional ownership, N1NST is the number of institutional owners, CONC is a measure ofconcentration of institutional ownership, i.e., the interaction of percentage institutional ownership and the number of institutional owners, MGR is the percentage of managerial ownership, SIZE is the natural logarithm of sales, EVAR is standard deviation of earnings (scaled by lagged total assets), LEV is total debt divided by lagged total assets , ILBEXI is the absolute value of earnings before extraordinary items scaled by lagged total assets, i and t are firm and time subscripts respectively.

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Sample and descriptive statistics We obtained ownership data from the Disclosure Database distributed by Disclosure, Incorporated for the years 1989 to 1995. Specifically, we collected the percent of outstanding shares owned by institutions, the number of institutional owners and percent of outstanding shares owned by corporate managers. These data are reproduced in the database from SEC filings 13-F, l3-D, 13-G, 14-D, and Forms 3 and 4. From the initial sample obtained from the Disclosure Database we first eliminate firms that belong to the financial services or the utilities industry. Next, we exclude firms for which the required accounting data are not available from the 1995 COMPUSTAT annual database. Finally, we eliminate firms that do not have ten consecutive years ofdata. We impose this (admittedly arbitrary) restriction to enable reasonable estimates of discretionary accruals. To reduce the effects ofextreme observations we delete observations where the estimated discretionary accruals are more than three standard deviations from the mean. After all these data filters, we are left with 7808 firm year observations for regression analysis. For conducting additional analysis, we obtain stock returns for the above sample from the 1995 CRSP database. After eliminating observations due to missing stock returns, 5707 firm year observations remain for return analysis.6 Table 1 presents the descriptive statistics for the various variables used in empirical tests. Of particular interest is the level of institutional ownership as measured by the percentage oftheir stockholdings relative to the total shares outstanding. Both the median and mean percentage institutional ownership (PINST) are about 35%. The distribution ofpercentage institutional ownership compares well with that reported in prior research (e.g., Lang and McNichols, 1993; Eames, 1997; Bushee, 1997). The mean and median total assets (not reported) are $1552 million and $152 million respectively, indicating a positively skewed distribution of firm size. The average income before extraordinary items scaled by lagged total assets is positive (0.043). The mean total accruals scaled by lagged total assets is negative (-0.038), primarily due to depreciation charges. The estimated discretionary accruals using the modified Jones (1991)

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model is, on average, negative (-0.006), comparable to that obtained in prior research by Subramanyam (1996) and Clikeman (1996). Results Table 2 provides evidence on the relation between institutional ownership and discretionary management behavior. Viewing absolute abnormal (discretionary) accruals as a measure of managerial discretion, results in Panel A of Table 2 reveal that firms with high institutional ownership exhibit smaller discretionary accruals. Specifically, the relation between absolute discretionary accruals and both measures of institutional ownership is negative (coefficient on PINST

(~) =0.022; coefficient on NINST (72) =0.005) and statistically

significant at the 1% level. We next extend the regression specification to provide evidence on the association between the.level of concentration in institutional ownership (CONC) and discretionary accruals (see Panel B). The coefficient on CONC is positive (y~ = 0.014) and statistically significant at the 1% level (two-tailed test). This suggests that the presence of diffuse institutional holders presents an obstacle to the ability of institutiOns to collectively monitor managers. However, the inclusion of CONC does not alter the previously obtained negative association between institutional ownership and discretionary accruals. While our initial analysis suggests a negative association between institutional ownership and discretionary accruals, it is possible that this relation is influenced by other factors that determine managers accounting choices. To examine this possibility, we estimate regressions after including variables that influence managers discretionary behavior (see Panel C of Table 2). The coefficients on both measures of institutional ownership, PINST and NINST, are still negative (~ =0.022; ~ =0.OlO) and statistically significant (p<zO.Ol, two tailed test).7 Further, the coefficient on CONC is significantly positive as before. All the additional factors included in the regression with the exception of managerial ownership and size are statistically significant.

