4-IJAEBM-Volume-No-1-Issue-No-1-INSTITUTIONAL-OWNERSHIP-HETEROGENEITY-AND-ACCRUALS-MANAGEMENT-A-PANE by ISERP ISERP

Iskandar REBAI (IJAEBM) INTERNATIONAL JOURNAL OF ADVANCED ECONOMICS AND BUSINESS MANAGEMENT Vol No. 1, Issue No. 1, 025 - 032

INSTITUTIONAL OWNERSHIP HETEROGENEITY AND ACCRUALS MANAGEMENT: A PANEL DATA ESTIMATION Iskandar REBAI

Faculty of Economic Sciences and management Sfax, Tunisia

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E-mail: r_iskandar2002@yahoo.fr

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Abstract

This study has examined the association between institutional investors’ ownership and accruals management practice using panel regressions with fixed and random effects. It has investigated this relationship for a sample of 123 US firms. It has examined also the effect of institutional ownership on earnings management of firms having different information environment (S&P 500 versus non S&P 500). Results have shown that the involvement of investment funds and banks in the firms’ capitals exacerbates earnings management behaviors. Moreover, the hypothesis of the relevance of the environment information in the explanation of the institutional investors’ behavior has been confirmed.

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Keywords: Institutional investors, discretionary accruals, earnings management

information and in the realization of sophisticated financial analysis. A process associated with the limitation of opportunistic behavior of managers in terms of earnings management [5], [6].... However, others believe that the institutional investors incite managers to manage results because of their short-term horizon and their private relationship with the firm [7], [8].... Nevertheless, institutional investors have different investment horizons and motivations [9], [10]. Therefore, their influence on the maneuvers of leaders is different. A major contribution of this study is that it examines how different types of institutional investors, who have different strategies, influence managerial' behaviors. We emphasize on three types of institutional investors that have different characteristics: pension funds, investment funds and banks. In addition, we think that previous studies neglect the role of the information environment of firms in explaining the behavior of institutional investors. Our study assumed an influential role of the information environment on the behavior of institutional investors. In fact, companies that belong to the S & P 500 stock index are generally of great size, use the services of highly experienced analysts and are subject to effective control by the different stakeholders [11]. Therefore, the behavior of institutional investors appears to be different in these firms [12]. The study of the information environment is an important contribution of our research to the existing literature. The remainder of the paper is organized as follows. The next section gives the materials and methods used. Section 3 presents results and discussions.

1. INTRODUCTION

Earnings management is a common practice in the United States. Indeed, managers exploit the weakness of control to alter the results of their firms. In this context, the Sarbanes Oxley Act (2002) is a response to scandals in many companies, in particular, WorldCom and Enron. This act was passed by the Congress in July 2002 to strengthen the fiduciary responsibility in companies and hence restore investor confidence. In fact, penalties were introduced for violations recorded [1]. Moreover, the motivation to manipulate results stem from different motivations. Particularly, the intention of managers to maximize their compensation, to improve their reputation and to protect themselves against the threat of takeover [2]. However, a party appears to have a privileged position to effect change: institutional investors. Institutional investors have become the largest holders of firm's capitals over the last twenty years and the most active players in corporate governance [3]. According to [4], institutional investors hold about half of the shares of American firms. Similarly, in 2008, The Conference Board said that institutional participation is 66.3% of all U.S firms' shares in 2006. Towards the end of 2007, they held 76.4% of the 1000 largest U.S companies' shares. Nevertheless, the researches that exist on the relationship between institutional investors and earnings management provide diametrically opposed results. Indeed, some authors believe that institutional investors are more informed with respect to individual investors. In fact, they spend enormous resources in gathering and interpreting

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II. MATERIALS AND METHODS 2.1. Data The sample used in our survey is composed of data carrying on firms of the American economy detected from the firms’ yearly reports distributed by the Security and Exchange Commission. From an initial sample, we eliminated the financial firms and insurance companies as well as firms whose data are missing or the yearly reports are distributed for less than four consecutive years. Our final

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sample is limited to 123 American firms1 for the period from 2002 to 2005. 2.2. Variables description 2.2.1. The dependent variable

