"A Theory of Income Smoothing When Insiders Know More Than Outsiders"
Bart Lambrecht, Lancaster University
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 underproduce in an attempt 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 La<::>er curve" in that the total outside equity value is
an inverted U-shaped function of outsiders' ownership share. A disclosure environment
with adequate quality of independent auditing mitigates this problem, implying that
accounting quality can enhance investments, size of public stock markets and economic
growth.
J.E.L.: G32, G35, M41, M42, O43, D82, D92
Keywords: payout policy, asymmetric information, under-investment, accounting qual-
ity, <::>nance and growth.