13

The insignificance ofmanagerial ownership variable (MGR) is puzzling especially in light of evidence in prior work by Warfield et al. (1995) and Dhaliwal et al. (1982).8 The role ofinstitutional investors in myopic management behavior Hypothesis Institutional investors are often accused ofbeing transient owners who lack the incentives to monitor the firms they own (Porter, 1992). Thatis, institutions may prefer to sell the stocks of firms instead ofincurring costs of governing the firm (Coffee, 1991). Further, fund managers of institutions may be evaluated on metrics based on short term result, e.g., their quarterly performance. Such short-term evaluation of institutional investors is a potential motivation for fund managers to trade excessively surrounding earnings announcements. Consistent with this view, empirical findings by Potter (1992) and Kim, Krinsky, and Lee (1996) suggest that firms with high level ofinstitutional ownership tend to have greater stock return volatility and trading volume surrounding earnings announcements. In addition, transient institutional owners may find selling the stock, especially given liquid stock markets, to be more attractive than monitoring since the benefits to monitoring will not accrue to them in the short run. The lack of monitoring may lead institutions to be less aware ofthe long term goals and objectives of the firms managers. Information asymmetry about future firm prospects between owners and managers is cited as a prominent reason for American managers to excessively focus on shortterm profits (Jacobs, 1991; Dertouzos et a!. 1988; Business Week, 1987). For example, Jacobs (1991, pg. 10) argues that
0

Lack ofcommunication prevents investors from understanding managements long-term goals and objectives. Because most investors are detached from the businesses they fund, they rely on outward manifestations ofwhat is really going on within the company; namely, quarterly earnings and other accounting.measures of performance.
...

Hence, if institutional investors focus on short-term accounting performance measures (e.g., current earnings) as measures of long-term performance, managers may be compelled to

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artificially inflate current earnings to preclude myopic institutions from selling large blocks of the firms stock.9 Recent theoretical work (e.g., Narayanan, 1985; Trueman and Titman, 1988; Stein, 1989) examines managers incentives to alter earnings under the assumption ofimperfect and/or asymmetric information between managers and outside investors. Stein (1989) provides a theoretical model that illustrates how asymmetric information can lead to myopic management behavior. In this model, managers are posited to be better informed about cash flow prospects of the firm than investors and also possess the ability to intertemporally allocate earnings. Under the assumptions that i) investors use current earnings as a signal of long-term performance in determining stock prices and, ii) managers put more emphasis on current stock price, Stein (1989) argues that managers have incentives to intertemporally allocate and manipulate earnings. Institutions, who often hold a substantial stake in the firm, may act as long-term owners with incentives to govern the firms activities. Governance by such dedicated long-term owners will potentially result in reduced information asymmetries and thereby, mitigate managerial incentives for inflating current earnings. Hence, our second null hypothesis can be stated as follows: H2: Ceteris pan bus, the probability that managers use income increasing accruals is not influenced by the level of institutional ownership.

Research method To test hypothesis 2, we use a probit model that relates the sign of discretionary accruals (i.e., whether they are income increasing or income decreasing) to the level of institutional ownership. As before, we control for factors such as risk, earnings performance, leverage, level ofmanagerial ownership and size as control variables. Accordingly, the following pooled-crosssectional probit regression is estimated: SIGNI~= ~ + ~ PINS7 + i52NINS7~ + ~CONCU+ c5~ MG1~~ + 5SIZE~~ +86EVAR,~+87 LEVg + ~IBEX~~ +

(3)

15

where SIGN = 1 if DACC is positive, and 0 if DACC is negative.0 Results Results of estimating the probit regression (equation (3)) relating the probability of managers using income increasing discretionary accruals and institutional ownership variables are presented in Panel A of Table 3. We find that neither the percentage institutional ownership (PINST) nor the number ofinstitutional investors (NINST) is systematically re1atedto~th~ type of accrual manipulation suggesting that the extent ofownership does not motivate managers to choose income increasing accounting accruals. Specifically, the coefficient on P1NST (6~ =