2.2.2. The independent variables

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The most direct method to detect and to measure earnings management is to use a model based on accruals. The earnings management will be represented therefore by the discretionary accruals which represent the difference between the total accruals cleared by firms and during a particular exercise and the non discretionary accruals that reflect the normal level of the activity of the firm. The total accruals (ACCT) have been calculated using the method of cash flow, according to which the total accruals are the difference between the net profit (NR) and cash flows of exploitation (CFL). ACCTt  RNt  FTEt (1) Shang (2003) uses a model based on accruals developed by [13] to measure the earnings management. [14] Adopts it to discern if the market overestimates the persistence of accruals. Nevertheless, authors try to use the modified Jones model to study the effect of the earnings management on the phenomenon of decision making in the firm. The total accruals calculation was about the period going from 2003 to 2005. The total accruals are decomposed in two parts: the discretionary accruals (ACCD) and the non discretionary accruals (NDACC). Thus, ACCDit  ACCTit  ACCNDit (2) We used the model of [15] for the discretionary accruals evaluation. It takes the discretionary accruals evaluation as a basis on controlling the non discretionary part. The model of [15]: ACCTit= a0 + a1 (CAit-CCit) +a2 (IMMOit) + vit (3) With, ACCTit, the total accruals of the equation (3) standardized by the total asset in the beginning of the period; CAit, business number of the year t less the business number of the year t-1 standardized by the total asset in the beginning of the period; CCit,

the net accounts receivable of the year t less net accounts receivable of the year t-1, standardized by the total asset in the beginning of the period; IMMOit, immobilizations of the year t standardized by the total asset in the beginning of the period; it, term of mistake representing the discretionary accruals evaluation (ACCD); i, parameters of models to estimate. Thus, the discretionary accruals represent terms of mistakes that result from the equation (3) ACCDit = ACCTit – [â0+ â1 (CAit-CCit) +â2 (4) (IMMOit)]

a) Pension funds ownership

According to [16], pension funds are encouraged to play an active role in monitoring and communication with the firm's leaders. Similarly, [17] and [18] consider that the pension fund activism is the subject of an evolution from the model of control by the market to a political model of control. So, we can predict a negative association between pension funds ownership and earnings management. b) Investment funds ownership

Investment funds are short term oriented. Their possession is about one year [19]. Indeed, contrary to the pension fund managers, managers of investment funds are subject to performance constraints required by their superiors. As such, [9] and [20] believe that the internal compensation system of these investors is based on the quarterly performance level of their holdings. Thus, fund managers are replaced each time the result reached by the company is inadequate. In addition, clients of investment funds are individual investors, who are based in their investment decisions on short-term information collected from newspapers and magazines [21]. Indeed, the involvement of investment funds in the capital incites managers to manage earnings.

43 firms belonging to the S&P 500 stocks and the others

don’t belong to the S&P 500 stocks.

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c) Banks ownership [7] notes that banks don’t press leaders to manage results since they have a long-term investment horizon. As a result, banks inhibit earnings management. However, as soon as the bank is present in the firm’s capital, it has more of luck to reach the relevant information sources regarding the firm’s financial situation. Therefore, leaders give up the earnings management in order to signal capacities of their firms to banks. 2.2.3. The control variables

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 Managerial ownership is defined as the proportion of capital held by managers. Managerial ownership can align the interests of managers with those of shareholders. We therefore expect a negative relationship between managerial ownership and earnings management.  The debt ratio is measured as total debt divided by total assets. In the case of a lack of internal financial resources, the company uses debt. However, more the ratio of debts increases more the possibility to manipulate results to rape contracts of debts increases. To this consideration, [22] bring back that firms that violate contracts of debts use more discretionary accruals to increase results. Thus, we can say that more the level of debts is raised more the leader manages results through the discretionary accruals.  Liquidity is measured as current assets divided by current liabilities. [3] notes that the variation of the liquidity degree explains the change in the discretionary accruals level. In fact, [23] note that more the liquidity lowers, more it is necessary to manage results toward the rise to compensate the lack of liquidity. Consequently, more the liquidity lowers more the level of earnings management by discretionary accruals increases.  The size is measured by the logarithm of total assets. Leaders of the big firms are motivated to manage their results to decrease their political visibility. So, we predict a positive relationship between size and earnings management.

