Institutional investors and earnings management: Malaysian evidence

Purpose - The purpose of this paper is to study the impact of institutional shareholdings on earnings management activities of their portfolio firms. Design/methodology/approach - Using a final sample of 94 top firms on the Bursa Malaysia based on market capitalization as at 31 December 2007, this paper uses the magnitude of discretionary accruals as the proxy for earnings management. The paper measures the aggregate institutional ownership percentage of shareholdings of the five top institutional investors which are further divided into two categories: pressure sensitive consisting of percentage ownership by banks and insurance companies; and pressure insensitive institutional investor consisting of percentage shareholdings by unit trusts, pension funds and state-owned institutions. Data were collected over a six-year period from 2002 to 2007. The year it started was also when all the listed companies in Bursa Malaysia started adopting the MCCG requirements as mandatory reporting in annual reports. Findings - The results show that only Malaysia Shareholders Watchdog Group (MSWG) institutional shareholdings are effective in mitigating self-serving earnings management behavior of their portfolio firms. Within MSWG shareholdings, Permodalan National Berhad (PNB) is the most effective institutional shareholder in mitigating opportunistic earnings management behavior. Overall, the findings suggest that ownership may not be enough to mitigate earnings management. Firms may have to engage in shareholder activism such as through proxy voting and establishing direct dialogues with management in order to preserve the value of their investments. Research limitations/implications - One of the limitations in this study is measurement error which is a critical problem for studies on earnings management. Hence, this study inherits all the limitations of the Jones model although it is noted that it and the modified Jones model are extensively used in earnings management literature. Overall, this study provides empirical evidence to assess the merits of calls for institutional investors to play a greater role in portfolio firms' corporate governance practice in Malaysia. In essence, the results from the study provide evidence that ownership alone is not enough and institutional investors need to be involved in shareholder activism in order to be effective as an external monitor. In other words, by engaging in shareholder activism, institutional investors would be better able to safeguard the value of their investment. Moreover, the size of their shareholdings should provide powerful incentive for them to monitor their investee firms. Originality/value - This is the first published paper that focuses on institutional investors and earnings management in Malaysia, as previous studies have focused more on developed countries. This study aims to provide empirical evidence on the effectiveness of institutional investors in mitigating opportunistic earnings management, in order to ascertain their generalizability to developing countries like Malaysia.