Institutional Investors and Accounting Restatements
Abstract
This paper examines how institutional investors respond to accounting restatements. We show that transient institutional investors, defined as institutions with shorter investment horizons and higher portfolio turnover, significantly reduce their holdings in a restating firm at least one quarter prior to the quarter of the restatement. This result holds after controlling for factors such as return momentum, unexpected earnings, size, book-to-market, and the portfolio weight of the firm to the institution. We find no evidence that other types of institutional investors adjust their holdings in advance of accounting restatements, although all types of institutions reduce their holdings after the restatement announcement. We also show that the market reaction to accounting restatements for firms with high institutional ownership is more strongly associated with diminished company prospects (measured as revisions in analyst forecasts) and increased uncertainty (measured as changes in forecast dispersion) relative to firms with low institutional ownership. Finally, after controlling for return momentum and firm size effects, we show that institutional investors trade earlier than individual investors within the restating quarter. Overall, our results suggest that the sophistication of institutional investors enables them to anticipate potential accounting problems and adjust their holdings downwards prior to the restatement.