A Theory of Income Smoothing When Insiders Know More than Outsiders

Abstract:     
We develop a theory of income smoothing by firms when insiders know more about income than outside shareholders, but property rights ensure that outside shareholders can enforce a fair payout. Insiders report income consistent with outsiders' expectations and underproduce in order not to unduly raise expectations about future income. The observed income and payout process are smooth and adjust partially and over time towards a target. The underproduction problem is more severe the smaller is the inside ownership and results in an "outside equity Laffer curve", but the problem is mitigated by the quality of independent auditing information and by introducing stock-based compensation.

Number of Pages in PDF File: 46

Keywords: income smoothing, payout policy, asymmetric information, under-investment, accounting quality, measurement error, finance and growth

JEL Classification: G32, G35, M41, M42, O43, D82, D92

working papers series