[24] as well as [25] show that in opposition to the individual investors, the institutional investors have a preference for the investment in the big firms. [25] stipulates that the positive relation between the institutional involvement and the size of the firms essentially drifts to the legal constraints and the relatively important transparency level in the big businesses. Nevertheless, these firms are submitted to more of control on behalf of the different taking parts and resort more than the others to financial analyst services. In this order of idea, [3] considers that firms that belong to the S&P 500 stocks have a more elevated stock capitalization and a more important transparency level in contrast with non S&P 500 firms. The informational environment of firms belonging to the S&P 500 stocks is supposed more rigorous in comparison with to the one of the other firms. We think that the influence of the institutional investors on managerial latitude concerning earnings management varies depending on whether the studied firms belong or no to the S&P 500 stocks [12].

2.2.4. Information environment hypothesis

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2.3. Estimation method

We focus on panel data. The study period is from the year 2002 to 2005. One possible estimation methods is the method of least squares (OLS). This estimate assumes that all parameters are identical. The model would be consistent. However, the risk of sample heterogeneity exists, making biased estimates by OLS. So we adopt an estimation based on panel fixed and random effects. ACCD = f (INSD, DET, LIQ, LTA, PFP, PFI, PBQ, error term) With;  ACCD : The magnitude of discretionary accruals measured by the absolute value of discretionary accruals from equation (4);  PFP: pension funds ownership;  PFI: investment funds ownership;  PBQ: banks ownership;  INSD: managerial ownership;  DET: the total debt of total assets;  LIQ: current assets divided by current liabilities;  LTA: the logarithm of total assets;  α i, β i, δ i,: the model parameters to estimate;  u, v, w: error terms.

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III. RESULTS AND DISCUTIONS 3.1. The impact of different institutional ownership on the accruals management Assuming that the effect of independent variables on the endogenous variable is linear and that the available data are panel data, we can specify the following econometric equation:

The results of equation (5) regression by the panel fixed effects method are presented in the following table: Table I Regression results of equation (5) The dependent variable: the discretionary accruals Explanatory Variables

Coefficients

0.0027 -0.000007 0.0009 0.000063 -0.000024 -0.017 00000009 0.0005 Hausman = 24.06 Prob = 0.0011

0.56 -0.01 4.41 *** 2.26 *** -0.96 -9.16 *** 0.18 1.47 F = 38.41 Prob F = 0

(T-Student) (*) Indicate significance at the 10% (**) Indicate significance at the 5% (***) indicate significance at the

   

(T-Student)

Constant PFP PFI PBQ INSD DET LIQ LTA Within R 2 = 0.35 Between R 2 = 0.09 Overall R 2 = 0.10

3.1.1. Role of pension funds

Pension funds ownership doesn't affect the earnings management by discretionary accruals. We therefore reject our hypothesis. Thus, despite their activism and their long-term investment horizon, pension funds can not limit the earnings management. So, to reduce monitoring costs, pension funds play a stowaway role.

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Investment funds have a positive influence on the level of earnings management. [26] suggest that investment funds have a short term investment horizon. Managers of investment funds sell their detention following the decline in short-term performance. Thus, their presence in the firm's capital encourages managers to manage results upward. [27] noted that following the increase in the level of earnings management of 10%, investment funds limit their holding in the company of only 0.7%.

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ACCDit = α0 + α1 INSDit + α2 DETit + α3 LIQit + α4 LTAit + α5 PFPit + α6 PFIit + α7 PBQit+ + uit (5)