0.051; p=0.53) and NJNST (62 = 0.032; p=O.4.O) are both statistically insignificant. We also find that concentration in institutional ownership (CONC) is insignificantly related to the probability of managers choosing income increasing accruals (6~ = 0.001; p=OA.l) suggesting that collective action problem is not severe in the determination of the sign ofaccruals. To examine potential omitted variables we estimate equation (3) after including several variables that capture other motivations for discretionary management behavior. As before, we use size, leverage, earnings variability, current earnings and managerial ownership as control variables. The results of this estimation is presented in Panel B of Table 3. While the inclusion of these variables does not alter the coefficient on PINST, the coefficient on NINST is significantly positive (62 = 0.09 1) at the 5% level (two-tailed test) suggesting that the level of institutional ownership as measured by NINST encourages income increasing accrual decisions. The stock markets response to discretionary management behavior Pricing ofdiscretionary accruals Several researchers have argued that managers may have incentives to engage in communicating their private information through discretionary accounting choices (see Schipper, 1989; Healy and Palepu, 1993). Recent empirical evidence (Subramanyam, 1996; Ahmed, 1996) on the pricing of such discretionary accruals is consistent with the market viewing discretionary 16

accruals as a credible means ofcommunication ofprivate information on future economic prospects. Specifically, theirresearch findings suggest that capital market participants appear to price discretionary accruals positively. This positive association between stock returns and discretionary accruals is consistent with investors interpreting thediscretionary component of accruals as improving the ability of earnings to reflect fundamental economic value. Under this explanation, managers use their discretion to manipulate accruals with a view to communicating theirprivate information in an asymmetrically informed market. Further, Hunt, Moyer and Shevlin (1997) argue that information asymmetry is a necessary condition for managers to have incentives to signal their private information tO the market. We assert that if institutional monitoring results in reducing information asymmetries, then managerial incentives for signaling private information through discretionary accruals will diminish with the level of institutional ownership. Consequently, the relation between stock prices and discretionary accruals is expected to decline with the level of institutional ownership. To test for the differential informativeness ofdiscretionary accruals conditional on the level of institutional ownership, we regress firms stock returns on earnings and its components with an institutional ownership interaction term on the discretionary accrual component. Specifically, the following pooled cross-sectional regression model is formulated: RE7~ =
+ /3~OCF~ + I32NDACCU + I3~DACCI~ + J34DACC *

P1NS71

+J35DACC*NINS7~ I36DACC*CONC~~ +J37DACC* MGR1~ +~, where RET is the annual return for firm i for period t, OCF is operating cash flows determined by subtracting total accruals from earnings before extraordinary items, NDACC is the nondiscretionary component, of accruals, and DACC is the discretionary component of accruals. All the independent variables are scaled by lagged total assets.

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Table 4 provides evidence that the pricing implications of discretionary accruals varies systematically with the level ofinstitutional ownership. The regression results of estimating equation (4) indicates that the coefficient on operating cash flows, discretionary and nondiscretionary accruals are positive and significant at the 0.01 level, consistent with findings in prior research (e.g., Subramanyam, 1996). Of particular interest is the coefficient on discretionary accruals which is positive

($~ =1.013) and significant (p-value<0.Ol, two-tailed

test) consistent with investors on average interpreting the discretionary component of accruals as a credible form ofcommunication ofprivate information. However, this tendency ofthe market to place a positive weight on discretionary accruals reduces systematically with the level of institutional ownership. The coefficient on the interaction variable (DACC*PINST) is negative
($2

