Regulatory Scrutiny and Foreign Institutional Ownership: A Cross-country Analysis

Institutional investors are known to underinvest in stocks of foreign firms, as referred to the “home bias puzzle” (French and Poterba, 1991; Coval and Moskowitz, 1999; Chan, Covrig, and Ng, 2005). This study explores the Public Company Accounting Oversight Board (PCAOB) international inspection program as an exogenous shock to the stringency of public auditor regulatory oversight. We examine whether a stricter auditor regulatory oversight alleviates the bias that institutional investors exhibit on foreign investments. Specifically, we focus on a sample of international firms that are audited by non-U.S. auditors and adopt a differences-in-differences (DiD) research design. We test whether these firms attract more foreign institutional ownership if their auditors are subject to PCAOB international inspection.

Prior studies find that PCAOB international inspections improve audit quality of foreign auditors (Lamoreaux, 2016; Fung, Raman, and Zhu, 2017; Krishnan, Krishnan, and Song, 2017). Literature in home bias has shown that better financial report quality and information environment play important roles in mitigating institutional investors’ bias towards domestic investments (Kang and Stulz, 1997; Dahlquist and Robertsson, 2001; Jeske, 2001; Young and Guenther, 2003; Ahearne, Griever, and Warnock, 2004; Bradshaw, Bushee, and Miller, 2004; Portes and Rey, 2005; Covrig, DeFond, and Huang 2007). As such, we predict that institutional investors will value the additional monitoring and improved audit quality brought about by PCAOB inspections and thus they will be more likely to hold stocks of foreign firms whose auditors are exposed to PCAOB inspections. In cross-sectional analyses, we intend to isolate whether and how the impact of PCAOB international inspection on foreign institutional ownership varies with the presence of a strong local audit oversight system, the strength of legal institutions and disclosure standards in firms’ home countries, and firms’ information environment. This study differs from extant PCAOB inspection literature by investing its impact on firms’ foreign institutional ownership, which is unexplored in prior studies. We complement and extend the recent evidence on the positive externality of PCAOB inspection. Finally, our study contributes the literature examining how accounting choice or accounting regulation impacts institutional investor home bias.