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Prior studies argue that stable shareholders do not encourage firm managers to manage their earnings to achieve short-term earnings goals. They also state that firm managers with stable shareholders have an incentive to report smooth earnings to maintain long-term relationships with such shareholders. We focus on cross-shareholdings and stable shareholdings owned by financial institutions as stable shareholdings in Japan, and investigate the effect of these ownership structures on earnings management patterns. Specifically, we hypothesize that stable shareholdings are positively associated with the informational components of earnings smoothing. Consistent with our hypothesis, we first find that as stable shareholdings increase, managers are more likely to conduct earnings smoothing that provides useful information to stable shareholders. Further, our additional analysis shows that stable shareholdings reduce incentives for managers to cut discretionary expenditures to meet short-term earnings benchmarks, implying that stable shareholdings could reduce the possibility of a myopic problem. These results suggest that managers with stable shareholdings tend to report smoother and less volatile earnings, and do not tend to pursue earnings management to attain short-term earnings targets.

To test the implication of Watts’ (2003) argument that accounting conservatism increases the efficiency of executive compensation contracts, we investigate the relation between accounting conservatism and earnings‐based executive compensation contracts in Japanese firms. We focus on Japanese executive compensation practices because the demand for accounting conservatism is likely to be greater for Japanese than for US firms given the predominance of earnings‐based executive compensation contracts and relatively weak corporate governance of compensation contracts in Japan. We also investigate how the quality of the ex‐ante information environment affects the relation between accounting conservatism and earnings‐based executive compensation contracts. Consistent with our expectations, we find a positive relation between accounting conservatism and the compensation earnings coefficient. We also show that this positive relation is greater for firms with poor ex‐ante information environment. These results suggest that the demand for accounting conservatism is greater for firms that use more earnings‐based executive compensation contracts and have more serious ex‐post settling‐up problems.

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