On the Association between Institutional Investors and Earnings Quality: Does Investor Protection Strength Matter?

The aim of this study is to examine (i) whether long-term institutional investors are associated with better earnings quality at the international level, and (ii) whether this relationship varies with the strength of investor protection. Using firm level data from 44 different countries, we document a positive association between strategic institutional ownership and firm earnings quality. More importantly, we find that the documented association is stronger in countries with higher quality investor protection. We show that this association is not solely due to institutional investors investing in firms with high earnings quality. We conclude that institutional investors can play a better monitoring role in countries with strong investor protection. This study makes several contributions to the literature. First, while there is a large body of research on institutional investors and earnings quality in the U.S, international studies are scarce. The evidence from the U.S. remains parochial without the ability to generalize to other markets. Second, we add to the literature on investor protection, by providing evidence that institutional investors play a better monitoring role in countries with stronger investor protection. Third, Leuz et al. (2003) find that earnings management is lower in countries with strong investor protection, they attribute their findings to the lower incentive to manipulate earnings in such countries. While their results suggest that the degree of investor protection shapes managers incentive to manipulate earnings, ours suggest that it also shapes the ability of institutional investors to play their monitoring role.