=0.827) and statistically significant at the 5% level (two-tailed test). This result augments

our evidence on the reduced information asymmetry and the attendant effects on management behavior when institutional ownership is high. Implication ofinformation contained in current earningsfor current andpast returns In this section we conduct auxiliary tests of the influence ofinstitutional investors on management behavior by examining whether stock prices of firms with high institutional ownership appear to place a greater emphasis on current earnings vis-a-vis future earnings. Transient institutional investors, who are less informed about the future prospects ofthe firm than managers, may focus on current earnings as an indicator of long term performance. Such focus may motivate managers to upwardly manipulate current earnings (Stein, 1989). Empirical research by Jacobson, and Aaker (1993) finds that U.S. investors place a greater weight on short-term measures such as current earnings relative to future-term measures such as long-term profitability. This is consistent with the presence of greater information asymmetry between U.S. investors and managers because, in the absence ofinformation asymmetry about future prospects, investors are likely to depend less on current earnings relative to future profitability measures in determining stock prices. We extend Jacobson, and Aakers

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(1993) work by examining whether information asymmetries differ cross-sectionally across firms in the U.S as a function ofthe level of institutional ownership. Active governance by long-term institutional investors is likely to reduce information asymmetries about future performance. Hence, we expect stock prices offirms with higher institutional ownership to reflect a lower dependence on current earnings relative to future earnings.
O

We adopt an approach suggested by Kothari and Sloan (1992) to assess the extent to

which stock prices reflect the relative dependence on current and future earnings. If institutional owners reduce the information,asymmetry about future performance, market prices of firms with high institutional ownership should reflect more information about future firni performance than that contained in current earnings. Kothari and Sloan (1992) suggest an equation of the following form:
=

co~ + w~ 1BEX~E /F~_~ +

(5)

where F, /P1~ is one plus the buy-and-hold return for firm i over the period t-r to t, and IBEX,1 is earnings before extraordinary items. a~ represents the markets response to earnings information at time t. Kothari and Sloan (1992) note that as ~rincreasesit is more likely that the information contained in earnings at time t would be incorporated in the return over the period t-~rto t. This is because the markets expectation about future firm performance reflects a richer information set than a time series expectation based on earnings. Therefore, o~ will increase with the time interval over which the return is estimated. Underthe hypothesis that institutional owners reduce information asymmetry about future firm performance, the information reflected in current earnings will be incorporated much earlier for firms with high institutional ownership than for firms with low institutional ownership. Alternatively, the ratio ofthe estimatedcoefficient w, for r=2 to o.~ for ~ = 1 will be higher for firms that have a higher percentage of institutional owners. To conduct this analysis, we classify firms into two institutional ownership groups (HIGH/LOW) depending on whether the institutional ownership percentage is abovelbelow the median percentage.

19

Results of estimating equation (5) for the two institutional ownership groups (HIGH and LOW) are presented in Table 5. The estimated coefficients (o~) for both groups increase with time interval V over which returns are computed, consistent with the findings of Kothari and Sloan (1992). Specifically, o.~ increases from 0.66 (0.99) for ~r=1to 1.12 (2.56) for r=2 for firms in the LOW (HIGH) groups. More important, the ratio of the earnings response coefficient for r=2 to ~r=1is greater for firms with high institutional ownership (2.59) than for firms with low institutional ownership (1.70). 12 This result is consistent with findings reported earlier that institutional owners reduce the level of information asymmetry, which in turn, mitigates myopic management behavior. Conclusions The explosive growth in institutional investment in the last two decades has made institutional investors the dominant and potentially powerful shareholders. This has fueled a widespread debate on their role in corporate governance. In this study, we primarily examine two questions relating to the debate: i) do institutional investors monitor corporate managers? and ii) are institutional investors transient and myopic that provide insufficient incentives to govern the firm? We investigate these questions by examining the extent to which managers manipulate accounting numbers and the attendant market reaction to such discretion. First, we find that institutional owners impede rather than encourage earnings management. This evidence is consistent with institutional owners preventing discretionary management behavior through monitoring. Second, we find that the extent to which market prices discretionary accruals diminishes with the level of institutional ownership. Prior research documents that, in an asymmetrically informed market, discretionary component of earnings is priced,by investors and, as such, provide incentives for managers to influence the stock price through accounting choices. Our evidence suggests that institutional owners inhibit such incentives to manipulate earnings because ofthe reduced level ofinformation asymmetry.

