Abstract

The widespread practice of earnings management adversely impacts the quality of financial reports and increases information asymmetries between owners and managers. The present study investigates the effect of shareholder activism (as expressed by the proxy proposals sponsored by shareholders), and monitoring by the largest institutional owner on earnings management. Our longitudinal analyses indicate that the number of shareholder proposals received by firms is positively related to subsequent earnings management, yet concurrently, monitoring by the largest institutional owners is negatively related to earnings management. Our findings shed light on the equivocal results reported by prior research regarding the impact of shareholder activism on firm performance, on one hand, and ownership monitoring and performance, on the other.

Introduction

The manipulation of the firms’ earnings reported in the financial statements, also known as earnings management, is common among public companies (Pfarrer et al., 2008). Healy and Wahlen (1999: 368) note that: “Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers”. Therefore earnings management could be used to obscure the actual performance of the firm from shareholders and others, as reported numbers are not necessarily reflective of the underlying financial fundamentals of the firm (Klein, 2002). One of the main goals of the Sarbanes–Oxley Act of 2002 (SOX) was to limit earnings manipulations (Securities and Exchange Commission, 2003), in particular as earnings management could exacerbate informational asymmetries between shareholders and management and mislead the market participants regarding the firm’s financial situation (Chih et al., 2007). A report by the U.S. General Accounting Office (GAO) indicates that during the period 1997–۲۰۰۲ almost 10% of all public companies restated their financial statements due to accounting irregularities, with an accompanying $100 billion wipeout of market value (Harris & Bromiley, 2007). The prevalence of restatements of financial reports raises the question whether such restatements are not just the tip of the iceberg, with many more firms engaging in the legal, yet questionable, practice of earnings management (Dechow et al., 1995; Healy & Wahlen 1999). Furthermore, prior research has found that earnings management is associated with increased costs of capital (Botosan, 1997; Lang & Lundholm, 1996), and declines in stock prices (Dechow et al., 1996).