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Institutional Ownership Type and Earnings

Quality: Evidence from Iran

Sasan Mehrani, Mohammad Moradi & Hoda Eskandar

To cite this article: Sasan Mehrani, Mohammad Moradi & Hoda Eskandar (2016): Institutional
Ownership Type and Earnings Quality: Evidence from Iran, Emerging Markets Finance and
Trade, DOI: 10.1080/1540496X.2016.1145114

To link to this article: http://dx.doi.org/10.1080/1540496X.2016.1145114

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Emerging Markets Finance & Trade, 1–20, 2016
Copyright © Taylor & Francis Group, LLC
ISSN: 1540-496X print/1558-0938 online
DOI: 10.1080/1540496X.2016.1145114

Institutional Ownership Type and Earnings Quality:

Evidence from Iran
Sasan Mehrani1, Mohammad Moradi1, and Hoda Eskandar2
1
Faculty of Management, University of Tehran, Tehran, Iran; 2Faculty of Economics and Accounting,
Department of Accounting, Central Tehran Branch, Islamic Azad University, Tehran, Iran

ABSTRACT: Institutional ownership is an important factor in corporate governance. Institutional investors

play important roles in firms because of their substantial shareholdings and their capability to monitor
managers. However, the question is whether they are capable of monitoring the managers. The literature
has provided different evidence for the monitoring role of institutional investors. This study attempts to
provide insights into the monitoring roles of institutional investors by examining the relationship between
institutional ownership and earnings quality on the Tehran Stock Exchange. Institutional investors are
classified into two groups, namely active institutional investors and passive institutional investors, based
on their monitoring power in Iran. A multidimensional method is used to measure the various aspects of
earnings quality, such as earnings response coefficient, predictive value of earnings, discretionary
accruals, conservatism, and real earnings management. The results show that institutional ownership
has a positive effect on earnings quality. Similar to total institutional ownership, active institutional
ownership has positive effects on proxies of earnings quality. Nonetheless, passive institutional ownership
does not have any power to affect earnings quality. Moreover, lead-lag tests of the direction of causality
suggest that institutional ownership leads to more earnings quality and not the reverse.
KEY WORDS: active institutional ownership, corporate governance, earnings quality, institutional owner-
ship, passive institutional ownership

Corporate governance has recently received considerable attention due to financial scandals. The
reason for this attention is the interest in conflicts among shareholders in corporate structures. These
conflicts stem from different goals and preferences of the shareholders. In the absence of corporate
governance, managers can act in their own self-interest, rather than in the interests of investors (Gillan
and Starks 2003). Fortunately, corporate governance mechanisms can restrict managers’ self-interest
decisions. Corporate governance mechanisms can be divided into internal control mechanisms, such as
the board of directors’ characteristics, and external control mechanisms, such as stockholders and the
market. The emergence of institutional investors is one of the external control mechanisms.
Institutional investors are large investors, such as insurance companies, banks, pension funds,
financial institutions, and investment companies. Institutional investors have an influence on firms
because of their substantial shareholdings, and they can monitor managers. Their presence can change
a firm’s behavior through their monitoring activities (Velury and Jenkins 2006). Nonetheless, their
efficiency in monitoring managers remains uncertain. There are two different schools of thought
regarding the monitoring role of institutional investors. The efficient monitoring school argues that
institutional investors have incentives to become active monitors. Due to high costs, only large
investors would have the incentive to engage in active monitoring (Pound 1988). They have a relative
advantage in information collection and analysis over smaller investors. Many academic studies have
documented evidence consistent with this school of thought (e.g., Ramalingegowda and Yu 2012;
Hadani, Goranova, and Khan 2011; Velury and Jenkins 2006; Jung and Kown 2002; Fan and Wong
2002). The private benefit school, in contrast, focuses on private benefits, and it believes that

Address correspondence to Hoda Eskandar, Faculty of Management, University of Tehran, Tehran, Iran.
E-mail: heskandar@ut.ac.ir
2 S. MEHRANI ET AL.

institutional investors cannot actively monitor management activities due to the presence of free riders
and lack of sufficient experience; instead, they compromise with managers (Admati, Petleidere, and
Zechner 1994). Therefore, institutional investors might not engage in controlling managers to report
high-quality earnings (e.g., Noravesh and Kordlar 2005; Koh 2003).
Financial statements, especially income statements, provide important sources of information about a firm.
The focus on earnings is justified because it is a summary measurement of a firm’s performance (Niu 2006).
The quality of reported earnings is vital for the efficient allocation of resources in capital markets. Investors,
creditors, and analysts rely on earnings quality to make investment and valuation decisions. Earnings quality
is a complex and multidimensional concept, and a uniform method has not yet been identified to measure it
(Schipper and Vincent 2003). Nevertheless, academic studies have devised various measurements of earnings
quality. These measurements have become proxies for earnings quality in a generic sense (Dechow, Ge, and
Schrand 2010). Although quality of earnings is a multidimensional concept, researchers have generally
measured only one or two dimensions in their studies (e.g., Ajinkya, Bhojraj, and Sengupta 2005; Jung and
Kown 2002; Chung, Firth, and Kim 2002). In this manner, they have drawn misleading conclusions. In this
study, to overcome this problem, a multidimensional perspective is used to evaluate earnings quality. We
examine five dimensions of earnings quality: earnings response coefficient (ERC), predictive value of
earnings, discretionary accruals, conservatism of earnings, and real earnings management (REM). These
dimensions will be discussed in the “Methodology” section.
This study is designed to provide insights into the monitoring role of institutional investors in firms
listed on the Tehran Stock Exchange (TSE). Prior studies examining this relationship in different countries
have produced mixed results. A sound motivation for the study is to contribute to the interesting Iran
market. Although several studies have examined this relationship (e.g., Velury and Jenkins 2006; Hsu and
Koh 2005), this research proves to be different for the following reasons. First, few studies have discussed
the relationship between institutional ownership and earnings quality in developing countries. In this study,
Iran was selected. Institutional ownership in Iran differs that in other countries (Mashayekhi and
Mashayekh 2008). Therefore, differences in institutional ownership between Iran and other countries
can result in different relationships between institutional ownership and earnings quality. Second, based on
institutional ownership characteristics in Iran, this study divides ownership into active institutions and
passive institutions, so studying them is interesting. Moreover, this article makes a methodological
contribution by identifying various dimensions of earnings quality.

Background and Motivation

In this study, Iran is selected because its institutional ownership’s characteristics are interesting. In Iran,
institutional owners are affiliated with governmental institutions. They are seen as instruments of
government policy with little appreciation for their commercial or monetary roles. However, in most
developed countries, institutional owners are private institutions. On the TSE, the percentage of foreign
institutional ownership is low. The TSE has less than 1% foreign institutional ownership, compared to
developed countries, where it is approximately 50% or more. It is very difficult for Western investors to
access Iran, the country in question. Institutional owners have mainly increased their economic roles
during the absence of international companies in Iran (Elahee, Sadrieh, and Wilman 2015).
During the last few decades, developed countries have experienced an increase in institutional
ownership of publicly listed companies. In the UK and USA, for example, less than 10% of all public
equity is held by physical persons. Moreover, a number of new institutions have entered the scene and
have become important owners alongside the more traditional institutional investors, such as pension
funds and investment funds (Li et al. 2006). Institutional owners in Iran consist of fewer experts, and
they are less diversified than in developed countries. For example, there are few mutual funds in Iran.
In past decades, institutional investors have developed rapidly in Iran since privatization was started
and the first stock exchange law was established. Selling shares of governmental companies to the
public through the TSE has commenced in recent years for the fulfillment of Article 44 of the Iranian
constitution. Institutional investors have been the main customers of their initial public offerings.
 INSTITUTIONAL OWNERSHIP TYPE AND EARNINGS QUALITY 3

