Institutional Ownership, Audit Choices and Quality: Evidence from Russell Index Reconstitutions

This paper investigates the monitoring effect of institutional investors on portfolio firms’ audit policy. We identify an exogenous discontinuity in institutional ownership around the Russell index threshold, and test the effect of instrumented ownership on firms’ audit choices and quality. We find that an exogenous increase in a firm’s institutional ownership significantly enhances its auditor committee effectiveness and increases the likelihood to appoint auditors with industry expertise. Meanwhile, the firm is less likely to have accounting restatements and to receive material internal control weakness opinions from external auditors. Auditors perceive firms with such improvements to have lower audit risk hence charge lower fees. Overall, the results suggest that institutional ownership increases firms’ demand for high audit quality.