Do foreign institutional investors vote with their feet when firms engage in distinctive characteristics of real earnings management

Regulatory restrictions prohibit certain types of foreign institutional investors (FIIs) from appointing board members of listed firms in which they invest in Taiwan, which creates unfavorable monitoring conditions and may reduce the willingness of FIIs to extend their efforts to engage in more corrective corporate governance practices. Abnormal business activities can indicate either opportunistic earnings manipulation without an economic basis or a non-opportunistic size-adjustment of anticipated future opportunities which, in turn, result in different forms of economic consequences. The distinctive characteristics of abnormal business activities provide an appropriate setting for us to examine whether FIIs involved in governance practices of their invested firms engage in such earnings reporting behavior, i.e. decreasing (increasing) their ownership stake when firms engage in opportunistic (non-opportunistic) real earnings management (RM). Empirical result shows that FII ownership decreases (increases) when firms engage in opportunistic (non-opportunistic) RM in Taiwanese listed firms. Further analyses document that this association is stronger after the deregulation of FIIs in 2003, in firms with low auditor expertise, FII ownership below 10%, or high FII shareholding volatility. This finding indicates that FIIs are likely to opt for a ‘vote with their feet’ strategy in their portfolio firm’s earnings reporting and correctly price the impact of managerial decisions.