These developments have given new impetus to the discussion about the monitoring role of institu-
tional investors as the main owners of publicly listed companies.
In developed countries, institutional investors play leading roles as reference shareholders, and many firms
count both mutual funds and pension funds among their shareholders. Even when institutional ownership is
not extremely high, the dispersion of corporate ownership structures encourages institutional investors to play
active roles. Thus, they often help to alleviate the managerial discretionary problem (Li et al. 2006). However,
in Iran, a higher corporate ownership concentration, pyramidal ownership structures, and poor legal protec-
tion for shareholders have prevented some institutional investors from having sufficient power to control
large dominant shareholders. In this context, the interlocking of shares between corporations and the
separation between voting rights and cash flow rights allow banks or other nonfinancial firms to build a
controlling presence and to engage in a broad range of actions to the detriment of other institutional investors.
Consequently, institutional investors can either engage in monitoring managerial discretion activities to
alleviate agency conflicts or collude with large shareholders to expropriate benefits from minority share-
holders (Li et al. 2006; Elahee, Sadrieh, and Wilman 2015).
Iranian commercial law is very old, and corporate governance mechanisms are weak, so there is no
legal protection from owners without representation on the board of directors. These owners do not
have sufficient power to affect firms’ decisions. In contrast, owners with representation on boards of
director have sufficient power to play active roles and to affect firms’ decisions (Mashayekhi and
Mashayekh 2008). Consistent with these characteristics, not all institutional owners have identical
characteristics. Some of them, such as banks, insurance companies, and pension funds, generally have
representation on boards of director and so have sufficient power and a tendency to monitor managers.
They are called “active” and are long-term-oriented. These institutions have control or significant
influence of investee firms. They are institutional investors that only have investment relationships
with firms in which they own equity, and they are less subject to pressure from the firms in which they
invest and therefore are better suited to monitor, discipline, and impose controls on corporate
managers. They are willing to affect firms’ decisions. An extremely high ownership concentration
allows them to use their power to extract private benefits from small shareholders. In contrast, others
(e.g., investment companies or investment advisors) do not have representation on boards of directors
and do not have the power to monitor managers. They are less willing to challenge management
decisions. These owners are called “passive” and sort-oriented. These owners’ rights are exposed to
high risks because of weak legal protection (Elahee, Sadrieh, and Wilman 2015).
According to the above discussion, this article is interesting. Although some scholars have examined the
relationship between institutional ownership and earnings quality, most studies have been based on the
efficient markets of developed countries with different ownership from Iran. Therefore, differences in
institutional ownership between Iran and other countries could result in a different relationship between
institutional ownership and earnings quality. Moreover, consistent with differences in institutional owner-
ship types, their monitoring roles might be different. Therefore, this study divides them into “active” and
“passive” groups and investigates their effects on earnings quality.

Literature Review and Hypothesis Development

There are two different schools of thought in the literature regarding the monitoring role of institutional
investors. According to efficient monitoring school, institutional investors, compared to small individual
investors, possess greater expertise and therefore are capable of actively monitoring managers. The size of
institutions’ shareholdings and their informational advantage (e.g., quality of research, ability to collect, and
process information) provide them with strong incentives to engage in efficient monitoring (e.g., Shleifer and
Vishny 1986). They have incentives to monitor financial reporting. Therefore, the presence of these investors
increases earnings quality. Bathala, Moon, and Rao (1994) showed that institutional investors have the
incentive to monitor financial reporting quality and can penalize managers for the low quality of their reported
accounting information. They stated that institutional ownership provides circumstances for collective action.
Larger investors can easily sell large amounts of their stock, and the amount of their stock is so high that it is
4 S. MEHRANI ET AL.

not possible to sell it without affecting the stock price. Therefore, firm managers will be more concerned
about institutional investors selling their stock. In addition, institutional investors can use such an ability to
dismiss firm managers. Hadani, Goranova, and Khan (2011) showed that institutional owners constrain the
self-serving manipulations of accounting numbers. Velury and Jenkins (2006) showed that institutional
ownership is positively associated with ERC, timeliness, and predictive value. However, it is not significantly
associated with abnormal accruals. Briefly, their study showed that institutional ownership improves earnings
quality. Jung and Kown (2002) stated that increasing institutional presence would increase the ERC.
Additionally, Fan and Wong (2002) found a positive relationship between institutional ownership and
ERC in East Asia. Bushee (1998) showed that lower institutional ownership causes more earnings manage-
ment. Their findings showed that institutional investors play a monitoring role as sophisticated investors,
compared to individual investors. Therefore, managers’ incentives for earnings management are decreased.
Using discretionary accruals as a measurement of earnings management, Chung, Firth, and Kim (2002) found
that the presence of institutional investors inhibits managers from changing reported earnings toward the
managers’ desired level. Mitra and Cready (2005) documented that institutional ownership is negatively
related to managerial flexibility in the accrual process. Chung et al. (2002) examined the effects of
institutional ownership on information preparation methods. They found that institutional investors decrease
earnings management and affect the quality of accounting. Ramalingegowda and Yu (2012) showed that
higher ownership by institutions that are likely to monitor managers is associated with more conservative
financial reporting. Additionally, Barber and Odean (2008) and Barber et al. (2009) argued that institutional
investors are more likely to drive the demand for conservatism than individual investors. Ajinkya, Bhojraj,
and Sengupta (2005) showed that higher institutional ownership increases conservatism.
In contrast, proponents of the private benefit school argue that larger investments by institutional investors
provide an opportunity to access private information that can be exploited for self-interested behavior on the
part of institutions viewed as short-term-oriented (Hsu and Koh 2005). Therefore, it is expected that
concentrated ownership in the hands of these investors reduces earnings quality. Moreover, they might not
monitor financial reporting due to factors such as free riders and their relationships with the firms’ managers.
There is some evidence for the negative effect of institutional ownership on financial reporting quality. Jarrell
and Poulsen (1987) showed that institutional investors vote in agreement with their economic interests
because of their sophistication and information advantage. However, counterarguments hold that the myopic
behavior of institutional investors can lead to institutional investor passivity with regard to corporate
governance (e.g., McConnell and Servaes 1990). For instance, although less likely in environments in
which laws and regulations are more protective of investors (such as the US and the UK), the presence of
a diffuse ownership structure can provide institutional investors with incentives to collude with managers to
extract private benefits and can contribute to the entrenchment of incumbent managers (e.g., Pound 1988).
Agrawal and Mandelker (1990) suggested that institutional voting might result from the tendency of
institutions to vote with management, to abstain from voting, or to sell their shares. Prendergast (2002)
showed that institutional investors likely have privileged access to management and inside information; they
might rely more on direct monitoring and less on monitoring through accounting numbers. Kim (1993)
asserted that institutional investors have access to private information that is extracted for commercial
purposes, and as a result, financial reporting quality is not important to them. Heflin and Shaw (2000)
showed that there is an informational advantage for block holders. They found that block holder ownership is
positively associated with various measurements of information asymmetry. Noravesh and Kordlar (2005)
showed that companies with more institutional ownership have stock with more future earnings information
than those with less institutional ownership. They interpreted their results as being due to information
asymmetry and institutional investors’ access to the private information.
As a result, the first hypothesis is:
H1: “Ceteris paribus, there is a significant relationship between institutional ownership and earnings
quality.”

