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A Theory of Income Smoothing When Insiders Know More Than Outsiders

  • Viral V. Acharya
  • Bart M. Lambrecht

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 under-invest in production and effort so as not to unduly raise outsiders' expectations about future income, a problem that is more severe the smaller is the inside ownership and results in an "outside equity Laffer curve". A disclosure environment with adequate quality of independent auditing mitigates the problem, implying that accounting quality can enhance investments, size of public stock markets and economic growth.

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File URL: http://www.nber.org/papers/w17696.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17696.

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Date of creation: Dec 2011
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Handle: RePEc:nbr:nberwo:17696
Note: CF LE
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  1. Anand Mohan Goel & Anjan V. Thakor, 2004. "Why Do Firms Smooth Earnings?," Finance 0411021, EconWPA.
  2. Tirole, Jean & Fudenberg, Drew, 1995. "A Theory of Income and Dividend Smoothing Based on Incumbency Rents," Scholarly Articles 3160494, Harvard University Department of Economics.
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