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Asian Review of Financial Research Vol.28 No.1 pp.109-133
Institutional Investor Horizon and Its Influence on the Effectiveness of Internal Control
Jeongsun Yun Associate Professor, School of Business Administration, Kookmin University
Yura Kim* Assistant Professor, School of Business Administration, University of Seoul
Key Words : Institutional Investors,Internal Control,Investment Horizon,Management Discipline,Material Weakness


Institutional investors have increased their presence in financial markets (Gompers and Metrick, 2011), securing positions as dominant players by becoming actively involved in firms' operations. Active institutions influence the board of directors and management, thus bringing about changes in corporate policies, influencing governance, and affecting the quality of financial reporting and corporate disclosure. While some studies have found that institutional investors actively monitor firms' management and mitigate managerial agency problems (e.g., Kaplan and Minton 1994; Chung, Firth, and Kim 2002), other studies have argued that institutional investors seeking to maximize personal benefits influence firm management, prompting managerial opportunism such as earnings management (e.g., Agrawal and Knoeber, 1996; Black, 1998; Parrino, Siasand, and Starks, 2003). Recent papers have focused on the investment horizons of institutional investors, such that long-term institutional ownership improves corporate governance (Lee and Chung, 2012), exhibits less tax avoidance (Khurana and Moser, 2013), and increases investment (Derrien, Kecskés, and Thesmar, 2012). Firms with large portions of transient institutions are more likely to reduce research and development expenditures (Bushee, 1988) and get lower premiums at acquisitions (Gasperet al., 2005). In Korea, domestic institutional investors exhibit short-term trading behavior and fail to contribute to the increase in earnings quality (Cheon, 2003). Likewise, Kwon (2007) classified institutional investors into four types: financial institutions, security companies, insurance companies, and foreign investors. He found that foreign investors and insurance companies improved earnings quality, whereas other local institutional investors tended to focus on short-term profits and did not contribute to the increase in earnings quality. Research has indicated that short-term investors have less incentive to engage in improving a firm's long-term performance, but use their informational advantage to enjoy the personal benefits of short-term stock trading (Park and Song, 2014). Thus, the monitoring role played by institutional investors is closely related to their investment behavior. In this paper, we study the effect of the investment horizons of institutional investors on the effectiveness of internal control systems over financial reporting. Specifically, we examine how the investment horizons of institutional investors effect the disclosure of material weaknesses in internal control over financial reporting under Section 404 of the Sarbanes-Oxley ACT of 2002. We measure institutional investors' portfolio turnover using churn rate, as introduced by Gasper et al. (2005), which measures how frequently an institution buys and sells its stocks. Our measure of a firm's investment horizon is the weighted average of the total portfolio churn rates of its institutional investors. We find that institutional investor ownership decreases both the frequency and the number of material weaknesses under the SOX 404. However, this positive relationship is weakened as institutional investors' investment horizon for each firm is short-term. These findings suggest that institutional investors' influence over the effectiveness of internal control is closely dependent on their investment horizons. Our results contribute to the literature that the role of institutional investors in enhancing internal control systems is closely related to institutions' investment horizons.
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