Are Income Smooth Associated with a Lower Cost of Capital? －Focuses on KSE and KOSDAQ Listed Firms－
Asian Tax Journal Vol. 13 No. 1 (2012), pp. 33-63
Abstract
Income smoothing has existed for decades, and there are generally two schools of thought as to what motivates managers to smooth. First, income smoothing presents an arguably efficient vehicle for managers to reveal private information. Second, income smoothing represents “garbling”, that is, smoothing is an exercise undertaken by managers in an attempt to fool analysts and others and to enhance managerial compensation. Using survey data, Graham et al. (2005)report that corporate executives express a strong desire to report smooth earnings paths, holding cash flow volatility constant. Surprisingly, executives also indicate a willingness to sacrifice long －term value to achieve smoother earnings. A primary motivation offered for such behavior is that executives believe that investors perceive firms with smoother earnings to be less risky, and thus demand a lower expected return, or cost of capital. Prior studies examines income smoothing in the context of equity markets. However, this study is to complement these studies by examining income smoothing using cost of capital data. That is, the objective of this study is to investigate the effect of income smoothing on cost of capital (weighted average cost of capital；WACC). The basic idea is that the firm value does not depend on how the stakeholders finance it, but this is the stockholders (equity) and creditors (liabilities to banks, bondholders, etc). If income smoothing is informative, or only firms with good prospects elect to smooth, then smoothing firms may exhibit a lower cost of capital. On the other hand, if income smoothing is garbling and investors can recognize smoothing as garbling, then smoothing firms could exhibit a higher cost of capital as investors and creditors punish managers for gaming earnings. We examine all listed firms in the Korean stock market. Tests are performed using a full sample of KSE and KOSDAQ listed firms and also using subsamples of each stock exchange. Income smoothing is measured using two proxies following Leuz et al. (2003) and Tucker and Zarowin (2006). WACC data are extracted from the KIS－VALUE database provided by KIS (Korea Investor Service). We obtain a final sample that consists of 2,579 firm－years for KSE and 3,403 firmyears for KOSDAQ listed firms from 2002 to 2009 are gathered from KIS－VALUE files. The results of this paper indicate that higher (lower) income smoothing firms exhibit a lower (higher) cost of capital in all listed firms (KSE and KOSDAQ listed firms). Therefore, income smoothing appears to be a significant determinant of the cost of capital. This results are still hold even after appling a fractional ranks variable and a continuous variable as a dependent variable. And also t－statistics from Newey and West (1987) are significant, suggesting that our results are robust. Our results support the notion that income smoothing represents an information－signaling mechanism, rather than a garbling device. Thus, we document empirically that an important effect of managers’ use of financial reporting discretion is to reveal more information about firms’ future earnings and cash flows. Our work contributes to the literature by shedding new light on this information－versus－garbling debate. Therefore, these findings are very useful and provide a lot of important implications to regulators, investors and creditors that are interested in income smoothing behavior. Academics can also apply the discussion in this paper for related researches.
Keywords
- Income smooth
- Weighted average cost of capital
- Market’s perception
- Private information
- KSE and KOSDAQ listed firms
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