The Relationship Between Institutional Investment and Earnings Management: Empirical Evidence from Turkey

The Relationship Between Institutional Investment and Earnings Management: Empirical Evidence from Turkey

Aslı Aybars (Marmara University, Istanbul, Turkey)
Copyright: © 2014 |Pages: 21
DOI: 10.4018/ijcfa.2014010101
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Abstract

The emergence of corporate scandals at the end of the 20th and beginning of the 21th century raised doubts regarding the integrity of financial reporting and the soundness of firms' corporate governance practices. The practice of earnings management is considered to be one of the important causes of these scandals due to its harm to the transparency and quality of financial statements. The discretion exercised by managers in accounting result in agency costs arising from the mismatch between the goals and desires of the principle and the agent causing investors to make suboptimal decisions. The recent surge in institutional investors' shares and associated degree of activism increased their importance as an external control mechanism of corporate governance. Accordingly, the primary purpose of this study is to evaluate the role of these investors on earnings management and alignment of the interests of owners and managers within the context of agency theory. Consequently, two main hypotheses; namely, active monitoring and managerial myopia induced by institutional investors are tested by panel data analysis utilizing data belonging to the firms listed on Borsa Istanbul during the 7 year period between 2005 and 2011, inclusive. The absolute value of discretionary accruals obtained from the performance adjusted cross-sectional industry based accrual model proposed by Kothari, Leone and Wasley (2005) is used as the proxy of earnings management to evaluate whether the presence of institutional investors mitigate or stimulate managers' discretionary accounting practices. Additionally, further analysis is conducted to evaluate the existence of monitoring and clientele effects to better interpret the direction of the relationship between the associated variables of interest.
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2. Literature Review

Initial research focusing on the association between institutional ownership and earnings manipulation mainly utilizes variables based on R&D expenditures as proxies of managerial discretion (Graves, 1988; Hill & Hansen, 1989; Hansen & Hill, 1991; Baysinger, Kosnik & Turk, 1991; Eng, 1995; Bushee, 1997; Majumdar & Nagarajan, 1997; Bushee, 1998). Cuts or increases in firms’ expenditures regarding these long-term investments can be utilized as tools of earnings management. However, together with the advances in theoretical and empirical literature related to the generation of aggregate accrual models, measures other than R&D related proxies are introduced into econometrical models in this array of empirical studies. Furthermore, the improvements in literature related to accruals management increased the generalizability of the theories since this method of earnings management can be used by all firms and is not as costly as investments in R&D (Koh, 2007).

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