Some researchers have shown that institutional investors are not a homogeneous group. For
example, Duggal and Millar (1994) suggested that the monitoring role of institutional investors
 INSTITUTIONAL OWNERSHIP TYPE AND EARNINGS QUALITY 5

depends on the type of institution. Different investors have different objectives and styles, are subject
to different legal restrictions, and face different competitive pressures, which will affect not only the
investment horizon but also their governance roles. Therefore, all institutional investors are not alike
(Cornett et al. 2007; Bushee 1998).
As mentioned with regard to motivation and background, in this study, institutional investors are
divided into passive institutional investors and active institutional investors, based on their ownership
power. Active institutional investors have representation on boards of directors, so they have sufficient
power and a tendency to monitor the managers. They are long-term-oriented and focus on long-term
performance. These investors actively monitor managers and hold them accountable. They engage in
more efficient monitoring. Therefore, the presence of these investors increases financial reporting
quality (Cornett et al. 2007). In Iran, these owners include pension funds, banks, and insurance
companies. In contrast, some institutional investors do not have any representation on boards of
director, so they do not have the power to monitor the managers. Such institutions are less likely to
oppose managerial decisions, thus impeding their effective monitoring-managerial discretion. These
investors are prepared to encourage managerial opportunistic practices if they generate significant
abnormal returns. These passive institutional investors have a high portfolio rotation. They can easily
liquidate their investments if the firm performs poorly, and have less incentive to monitor them (Maug
1998). They are short-term-oriented and transient. They prefer short-term performance to long-term
performance (Potter 1992). Their overemphasis on current performance (and earnings) can provide the
incentives for earnings management and decrease the quality of financial reporting. In Iran, these
investors include investment firms and investment advisors.
Baik, Kang, and Kim (2010) showed that large holdings by transient institutions facilitate man-
agers’ opportunistic behavior, such as earnings management. They suggested that higher transient
institutional ownership might cause more manipulation of accounting choices, which in turn decreases
accruals quality. Yan and Zhang (2009) and Gaspar, Massa, and Matos (2005) showed that short-term
institutional investors (passive) could trade on the basis of noise or imperfect short-term informational
signals. This behavior could influence managers’ discretionary activities and hence increase asym-
metric information problems. Koh (2007) predicted a positive association between transient institu-
tional ownership and income-increasing earnings management. Bushee (1998) divided institutional
ownership into active and passive and concluded that the presence of passive institutional investors
increases the likelihood of earnings management and therefore decreases earnings quality. Bushee
(2001) further showed that transient investors prefer short-run returns. Gaspar, Massa, and Matos
(2005) documented that short-term institutional investors conduct weak monitoring and allow man-
agers to pursue value-reducing mergers and acquisitions. Parrino, Sias, and Starks (2003) showed that
short-term institutional investors might trade frequently to exploit their informational advantage. This
behavior is particularly true in a liquid market, such as the US, where they can maintain the liquidity of
their holdings and offload ownership blocks without depressing stock prices.
Njah and Jarboui (2013) showed that the presence of active institutions ultimately limits managerial
accruals discretion. The monitoring role exerted by active institutional investors restricts the opportu-
nities for earnings management around mergers and acquisitions.
Attig et al. (2012) argued that the presence of long-term institutional owners improves govern-
ance stemming from two sources. The first relates to the monitoring role, and the second relates to
its informational role. Long-term institutional owners safeguard their investments by imposing
disciplinary mechanisms on managers that align their interests with those of shareholders.
Additionally, they prevent managerial myopia and encourage managers to focus on long-term
firm value. Therefore, long-term owners play more valuable governance role in mitigating asym-
metric information and agency problems. These investors benefit from economies of scale in
gathering and processing corporate information resulting in more efficient monitoring and infor-
mation quality. Elyasiani and Jia (2010) showed that long-term institutional ownership increases
institutions’ incentives to engage in corporate monitoring on an ongoing basis. Active institutional
monitoring can help to solve firms’ agency and information asymmetry problems stemming from
6 S. MEHRANI ET AL.

the atomized structure of (US) corporate shareholdings. Chung, Firth, and Kim (2002) argued that
the presence of active institutional ownership decreases the usage of non-conservative accounting
methods and consequently, increases earnings quality. Elyasiani and Jia (2010) suggested that the
presence of long-term institutions increases analyst coverage for the company, resulting in greater
transparency and hence lower transaction and financing costs. Admati and Pfleiderer (2009)
argued that institutions with large, stable ownership could monitor managers to avoid the transac-
tion costs and price impacts that would result from the sale of large block holdings. Chen,
Harford, and Li (2007) provided some evidence in support of the efficient monitoring roles of
long-term institutional investors. Elyasiani, Jia, and Mao (2010) showed that the presence of active
institutional owners is associated with less uncertainty and conveys higher quality information
about management’s commitment to a firm’s long-term prospects. These investors’ ability to
convey private information through their threat to exit can pressure management to improve
information quality. Francis, Nanda, and Olsson (2008) found evidence of a robust negative
relationship between institutional ownership stability and the cost of debt, which is a commonly
used proxy for information quality. Koh (2007) showed that long-term institutional investors
constrain accruals management, and short-term institutional ownership is not associated with
aggressive earnings management. His study emphasized the importance of explicitly considering
the type of institutional ownership when investigating the association between institutional own-
ership and earnings quality. Chen et al. (2007) argued that independent long-term institutions with
large ownership actively oversee managers in their merger and acquisition decisions.
Elyasiani and Jia (2008) asserted that, although the arguments above support more efficient
monitoring by active institutional owners, their governance roles might be impaired by their tendency
to exhibit loyalty to managers. Pound (1988) stated that institutional investors with more stable
ownership have a tendency to vote in favor of entrenched management. Similarly, relationship
investing can translate into a mutually beneficial business relationship, in which case long-term
institutional owners might agree with management’s decisions (Brickley, Lease, and Smith 1988).
The intensity of institutional monitoring can also be limited by institutions’ sensitivity to liquidity
shocks and the direct and indirect costs of their potential exit strategies. Such considerations will
render institutions’ threats to exit less credible, which in turn will exacerbate managerial myopia
(Admati and Pfleiderer 2009).
Overall, the discussion above suggests that active and passive institutional investment could
provide either a positive (i.e., relationship investing, greater transparency, and improved disciplinary
influences) or a negative (i.e., loyalty to incumbent management and less credible threat to exit)
influence on corporate governance. Therefore, the second and third hypotheses are:
H2: “Ceteris paribus, there is a significant relationship between active institutional ownership and earn-
ings quality.”
H3: “Ceteris paribus, there is a significant relationship between passive institutional ownership and
earnings quality.”
While we examine how institutional ownership can affect earnings quality, other factors also have
effects. Prior research has recognized several factors that influence earnings quality. For example,
Watts and Zimmerman (1990) asserted that the managers of large firms are politically more sensitive,
and they prefer to decrease political costs through the accrual components of earnings. Billings (1999)
concluded that higher debt causes the selection of certain accounting methods, which increase earn-
ings. McNichols (2000) showed a positive relationship between growth and the accrual components of
earnings. Jung and Kown (2002) found that the ERC is affected by growth. Hayn (2000) and Basu
(1997) showed that ERCs in loss firms are seriously critical. Given that earnings quality is likely to be
affected by other factors, in addition to institutional ownership, several control variables have been
introduced to capture these effects. The control variables are the firm size, debt, growth, and
profitability.
 INSTITUTIONAL OWNERSHIP TYPE AND EARNINGS QUALITY 7

Methodology
The sample consists of all of the firms listed on the TSE excluding financial firms from 1999 to 2006.
We collected data on ownership structure and financial and accounting directly from annual reports
and from TSE reports obtained from electronic data and the Internet.

