The Earnings

This paper studies the impact of institutional shareholdings on earnings management activities of their portfolio firms.

If you have a pension plan at work, a mutual fund or insurance, then you are actually benefiting from the expertise of institutional investors. Some other examples of institutional investors include banks, labour union funds and finance companies. Companies with poor earnings prospects will typically have lower share prices than those with good ones.

Earnings are the most important item in financial statements. Earnings management describes sensible and legal practices of a well-managed business that delivers value to shareholders. A number of euphemisms have been used to describe earnings management activities, among which are; income smoothing, financial statement manipulation, window dressing, accounting hocus-pocus, and juggling the books.

This paper studies the impact of institutional shareholdings on earnings management activities of their portfolio firms. A final sample consisting of 94 top firms on the Bursa Malaysia, based on market capitalization as at 31 December 2007, was selected. This paper uses the magnitude of discretionary accruals as the proxy for earnings management. Discretionary accruals refer to non-obligatory expenses/assets that have yet to be realized but recorded within the accounting system. An example of this would be an anticipated bonus for management.

The paper measures the aggregate of institutional ownership, the percentage of shareholdings of the five top institutional investors which are further divided into two categories: pressure-sensitive and pressure-insensitive institutional investors. Pressure-sensitive institutional investors are those with an existing or potential relationship with the firm, consisting of percentage of the ownership by banks and insurance companies. Pressure-insensitive institutional investors are those with no business relationship with the firm, consisting of the percentage of shareholdings by unit trusts, pension funds and state-owned institutions.

Data were collected over a six-year period of time. The year when it started was also the time when all of the listed companies in Bursa Malaysia began to adopt the Malaysia Code on Corporate Governance (MCCG) requirements as a mandatory reporting in the annual reports, focusing on transparency and accountability.

The results show that only Malaysia Shareholders Watchdog Group (MSWG) institutional shareholdings are effective in mitigating self-serving earnings management behaviour of their portfolio firms. Within MSWG shareholdings, Permodalan National Berhad (PNB) is the most effective institutional shareholder in mitigating opportunistic earnings management behaviour.

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.

Still, the desire to put the best face on financial statements isn't exactly a new development. After all, everybody wants to tell a good story.

Rashidah Abdul Rahman,
Accounting Research Institute, Universiti Teknologi MARA, Malaysia

Azlina Abdul Jalil,
Faculty of Business and Accountancy,
University of Malaya, Kuala Lumpur, Malaysi

Published: 19 Mar 2012

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Institute of Research, Development and Commersialisation (IRDC) Universiti Teknologi MARA (UiTM) Shah Alam, 50450 Shah Alam Selangor Malaysia

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