An empirical study of income smoothing behavior on reported earnings and their market reactions

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In this study, I examine three issues regarding earnings management and the market reaction to it:(1) earnings persistence and market responses to it(2) information usefulness of supplemental information of security (realized and unrealized) gains and losses (SGL) on banks' holding securities(3) management discretion on accounting earnings induced by the governmental dividend payment restriction on Japanese banksAs for (1), I found that earnings persistence captured by applying ARIMA process to reported earnings in priced; that is, higher persistence is favorably valued in the market. This result is consistent with prior research in US market.Several studies both in Japanese and US markers show that supplemental disclosure on SGL is valued in banks' equities. However considerable portion of banks' holding securities consists of equities, this may implies that market participants are able to make reasonable estimation from stock market index. Empirical results support this possibility; once market index is included in the bank stock price model, realized SGL loses its statistical significance. Inclusion of market index in the model also reduces the significance of unrealized SGL, especially for money center banks whose security portfolio is similar to the market portfolio.With regard to bank managers' discretion, I examine earnings management motivated by dividend payment policy under the capital regulation (dividend guideline). Under this guideline, a bank with low current earnings is predicted to be forced income increasing discretion to keep stay with a certain level of dividend payout ratio. To test this hypothesis, I exclusively focus accruals and deferrals (A&D) of banks as management source of discretion. Empirical tests support this prediction. The behavior of A&D is consistent with income increasing motivation. Further, that behavior significantly diminishes after the suspension of the guideline, which also suggests the existence of earnings management.