A Theory of Income Smoothing When Insiders Know More than Outsiders
51 Pages Posted: 16 Mar 2012
Date Written: March 13, 2012
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. To avoid intervention, 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 underproduce in an attempt not to unduly raise outsiders' expectations about future income, a problem that is more severe the smaller is the inside ownership. This results in an "outside equity Laffer curve" in that the total outside equity value is an inverted U-shaped function of outsiders' ownership share. A disclosure environment with adequate quality of independent auditing mitigates this problem, implying that accounting quality can enhance investments, size of public stock markets and economic growth.
Keywords: payout policy, asymmetric information, under-investment, accounting quality, finance and growth
JEL Classification: G32, G35, M41, M42, O43, D82, D92
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