Institutional Investors on Boards and Audit Committees and Their Effects on Financial Reporting Quality

Manuscript Type: Empirical Research Question/Issue: This study examines how the presence of representatives of institutional investors as directors on boards or on audit committees enhances financial reporting quality, reducing the probability that the firm receives qualified audit reports. We focus on directors who maintain business relations with the firm on whose board or committee they sit (pressure-sensitive directors). We also investigate the specific role of bank directors and examine their effects on financial reporting quality when they act as shareholders and directors. Research Findings/Insights: Our results suggest that institutional directors are effective monitors, which leads to higher quality financial reporting and, therefore, a lower likelihood that the firm receives a qualified audit report. Consistent with the relevant role of business relations with the firm, we find that directors appointed to both boards and audit committees by pressure-sensitive investors have a larger effect on financial reporting quality as it is more likely that the auditor issues an unqualified audit opinion. Nevertheless, when analyzed separately, only savings bank representatives on the board increase financial reporting quality. Theoretical/Academic Implications: The results confirm that board characteristics have an important influence on financial reporting quality, in line with the views that have been expressed by several international bodies. The findings also suggest that both researchers and policy makers should no longer consider institutional investors as a whole, given than directors appointed by different types of institutional investors have various implications on financial reporting quality, measured by the type of audit opinion. Practitioner/Policy Implications: This study makes its core contribution by empirically showing that directors appointed by different types of institutional investors have diverse implications on financial reporting quality. This evidence can be potentially helpful in providing a basis for regulatory actions, namely those aiming to influence the structure of the board of directors. The results have important implications for supervisors and regulators, who will benefit from an understanding of how the presence of directors on boards of savings and commercial banks in nonfinancial firms affects financial reporting quality in a bank-based system.