State-dependent Institutional Monitoring

Abstract

Background: This study whether the effectiveness of institutional monitoring varies with the economic conditions of emerging capital markets. Methods: We compute a proxy for total institutional ownership using trading volume data by investor type for Korea. Then, we analyze the impact of the proportion of institutional trading volume on corporate earnings management and, in particular, whether the association between the two varies with the economy’s expectation of market growth. Results: We find that the proportion of institutional trading is positively correlated with earnings management and that, in Korea, institutional investors reveal a strong preference for short-term investments, on average. This implies an increase in opportunistic earnings reporting by management to meet the earnings expectations of institutional investors. In Korea, the diminished effectiveness of institutional monitoring is more pronounced in the post-financial-crisis period, which is characterized by sluggish market growth. Thus, institutional investors’ long-term investment preferences and monitoring may be weakened because the costs of monitoring may outweigh its benefits. Conclusion: Overall, the results highlight that firms with a high proportion of institutional investors manage their earnings using accruals and, in a market with low growth prospects, less effective institutional monitoring increases opportunistic earnings reporting by management.