20

Third, we do not find any evidence that indicates the influence of institutional owners in encouraging myopic management behavior. On the contrary, we find that the stock prices of firms with high levels ofinstitutional ownership incorporate information about future earnings faster than those with low levels of institutional ownership. Collectively, we view the evidence as inconsistent with assertions that institutional owners do not engage in governing the firms they invest in.

21

Endnotes Current earnings can be improved by either short-term real economic decisions (e.g., reducing research and development expenditures) or by accounting manipulations. We focus primarily on accounting manipulations. However, we also perform certain additional tests that captures the effects ofboth accounting manipulations and economic decisions on accounting earnings.
2

Recent work by Clikeman (1996) also examines the relation between discretionary accruals

and institutional ownership and reports a negative relation consistent with our findings. However, his analysis is restricted to examining whetherinstitutional owners constrain earnings management. In addition to examining whether institutional investors monitor managers, we contribute by examining the pricing effects of managements discretionary behavior and the differential pricing implications of current earnings relative to future earnings in the presence of institutional owners. ~While Guay et al. (1996) conjecture that discretionary accrual models randomly decompose accruals intO discretionary and non-discretionary components, Dechow et al. (199i7) argue that discretionary accruals models contaminate discretionary accruals with non-discretionary accruals. ~By shareholder activism we refer to shareholder voice, i.e., active monitoring of the management of firms rather thanefficient portfolio selection without an active role in monitoring.
O

~We use absolute earnings instead of actual earnings to be consistent with the dependent variable, IDACCI, which captures only the magnitude of managerial discretion.
6

The observations for return analysis are obtained after deleting observations with extreme

returns, i.e., returns that differed from the sample mean by more than three standard deviations. Recent work by Dechow et al. (1997) argue that discretionary accruals estimated using Jones or modified Jones model misclassifies nondiscretionary accruals as discretionary accruals. If the estimated discretionary accruals are contaminated with nondiscretiortary accruals then we should observe the same negative relationship between institutional ownership and nondiscretionary accruals as with discretionary accruals. Accordingly, we estimate equation (2) with nondiscretionary accruals instead ofdiscretionary accruals as the dependent variable. We find (results not reported) no systematic relation between absolute nondiscretionary accruals and the level ofinstitutional ownership.
~

Warfield et a!. (1995) document a negative relation betweenmanagerial ownership and

magnitude of discretionary accruals. They measure discretionary accruals as the change in total accruals. As a robustness check, they also estimate Jones (1991) model to obtain an alternative measure of discretionary accruals. The results of this sensitivity analysis do not suggest a

22

significant relation between managerial ownership and magnitude of discretionary accruals (see footnote 28 in theirpaper). ~Prior research (Eames, 1996; Lang and McNichols, 1993) examines whether institutional owners are myopic by investigating the association between unexpected earnings and change in the level of institutional holdings. These studies explore one reason, i.e., institutions myopic trading behavior, why institutional owners may not monitor. In contrast, we examine a broader question of whether institutional investors play a role as corporate monitors.
10

To be consistent with equation (2) actual amounts of income before extraordinary items are

usedinstead ofabsolute amounts. ~ We also examine whether the inferences from our empirical analyses are robust to the inclusion of factors such as size, leverage and earnings variability. We find thatour inferences (results unreported) are unaltered.
0

12

To examine whether the difference between the two ratios is statistically significant we

conduct simulation analysis using observations generated from a normal distribution with the mean and variance characteristics of the coefficients reported in Table 5. We find that the difference is statistically significant at a p-value ofless than 0.01. We also recognize that the earnings response coefficient, w1 (and hence, the ratio) estimated for the two groups is influenced by factors other than information asymmetries, such as persistence, earnings variability and size. Therefore, we re-estimate equation (5) after controlling for these factors and find that the tenor of conclusions is unaltered.