3.1.2. Role of investment funds

3.1.3. Role of Banks

The participation of banking institutions in the capital has influenced positively the level of earnings management by discretionary accruals. Banks are sensitive to leadership decisions [2]. In fact, in addition to their investment relationship with the firm, they generally establish a business relationship with the managers. They often play the role of shareholder and creditor at a time. This dependence vis-à-vis the company, place them in a difficult position when trying to control managers. Therefore, banks are reluctant to oppose the decisions of leaders even those that are harmful to the interests of shareholders. Thus, they incite managers to manipulate results through discretionary accruals. 3.1.4. Control variables effects Our assumption that the managerial ownership limits manipulation of the results is infirmed. Indeed, the variable "INSD" doesn't influence earnings management through discretionary accruals. Similarly, the liquidity and the size don't have an influence on the earnings management. Thus, although the weak of liquidity level and the big size of the firm, earnings management level doesn't change. However, the variable "DET" has influenced negatively the earnings management practice. So, we infirmed our hypothesis that more the ratio of debts increases more the possibility to manipulate results to rape contracts of debts increases.

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The dependent variable: the discretionary accruals

3.2. The impact of the informational environment of firms on the institutional investors' behaviors regarding earnings management 3.2.1. The firms surveyed belong to the S & P 500 stock index ACCDit = β0 + β1 INSDit + β2 DETit + β3 ROAit + β4 LTAit + β5 PFPit + β6 PFIit + β7 PBQit + vi (6)

Explanatory Variables Constant PFP PFI PBQ INSD DET LIQ LTA R2Within = 0.43 R2Between = 0.05 R2 overall = 0.03

0.012 -0.0004 0.00012 0.00011 -0.00007 -0.02 0.00008 -0.00008

(T-Student) 1.37 -1.49 3.57 *** 0.96 -0.90 -5.47 *** 0.15 -0.13

Hausman =11.72 Prob = 0.11

F = 64.24 Prob F = 0

(T-Student) (*) Indicate significance at the 10% (**) Indicate significance at the 5% (***) indicate significance at the 1%

   

Coefficients

3.2.2. The firms surveyed are not belonging to the S & P 500 stock index

ACCDit = δ0 + δ1 INSDit + δ2 DETit + δ3 LIQit + δ4 LTAit + δ5 PFPit + δ6 PFIit + δ7 PBQit + wit (7)

The regression results of equation (7) by the method of panel random effects are presented in the following table: Table III Regression results of equation (7)

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Coefficients

Constant PFP PFI PBQ INSD DET LIQ LTA Within R 2 = 0.14 Between R 2 = 0.07 Overall R 2 = 0.08 (Z)

0.006 0.00003 -0.0000007 0.00011 -0.00002 -0.007 -0.00001 0.0002 Hausman = 10.44 Prob = 0.16

2.81 *** 0.35 -0.31 3.99 *** -0.81 -3.64 *** -0.16 1.11 F = 15.41 Prob F = 0

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The regression results of equation (6) by the method of panel fixed effects are presented in the following table: Table II Regression results of equation (6) The dependent variable: the discretionary accruals

Explanatory Variables

   

(*) Indicate significance at the 10% (**) Indicate significance at the 5% (***) indicate significance at the 1%

3.2.3. The changing of informational environment results analysis

The estimation of equation (6), where firms surveyed belong to the S & P 500 stock index, has shown that investment funds have a positive influence on the level of earnings management, pension funds and Banks do not affect earnings management through discretionary accruals. However, the estimation of equation (7) for firms that do not belong to the S & P 500 stock index has shown no significant effect of pension funds and investment funds on the level of earnings management. Nevertheless banks exerted a positive effect. So, our hypothesis of the relevance of the information environment of firms in explaining the behavior of institutional investors is supported in the case of investment funds and banks. The passivity of pension funds in the S & P 500 companies is explained by their preference to play stowaway role. In fact, the leaders of these companies are generally subject to an effective control by various stakeholders. However, the passive behavior of investment funds in companies that do not belong to the S & P 500 seems to be surprising since these institutions do not establish business relationships with the managers. 3.3 Conclusion

