Abstract

We examine the impact of institutional ownership on earnings quality in China. We have employed two proxies of earnings quality: discretionary accruals and real earnings management. Using 19,743 firm-year observations from 2009 to 2017, we find that firms with higher institutional ownership are more likely to display higher earnings quality in lower discretionary accruals and lesser real activities manipulation. Our results are robust after controlling for endogeneity.

Introduction

Since the early 1990s, China has conducted a series of accounting, auditing, and stock market reforms to ensure convergence with IFRS, greater participation of home-grown audit firms in the audit market, liberalization of its stock markets and “…incentivize the development of institutional investors, including opening Chinese stock exchanges to qualified foreign institutional investors, social security funds, and insurance companies” (Lin and Fu, 2017, p. 17). All these reforms have resulted in a more vibrant stock market with greater participation of institutional investors. Institutional ownership of China’s A-Shares market capitalization (18.7%) doubled in 2021 compared to 2014 and is over ten times higher than in 2003 (Lin and Puchniak, 2021). In spite of the reforms and growing institutional ownership, concentrated ownership, particularly the presence of state-owned enterprises (SOEs), remains a common feature of the Chinese stock market. Given its comparatively weaker institutional environment, we examine whether institutional investors influence earnings quality in Chinese A-share firms.

Prior research shows that good corporate governance plays an important monitoring role, which improves accounting quality (Becker et al., 1998; Francis and Krishnan, 1999; Xie et al., 2003). As part of corporate governance in this paper we examine whether institutional investors influence earnings quality in Chinese A-share firms. The active monitoring hypothesis suggests that institutional investors are likely to manage their investment due to their magnitude of investment actively. Such active monitoring has been shown to improve stock price performance (Jiambalvo et al., 2002) and firm profitability (Lin and Fu, 2017; Guo and Platikanov, 2019; Ding et al., 2020). In advanced economies, the quality of earnings increases with an increase in institutional ownership (Velury and Jenkins, 2006). However, earnings quality may be imperiled by institutional investors who predominantly focus on short-term gains, pressuring corporate managers to make accounting decisions that boost short-term earnings at the expense of long-term value (Graves and Waddock, 1990; Laverty, 1996; Porter, 1992). For example, Chen et al. (2015) find that higher institutional investment in Chinese firms is associated with less conservative financial reporting as institutional investors in the Chinese market have short-term investment incentives. However, no study has examined whether institutional ownership impacts the quality of accounting earnings proxied by accruals and real earnings management in China.

Conclusions

In this paper, we examine the impact of institutional ownership on earnings quality in China, a capital market characterized by SOEs and concentrated ownership, creating incentives for self-serving and opportunistic behaviors such as misuse of insider information and earnings management. Employing two proxies of earnings quality: discretionary accruals and real earnings management, and using 19,743 firm-year observations from 2009 to 2017, we find that firms with higher institutional ownership are more likely to display higher earnings quality both in the form of lower discretionary accruals and lesser real activities manipulation.

When we conducted a sub-sample analysis based on state ownership, the results showed that institutional ownership reduces |DACC| in the non-SOE subsample but not in the SOE subsample. In contrast, institutional ownership is associated with a significantly lower level of real activities manipulation in SOE firms but not in non-SOE firms. These results imply that higher institutional ownership is significantly associated with higher earnings quality in both SOE and non-SOE firms, but the channel of the effect is different. For SOE firms, it is via reduced real management activities, while in non-SOE firms, it is via improved accruals management. When we further classify SOE firms into local and central SOEs, we find that institutional ownership constrains real activity manipulation only in the local SOEs. Our results are robust after controlling for endogeneity.

These results have important policy implications for regulators, investors, and audit firms in China. For example, our findings will help external capital providers and other stakeholders assess the pervasiveness of earnings management and the integrity of the financial reporting of Chinese SOE and non-SOE firms. Our findings suggest that in SOE firms, institutional ownership can be instrumental in improving earnings quality, which is a major issue.