23

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24

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25

Jacobson R. And D. Aaker. 1993, Myopic Management Behavior with Efficient, but Imperfect, Financial Markets- A Comparison of Information Asymmetries in the U.S. and Japan. Journal of Accounting and Economics (1993), 83-405. Jensen, M. And W. Meckling. Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure. Journal ofFinancial Economics (1976), 305-360. Jones, J.J. Earnings Management During Import Relief Investigations. Journal ofAccounting Research (1991), 193-228. Kim, 3., I. Krinsky, and J. Lee. Institutional Holdings and Trading Volume Reactions to Quarterly Earnings Announcements. Journal ofAccounting, Auditing and Finance (1996), 1-14.
0

Kothari, S.P and R.G. Sloan. Information in Prices About Future Earnings: Implications for Earnings Response Coefficients. Journal ofAccountingand Economics (1992), 143-171. Lang, M., and M. McNichols. Institutional Trading and Corporate Performance. Working Paper. Stanford University, 1993. Maug, E. Institutional Investors as Monitors: On the Impact of Insider Trading Legislation On Large Shareholder Activism. Working Paper. London Business School, 1995. McConnell, J.J., and H. Servaes. Additional Evidence on Equity Ownership and Corporate Value. Journal ofFinancial Economics (1990), 595-612. Narayanan, M.P. Managerial Incentives for Short-Run Results. Journal ofFinance (1985), 1031-1051. Parthiban, D., M.A. Hill, and J. Gimeno. The Role of Activism by Institutional Investors in Influencing Corporate Innovation. Academy ofManagement Proceedings, Pennsylvania (1996), 378-382. Porter, M.E. Capital Disadvantage: Americas Failing Capital Investment System. Harvard Business Review (1992), 65-82. Potter, G. Accounting Earnings Announcements, Institutional Investor Concentration, and Common Stock Returns. Journal ofAccounting Research (1992), 146-155. Press, E.G., and J.B. Weintrop. Accounting-Based Constraints in Public and Private Debt Agreements : Their Association with Leverage and Impact on Accounting Choice. Journal ofAccounting and Economics (1990), 65-95. Richardson, V.J. An empirical Investigation of the Relationship Between Information Asymmetry and Earnings Management. Working Paper. University of Illinois, 1997.

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Rock, E.B., 1991, The Logic and (uncertain) Significance of Institutional Shareholder Activism. The Georgetown Law Journal (1991), 445-506. Schipper, K. Commentary on Earnings Management. Accounting Horizons (1989), 9 1-106. Shleifer, A., and R.W.Vishny. Large Shareholders and Corporate Control. Journal ofPolitical Economy (1986), 461-488. Smith, M.P. Shareholder Activism by Institutional Investors: Evidence from CALPERS. Journal ofFinance (1996), 227-252. Stein, J.C. Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior. Quarterly Journal ofEconomics (1989), 655-669. Subramanyam, K.R. The Pricing ofDiscretionary Accruals. Journal ofAccounting and Economics (1996), 249-28 1. Taylor, W. Can Big Owners Make a Big Difference?, Harvard Business Review (1990), 70-82. The New York Times. Institutions Proxy Power Grows, (Jul 5, 1988), Dl. The Wall Street Journal. Recent Wave of Activism in Boardroom Will Gain Momentum, Survey Suggests. (Dec 9, 1992), A5. Trueman, B., and S. Titman. An explanation for Accounting Income Smoothing: Discussion, Journal ofAccounting Research (1988 Supplement), 127-143. Wahien, J.M. The Nature of Information in Commercial Bank Loan Loss Disclosures. The Accounting Review (1994), 455-478. Warfield, T., J.J.Wild and K.Wild. Managerial Ownership, Accounting Choices, and Informativeness of Earnings. Journal ofAccounting and Economics (1995), 61-91. Washington Post. Westinghouses Outside Directors to Gain Power. (Dec 4, 1992), B3. Watts, R.L. Discussion of Financial Reporting Standards, Agency Costs, and Shareholder Intervention. Journal ofAccounting Literature (1988), 125-132. Watts, R.L and J.L.Zimmerman. Towards a Positive Theory ofthe Determination of Accounting Standards. The Accounting Review (1978), 112-134. Watts, R.L and J.L.Zimmennan. Positive Accounting Theory. Prentice-Hall, Englewood Cliffs, NJ, 1986.

