Narrow Results

This paper examines the association between institutional ownership and income smoothing through bank loan loss provisions for a sample of Japanese banks during the period 1991–1999. We find that as the percentage of institutional ownership of banks increases, income smoothing via loan loss provisions increases. Additional tests show that there is a significant positive relationship between the extent of income smoothing and the percentage ownership of banks by domestic financial institutions and affiliated (keiretsu) institutions. Consistent with the idea that foreign institutional holders do not play an important role in the corporate governance of Japanese banks, we do not find a significant association between foreign institutional ownership and the extent of income smoothing. Our results imply that institutional owners may play a different role in monitoring income smoothing during the recessionary period in Japan from the normal economic periods studied in most prior studies.

This paper examines the effect of income smoothing on information uncertainty, stock returns, and cost of equity. I show that income smoothing through both total accruals and discretionary accruals tends to reduce firms' information uncertainty, as measured by stock return volatility, analyst earnings forecast dispersion, and analyst earnings forecast error. Further, I provide evidence that stocks of income smoothing firms are priced with a premium. Controlling for earnings shocks and other firm characteristics, income smoothing firms have significantly higher abnormal returns around earnings announcement. In addition, I show that income smoothing reduces firms' implied cost of equity or expected returns. The result is more robust over short horizons up to two years.

In practice, it is observable that firms tend to smooth periodical earnings because periodical earnings are considered by capital markets as a proxy for firms' success, and therefore, are often operationalized by the respective compensation plans for managers. Considering financial hedging strategies such as purchasing financial derivatives, income smoothing can lead to a restricted use of financial derivatives even if it decreases firm value because the periodical changes of the value of financial derivatives possibly cause undesired volatilities in periodical earnings. In this paper, a deductive multi-period analytical decision model based on the capital market theory is presented to explain the influence of income smoothing on firms' hedging strategy. Thereby, principal-agent relations between a firm's investors and managers (decision makers) are assumed. Moreover, the decision model is applied to a real data set by conducting a sensitivity analysis. To our knowledge, this is the first paper to operationalize accounting constraints to determine how much a firm should hedge its risk exposure.