Discussion Paper Details

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Title: A Theory of Income Smoothing When Insiders Know More Than Outsiders

Author(s): Viral V. Acharya and Bart Lambrecht

Publication Date: January 2012

Keyword(s): accounting quality, asymmetric information, measurement error, payout policy and under-investment

Programme Area(s): Financial Economics

Abstract: 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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Bibliographic Reference

Acharya, V and Lambrecht, B. 2012. 'A Theory of Income Smoothing When Insiders Know More Than Outsiders'. London, Centre for Economic Policy Research.