Endogeneity
Institutional ownership is endogenously determined by firm characteristics (e.g., Ramalingegowda and
Yu 2012; LaFond and Roychowdhury 2008; Ajinkya, Bhojraj, and Sengupta 2005). To the extent that
these economic determinants of institutional ownership also explain earnings quality, they can
introduce a spurious relationship between earnings quality and institutional ownership. Therefore,
this issue is addressed before drawing the conclusion that institutional ownership has a causal effect on
a firm’s earnings quality.
To mitigate this concern, we follow prior research and perform our analyses using a measurement
of residual ownership, defined as the residual from a regression of ownership on its economic
determinants.
Based on Ramalingegowda and Yu (2012), the variation in institutional ownership is attributed to
four sources, and multiple proxies are used to capture them. First, as fiduciaries, institutions prefer
firms that the courts consider to be prudent investments. This “prudence” motive is captured by firm
age, dividend yield, membership in the TSE top 50, and stock price volatility. Second, because
institutions tend to make larger investments, they prefer firms that have high liquidity and low
transaction costs. These liquidity and transaction cost motives are captured by firm size, stock price,
and share turnover. Third, institutions prefer to invest in firms based on historical return patterns. This
preference is captured by firm size, book-to-market ratio, and momentum. Finally, Tobin’s Q and bid-
ask spreads are included to capture the influence of growth options and information asymmetry. The
endogeneity model is as follows:

Type Ownt ¼ α þ β1 MBt1 þ β2 MVt þ β3 Volatilityt2;t þ β4 Turnover3

þ β5 Pricet þ β6 TSE50 þ β7 Momentum3;0 þ β8 Momentum12;3 (1)
þ β9 Aget þ β10 Divt þ β11 Spreadt1 þ β12 TOBINSQt1 þ ε1

where
Type Own: percentage of common shares held by institution owners (INST), active institu-
tional owners (AC: institutions with representation on board of directors) or passive institu-
tional owners (PASS: institutions without representation on board of directors) at the end of
the year t,
MB: market to book ratio,
MV: market value of equity,
Volatilityt-2,t: the variance of monthly returns over the previous two years (from year t-2 to t),
Turnover−3: monthly volume divided by shares outstanding, measured three months prior to
the end of year t,
PRICE: share price,
TSE 50: dummy equal to 1 if the firm is included in the TSE top 50 index at the end of year t,
and 0 otherwise,
Momentum −3, 0: firm’s gross return for the three months prior to the end of year t,
Momentum−12, −3: firm’s gross return for the nine months ending three months prior to the
end of year t,
Age: the number of years a firm listed on TSE at the end of year t,
Div: dividends,
8 S. MEHRANI ET AL.

Spread: average of daily bid-ask spread, computed as (ask-bid)/[(ask+bid)/2],

TOBINSQ: market value of assets divided by book value of assets, where the market value of
assets is computed as book value of assets plus market value of equity less the sum of book
value of equity and balance sheet deferred taxes.
ε: residual term.
First, ownership (i.e., INST, AC, and PASS) is regressed on a variety of firm characteristics that explain
ownership. Then, the regression residuals are extracted as residual ownership measurements (RINST, RAC,
and RPASS, respectively). Hence, all of the analyses use residual institutional ownership, rather than raw
institutional ownership. The inferences are similar, however, when raw institutional ownership is used.

Earnings Quality
In this study, various dimensions of earnings quality are applied, including: ERC, predictive value of
earnings, discretionary accruals, conservatism, and REM.

Earnings Response Coefficient

The correlation between earnings and stock return and earnings explanatory power, is one criterion of
earnings quality. Studies have traditionally focused on evaluating earnings quality in terms of conformity to
the conceptual framework. Ball and Brown (1967, 1968) and Beaver (1968) changed this perspective. They
showed that earnings news is associated with various equity market attributes, because these outcomes result
when investors change their evaluations. They conclude that investors use earnings information in their
decisions. Thus, a returns-based ERC is a proxy for earnings quality (Dechow, Ge, and Schrand 2010). This
argues that ERC measures precision of earnings information and it is supported empirically. Imhoff and Lobo
(1992) found a negative relationship between ERC and analyst forecast dispersion, which they interpreted as
evidence that higher quality earnings are associated with lower ex ante inherent uncertainty about earnings
and information that has been provided to analysts. Liu and Thomas (2000) also stated that ERC is a
measurement of earnings quality. They argued that a higher ERC is associated with the predictability of the
fundamental earnings process.
Consistent with Beaver (1989), we assume that changes in stock prices are responses to changes in
earnings over a given period. The ERC (sensitivity of returns to earnings) is obtained by running a
regression with returns as the dependent variable and earnings as the independent variable. Therefore,
the return is related to earnings, and the ERC is assumed as the measurement of earnings quality.
Specifically, the following models are used:

RETBit ¼ α þ β1 ΔEARN  RINSTit1 þ β2 ΔEARNit þ β3 GROWTHit

(2)
þ β4 SIZEit þ β5 DEBTit þ β6 LOSSit þ εit

RETBit ¼ α þ β1 ΔEARN  RACit1 þ β2 ΔEARAN  RPASSit1 þ β3 ΔEARNit

(3)
þ β4 GROWTHit þ β5 SIZEit þ β6 DEBTit þ β7 LOSSit þ εit

where
RETB: 12-month stock return ending 4 months after the fiscal year end for year t,
ΔEARN: changes in net income before extraordinary items and discontinued operations from
year t − 1 to year t,
RINST: residual institutional ownership estimated by model (1),
RAC: residual active institutional ownership estimated by model (1),
RPASS: residual passive institutional ownership estimated by model (1),
GROWTH: market value to book value of stockholders’ equity,
 INSTITUTIONAL OWNERSHIP TYPE AND EARNINGS QUALITY 9

SIZE: the natural logarithm of total assets,

DEBT: long-term debt scaled by total assets,
LOSS: a dummy variable set equal to one if the firm reported a loss and zero, otherwise,
ε: residual term

Predictive Value of Earnings (PRED)

Predictive value is the quality that increases the likelihood of correctly forecasting future outcomes
from past or present events. When historical earnings data can predict future earnings, the possibility
of evaluating future profitability and future cash flows is provided. In this situation, it is supposed that
earnings have high quality. There are two interpretations of the predictive value of earnings. Some
researchers have argued that current earning is a good predictor of future earnings (e.g., Freeman,
Ohlson, and Penman 1982). Others have argued that current earnings are generally a good predictor of
future cash flows (e.g., Dechow 1994). We examine whether earnings have predictive value or not by
analyzing the relationship between current earnings operating cash flow in the subsequent year.
Specifically, these following models are used:

CFOitþ1 ¼ α þ β1 RINST  OPINit þ β2 OPINit þ β3 GROWTHit

(4)
þ β4 SIZEit þ β5 DEBTit þ β6 LOSSit þ εit

CFOitþ1 ¼ α þ β1 RAC  OPINit þ β2 RPASS  OPINit þ β3 OPINit

(5)
þ β4 GROWTHit þ β5 SIZEit þ β6 DEBTit þ β7 LOSSit þ εit

where
CFO: cash flow from operations at the end of year t + 1 scaled by beginning total assets;
OPIN: income before extraordinary items and discontinued operations scaled by beginning
total assets,
the other variables are as previously defined.

