Do Income Smoothing Practices Explain the Lower Earnings-Price Ratio of Japanese Firms Compared to Those of the U.S. Firms?

Abstract

This study examines the variation in earnings-price ratios across Japanese and U.S. firms. The earnings-price ratio is one of the indicators often used by investors to determine their trading strategy. Previous literature document that Japanese firms have consistently lower earnings-price ratios than U.S. firms even though the earnings of Japanese firms have been adjusted to the U.S. GAAP. The objective of this study is to show that Japanese firms engage in income smoothing practices that stabilize earnings, thereby increasing Japanese investors’ willingness to pay higher prices for Japanese stocks. Comparing the income smoothing index and proportion of firms identified as smoothers shows that the intensity of Japanese firms practicing income-smoothing is greater than that of U.S. firms. The results also show that income-smoothing index is significant in explaining the cross-sectional variation of earnings-price ratios for Japanese firms but it is not significant for U.S. firms. Two potential explanations for the results of U.S. firms are as follows. First, income smoothing is not practiced widely across firms in the U.S. Therefore, the variation of income smoothing does not explain the variation in the cross-sectional earnings-price ratios. Second, even if U.S. firms practice income smoothing, the investors are aware of it and do not take earnings figures literally.Another results show that controlling for income smoothing does not eliminate the differences in the earnings-price ratios of the Japanese and U.S. firms. It is appropriate to conclude that although income smoothing plays a role in explaining the variations of earnings-price ratios across Japanese firms, it is not the only factor that contributes to the differences in the earnings-price ratios of Japanese and U.S. firms. Other factors may play a role which are either country-specific (such as inflationary expectations, tax regimes) or firm-specific (such as quality of earnings, real returns) as suggested by Brown (1989). The overall results are consistent across samples.

Corporate governance and income smoothing in China

“…The basic logic is that if the variability of sales is greater than the variability of income, then the firm is considered to artificially smooth income. Several recent studies (Ashari et al, 1994;Michelson et al, 1995;Carlson and Bathala, 1997;Kusuma, 2005) have used this coefficient of variation model to determine the presence of income smoothing. Two measures of income are examined in this study.…”

“…It seems that Chinese firms have higher income-smoothing intensity than their counterparts in Japan, Singapore and the USA where 11.5, 35 and 40 percent of firms were reported as income smoothers, respectively (Kusuma, 2005;Ashari et al, 1994;Michelson et al, 1995).…”

Investigating Income Smoothing: Empirical Evidence From Serbian’s Hotel Companies

“…Although this misleading of users of the financial statements at first appear to have a negative effect, positive effects of this type of earnings management exist (Thu, & Khuong, 2017). Kusuma (2005) stands out that managers know that investors prefer smoothed income numbers for several reasons: 1. smoothed income numbers reduce the estimate of various claimants of the company about the volatility of its underlying earnings process and thereby reduce the assessment of the probability of bankruptcy, 2. income smoothing reflects the accuracy of the manager's knowledge of the company's future performance, 3. investors hate shocks because shocks in earnings forecasts increased investors' risk. The purpose of income smoothing is as follows (Alexandri, & Anjani, 2014):…”