27

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28

Table 1 Descriptive Statistics Variable N Mean Std.dev. Median First Quartile 15.40 11.00 2.43 0.004 0.010 -0.082 -0.038 3.935 0.070 0.034 -0.138 Third Quartile 54.97 100.00 26.35 0.014 0.091 0.002 0.027 6.810 0.333 0.086 0.319

PINST( %) N1NST MGR(%) CONC IBEX ACC DACC SIZE LEV EVAR RET

7808 7808 7808 7808 7808 7808 7808 7808 7808 7808 5707

35.72 84.61 17.82 0.011 0.043 -0.038. -0.006 5.378 0.224 0.07 1 0.126

23.27 128.29 20.21 0.012 0.106 0.085 0.065 2.148 0.192 0.074 0.419

35.07 30.00 10.65 0.008 0.049 -0.043 -0.004 5.283 0.207 0.052 0.066

PINST is the percent ofequity shares held by institutional investors, NINST indicates the number ofinstitutional owners, MGR represents percentage of shares held by inside owners, i.e., individuals (officers, directors, and principal owners) who can exercise significant influence over corporate affairs, CONC is the interaction of PINST and NINST, IBEX represents income before extraordinary items scaled by lagged total assets, ACC is total accruals scaled by lagged total assets, Discretionary accruals (DACC), is measured as the difference between ACC and nondiscretionary accruals. Non-discretionary accrual (NDA~) is calculated as per the modified Jones model in Dechow et al (1995): NDACC~ = a (1/TA i,t.1) + a (ASAL~ /TA j,t.1~i~REC s/TA i,t-1)+ 1 2 a3 (PPE ~/TA1,~.1 TA ), j,t1 is lagged total assets, z~ SALE is the change in net sales, L~.REC is the change in net receivables, PPE~ is gross property, plant and equipment, SIZE is natural logarithm ofthe sales, LEV indicates the ratio oftotal debt scaled by lagged total assets, EVAR is the standard deviation ofannual earnings divided by laggedtotai assets, and RET is the annual stock return measure over a twelve month period ending three months after the fiscal year end. The sample is comprised offirm-year observations drawn from the 1989-1995 fiscal years.

29

......

..~

Table 2 Regression of absolute discretionary accruals on institutional ownership and, other determinants of the magnitude of absolute discretionary accruals
.

IDACC,11= y~ +y1PINS7, +y2NINS7, +y3CONC,1 -i-y4MGR~~ +y5SIZE,~y6EVAR~, +y7LEV,, +y8IIBEXI,~+v~, (2)

71 72

74

75
0

77

78
,

Sample size
7808

AdJ.R2 %
5.41

F value (sig.level)
105.110 (0.0001)
190.551 (0.000 1) 106.342 (0~0001)

PanelA 0.056** (43.735) Panel B ~0.022** (-6.439) ~0.005** (-7.986)

0

0.063**
(63.231) Panel C 0.050** (22.345)

~0.033**
(-11.867) ~0.022** (-6.43 1)

~O.O10** 0.014~ (-9.556) (5.636)

_0.O10** 0.O10** (3.954) 0.002 (0.803) -0.001 (-1.289) 9** (1 1.631) 0.012** O.029** (4.208)

7808

6.79

7808

9.74

(-6.583)

(4.566)

IDACCI represents the absolute amounts of Discretionary accruals, PINST represents the percentage of equity shares held by institutional investors, NINST indicates the number of institutional owners CONC is the interaction of PINST and NINST MGR represents percentage of shares held by inside owners i e individuals (officers, directors, and principal owners) who can exercise significant influence over corporate affairs, SIZE represents the natural logarithm of the firms sales, LEV indicates the ratio of total debt scaled by lagged total assets, EVAR is the standard deviation of earnings scaled by total lagged assets, and IIBEXI is the absolute value of income before extraordinary items scaled by lagged total assets. A (*/**) indicates statistical significance at (0.05/0.01) level, based on two tailed tests.

