Blockholder Heterogeneity and Financial Reporting Quality

The following post comes to us from Yiwei Dou of the Department of Accounting, Taxation & Business Law at New York University; Ole-Kristian Hope, Professor of Accounting at the University of Toronto; Wayne Thomas, Professor of Accounting at the University of Oklahoma; and Youli Zou of the Accounting Area at the University of Toronto.

An issue of considerable interest to accounting researchers is the association between shareholders and firms’ financial reporting quality (FRQ). In our paper, Blockholder Heterogeneity and Financial Reporting Quality, which was recently made publicly available on SSRN, we examine a specific type of shareholder, blockholders, because (1) they offer a sample of shareholders that are expected to have a significant impact on firms’ financial reporting decisions and (2) we are able to track individual blockholders and their association with FRQ. As discussed in more detail below, these two sample design features allow us to provide a test of the extent to which (large) shareholders influence FRQ. Blockholders also provide an interesting and economically important sample because of their large presence in U.S. capital markets in recent years.

There are two opposing predictions on the expected association between blockholders and FRQ. First, a large body of research suggests that an important role of shareholders is monitoring managerial behavior. Managers, when left unmonitored, are more likely to make suboptimal decisions, manage earnings, or commit fraud (e.g., Beasley, 1996; Bertrand and Mullainathan, 2003; Leuz, Nanda, and Wysocki, 2003; Hope and Thomas, 2008). While all shareholders have the responsibility to monitor managerial activities, the benefits of doing so by any individual shareholder are proportional to the percentage of shares owned (Jensen and Meckling, 1976; Shleifer and Vishny, 1997). When ownership is widely dispersed, it is economically less desirable for any individual shareholder to incur significant monitoring costs, because she will receive only a small portion of the benefits. Shareholders are willing to incur necessary monitoring costs only if they have a large enough ownership stake (such as blockholders). Thus, because of their monitoring role, blockholders may serve to increase firms’ FRQ.

An alternative view is that blockholders reduce FRQ by exerting significant capital market pressures on managers to meet short-term earnings benchmarks. Managers may be more inclined to manipulate performance to meet earnings benchmark to avoid market penalties (i.e., investors “voting with their feet”) or prevent shareholder activism, both of which could be more pronounced when large shareholders are present. Furthermore, large shareholders may benefit directly from earnings management through the firm creating more efficient contracts (Dye, 1988; Dou, Hope, and Thomas, 2013), reducing the cost of external financing and debt covenant violations (DeFond and Jiambalvo 1994; Hribar and Jenkins, 2004; and Jiang, 2008), extracting private benefits from smaller shareholders (Shleifer and Vishny, 1997), and selling higher-priced stocks to second-generation shareholders (e.g., Barth, Elliott, and Finn, 1999; Bartov, Givoly, and Hayn, 2002). Thus, certain large shareholder may be less willing to restrict managerial discretion in financial reporting, resulting in lower FRQ.

Because certain blockholders may positively affect FRQ while others have a negative effect, treating all blockholders as a homogeneous group could lead to relatively weak tests of investors’ influence on FRQ. This is perhaps why prior research (discussed more in the next section) offers mixed evidence on the extent to which large shareholders affect FRQ. To address heterogeneity across blockholders, we initially classify blockholders into the following broad types: (1) activists and pension funds, (2) banks and trusts, (3) corporations, (4) hedge funds, (5) insurance companies and money managers, (6) mutual funds, (7) venture capitalists and LBOs, and (8) individuals. To the extent blockholders’ influence on FRQ can be generalized to their type, we expect type indicators to be associated with several measures of FRQ (absolute value of abnormal accruals, real earnings management, and restatements). Our evidence shows, however, only moderate explanatory power across blockholder types, offering the conclusion that investors aggregated into these groups have little impact on FRQ.

Next, and the primary focus of our study, we take advantage of our hand-collected sample of all individual blockholders of S&P 1500 firms to test the impact of investors on FRQ. Manually collecting data on individual blockholders from annual proxy statements for the years 2002–2009 involves significant data cleaning and checking for double counting. Our final sample consists of 23,555 blockholder-firm-year observations for 8,409 firm-years, with 574 uniquely identified blockholders.

Blockholders have heterogeneous beliefs, skills, and preferences and influence corporate policies through different channels and to various extents. These channels include direct communication with management, insider positions (management or director), and changes to corporate governance practices such as board characteristics. Thus, it is perhaps not surprising that research shows blockholders individually affect firms’ operational decisions (Cronqvist and Fahlenbrach, 2009). Recent research in accounting also suggests that individual managers affect FRQ (Bamber, Jiang, and Wang 2010; Ge, Matsumoto, and Zhang 2011; Yang, 2012). Combining these two streams of research, we expect FRQ to vary across individual blockholders, even within blockholder type. We find evidence that individual blockholder effects substantially increase the explanatory power across each of our FRQ measures. Additional tests support the role of blockholders in influencing FRQ rather than blockholders selecting firms based on their FRQ.

We also examine the implications of blockholders’ effect on FRQ. We find that the presence of blockholders associated with high FRQ leads to more persistent earnings and greater price reaction to earnings news. Thus, the influence of (large) investors on FRQ leads to consequences that are of importance to capital market participants.

Finally, we explore the sources of the individual blockholder effects. Motivated by prior research, we consider the following characteristics: being the largest (or dominant) shareholder, holding insider positions (i.e., having a representative on the board of directors or as a corporate officer), being an aggressive monitor of management, being located geographically close to the firm in which they invest, and holding a stake more than three years. Although some of these characteristics are statistically significant, overall our results suggest that the explanatory power of these observable characteristics is moderate. These findings suggest that a significant proportion of blockholder heterogeneity remains to be explained, and thus there is ample opportunity for future research to understand the mechanisms through which shareholders impact financial reporting.

The full paper is available for download here.

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