Institutional investors, long-term investment, and earnings management.

Abstract

This dissertation examines the influence of institutional investors on the incentives of corporate managers to alter long-term investment for earnings management purposes. The motivation for examining this relation stems from recent concerns that corporate managers myopically sacrifice long-term investment to maintain short-term earnings growth in the face of pressure from the capital markets. Such myopic investment behavior represents a form of earnings management; i.e., altering reported earnings to obtain private gain. I examine the influence of institutional investors on these earnings management incentives because they have become the largest class of U.S. investors, and prior work promotes two competing views on how institutional investors affect incentives to manage earnings. Many critics allege that the frequent trading and fragmented ownership of institutional investors create incentives for managers to avoid earnings disappointments that would trigger large-scale institutional investor selling and cause a temporary undervaluation of the firm' s stock price. Others argue that the large stakeholdings and sophistication of institutional investors allows them to monitor managers so that they maximize long-run value rather than meet short-term earnings goals. I examine these competing views by testing whether institutional ownership affects R&D spending for firms whose managers have the incentives and the opportunity to reverse a decline in earnings with a reduction in R&D. The results indicate that managers are less likely to cut R&D to reverse an earnings decline when institutional ownership is high, consistent with institutions serving a monitoring role, relative to individual investors, in reducing earnings management incentives. I also classify institutions into groups based on past portfolio characteristics to test whether groups exhibiting the characteristics argued to induce myopic behavior actually encourage such behavior. I find that predominant ownership by transient institutions--institutions that trade frequently, hold diversified portfolios, and follow momentum trading strategies (i.e. buying (selling) firms with good (bad) earnings news)--significantly increases the likelihood that managers cut R&D to manage earnings, controlling for the overall level of institutional ownership. This result supports the assertions that heavy institutional trading and fragmented ownership lead to myopic investment behavior by corporate managers, but only when institutions exhibiting such behavior hold concentrated ownership positions.