Does the Presence of Institutional Investors Influence Accruals Management? Evidence from Australia

Recent debates on the corporate governance role of institutional investors have centred around whether they monitor their portfolio firms (exercise voice) or vote with their feet (exit). We examine these competing views in the context of how institutions’ voice vs exit role, proxied by institutional ownership levels, is associated with their portfolio firms’ earnings management in multiple settings. We extend Koh (2003, The British Accounting Review, 35, 105–128) by examining the effect of both short‐term and long‐term oriented institutional ownership on the extent of earnings management by portfolios firms with different incentives for earnings management. Specifically, we expect that the non‐linear relation between institutional ownership and earnings management found in Koh (2003) is more likely to be present for portfolio firms with stronger incentives to meet/beat earnings thresholds. Our results suggest that transient and long‐term oriented institutions co‐exist and have differential effects on portfolio firms’ earnings management. Transient institutions are associated with upward accruals management, while long‐term oriented institutions constrain such upward accruals management for portfolio firms that have strong incentives to do so (specifically, firms with non‐discretionary earnings below prior year earnings). This suggests long‐term oriented institutions can act as a corporate governance mechanism to mitigate aggressive earnings management. Overall, we find that the association between institutional ownership and earnings management is not systematic across all firms and is context dependent, suggesting complex associations between institutional ownership and earnings management strategies exist.