Discretionary Accruals (DISACC)

Prior studies have examined earnings management by examining the magnitude of discretionary
(abnormal) accruals. Larger or smaller discretionary accruals suggest, respectively, more or less
earnings management (Velury and Jenkins 2006). Earnings quality is high when earnings are unma-
naged. Despite the extensive use of discretionary accruals as measurements of earnings quality, there is
little evidence according to which the discretionary accruals model is more appropriate (Gul, Fung,
and Jaggi 2009). Consistent with Gul, Fung, and Jaggi (2009), we use the magnitude of discretionary
accruals, as measured by the model suggested by Ball and Shivakumar (2006). They show that
nonlinear accruals models are a substantial improvement, explaining up to three times the amount
of variation in accruals as do conventional linear specifications, such as the Jones (1991) model. We
use the following model for estimating discretionary accruals, given by the residual term (εit):

ACCit ¼ α þ β1 CFOitþ1 þ β2 CFOit þ β3 CFOit1 þ β4 ΔREVit þ β5 PPEit

(6)
þ β6 ΔCFOit þ β7 DΔCFOit þ β8 ΔCFOit  DΔCFOit þ εit

where
ACC: the absolute value of the difference between earnings before extraordinary items and
operating cash flow,
10 S. MEHRANI ET AL.

CFO: operating cash flow,

ΔCFO: changes in CFO,
ΔRev: changes in net sales revenue,
PPE: property, plant, and equipment (net),
DΔCFO: a dummy variable that is 1 when ΔCFO < 0 and zero otherwise,
all of the variables are scaled by beginning total assets.
Our test is conducted based on the absolute value of discretionary accruals (ABSTDA) under the
premise that upward as well as downward adjustments of reported earnings are considered a type of
earnings management that lowers the quality of reported earnings (Myers, Myers, and Omer 2003).
Specifically, the following models are used:

ABSTDAit ¼ α þ β1 RINSTit1 þ β2 GROWTHit þ β3 SIZEit þ β4 DEBTit þ β5 LOSSit þ εit (7)

ABSTDAit ¼ α þ β1 RACit1 þ β2 RPASSit1 þ β3 GROWTHit þ β4 SIZEit þ β5 DEBTit

(8)
þ β6 LOSSit þ εit

where
ABSTDA: the absolute value of discretionary accruals scaled by beginning total assets,
the other variables are as previously defined.
Conservatism (CONS): The concept of conservatism has much influence on accounting
procedures. Conservatism has been a qualitative characteristic of financial reporting for at least five
centuries (Basu 1997), and it has been the subject of academic studies. Accountants traditionally
expressed conservatism according to the rule “anticipates no profits, but anticipate all losses.” Basu
(1997) interpreted it as accountants’ tendency to require a higher degree of verification for recognizing
good news than bad news. Based on this interpretation, earnings reflect bad news more quickly than
good news. Recent studies have distinguished conditional conservatism, which is the timelier recogni-
tion of bad news compared to good news in earnings, from unconditional conservatism, which
describes an ex ante policy that results in lower book values for assets (higher book values for
liabilities) in the early periods of an asset or liability’s life. Conservatism is one dimension of earnings
quality, indicating that it increases the quality of earnings (Dechow, Ge, and Schrand 2010). The most
frequently used measurement of timely loss recognition is the reverse earnings-returns regression from
Basu (1997):

NIit ¼ α þ β1 RETit þ β2 DRit þ β3 RETit  DRit þ εit (9)

where
NI: earnings before extraordinary items scaled by market value of stockholders equity.
RET: stock return over the fiscal year t.
DR: a dummy variable equals to 1 if the RET < 0 and zero otherwise.
Positive returns show good news, and negative returns show bad news. If return is positive, the
model will be NI = α + β2 RET +ε. In this model, β2 shows an earnings response to good news. If
return is negative, it will be NI = α + β1 + (β2 + β3) RET +ε, indicating that (β2 + β3) shows an
earnings response to bad news. Basu (1997) argued that the earnings response to bad news is timelier
than good news, indicating β2 + β3 > β2, so β3 > 0. Therefore, β3 shows conservatism.

NIit ¼ α þ β1 RINSTit1  RETit  DRit þ β2 RINSTit1  RETit þ β3 RINSTit1  DRit

þ β4 RINSTit1 þ β5 RETit þ β6 DRit þ β7 RETit  DRit þ β8 GROWTHit (10)
þ β9 SIZEit þ β10 DEBTit þ β11 LOSSit þ εit
 INSTITUTIONAL OWNERSHIP TYPE AND EARNINGS QUALITY 11

NIit ¼ α þ β1 RACit1  RETit  DRit þ β2 RPASSit1  RETit  DRit þ β3 RACit1  RETit

þ β4 RACit1  DRit þ β5 RACit1 þ β6 RPASSit1  RETit þ β7 RPASSit1  DRit
(11)
þ β8 RPASSit1 þ β9 RETit þ β10 DRit þ β11 RETit  DRit þ β12 GROWTHit
þ β13 SIZEit þ β14 DEBTit þ β15 LOSSit þ εit

where the variables are as previously defined.

Real Earnings Management

REM is defined as real activities manipulation. Real activities manipulation is motivated by managers’
desire to mislead at least some stakeholders into believing that certain financial reporting goals have
been met in the normal course of operations. To detect real activities manipulation to avoid losses,
patterns in CFO, expenses and production costs for firms close to the zero earnings benchmark are
investigated (Roychowdhury 2006; Dechow, Kothari, and Watts 1998).
Roychowdhury (2006) and Dechow, Kothari, and Watts (1998) expressed normal cash flow from
operations as the following regression:

CFOit =At1 ¼ α þ β1 ð1=Ait1 Þ þ β2 ðREVit =Ait1 Þ þ β3 ðΔREVit =Ait1 Þ þ εit (12)

where
A: total assets,
REV: sales revenue,
the other variables are as previously defined.
They estimated normal production costs as the following:

PRODit =At1 ¼ α þ β1 ð1=Ait1 Þ þ β2 ðREVt =Ait1 Þ þ β3 ðΔREVit =Ait1 Þ

þ β3 ðΔREVit1 =Ait1 Þ þ εit (13)

where
PROD: cost of goods sold plus inventory changes (COGSt+ΔINVt)
the other variables are as previously defined.
Normal expenses are estimated by them as the following model:

EXPit =At1 ¼ α þ β1 ð1=Ait1 Þ þ β2 ðREVit1 =Ait1 Þ þ εit (14)

where
EXP: total expenses,
the other variables are as previously defined.
Abnormal CFO, abnormal PROD and abnormal EXP are the actual values minus the normal values
calculated using the estimated coefficients from the above equations. Our test is conducted based on
the absolute value of abnormal values (ABST), under the premise that upward as well as downward
adjustments are considered to be a type of earnings management that lowers the quality of reported
earnings. Therefore, the following models are used for CFO, PROD and EXP:

ABSTValueit ¼ α þ β1 RINSTit1 þ β2 GROWTHit þ β3 SIZEit þ β4 DEBTit þ β5 LOSSit þ εit (15)

12 S. MEHRANI ET AL.

ABSTValueit ¼ α þ β1 RACit1 þ β2 RPASSit1 þ β3 GROWTHit þ β4 SIZEit

(16)
þ β5 DEBTit þ β6 LOSSit þ εit

where
ABSTValue: the absolute value of abnormal CFO (ABSTCFO), abnormal PROD (ABSTPROD),
or abnormal EXP (ABSTEXP),
the other variables are as previously defined.

