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Relationship-Specificity, Contract Enforceability, and Income Smoothing

52 Pages Posted: 9 Feb 2013  

Yiwei Dou

New York University (NYU) - Department of Accounting

Ole-Kristian Hope

University of Toronto - Rotman School of Management

Wayne B. Thomas

University of Oklahoma - Michael F. Price College of Business

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Date Written: February 8, 2013

Abstract

Contracting parties, such as the firm and its supplier, have cost-reducing incentives to make investments which support the unique transactions between them. However, to the extent that one party may renege on its contractual obligations, the other party incurring the cost of the relationship-specific investment bears additional risk and is less willing to invest such that sub-optimal investment occurs. In countries where enforceability of explicit contracts is particularly weak, parties have incentives to signal their willingness to fulfill implicit claims and maintain long-term relationships. We predict that firms engage in income smoothing to send such a signal to their suppliers. Consistent with these expectations, we find that firms that both reside in countries with weak contract enforceability and operate in industries with a greater need for relationship-specific investments tend to smooth reported income more. We further decompose income smoothing into “informational” and “garbled” components and find that results are driven by the informational component of income smoothing. Our results support the important role that accruals play in providing information in the presence of incomplete contracts.

Keywords: Income Smoothing, Informational Component, Relationship-Specific Investments, Contract Enforceability, Legal Protection, International

JEL Classification: F14, F30, G30, K12, L14, M41, M43

Suggested Citation

Dou, Yiwei and Hope, Ole-Kristian and Thomas, Wayne B., Relationship-Specificity, Contract Enforceability, and Income Smoothing (February 8, 2013). Accounting Review, Forthcoming; Rotman School of Management Working Paper No. 2213827. Available at SSRN: https://ssrn.com/abstract=2213827

Yiwei Dou

New York University (NYU) - Department of Accounting ( email )

40 West 4th Street
Suite 10-180
New York, NY 10012
United States

Ole-Kristian Hope (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

HOME PAGE: http://www.rotman.utoronto.ca/FacultyAndResearch/Faculty/FacultyBios/Hope.aspx

Wayne B. Thomas

University of Oklahoma - Michael F. Price College of Business ( email )

Michael F. Price College of Business,
307 W Brooks, Rm 212B
Norman, OK 73019
United States
405-325-5789 (Phone)
405-325-7348 (Fax)

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