Taking a long view: Investor trading horizon and earnings management strategy

Abstract

AbstractThis paper studies how the investment horizon of institutional investors affects firms' earnings management strategy in terms of trade‐off decisions between accrual management and operational adjustment. We find that when overall earnings management motives are held fixed, firms in which long‐term investors hold large stakes are more likely to manage earnings by adjusting operational decisions than by manipulating accruals. The preference for real earnings management is more pronounced when long‐term investors face performance pressures and when they have a strong influence on managers. We further document that real earnings management helps smooth earnings, and the future adverse consequences of operational adjustment are relatively less severe for firms with a greater proportion of long‐term investors than for those with more short‐term investors. Our findings are robust to the endogenous choice of ownership structure. Overall, the evidence suggests that firms choose earnings management methods to meet the earnings expectations of institutional investors, who have different earnings target windows.