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Stable shareholdings, the decision horizon problem, and patterns of earnings management



Previous studies argue that stable shareholdings with long-term horizon create incentives for managers to pursue long-term stable earnings and restrict them from conducting myopic behavior. Due to their asymmetric payoff function, stable shareholders are not expected to respond favorably to temporarily inflated earnings that cause higher volatility of earnings. To test the implications of this argument, we focus on cross-shareholdings and stable shareholdings by financial institutions as stable shareholdings in Japan and investigate the effect of these ownership structures on two earnings management patterns: earnings smoothing and big bath. Consistent with our hypothesis, we find that under the stable ownership structure, stable shareholders encourage managers to perform earnings smoothing, which decreases earnings volatility, and discourage them from engaging in big bath, which increases earnings volatility. Further, additional analysis reveals that stable shareholdings reduce incentives for managers to reduce discretionary expenditure for short-term earnings benchmarks; this implies that stable shareholdings can reduce the possibility of the myopic problem. Our results suggest that stable shareholders pressurize managers to create stable earnings strings through earnings management and prevent them from pursuing short-term earnings goals.

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