Results
Table 1 presents descriptive statistics for the main variables. The average raw ownership by total,
active and passive institutions is 46%, 30%, and 14%, respectively. Therefore, institutional
investors, on average, hold approximately 46% of the total shares outstanding of the sample

Table 1. Descriptive statistics of the main variables

Variable Mean Median Minimum Maximum Std. deviation

RET 0.49 0.29 −0.58 5.60 0.81

ΔEARN 0.04 0.11 −0.29 1.58 0.14
OPIN 0.28 0.22 −0.11 3.46 0.29
ACC 0.03 0.06 −3.95 4.34 0.41
CFO 0.21 0.15 −0.41 4.14 0.31
ΔREV 0.89 0.14 0.09 2.68 0.35
PPE 0.74 0.25 0.01 54.25 4.51
NI 0.28 0.21 −0.23 5.12 0.37
PROD 1.11 1.06 −0.22 7.00 0.55
EXP 0.80 0.77 −0.21 5.85 0.45
REV 1.06 1.01 0.08 7.43 0.52
INST 0.46 0.41 0.00 0.99 0.31
AC 0.30 0.27 0.00 0.97 0.30
PASS 0.14 0.14 0.00 0.47 0.10
RINST −0.02 −0.01 −7.51 0.57 0.44
RAC −0.02 −0.02 −7.52 0.62 0.44
RPASS −0.00 −0.00 −0.24 0.34 0.10
GROWTH 0.24 0.19 −0.41 2.52 0.29
SIZE 25.30 25.83 19.94 31.59 2.09
DEBT 0.08 0.06 0.00 0.41 0.07
LOSS 0.03 0.00 0.00 1.00 0.14

Notes: RET is 12-month return; ΔEARN is the changes in net income before extraordinary items and discontinued
operations from year t − 1 to year t; OPIN is income before extraordinary items and discontinued operations scaled by
beginning total assets; ACC is the absolute value of difference between earnings before extraordinary items and
operating cash flow scaled by beginning total assets; CFO is cash flow from operations (scaled by beginning total
assets.); ΔREV is the changes in net sales revenue scaled by beginning total assets; PPE is property, plant, and equipment
(net) scaled by beginning total assets; NI is earnings before extraordinary items scales by market value of stockholders
equity; PROD is cost of goods sold plus inventory changes scaled by beginning total assets; EXP is total expense scaled
by beginning total assets; REV is sales revenue scaled by beginning total assets; INST is the percentage of common
shares held by institutions; AC is the percentage of common shares held by Active institutions (with presentation on the
board of directors); PASS is the percentage of common shares held by passive institutions (without presentation on the
board of directors); RINST is the residual institutional ownership; RAC is the residual active institutional ownership;
RPASS is the residual passive institutional ownership; GROWTH is market value to book value of stockholders’ equity;
SIZE is the natural logarithm of total asset; DEBT is long-term debt scaled by the beginning of total assets; and LOSS is
a dummy variable set equal to one if the firm reported a loss; otherwise zero.
 INSTITUTIONAL OWNERSHIP TYPE AND EARNINGS QUALITY 13

firms. Active institutional investors, on average, own 30% of the total shares outstanding of the
sample firms, but the mean of passive institutional ownership is much less (approximately 14% of
common shares outstanding). The means of their residuals are −0.02, −0.02, and −0.00, respec-
tively. Stock return is approximately 49%. The mean of accruals is 3% of total assets. NI and
OPIN both have a mean of 0.28. CFO is 21% of the beginning assets on average. Sales revenue
and its changes are approximately 1.06 and 0.89, respectively. The mean of PPE is 0.74. PROD
and EXP are, on average, 1.11 and 0.8.
Mean long-term debt is approximately 8% of the total assets, indicating that firms in Iran do not
heavily rely on debt. This finding implies that their default risk is low, because Iran is an Islamic
country and companies have few long-term liabilities because of the forbiddance of bonds. The firms’
average size is approximately 25.30. The average firm growth is 0.24 in our sample.
Table 2 documents the Pearson’s correlations between explanatory variables. The firm growth is
positively associated with size suggesting that larger firms have more growth. In addition, growth is
negatively associated with loss, suggesting that loss firms have less growth.
Table 3 shows the results of the endogeneity model (Eq. (1)). It shows that all types of institutions
tend to invest more in firms having lower volatility. However, there are also significant differences
across different types of institutions. For example, while active institutions prefer younger firms with
larger spread, passive institutions invest more in older firms with smaller spread. Further, there is a
positive relationship between active institutional ownership and market value. However, there is not a
significant relationship between MV and passive ownership. There is a positive relationship between
passive share turnover and institutional ownership, but, there is no relationship for active ownership.
To test the univariate relationship between institutional ownership and the measurements of earn-
ings quality, we divide the sample into two categories based on RINST. We then compare the
measurements of earnings quality from the highest and lowest median values of RINST. Table 4
represents the results of the univariate tests. For most measurements, the difference between the
highest and lowest median values is significant, providing preliminary support for our hypotheses.

Table 2. Correlation matrix of the main variables

Variable (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

RINST 1 .97 0.14 0.01 −0.05 0.01 −0.02 −0.02 −0.02 −0.04
(1) (.00)** (0.00) * (0.84) (0.26) (0.90) (0.59) (0.63) (0.71) (0.43)
RAC 1 0.09 0.01 −0.03 0.02 −0.01 0.01 −0.02 −0.04
(2) (0.06) (0.84) (0.54) (0.73) (0.80) (0.91) (0.65) (0.41)
RPASS 1 0.00 0.06 0.01 0.02 −0.01 −0.07 −0.15
(3) (0.99) (0.16) (0.89) (0.61) (0.89) (0.13) (0.00)**
ΔEARN 1 0.43 0.49 0.55 0.07 −0.05 −0.11
(4) (0.00)** (0.00)** (0.00)** (0.12) (0.30) (0.01)*
OPIN 1 0.32 0.30 0.09 −0.09 −0.18
(5) (0.00)** (0.00)** (0.05)* (0.06) (0.00)**
RET 1 0.25 0. 26 −0.03 −0.13
(6) (0.00)** (0.00)** (0.47) (0.01)*
GROWTH 1 0.26 0.16 −0.12
(7) (0.00)** (0.00) (0.01)*
SIZE 1 0.05 −0.10
(8) (0.32) (0.03)
DEBT 1 0.02
(9) (0.64)
LOSS 1
(10)

Notes: ***, **, and * denote significance at 0.001, 0.05, and 0.10 levels, respectively, based on t-tests (two-tailed).
14 S. MEHRANI ET AL.

Table 3. Endogeneity results [Eq. (1)]

Variable INST AC PASS

(Constant) 0.40 0.33 0.07

(8.37) (7.25) (4.13)
MB 0.0 0.00 −0.00
(0.65) (1.30) (−1.79)*
MV 0.04 0.05 −0.00
(5.01)*** (5.56)*** (−1.01)
Volatility −0.00 −0.00 −0.00
(−3.84)*** (−3.19)*** (−2.29)**
Turnover −0.00 −0.00 0.00
(−0.59) (−1.25) (1.81)*
Price 0.00 0.00 0.00
(2.04)** (1.22) (2.58)**
TSE50 0.02 −0.01 0.03
(0.64) (−0.27) (2.67)***
Momentum−3,0 −0.00 −0.00 −0.00
(−1.07) (−0.89) (−0.64)
Momentum−12,-3 −0.00 −0.00 0.00
(−0.10) (−0.30) (0.56)
Age −0.00 −0.01 0.00
(−2.44)** (−4.66) *** (6.06)***
Div 0.00 0.00 0.00
(0.79) (0.45) (1.06)
Spread 3.76 4.83 −1.07
(2.29)** (3.06)*** (−1.93)*
TOBINSQ 0.02 0.02 −0.00
(1.63) (1.70)* (−0.02)
Adjusted R2 %15 %16 %13
F 7.38 8.13 6.52

Notes: T-statistics are shown in parentheses. ***, **, and * denote significance at 0.001, 0.05, and 0.10 levels,
respectively, based on t-tests (two-tailed).