30

Table 3 Probit regression of income increasing discretionary accruals on institutional ownership and other determinants of ~managerialdiscretion SIGN1~= 5~ + 6~ PINSI, +62 NINSI, + 63CONC,~ + ~ MGR,~+ SSIZEU +66EVAR1~+ 6~ LEV,, + b IBEX~~ + K1,
61 PanelA ~0.087** -0.05 1 (0.404) 66

6768

Sample size
7808

F-value (sig.level)
3.815 (0.2821)

(9.109)
Panel B

0.032 (0.397)

-0.014 (0.841)

-0.03 1
(0.625)

0.083
(0.406)

0.091*
(4.555)

-0.060
(0.411)

0.006
(0.006),

-0.058**
(20.941)

0.153 (0.437)

0.453** (30.710)

1.461** (89.914)

7808

124.754

(0.0001)

SIGN is an indicator variable where income increasing discretionary accruals are coded as 1, otherwise it is coded as 0, PINST represents the percentage of equity shares held by institutional investors, NINST indicates the number of institutional owners, CONC is the interaction of PINST and NINST, MGR represents percentage ofshares held by inside owners, i.e., individuals (officers, directors, and principal owners) who an exercise significant influence over corporate affairs, SIZE represents the natural logarithm of the firm s sales, LEV indicates the ratio of total debt scaled by lagged total assets, EVAR is the standard deviation of earnings scaled by total lagged assets and IBEX is income before extraordinary items scaled by lagged total assets Parameter estimates and t statistics (in parentheses) are presented for the regression A (*/**) indicates statistical significance at (0 05/0 01) level based on two tailed tests

31

Table 4 Regression analysis of cross-sectional variation in the pricing of discretionary accruals REI, /3~ + J3~ OCF~ + 132 NDACC~+ J33DACC,1 + /34DACC * PINS7, + /35DACC * NINSI, +/36DACC*CONC,, +/37DACC*MGR,~+~
/32
0

(4)

13o
0.10P~ (10.399)

13
1.013** (18.295)

133
1.020** (3.570)

134
~0.827* (-1.939)

135
0.337 (1.227)

/36

/37

Sample size
5707

Adj.R2 %
7.04

F value (sig.level)
62.699 (0.0001)

l.332** (14.268)

2.451 (0.279)

-0.137 (-0.279)

RET is the annual stock return measure over a twelve month period ending three months after the fiscal year end, OCF.is operating cash flows, NDACC represents nondiscretionary accruals, DACC represents discretionary accruals, PINST represents the percentage of equity shares held by institutional investors, NINST indicates the number of institutional owners, MGR represents percentage of shares held by inside owners, i e individuals (officers, directors, and principal owners) who can exercise significant influence over corporate affairs A (*/**) indicates statistical significance at ( 0 05/0 01) level, based on two tailed tests. The sample is comprised of firm-year observations drawn from the 1989-1995 fiscal years.
, .

32

Table 5 Regression of stock returns on current earnings with varying time intervals for returns and for different levels of institutional ownership P~ /F~~ = (00
+ (01

IBEX11 ~

(5) Ratio
.

r=1

~=2

[r=2]/~r=

1]

High Institutional Ownership

0

w0
.

1.22 (65.538)
0

1.19 (50. 104) 1.12 (21.730) 1.70

,

w1
0

0.66 (18.029)

Low Institutional Ownership

w0

1.26 (89.303) 0.99 (17.361)

1.21 (59.995) 2.56 (32.145)

w1

2.59

P~ I ~ is one plus the buy-and-hold return forfirm i over the period t-r to t, IBEX,~ is earnings before extraordinary items. co~represents the markets response (response coefficient) to earnings information.

33