Taking a Long View: Investor Trading Horizon and Earnings Management Strategy

Abstract

This paper studies how the investment horizon of institutional investors affects firms’ earnings management strategies. We find that firms with long-term investors are more likely to manage earnings through real activities manipulation than through accruals. The impact of the investor trading horizon on real activities manipulation is stronger in smaller firms, when market uncertainty is high, when long-term institutional investors experience low fund flows, and as the proportion of long-term investor increases. Overall, the evidence suggests that firms manage earnings by adjusting long-term operating decisions rather than by short-term accounting manipulation when they are largely owned by long-term investors facing performance pressures. As a consequence, firms that engage in high real activities manipulation and are held by long-term investors experience better operating performance and long-run stock returns. Our identification strategy exploits the Russell 2000 Index as an instrumental variable for the investor horizon and confirms that our results are robust to endogeneity concerns.