The Effect of Shareholder Rights and Insider Ownership on Earnings Management

This paper examines whether shareholder rights, a fundamental governance mechanism that grants shareholders the rights to replace managers, can restrain earnings management. The disciplinary power associated with strong shareholder rights can deter managers from using income-increasing accruals to manage earnings. However, stronger shareholder rights also lead to less job security to managers and put greater pressure on them to perform well in the short term, providing them with an incentive to manage the earnings upward. Using the comprehensive shareholder rights measure as constructed by Gompers et al. (2003), we find that strong shareholder rights are associated with less income increasing discretionary accruals. We also examine the interactions between shareholder rights and managerial ownership, another important governance factor. Our results show that the disciplinary role of shareholder rights in restraining aggressive reporting becomes less significant in the presence of higher level of insider ownership, suggesting that an entrenchment effect from the ownership can insulate managers from shareholder discipline.