Table 4. Univariate test

Earnings quality proxy Low RINST High RINST Difference

ERC (Eq. (2)) −0.06 0.27 −0.33***

PRED (Eq. (4)) −0.09 −0.10 0.01
DISACC (Eq. (7)) 0.16 0.14 0.02*
CONS (Eq. (10)) 0.07 0.12 −0.05*
REM (Eq. (15)):
CFO 0.17 0.15 0.02*
PROD 0.21 0.19 0.02**
EXP 0.19 0.16 0.03**

Notes: T-statistics are shown in parentheses. ***, **, and * denote significance at 0.001, 0.05, and 0.10 levels,
respectively, based on t-tests (two-tailed).
 INSTITUTIONAL OWNERSHIP TYPE AND EARNINGS QUALITY 15

Regression Analysis
Table 5 represents the results of the regression models. Panel A shows the results for RINST, and panel B
shows the results for RAC and RPASS. These tables show the results of the main variables. For example,
the coefficients reported in panel A are β1 coefficients in institutional ownership models (Eqs. (2), (4), (7),
(10), and (15)). Similarly, the coefficients reported for active and passive ownership in panel B are β1 and β2
coefficients in institutional ownership type models (Eqs. (3), (5), (8), (11), and (16)).
The statistically significantly positive value of the estimated coefficient of ΔEARN*RINST indicates
that the higher the institutional ownership is, the higher ERC is (coeff. = 2.04, t = 2.64). This outcome
indicates that ERC increases by approximately 2.04 for each percentage point increase in shares held by
institutions, which means that institutional ownership increases ERC and, consequently, increases earn-
ings quality. Panel B shows that similar to total ownership, active institutional ownership is positively

Table 5. The relation between earnings quality proxies and institutional ownership
Panel A. Total Institutional Ownership

ERC PRED DISACC CONS REM-CFO REM-PROD REM-EXP

Main variables (Eq. (2)) (Eq. (4)) (Eq. (7)) (Eq. (10)) (Eq. (15)) (Eq. (15)) (Eq. (15))

RINST(β1 ) 2.04 0.27 −0.12 −1.54 −0.09 −0.06 −0.08

(2.64)*** (1.74)* (−3.70)*** (−1.18) (−2.90)** (−2.40)** (−2.73)**
GROWTH −0.32 0.18 −0.04 0.03 0.19 0.43
(−2.41)** (1.66)* (−0.92) (3.92)*** (0.60) (5.37)*** (10.21)***
SIZE 0.10 −0.06 0.00 −0.01 0.01 −0.01 −0.01
(6.19)*** (−4.33)*** (0.67) (−1.38) (1.36) (−1.04) (−1.23)
DEBT 0.10 0.23 0.41 −0.76 0.26 −0.31 −0.49
(0.22) (0.57) (2.41)** (−3.43)*** (1.60) (−2.23)** (−2.97)***
LOSS −0.32 0.02 0.34 −0.31 0.15 0.02 0.10
(−1.60) (0.20) (4.57)*** (−3.00)** (2.08)** (0.34) (1.40)
Other variables Included Included Included
R2 30% 4% 18% 12% 3% 7% 19%
F 35.52 3.81 18.79 6.96 3.79 7.41 23.31
Panel B. Institutional Ownership Type

ERC PRED DISACC CONS REM-CFO REM-PROD REM-EXP

Main Variables (Eq. (3)) (Eq. (5)) (Eq. (8)) (Eq. (11)) (Eq. (16)) (Eq. (16)) (Eq. (16))

RAC(β1) 2.29 0.31 −0.11 −0.75 −0.07 −0.05 −0.07

(3.18)*** (2.02)** (−3.36)*** (−0.81) (−2.31)** (−1.95)** (−2.32)**
RPASS(β2) 5.68 0.75 0.10 4.65 −0.14 −0.20 −0.08
(1.36) (0.52) (0.45) (1.41) (−0.67) (−1.15) (−0.40)
GROWTH −0.30 0.19 −0.04 0.23 0.03 0.19 0.43
(−2.21)** (1.72)* (−0.91) (3.89)*** (0.64) (5.41)*** (10.21)***
SIZE 0.09 −0.06 0.01 −0.01 0.10 −0.01 −0.01
(6.10)*** (−4.36)*** (0.77) (−1.56) (1.41) (−1.00) (−1.17)
DEBT 0.12 0.24 0.41 −0.76 0.25 −0.32 −0.49
(0.27) (0.58) (2.41)** (−3.36)*** (1.54) (−2.31)** (−2.99)**
LOSS −0.33 0.02 0.35 −0.35 0.15 0.01 0.10
(−1.63) (0.10) (4.60)*** (−3.29)*** (1.98)** (0.19) (1.35)
Other variables Included Included Included
R2 30% 4% 18% 14% 3% 7% 18%
F 331.2 3.42 16.90 5.70 2.76 6.12 19.03

Notes: T-statistics are shown in parentheses. ***, **, and * denote significance at 0.001, 0.05, and 0.10 levels,
respectively, based on t-tests (two-tailed).
16 S. MEHRANI ET AL.

associated with ERC (coeff. = 2.29, t = 3.18), which indicates that ERC increases by approximately 2.29
for each percentage point increase in shares held by active institutional investors. Active institutional
ownership increases ERC and so, increases earnings quality. Nonetheless, there is not a significant
relationship between passive institutional ownership and ERC (coeff. = 5.68, t = 1.36). In addition, the
large corporations’ earnings have a higher ERC. However, firms with more growth have lower ERC.
Total institutional ownership is positively associated with the predictive value of earnings
(coeff. = 0.27, t = 1.74). Institutional ownership increases the predictive value of earnings and
hence, increases earnings quality. Panel B shows that active institutional ownership is positively
associated with the predictive value of earnings (coeff. = 0.31, t = 2.02). Passive institutional
ownership is not significantly associated with the predictive value of earnings (coeff. = 0.75,
p-value = 0.52). In addition, the large firms’ earnings have a lower PRED. However, firms with
more growth have higher PRED.
Institutional ownership decreases earnings management by discretionary accruals (coeff. = −0.12,
t = −3.70). Similarly, active ownership is negatively correlated with discretionary accruals
(coeff. = −0.11, t = −3.36). However, passive ownership is not correlated with DISACC (coeff. =
0.10, t = 0.45). In addition, loss firms or firms with more debt use more discretionary accruals and so,
have lower earnings quality.
Total institutional ownership and its types are not significantly associated with conservatism. Loss
and debt are negatively associated with conservatism, indicating that loss or leveraged firms use
methods that are less conservative. Growth is positively associated with conservatism, which indicates
that firms with higher growth use methods that are more conservative.
Institutional owners decrease earnings management by manipulating real activities. Similarly, active
owners decrease REM. However, passive owners cannot influence real activities manipulation. Growth
is positively related to REM proxies, and debt is negatively related to them. Firms with less growth or
more debt have lower REM and so, higher earnings quality.

