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| Internal Control and the Governance Effect of Heterogeneous Institutional Shareholding |
| LI Wanfu, ZHAO Qingyang, ZHANG Huai, XIE Yong
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School of Accounting, Nanjing University of Finance & Economics;
Nanyang Business School, Nanyang Technological University;
School of Economics and Management, Fuzhou University |
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Abstract Institutional investors in China rely on professional teams, information, and capital advantage to actively participate in corporate governance, and they accordingly play an important role in the healthy development of the capital market.However, due to differences in trading styles, trading objectives, and information processing abilities, heterogeneous institutional investors may have different governance effects, and the relationship between their governance effects and internal corporate governance mechanisms may be different. Although a number of studies offer in-depth research on the governance effect of institutional investors, it is still rare to see studies of how the governance effect of heterogeneous institutional investors is affected by internal control, part of firms' internal governance mechanism. It is necessary to clarify the relationship between internal control and the governance effect of heterogeneous institutional investors to improve their governance effect and promote the healthy development of capital markets.
Based on China's capital market data, we examine the governance effect of heterogeneous institutional investors on earnings management under different internal control qualities. The results show that compared to non-local or short-term institutional investors, local or long-term institutional investors are more conducive to improving accruals quality and reducing earnings noise. When firms have material internal control weaknesses, the governance effect of local or long-term institutional investors in improving accrual quality and decreasing earnings noise is significantly weakened. The governance effect of heterogeneous institutional investors is more affected by internal control weakness in non-state-owned firms than in state-owned firms. When firms have material internal control weakness over financial reporting, the governance effect of heterogeneous institutional investors is significantly weaker. These findings imply that the relationship between institutional investors' governance and internal control is complementary rather than substitutional. This complementary relationship is primarily driven by internal control weakness over financial reporting.
In addition, this paper explores the impact of heterogeneous institutional investors on corporate governance. The results indicate that although local and long-term institutional investors have different governance effects on earnings management, there are some commonalities. In particular, the governance effects of local, long-term and local long-term heterogeneous institutional investors in suppressing earnings manipulation are complementary to internal control, and information is likely to be the cause of complementarity.
Our study contributes to the literature in three ways. First, in contrast to the literature, we consider the shareholding period and geographical location when distinguishing between heterogeneous institutional investors, and we divide them into local, long-term, and local long-term institutional investors. We investigate heterogeneous institutional investors' performance in governing earnings management under different internal control levels and different types of internal control deficiencies. Second, by demonstrating the relationship between internal control and the governance effect of heterogeneous institutional investors, this paper improves our understanding of the mechanism of the influence of heterogeneous institutional investors' shareholdings on corporate governance. It thus provides empirical evidence and guidelines for external regulators who aim to strengthen institutional investor management from the micro perspective of internal control and enriches the literature on the governance effect of institutional investors. Lastly, this paper explores the governance effect of heterogeneous institutional investors under different property rights and its relationship with internal control.
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Received: 26 March 2018
Published: 09 March 2020
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