Determinants and consequences of income smoothing at the firm and country level

• Applicant: Professor Dr. Jochen Bigus
• Subject Area: Accounting and Finance
• Term: from 2013 to 2019
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 242082030

The are many motives for income smoothing, such as increasing manager wealth, reducing information uncertainty, decreasing agency costs, lowering cost of debt, decreasing taxes and addressing risk averse shareholders payout preferences (Grant et al., 2009, Gassen et al., 2006). While income smoothing with publicly listed firms is well understood, there is scant research with regard to private firms or concerning macroeconomic aspects. The project aims to partially fill this gap by investigating two questions:(1) Do unlimited liability firms have different incentives for income smoothing to (private) corporations? (2) At the country level, does income smoothing reduce the market risk premium and GDP volatility?Concerning (1): We expect private unlimited liability firms in Germany to have different incentives for smoothing income to private corporations. There are three reasons for this claim. First, according to corporate law, payouts to shareholders are less strictly linked to net income than with corporations. Given that shareholders are risk averse, corporations may be more inclined to smooth income in order to smooth payouts. Second, due to unlimited liability and the fact that owners are at risk of losing virtually all their fortune, agency problems of debt are less severe such that there is less need to smooth income in order to signal low default risk to creditors. Third, since unlimited liability firms must not be run by professional managers while corporations may be, managers of corporations may have weaker tax-driven incentives for smoothing income. Even though unlimited liability firms represent 75 per cent of all firms, virtually no accounting research has been conducted on this type of firm, also because they are generally not re-quired to disclose accounting data. We have access to a unique database run by the Deutsche Bundesbank that contains such data. Concerning (2): Further, this is the first project to address the macroeconomic consequences of income smoothing. Markarian/Gill-de-Albornoz (2010) find that income smoothing reduces information uncertainty, thus reducing firm-specific (idiosyncratic) stock price volatility. We seek to investigate whether income smoothing at the country level reduces the market risk premium and GDP volatility and, if so, whether income smoothing in the financial and/or non-financial sector drives this relationship. We also expect the relationship to be stronger in countries with well-developed debt markets. Dou et al. (2012) find that income smoothing supports relationship-specific investments in countries with weak contract enforceability. In such countries we expect GDP growth rates to increase with country-level income smoothing.The project aims to improve our understanding of the drivers and consequences of income smoothing at the firm and macroeconomic level, which are of interest to the scientific community and the regulator alike.

• DFG Programme: Research Grants