Akinobu Shuto

Managerial Ownership and Accounting Conservatism in Japan: A Test of Management Entrenchment Effect

We examine the effect of managerial ownership on the demand for accounting conservatism in Japan. We find that within the low and high levels of managerial ownership, managerial ownership is significantly negatively related to the asymmetric timeliness of earnings, which is consistent with the implication of the incentive alignment effect. We also find a significant positive relationship between managerial ownership and the asymmetric timeliness of earnings for the intermediate levels of managerial ownership, as suggested by the management entrenchment effect. These evidences suggest the possibility that accounting conservatism contributes to addressing the agency problem between managers and shareholders. Copyright (c) 2010 Blackwell Publishing Ltd.

The Effect of Managerial Ownership on the Cost of Debt: Evidence from Japan

This article examines the effect of managerial ownership (MO) on the cost of debt as measured by the interest rate spread on corporate bonds for Japanese firms. First, the authors find that the MO is positively associated with interest rate spread after controlling for the other Japanese ownership structure, cross-shareholdings, and the stable shareholdings by financial institutions. Second, by employing factor analysis to measure the agency cost of debt (ACD) based on financial variables, the authors also find that MO has higher correlation with interest rate spread when the ACD at the time of bond issue is already larger. The results are robust to additional analyses, including the possibility of nonlinear relationship, bond rating, endogeneity problem, and Fama and MacBeth approach. The results suggest that prospective bondholders use MO information to anticipate a firm’s future ACD and estimate it higher when the current ACD at issuing bond is already larger. The results also suggest that accounting information is useful to estimate the ACD and increase the efficiency of bond contracting. Finally, although previous studies are often prone to emphasizing the findings on the Japanese unique ownership structure, the results of this article reveal that traditional agency theory on MO apply to Japanese bond market, which is consistent with the findings of U.S. firms.

Stable Shareholdings, the Decision Horizon Problem, and Earnings Smoothing

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.

Stable Shareholdings, the Decision Horizon Problem and Earnings Smoothing: THE DECISION HORIZON PROBLEM AND EARNINGS SMOOTHING

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.

Credibility of Management Earnings Forecasts and Future Returns

This study investigates the effect of managerial discretion over their initial earnings forecasts on future performance. First, by estimating the discretionary portion of initial management earnings forecasts (defined as discretionary forecasts) based on the findings of fundamental analysis research, we find that firms with higher discretionary forecasts are more likely to miss their earnings forecast at the end of the fiscal year and revise their forecasts downward to meet their earnings forecasts for the period, suggesting that forecast management through discretionary forecasting produces less credible management forecasts in terms of ex-post realization. Second, by using the hedge-portfolio test and regression analysis, we find that firms with higher discretionary forecasts earn consistently negative abnormal returns, suggesting that investors do not fully understand the implication of discretionary forecasts for the credibility of management earnings forecasts and thus overprice them at the forecast announcement.

The Effect of Institutional Factors on Discontinuities in Earnings Distribution: Public Versus Private Firms in Japan

Previous studies have shown that, compared with earnings distributions in other countries, there are clear discontinuities at zero in the distribution of earnings levels in Japanese firms. We predict that two unique institutional factors in Japan—(a) the alignment between financial and tax accounting and (b) the tight relationship between firms and their banks—cause the discontinuities in earnings distribution. Consistent with this prediction, we find that firms with high marginal tax rates and tight relationships with their banks are more likely to manage earnings to report slightly positive earnings. We also find that this relationship is more pervasive for private firms than public firms. We contribute to the literature by examining a significant research setting that has features of both institutional factors and loss-avoidance behaviors to enable deeper consideration during hypothesis development.

The Role of Accounting Conservatism in Executive Compensation Contracts

To test the implication of Watts’ (2003) argument that accounting conservatism increases the efficiency of executive compensation contracts, we investigate the relationship 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 larger for Japanese than U.S. firms because of the predominance of earnings-based executive compensation contracts and lack of explicit compensation contracts in Japan. Consistent with our arguments, we find a positive relationship between accounting conservatism and the compensation earnings coefficient. Furthermore, this positive relationship is greater for firms with poor ex-ante information environment. These results suggest that the demand for accounting conservatism is higher for firms that use more earnings-based executive compensation contracts and have more serious ex post settling up problems.In order to test the implication of Wattss (2003) argument that accounting conservatism can increase the efficiency of executive compensation contracts, we investigate the relationship between the adoption of accounting conservatism and the payment of excess executive compensation in Japanese firms. We focus on the executive compensation practice in Japan because the demand for accounting conservatism is likely to be larger for Japanese firms than it is for U.S. firms because of the lack of explicit compensation contracts in Japan. Consistent with the proposed arguments, we find that accounting conservatism is negatively related to excess cash compensation. We also find that this negative relationship is larger for firms with higher compensation earnings coefficients. These results suggest that the adoption of conservatism in accounting reduces the possibility of managers receiving excess cash compensation and that the demand for accounting conservatism in executive compensation contracts is larger when the ex post settling up problem is more serious.