Casualty Tests
The above results point to a positive relationship between institutional ownership and earnings
quality. This finding is consistent with monitoring institutions demanding high quality financial
reporting.
It is notable that, although the literature has traditionally assumed that firm’s earnings quality is an
outcome of ownership, few studies have proposed that ownership can be the consequence of earnings
quality as well (Demsetz and Villalonga 2001; Bhagat and Bolton 2008). Institutional investors might
hold on to companies. Firms with higher earnings quality can attract investment by institutions.
Therefore, higher earnings quality can lead to higher institutional stock holdings. This possible
relationship could undermine the claim that institutional ownership acts as a monitoring device that
influences companies to produce better earnings quality. Therefore, our regression equations are
susceptible to having reverse causality problems. This “reverse causality” explanation is plausible
because institutional ownership might prefer firms with higher earnings quality to reduce their own
monitoring costs. In addition, earnings quality and institutions’ monitoring could arise simultaneously,
driven by some unknown underlying factor (the “simultaneity” explanation) (Ramalingegowda and Yu
2012).
Consistent with Ramalingegowda and Yu (2012), tests are performed to provide evidence for the
direction of causality between monitoring institutions and earnings quality. Monitoring institutions’
current and lead residual ownership (i.e., RINSTt, RINSTt+1, RACt, RACt+1, RPASSt, and RPASSt+1,)
are added to the ERC, PRED, and CONS models (Eqs. (2)–(5) and (10)–(11)) to examine how these
proxies are related to lagged, current and lead residual ownership by monitoring institutions.
Moreover, according to Blanco, Lara, and Tribo (2014), the Granger (1969) test is used to investigate
causality in DISACC and REM models (Eqs. (7)–(8) and (15)–(16)).
 INSTITUTIONAL OWNERSHIP TYPE AND EARNINGS QUALITY 17

The Granger mathematical statement is the following:

Yit ¼ α þ β1 Yit1 þ β2 Xit1 þ εit

Xit ¼ χ þ δ1 Xit1 þ δ2 Yit1 þ εit

The test of the hypothesis that X does not Granger cause Y is given by the joint that ß2 = 0,
and the test of the hypothesis that Y does not Granger cause X is given by the joint test that δ2 =0.
Tables 6 and 7 report the results from estimating casualty equations. The results for the control
variables are similar to those in prior tables and thus are not reported for brevity. Consistent with
monitoring institutions demanding higher earnings quality, a significantly positive relationship was
found between most of the earnings quality proxies and lagged residual ownership by monitoring
institutions. In addition, consistent with the reverse causality explanation, there is no significant
relationship between earnings quality proxies and lead residual ownership by monitoring institutions.
Moreover, the relationship between earnings quality proxies and current residual ownership by
monitoring institutions is insignificant, providing no support for the simultaneity explanation. The

Table 6. Casualty tests for ERC, PRED, and CONS models

RINST RAC RPASS

Lagged Current Lead Lagged Current Lead Lagged Current Lead

Earnings Quality Proxy (t-1) (t) (t + 1) (t-1) (t) (t + 1) (t-1) (t) (t + 1)

ERC 2.04 1.53 1.31 2.29 −0.14 1.13 5.68 −0.61 −0.95
(2.64)*** (1.61) (1.37) (3.18)*** (−0.15) (0.99) (1.36) (−0.88) (−0.63)
PERD 0.27 0.18 0.19 0.31 0.26 0.06 0.75 0.01 0.16
(1.74)* (0.68) (0.69) (2.02)** (1.07) (0.17) (0.52) (0.03) (0.36)
CONS −1.54 −1.48 −1.35 −0.75 −0.23 1.25 4.56 1.01 2.29
(−1.18) (−1.11) (−1.01) (−0.81) (−0.16) (0.89) (1.41) (0.87) (0.71)

Notes: T-statistics are shown in parentheses. ***, **, and * denote significance at 0.001, 0.05, and 0.10 levels,
respectively, based on t-tests (two-tailed).

Table 7. Granger causality test for DISACC and REM models

ABSTDA ABSTCFO ABSTPROD ABSTEXP Result

−0.11 −0.07 −0.04 −0.08 Total institutional ownership Granger causes earnings quality.
(−3.87)*** (−2.97)** (−2.02)** (−2.41)**
0.01 0.02 0.01 −0.01 Earnings quality does not Granger cause institutional ownership.
(0.77) (0.77) (0.31) (−0.66)
−0.11 −0.07 −0.03 −0.07 Active institutional ownership Granger cause earnings quality.
(−3.96)*** (−2.97)** (−1.43) (−2.18)**
−0.00 −0.02 0.03 0.01 Earnings quality does not Granger cause active ownership.
(−0.16) (−0.81) (0.86) (0.26)
0.05 −0.25 −0.11 −0.16 Passive ownership does not Granger cause earnings quality.
(0.23) (−1.58) (−0.89) (−0.72)
−0.01 −0.09 −0.07 0.04 Earnings quality does not Granger cause passive ownership.
(−0.06) (−1.34) (−0.79) (0.66)

Notes: T-statistics are shown in parentheses. ***, **, and * denote significance at 0.001, 0.05, and 0.10 levels,
respectively, based on t-tests (two-tailed).
18 S. MEHRANI ET AL.

results of active ownership are similar to those of total ownership. However, passive residuals are not
related to earnings quality proxies, and vice versa.
This evidence indicates that changes in earnings quality do not lead to increases in institutional
ownership. Therefore, the causality flows from changes in institutional ownership to earnings quality
changes, and not vice versa.

Conclusion
Studying institutional investors’ behavior in Iran, a country with unique ownership characteristics, is
interesting. This article examines how the corporate governance role of institutional investors is
associated with their portfolio firms’ earnings quality in Iran.
On the whole, the results provide evidence that the institutional ownership has a positive effect on
most earnings quality proxies, consistent with Hadani, Goranova, and Khan (2011).
The findings show that institutional ownership increases ERC, indicating that these investors
actively manage their investment portfolios and, consequently, motivate managers to report high
quality earnings. Therefore, earnings information in firms with high institutional ownership is more
capable of explaining economic realities. This result is consistent with Velury and Jenkins (2006), Jung
and Kown (2002), and Fan and Wong (2002). Institutional ownership is positively associated with the
predictive value of earnings. Therefore, we can say that the presence of institutional ownership results
in earnings information being more relevant to evaluating future profitability and future cash flows.
This result is similar to Velury and Jenkins’ (2006) findings. Moreover, a negative relationship
between institutional investors and earnings management (real and accruals) indicates that institutional
investors discourage earnings management by manipulating accruals or real activities, indicating that,
when institutions have sufficiently high ownership levels, they can act as effective corporate govern-
ance mechanisms in mitigating REM and accruals management. This result is consistent with Chung,
Firth, and Kim (2002) and Hsu and Koh (2005).
Moreover, according to institutional owners’ characteristics in Iran, this study divided institutional
owners into active and passive. Similar to total institutional ownership, the results provide evidence
that active institutional ownership has a positive effect on proxies of earnings quality. The presence of
active institutional investors increases the ERC, improves predictive the value of earnings, and
decreases earnings management. Therefore, long-term-oriented institutional investors (active) monitor
corporate financial reporting and encourage higher earnings quality. These results prove that these
powerful investors in Iran have a tendency to monitor the managers and to use their power to affect the
managers’ decisions. This result is consistent with Attig et al. (2012), Elyasiani and Jia (2010), Admati
and Pfleiderer (2009), Francis, Nanda, and Olsson (2008), Koh (2007), and Chen et al. (2007).
Nonetheless, passive institutional ownership is not related to earnings quality proxies, provided that
these owners do not have the power in Iran and do not play any roles in managers’ decisions.
Further, causality tests suggest that ownership by monitoring institutions leads to more earnings quality
rather than the reverse. Collectively, these results are consistent with monitoring institutions demanding
earnings quality. These findings are consistent with those of Ramalingegowda and Yu (2012).

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