Tatsuo Inoue

Income smoothing and incentives by operating condition: An empirical test using depreciation changes in Japan☆☆☆

Abstract The purpose of this study is to examine incentives of Japanese managers to smooth income using depreciation changes under different operating conditions. Regression analysis is used to test the relation between smoothing behavior and six factors hypothesized to affect smoothing behavior. The primary finding of this study is that income smoothing by Japanese managers differs significantly by operating condition. The results indicate that, under certain operating conditions, firm size, income taxes, capital intensity, deviation in operating activities, and earnings variability represent significant incentives to smooth income using depreciation changes. Management bonuses are generally not significant due to the relatively smaller and more constant bonus amounts in Japan.

The Persistence and Forecast Accuracy of Earnings Components in the USA and Japan

Not all components of earnings are expected to provide similar information regarding future earnings. For example, basic financial statement analysis indicates that the persistence of ordinary income should be greater than the persistence of special, extraordinary, or discontinued operations. Because the market assigns higher multiples to earnings components that are more persistent, differentiating earnings components on the basis of relative persistence would appear to be useful. A focus on relative predictive value is consistent with research findings and user recommendations on separating earnings components that are persistent or permanent from those that are transitory or temporary. This paper examines the persistence and forecast accuracy of earnings components for retail and manufacturing companies listed in the worlds two largest equity markets; the USA and Japan. We find the forecast accuracy of earnings in both the USA and Japan increases with greater disaggregation of earnings components. The results further indicate that the improvements in forecast accuracy due to earnings disaggregation are greater in the USA than in Japan. The greater emphasis and more detailed guidelines for reporting earnings components in the USA produce a better differentiation in the persistence of earnings components resulting in greater forecast improvements from earnings disaggregation.

PREDICTING CONSOLIDATED EARNINGS IN JAPAN: THE INCREMENTAL USEFULNESS OF SUBSIDIARY EARNINGS

Abstract Despite the wide acceptance of consolidated earnings worldwide, parent-only financial statements have historically been the primary financial statements in Japan. We examine whether subsidiary earnings in Japan are incrementally useful in predicting consolidated earnings beyond the information already available in parent-only earnings. For each of the six primary earnings levels reported in Japan (sales, gross profit, operating income, current income, earnings before taxes, and net income), we find that the persistence of subsidiary earnings is similar to or greater than the persistence of parent-only earnings in explaining year-ahead consolidated earnings. Consistent with expectations based on earnings persistence, we find that, for each of the six earnings levels examined, subsidiary earnings improve the predictability of consolidated earnings beyond the information already found in parent-only earnings. Furthermore, we find that firm-specific characteristics such as the ratio of subsidiary assets to consolidated assets and the persistence of subsidiary earnings are related to the usefulness of subsidiary earnings in predicting consolidated earnings.