Stable Shareholdings, the Decision Horizon Problem and Earnings Smoothing

• Published date: 01 November 2014
• Date: 01 November 2014
• DOI: http://doi.org/10.1111/jbfa.12091
• Author: Akinobu Shuto,Takuya Iwasaki

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(9) & (10), 1212–1242, November/December 2014, 0306-686X

doi: 10.1111/jbfa.12091

Stable Shareholdings, the Decision

Horizon Problem and Earnings

Smoothing

AKINOBU SHUTO AND TAKUYA IWASAKI∗

Abstract: Prior studies argue that stable shareholders do not encourage firm managers to

manage their earnings to achieve short-term earnings goals. They also state that firm managers

with stable shareholders have an incentive to report smooth earnings to maintain long-term

relationships with such shareholders. We focus on cross-shareholdings and stable shareholdings

owned by financial institutions as stable shareholdings in Japan, and investigate the effect of

these ownership structures on earnings management patterns. Specifically, we hypothesize that

stable shareholdings are positively associated with the informational components of earnings

smoothing. Consistent with our hypothesis, we first find that as stable shareholdings increase,

managers are more likely to conduct earnings smoothing that provides useful information to

stable shareholders. Further, our additional analysis shows that stable shareholdings reduce

incentives for managers to cut discretionary expenditures to meet short-term earnings bench-

marks, implying that stable shareholdings could reduce the possibility of a myopic problem.

These results suggest that managers with stable shareholdings tend to report smoother and less

volatile earnings, and do not tend to pursue earnings management to attain short-term earnings

targets.

Keywords: stable shareholdings, earnings smoothing, horizon problem, myopic problem

1. INTRODUCTION

Bushee (1998) provides evidence that institutional ownership with short-term invest-

ment horizons induces managers to conduct earnings management to attain short-

term earnings goals. Such management behavior is often called the myopic problem

or the decision horizon problem (Smith and Watts, 1982; Narayanan, 1985; Stein, 1989;

∗The first author is at the Research Institute for Economics and Business Administration, Kobe University,

Kobe, Hyogo, Japan. The second author is at the Faculty of Commerce, Kansai University, Suita, Osaka,

Japan. The authors appreciate the helpful comments and suggestions received from Martin Walker (editor),

an anonymous reviewer,Nobuhiro Asano, Masahiro Enomoto, Hiroyuki Ishikawa, Souichi Matsuura, Shin’ya

Okuda, Koji Ota, Shota Otomasa, Fumihiko Kimura, Hiromi Wakabayashi, Tatsushi Yamamoto,Hidetsugu

Umehara, Atsushi Shiiba, Hironori Fukukawa, Takashi Yaekura,Takashi Obinata, Masaki Yoneyama, Keiichi

Oishi, and the participants of the workshops conducted at Osaka Gakuin University (Positive Accounting

Theory Workshop), TokyoUniversity, and Chuo University. Shuto acknowledges the financial support from

the Zengin Foundation for Studies on Economics and Finance. All errors are the responsibility of the authors.

Address for correspondence: Akinobu Shuto, Research Institute for Economics and Business Administra-

tion, Kobe University 2-1, Rokkodaicho, Nadaku, Kobe 657-8501, Japan.

e-mail: shuto@rieb.kobe-u.ac.jp

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Dechow and Sloan, 1991; Porter, 1992; Bushee, 2001; Cheng, 2004; Dikolli et al., 2009;

Cadman and Sunder, 2014). In contrast, some studies and anecdotes argue that stable

shareholdings with long-term investment horizons restrict managers from engaging in

such myopic behavior, and create incentives for these managers to pursue long-term

stable earnings (Abegglen and Stalk, 1985; Porter, 1992; Jacobson and Aaker, 1993;

Osano, 1996).

This study examines the implications of the aforementioned argument in relation

to stable shareholdings from the viewpoint of earnings management. In particular,

we focus on 1) cross-shareholdings, and 2) stable shareholdings owned by financial

institutions in the Japanese equity market, and investigate the effect of these ownership

structures on the major earnings management pattern, earnings smoothing. We focus

on the corporate ownership structure of Japanese firms because it has features that

are more relevant to our investigation compared to the structures of US firms. A

distinctive feature of the Japanese stock market is that stable shareholdings with long

investment horizons and foreign shareholdings with short investment horizons exist

simultaneously. This unique ownership structure provides a useful research setting for

studying the relationship between earnings management and the decision horizon

problem.

In light of the theoretical argument of prior studies, we predict that stable

shareholders with long-term investment horizons and firm managers have incentives to

report stable earnings strings through earnings management. First, from the perspec-

tive of stable shareholders, we predict that stable shareholders do not encourage firm

managers to pursue myopic behavior, and so firm managers do not have an incentive

to inflate their earnings to achieve their short-term earnings goals. In Japan, there are

stable shareholders that are highly concentrated among the corporate stockholders

with financial institutions. In this case, firms are closely connected; they affect each

other through cross-holdings of equity ownership, and generally depend on a large

commercial bank (i.e., the main bank) for their primary banking needs (Hoshi et al.,

1990, 1991; Aoki and Patrick, 1994; Douthett and Jung, 2001; Arikawa and Miyajima,

2007; Shuto and Kitagawa, 2011).1

One of the important features about the stable shareholding arrangements made

through cross-shareholdings and financial institutions is the implicit long-term contracts

among them. Sheard (1994, p. 318) defines “stable shareholding” as implicitly con-

tracting away some of the property rights associated with shareholding; in particular,

property rights pertaining to the transfer of shares or the exercise of corporate

control. In general, stable shareholders in Japan play the role of a “friendly” insider,

sympathetic to incumbent managers and agreeing not to sell shares to third parties.

Managers are able to develop operations according to a long-term perspective because

stable shareholdings decrease the threat of hostile takeovers and maintain long-term

business relationships (Abegglen and Stalk, 1985; Porter, 1992; Osano, 1996). Thus,

firm managers do not have an incentive to inflate their earnings to achieve their short-

term earnings goals because stable shareholders do not pressurize them to pursue

short-term earnings.

Second, from the perspective of managerial incentive, we predict that firm man-

agers with stable shareholders are more likely to report stable earnings strings, thereby

conveying credible information about themselves to stable shareholders in order to

1 It is widely known that the keiretsu system is the most typical form of organization in such corporate groups.

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