Abstract
This study analyzes the information contents of income smoothing behavior, especially the role of income smoothing behavior as a signal of future performance. What do smoothed earnings tell us about the future? To answer this research question, this paper focuses on earnings persistence and dividend policy based on two prior survey papers. These two issues (earnings persistence and dividend policy) are the foci of this study, based on Japanese managers’ responses to questions regarding their motivation for income smoothing. This paper provides two new pieces of evidence. First, income smoothing in the previous period relates positively to future earnings persistence. Second, firms that engage in more smoothing tend to pay more stable dividends in the future, even when we control for past dividend policy, fundamental factors, and corporate governance factors. These results indicate that income smoothing behavior is likely to reflect future stability of earnings performance. Income smoothing acts as a vehicle through which managers can reveal private information about future earnings persistence and future dividend policy. The empirical evidence supports the information view rather than a garbling view of income smoothing, and sheds light on the bright side of smoothed earnings rather than its dark side.
This article is reprinted from “Yusuka Takasu and Makoto Nakano, What do smoothed earnings tell us about the future? The Japanese Accounting Review, Volume 2, 1–32. 2012. Copyright © Research Institute for Economics and Business Administration, Kobe University.”
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Notes
- 1.
When asked why they smooth income, the top three answers among managers in the United States were that doing so (1) leads to perceptions among investors that the firm is not risky, (2) makes it easier for analysts/investors to predict future earnings, and (3) assures customers/suppliers that the business is stable (Graham et al. 2005).
- 2.
Shuto and Iwasaki (2012) found that a stable shareholder structure encourages managers to perform income smoothing in Japan. They focused on the determinants of income smoothing. Our study, in contrast, investigates both the economic consequences and signaling role of income smoothing.
- 3.
Although Nakano and Takasu (2011) analyzed earnings management in general situations, they did not focus on the income smoothing situation specifically.
- 4.
Note that there is little consensus regarding the reason why managers prefer stable dividends in Japan, despite their strong preference for stable dividends. This is one of the limitations of our research. Serita et al. (2011), however, provided a clue to interpreting this phenomenon. They showed that some institutional investors, specifically banks and pension funds, prefer stable dividends. If managers want to cater to the demands of these institutional investors, they might choose stable dividend policies. In particular, because Japanese firms are highly connected with a specific bank (i.e., main bank), managers might cater to the demands of that bank.
- 5.
Δfinancing item is the sum of the following items: change in short-term debt, change in commercial paper, change in current portion of bonds and convertible bonds.
- 6.
Δother allowance is the sum of the following items: change in allowance for doubtful accounts classified as fixed assets and change in long-term provision.
- 7.
This study uses discretionary accruals estimated from Kothari et al. (2005) model. This study focuses on income smoothing wherein proxies are calculated by considering the variability of earnings. Because Kothari et al. (2005) model uses ROA as an explanatory variable, the effect of earnings on discretionary accruals is, already and at least partially, removed from our main analyses. The results, however, remain unchanged even when we use alternative models, in particular Jones (1991) model and Dechow et al. (1995) model to calculate discretionary accruals.
- 8.
Tests are also performed using the gain/loss on the sale of marketable securities minus the median for the corresponding industry and year as RD. The results remain similar to those reported.
- 9.
To compute the after tax amounts, generally, 40 % is used as effective tax rate in Japan.
- 10.
In prior literature, normal asset sales are estimated to calculate abnormal asset sales (e.g., Gunny 2010). If a large part of RD is normal asset sales, our results might be misleading. We regard, however, this concern as a trivial one, because in the robustness checks where we assume only DAC to be the discretionary portion of NI, the results remain unchanged.
- 11.
This paper uses the industry codes of the Securities Identification Code Committee in Japan, which relate to 33 different industries.
- 12.
For example, assume an industry-year that includes three firms (A, B, and C). If A’s value of the proxy of Income-Smoothing (VNI/VPDI) is higher than those of the others and C’s value is lower than those of the others, we rank A, B, and C as 1, 2, and 3 respectively, and divide each ranking by the number of observations in the industry-year. Therefore, 1/3, 2/3, and 3/3 are the IS values of A, B, and C, respectively.
- 13.
Instead of NI t + 1, Tucker and Zarowin (2006) use the sum of net income from t + 1 to t + 3 as the dependent variable. Although we use the same variable as the dependent variable, the results remain unchanged.
- 14.
Even when unranked ROA t , unranked Growth t , and unranked VPDI t are used instead of Rank.ROA t , Rank.Growth t , and Rank.VPDI t , the empirical results remain unchanged.
- 15.
If clustering of the standard errors does not allow for the inclusion of all of our currently included year dummy variables, we combine at least two year dummy variables into one year dummy variable in order to estimate the regression.
- 16.
This criteria dramatically reduces the sample size. This is mainly because the calculation of our fourth income smoothing measure (see Sect. 5) requires current and past five years’ net income before accrual discretion and DAC (from year t − 5 to t) in order to calculate the measure for year t, and dividend policy measures (from year t + 1 to t +2) require both DPS t + 1 and DPS t + 2 in calculation.
- 17.
Following Ishikawa (2007), we adopt this criteria.
- 18.
Even when we skip criteria (9), the empirical results remain unchanged.
- 19.
The top and bottom 0.5 % of the regression variables are truncated twice [i.e., criteria (5) and (9)], not only to prevent outliers from affecting estimations of Regression (1), but also to obtain a large sample to test the hypotheses. To mitigate the effect of a change in the number of shares outstanding on dividends per share, criterion (8) is included. In addition, instead of using Rank.ROA t , Rank.Growth t , and Rank.VPDI t , to delete outliers, the ROA t , Growth t , and VPDI t values are used.
- 20.
Furthermore, we calculate the VIF in the logit regression of D_Stable t + 1. The results show that DIncrease t-1 has the highest VIF value (2.77). Considering the value of VIF under 10, there exists little concern about multicollinearity problem.
- 21.
When we analyze the relation between income smoothing measures that are based on DAC (i.e. IS2 and IS4, see also Sect. 5) and ROA persistence, the tenor of the results remains unchanged.
- 22.
In some model, observations’ number is not 15,890. This is because, in these models, some independent variables’ values can fit dependent variable values perfectly (e.g. observations whose DStable t-1 equal to one can fit DNothing t that equals to zero perfectly). Therefore, we have to drop these observations in the estimation.
- 23.
For example, Takasu (2012) attempts to figure out this puzzle. He uses cost of bank loans as a proxy for cost of capital. From his analysis, he finds an information asymmetry between a firm and capital providers plays a key role that determines the relation between income smoothing behavior and cost of capital.
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Takasu, Y., Nakano, M. (2014). What Do Smoothed Earnings Tell Us About the Future?. In: Ito, K., Nakano, M. (eds) International Perspectives on Accounting and Corporate Behavior. Advances in Japanese Business and Economics, vol 6. Springer, Tokyo. https://doi.org/10.1007/978-4-431-54792-1_2
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