Stable Shareholdings, the Decision Horizon Problem and Earnings Smoothing

Abstract

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.

The Influence of a Company’s Ownership Structure on Upward Real Earnings Management

“…The results of tests coincide with Ding et al [19] and Bozec [46], and they confirm a U-shaped (but not inverted) relationship between ownership concentration and the magnitude of real earnings management as well. Taking into account the magnitude of ownership concentration, we confirm partially the efficient monitoring hypothesis (Dechow et al [5], Chin et al [18], Saona and Muro [43], Alves [44]) and the expropriation hypothesis (Jaggi and Tsui [6], Waweru and Riro [16], Hamid et al [17], Yang et al [39], Shuto and Iwasaki [40], Dempsey et al [41], and Francis et al [42]). In accordance with our results, we observed a negative correlation between managerial ownership and total real earnings management; therefore, we did not acknowledge Hypothesis H3.…”

“…In accordance with some research, an increased ownership concentration increases earnings management [16][17][18]. The positive relationship between ownership concentration and accounting earnings management has also been confirmed in other studies, including [39][40][41][42]. However, some research has maintained that more peculiar relationships exist between ownership concentration and earnings management [18].…”

Investment Horizons and Information

“…7 In contrast to LIO firms using less equity, SIO firms use less debt. This is consistent with Bushee (1998), Shuto and Iwasaki (2014), and Wahal and McConnell (2000) that institutional investors with more stable holdings prevent myopic R&D behavior of firms (e.g., reduce R&D expense to reverse an earnings decline), but those with a high portfolio turnover counter this effect. 8 When shareholders produce information, however, information asymmetry problems are mitigated and debt is therefore no longer that essential.…”

Sign reversal in the relationship between income smoothing and cost of debt

“…The primary contribution of this study is to provide novel evidence that the garbling effect of smoothing can dominate debt contract design, where the sign of the relationship between cost of private debt and earnings smoothing depends (predictably) on the threat of managerial private benefits consumption in the contracting environment. Our study directly addresses a call for additional research on the relationship between smoothing and cost of debt (Lang & Maffett, ), and contributes new evidence to the international literature that examines the causes and consequences of income smoothing in capital markets (e.g., Black, Sellers, & Manly, ; Lang, Lins, & Maffett, ; Leuz, Nanda, & Wysocki, ; Shuto & Iwasaki, ).…”