Individual Large Shareholders, Earnings Management, and Capital‐Market Consequences

• Author: Yiwei Dou,Youli Zou,Ole‐Kristian Hope,Wayne B. Thomas
• Date: 01 July 2016
• Published date: 01 July 2016
• DOI: http://doi.org/10.1111/jbfa.12204

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(7) & (8), 872–902, July/August 2016, 0306-686X

doi: 10.1111/jbfa.12204

Individual Large Shareholders, Earnings

Management, and Capital-Market

Consequences

YIWEI DOU,OLE-KRISTIAN HOPE,WAYNE B. THOMAS AND YOULI ZOU∗

Abstract: Using a large hand-collected sample of all blockholders (ownership ࣙ5%) of S&P

1500 firms for the years 2002–2009, we first document significant individual blockholder effects

on earnings management (accrual-based earnings management, real earnings management,

and restatements). This association is driven primarily by these large shareholders influencing

rather than selecting firms’ financial reporting practices. Second, the market’s reaction to

earnings announcements suggests that investors recognize the heterogeneity in blockholders’

influence on earnings management. The results highlight the highly individualized effects of

blockholders and a mechanism through which shareholders impact reported earnings.

Keywords: blockholders, large shareholders, earnings management, fixed effects, market

reactions

1. INTRODUCTION

An issue of considerable interest to researchers is the role of large shareholders

in firms’ corporate decisions. Prior literature recognizes that blockholders exhibit

different characteristics and that blockholder identities are associated with firms’

operations. While financial reporting serves as an important communication device

between managers and capital markets, little is known about the implication of block-

holder identities on firms’ reporting decisions and the capital market consequences.

∗The first author is at Stern School of Business, New York University. The second author is at the Rotman

School of Management, University of Toronto and BI Norwegian Business School. The third author is at

the Michael F. Proce College of Business, University of Oklahoma. The fourth author is at the School of

Business, The George Washington University. The authors have received valuable comments from Hila

Fogel Yaari, Gus De Franco, Sasan Saiy, Sydney Shu, Kevin Veenstra, an anonymous reviewer, and workshop

participants at Singapore Management University, National University of Singapore, Syracuse University,

University of Toronto, Iowa State University, New York University, University of Oklahoma, Hong Kong

Polytechnic University, the CAAA Annual Conference (Montreal), the MIT Asia Conference, the AAA

Annual Conference (Anaheim), and the Temple Accounting Conference. They thank Heae-Me Chung,

Seil Kim, Shawn Lee, Ye-Ji Lee, Seung Min, and Jun Zhang Tan for their excellent research assistance. An

earlier version of this article was titled ‘Blockholder Heterogeneity and Financial Reporting Quality’. Hope

gratefully acknowledges the financial support of the CMA/CAAA Research Grant Program and the Deloitte

Professorship. (Paper received May 2015, revised revision accepted March 2016).

Address for correspondence: Ole-Kristian Hope, Rotman School of Management, University of Toronto,

Toronto, Canada

e-mail: okhope@rotman.utoronto.ca

C

2016 John Wiley & Sons Ltd 872

LARGE SHAREHOLDERS, EARNINGS MANAGEMENT 873

To fill this gap, this paper investigates (1) the effect of individual blockholders on

firms’ earnings management and (2) whether the identity of the individual block-

holders provides informational value to capital market participants during earnings

announcements.1By earnings management (EM), we mean managerial activities that

prevent reported earnings from truly reflecting firms’ fundamental performance.

Interestingly, the literature offers mixed predictions and findings on the relation

between EM and large shareholders. An argument for a negative relation comes from

the monitoring role of large shareholders in influencing managers’ real actions to

better align with those of shareholders. This alignment allows managers to focus

more on activities that create long-term value and worry less about managing current

earnings to achieve short-term performance benchmarks. In addition, more closely

monitored managers are less likely to engage in the extraction of private benefits and

therefore they have less to conceal from shareholders by managing earnings.2

An alternative view is that blockholders positively influence EM. Shleifer and

Vishny (1997) suggest that large shareholders have incentives to extract gains from

creditors and other shareholders. Specifically, large shareholders may benefit from

earnings management through the firm reducing the cost of external financing

and debt covenant violations (Jiang, 2008), extracting private benefits from smaller

shareholders (Shleifer and Vishny, 1997), and selling higher-priced stocks to second-

generation shareholders (Lopez and Rees, 2002). Thus, certain large shareholder may

motivate greater managerial discretion in financial reporting, resulting in more EM.

A third possibility is that investors have no influence on firms’ EM. Most investors

do not engage actively with management. In fact, the most common form of corporate

governance as documented by the survey evidence of McCahery et al. (2015) is

to ‘vote with their feet’ and exit the firm rather than to ‘use their voice.’ If this

effect dominates, we would expect no significant relation between large shareholders

and EM.

Because of the mixed evidence in prior research, treating all blockholders as a

homogeneous group likely confounds researchers’ ability to test the influence of these

shareholders on EM. It is entirely possible that certain large shareholders have a posi-

tive influence while others have a negative influence. Furthermore, even after holding

constant the direction of influence, blockholders have heterogeneous beliefs, skills,

and preferences. Thus, they may influence corporate policies to various extents. Prior

studies either overlook the heterogeneity or explore only one observable dimension

at a time. As many key important channels are not open to the public (e.g., private

communication), researchers might lose the opportunity to fully account for the

differences among blockholders. Cronqvist and Fahlenbrach (2009) show significant

blockholder fixed effects in operational, financing, and compensation policies of

1 Blockholders are shareholders who own 5% or more of a company. Using a random sample of 428 US

listed firms from 1995, Holderness (2009) finds that 96% of these firms have blockholders, and these

blockholders in aggregate own on average 39% of the common stock. In our larger and more recent

sample, before (after) requiring blockholders to have ownership stakes in more than one firm, the mean

ownership by all blockholders is 30.2% (23.9%). The recent growth of hedge funds and active involvement

of other blockholders (e.g., activists, venture capitalists, LBOs, and individuals) provide motivation for

understanding their association with EM.

2 Prior research relies on these arguments to motivate the prediction between institutional ownership and

EM (e.g., Chhaochharia et al., 2012), between blockholders and EM (e.g., Farber,2005), between corporate

governance and EM (e.g., Francis et al., 2005), between founding family control and EM (e.g., 2007),

between public ownership and EM (e.g., Hope et al., 2013), and between the legal environment and EM

(e.g., Leuz et al., 2003).

C

2016 John Wiley & Sons Ltd