A Theory of Income Smoothing When Insiders Know More Than Outsiders

In our paper, A Theory of Income Smoothing When Insiders Know More Than Outsiders, we consider a setting in which insiders have information about income that outside shareholders do not, but property rights ensure that outside shareholders can enforce a fair payout. Insiders report income consistent with outsiders’ expectations based on publicly available information rather than true income, resulting in an observed income and payout process that adjust partially and over time towards a target. Insiders under-invest in production and effort so as not to unduly raise outsiders’ expectations about future income, a problem that is more severe the smaller is the inside ownership and results in an “outside equity Laffer curve.” A disclosure environment with adequate quality of independent auditing mitigates the problem, implying that accounting quality can enhance investments, size of public stock markets and economic growth.

A fundamental property right conferred upon stockholders of a firm is that they are entitled to their fair share of the firm’s (distributable) net income. Since stock ownership is verifiable, this right is relatively easy to enforce provided that everyone agrees on what the income is. In a world of complete information, determining net income should be a relatively simple matter because it is clear to everyone to see how much money is left on the table after all senior claimants (e.g., creditors, managers, employees, taxman, etc.) have been paid. Matters become more tricky in a world of asymmetric information where inside shareholders may know more than outside shareholders.

How is income reported and payout determined if asymmetric information is a fact of life? What are the effects of information asymmetry on insiders’ production decision or incentives to put in effort? How does asymmetric information affect the time-series properties of reported income and payout? How does inside ownership affect income and operating efficiency? These are some of the questions we try to address in this paper.

We consider an all-equity financed firm that pays out each period all realized income. In our model outsiders can extract their share of income from the firm by a threat of collective action against insiders. While under symmetric information outsiders know exactly what they are due, under asymmetric information outsiders refrain from intervention for as long as the reported income (and corresponding payout) meets their expectations. Outsiders (supported by analysts) form their expectations about income on the basis of the information available to them. Outsiders’ income estimate is unbiased and “best” based on the information they have available, and it is therefore rational for them to require a payout that is consistent with their expectations. Hence, when the strength of property rights and pressure by outside investors keeps insiders to the straight and narrow, the equilibrium payout will be smooth compared to realized income as it is based on outsiders’ expectation. Insiders absorb short-term variation in income and, if necessary, have to “find the money” to keep outside investors at bay.

So far smoothing is fairly harmless in that it merely irons out variation in reported income. We call it “financial smoothing” because it merely alters the time pattern of reported income (through borrowing and savings) without changing the firm’s underlying cash-flows as determined by insiders’ production and effort decisions. Insiders may, however, also engage in “real smoothing” by manipulating production and effort decisions in an attempt to “manage” outsiders’ expectations. In particular, suppose outsiders cannot observe value-relevant variables (such as marginal costs) directly but have to rely on an incomplete set of observable proxies (such as output or sales) that are subject to measurement error in order to infer income indirectly. Then insiders may have an incentive to distort the observable proxy variables in order to lower outsiders’ expectations about current and future income.

Importantly, smoothing also happens in an inter-temporal sense. The efficient output and effort level is determined in our model by the contemporaneous level only of the latent marginal cost variable; however, the current effort and output decision not only affect current sales levels but also outsiders’ expectations of current and all future income. This exacerbates the previously discussed negative externality for insiders because bumping up sales now means the outsiders will expect higher income and payout not only now but also in future. Even though the spillover effect of a one-off increase in sales on outsiders’ future expectations wears off over time, it still causes insiders to underproduce even more and to put in even lower effort compared to what is first best.

Our theory of inter-temporal income smoothing yields rich, testable and novel implications on the time-series properties of reported income and payout to outsiders. First, “reported income” is smooth compared to “actual income” because the former is based on outsiders’ expectations whereas the latter corresponds to actual cash flow realizations. Second, reported income follows inter-temporally a target adjustment model. The “income target” is a linear, increasing function of sales, so that when there is a shock to sales (and therefore to the income target), reported income adjusts towards the new target, but adjustment is partial and distributed over time because outsiders only gradually learn whether a shock to sales is due to measurement error or due to a fundamental shift in the firm’s cost structure. Third, the current level of reported income can be expressed as a distributed lag model of current and past sales, where the weights on sales decline as we move further in the past. Since payout to outsiders is a fraction of reported income, it follows that also payout can be expressed as a distributed lag model of sales. Equivalently, current payout can be expressed as a target adjustment model where current payout depends on current sales and previous period’s payout, which is similar to the Lintner (1956) dividend model. Fourth, the total amount of smoothing can be broken up in two components: “real” smoothing and “financial” smoothing. While the latter does not alter the underlying cash flows, the former results in under-investment and implies that the output level (and therefore sales) becomes less sensitive to variation in the latent cost variable.

Importantly, smoothing increases with the degree of information asymmetry between insiders and investors. Holding constant the degree of information asymmetry (as determined by the variance of the measurement error), smoothing and underproduction in particular also increase with the outside shareholders’ ownership stake. Conversely, a higher level of inside ownership leads to less real smoothing. Indeed, the under-investment problem disappears as insiders move towards 100% ownership. We show that these effects lead to an “outside equity Laffer curve”: the value of the total outside equity is an inverted U-shaped function of outsiders’ ownership stake. The analogy with the taxation literature is straightforward: outsiders’ ownership stake acts ex post like a proportional tax on distributable income and undermines insiders’ incentives to produce and put in effort.

This final result suggests that low inside ownership could have detrimental consequences for the firm. We argue then that since outside equity may be crucial for the development and expansion of owner-managed firms, our results offer a rationale for imposing disclosure requirements on public companies and for improving accounting and auditing quality. We show that, all else equal, introducing independent accounting information, such as an unbiased but imprecise income estimate, improves economic efficiency, increases the outside equity value, and acts as a substitute for a higher inside ownership stake. The implication is that accounting quality, investments, size of public stock markets, and economic growth are all positively correlated in our model, and as empirically found in empirical literature on finance and growth.

The full paper is available for download here.