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[7] B.J. Bushee, Do institutional investors prefer near-term earnings over long run value?. unpublished, University of Chicago, 1999. [8] M. Lang and M. Mc Nichols, Institutional trading and corporate performance, unpublished n°1460, Stanford University, Graduate School of Business, 1998. [9] P.S. Bhattacharya and M. Graham, Institutional ownership and firm performance: evidence from Finland, unpublished, Deakin University, Australia, 2007. [10] L. Tihanyi, R.A. Johnson, R.E. Hoskisson and M.A. Hitt, Institutional ownership differences and international diversification: the effects of boards of directors and technological opportunity, Academy of Management Journal, 2003, vol. 46, n°2, pp. 195-211. [11] S. Mitra and W.M. Cready, Institutional stock ownership, accruals management and information environment, Journal of Accounting Auditing and Finance, 2005, vol. 20, n°3, pp. 257-286. [12] A. Zouari and I. Rebaï, Institutional ownership differences and earnings management : A neural networks approach, International Research Journal of Finance and Economics, 2009, vol. 34, pp. 42-55. [13] J.J. Jones, Earnings management during import relief investigation, Journal of Accounting Research, 1991, pp. 193228. [14] R. Sloan, Do Stock prices fully reflect information in accruals and cash flows about future earnings? The accounting Review, 1996, vol. 71, pp. 289-316. [15] P.M. Dechow, R.G. Sloan and A.P. Sweeney, Detecting earnings management, The Accounting Review, 1995, vol. 70, pp. 193-225. [16] L. Gillan and L.T. Starks, Corporate governance proposals and shareholder activism: the role of institutional investors, Journal of financial Economics, 2000, vol. 57, pp. 275-305. [17] J. Pound, Proxy contests and the efficiency of shareholder oversight Journal of Financial Economics, 1988, vol. 20, PP. 237-265. [18] B. Black, Agents Watching agents: the case for institutional voice, Journal of Applied Corporate Finance, 1992, pp. 19-32. [19] R.J. Gilson and R. Kraakman, Reinventing the outside director: an agenda for institutional investors, Stanford Law Review, 1991, vol. 43, pp. 863-906. [20] A. Khorana, Top management turnover: an investigation of mutual fund managers, Journal of Financial Economics, 1996, vol. 40, pp. 403-427. [21] D. DelGuercio and P.A. Tkac, The determinants of the flow of funds of managed portfolios: mutual funds versus pension funds, unpublished, University of Oregon Eugene, 2000. [22] M. DeFond and R. Jiambalvo, Debt covenant violation and manipulation of accruals, Journal of Accounting and Economics, 1994, vol. 17, pp. 145-176. [23] A. Sweeney, Debt-covenant violations and managers’ accounting responses, Journal of Accounting and Economics, 1994, pp. 281-309.

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Our research idea originates from a literature review of previous studies. By referring to the results of these studies, we determined our basic assumptions that address the effect of participation of institutional investors in the capital on earnings management [28], [11], [6], [29]. The present work has as objective to verify if institutional investors are able to limit the manipulation of results by the managers. The econometric analysis of the relationship between different institutional investors and the level of earnings management, on a panel of U.S. firms observed during the period 2003-2005, shows distinct behavior of institutional investors towards the manipulation of results. The influences of these investors vary with the type of institution studied. The result indicates that pension fund following passive behaviors despite their independence from the managers. However, investment funds and banks incite the managers to manipulate earnings through discretionary accruals. The empirical validations concerning information environment shows that, excluding pension funds, institutions studied have distinct behaviors in both categories of firms (S&P 500 versus non S&P 500). These results imply that the informational hypothesis is confirmed for the case of investment funds and banks. References

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[24] C. Hessel and M. Norman, Financial characteristics of neglected and institutionally held stocks, Journal of Accounting, Auditing and Finance, 1992, vol. 7, pp. 313-334. [25] V.M. Cready, Determinants of relative investment for stocks, Journal of Accounting and Financial, 1994, vol. 10, pp.487-507. [26] S.L. Jones, D. Lee and E. Weis, Herding and feedback trading by different types of institutions and the effect on stock prices, 1999, unpublished. [27] A. Shang, when executives are timing the market: portfolio decision and earnings management, unpublished, Havard University, 2003. [28] Chung, M. Firth and J.B. Kim, Earnings management, surplus free cash flow, and external monitoring, Journal of Business Research, 2005, vol. 58, pp. 766-776. [29] S. Wahal and J.J. MC Connell, Do institutional investors exacerbate managerial myopia? Journal of corporate Finance, 2000, n째6, pp. 307-329.

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