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‘Managerialism’, ‘ownerism’ and risk
Journal of Banking and Finance 7 (1983) t89-196. North-Holland Publishing Company
'MANAGERIALISM', 'OWNERISM' AND RISK Yakov AMIHUD Tel Aviv University, Tel Aviv, Israel New York University, New York, N Y 10003, USA
Jacob Y. KAMIN University of California, Los Angeles, CA 90024, USA
Joshua RONEN New York University, New York, N Y 10003, USA Received September 1978, final version received July 1982 This paper proposes that managers, having the value of their human capital dependent on the performance of the firm they manage, and being unable to diversify away this risk, are expected to attempt to reduce their employment risk internally by project selection or by income smoothing, intended to stabilize the firm's income stream. An empirical investigation shows that manager-controlled firms exercise 'income smoothing' to a greater extent than owner-controlled firms, have relatively lower unsystematic risk and perhaps lower systematic risk.
I. Introduction
It has been noted that 'since the professional manager finds his own present and future intimately bound up with that of the corporation, any desire to reduce the riskiness of his own position must be accomplished by changing the specific corporate environment he works in' [Donaldson (1963, p. 128)]. While the owners-shareholders of the corporation can reduce their risk by diversifying their portfolio holdings, the manager must act within the firm he manages to reduce its risk. Managerial theories of the firm by Monsen and Downs (1965) and Baumol (1967) led to the conclusion that the income streams in manager-controlled (MC) firms will be less variable than those in owner-controlled (OC) firms. This prediction was later supported by empirical studies by Boudreaux (1973), Palmer (1973) and Holl (1975). 1 This paper extends these empirical investigations to test for the differences between OC (owner-controlled) and MC (manager-controlled) firms with respect to their risk. We examine income statements to detect methods managers could possibly employ to reduce risk and find that 'income 1Recently, Amihud and Lev (1981) analyzed the manager's problem in the context of agency theory, and suggested that he attains risk-reduction by internal diversification, e.g., by performing conglomerate mergers. 0378-4266/83/$3.00 © Elsevier Science Publishers B.V. (North-Holland)
190
Y. Amihud et al., 'Managerialism ', "ownerism' and risk
smoothing' techniques, while used by most firms, are exercised to a greater extent by MC firms than by OC firms. The importance of this test lies in the fact that income smoothing is controlled by the firm and points to the explicit managerial intention to reduce risk. Then, we test for differences in risk between OC and MC firms, using risk measures which are derived from the firms' equity returns. These risk measures have not yet been examined in this context, inasmuch all studies on the subject employed data from the firms' financial statements. Since the manager's rewards are related to the performance of his firm's stocks, it stands to reason that his effort to reduce his risk will be reflected in the risk of his firm's stocks returns. In addition, these measures show evidence that MC firms tend to be more diversified in their operations than OC firms.
2. The manager's motivation in reducing risk Like any person, the manager's wealth consists of his portfolio of tangible and financial assets and of his human capital. Unlike other persons, however, the manager's 'investment' is concentrated mostly in the firm he manages. Hence, any activity in the firm the manager selects,~ affects the risk he bears in two ways: first, it affects the risk of his financial portfolio, which consists of 'his' firm's shares as well as other firm's shares. In this respect, he is similar to any other well-diversified owner of his firm. Second, it affects the risk of his income from his job with the company, which is assumed to be positively related to the firm's income. It follows that any chosen activity affects the manager's own risk more than it does to that of the owner. This argument can be applied to Mayer's (1972) capital market equilibrium model where investors have non-marketable assets. There he showed that the actual risk perceived by an investor in a firm is composed of two components: First, the covariance of the firm's returns with those of the market, and second, the covariance of his dollar return on his 'human capital' with that of the firm's returns. Obviously, this second component is particularly large for the firm's manager, whose compensation is usually a well-defined increasing function of his firm's returns. In addition, in case the firm's performance seems unsatisfactory, the manager may loose his job, and the value of his human capital in the job market will be reduced (due to the effect on future job opportunities). Thus, the riskiness of the firm to the manager is perceived to be far greater than it is to its investor-owner. An owner's portfolio does not require a job investment as a necessary ingredient; and if he holds a job in his OC firm, little risk will be added to his portfolio as a result, since the owner also controls his job security (he is not likely to fire himself), and he does not depend on the job market for employment. Mayers (1972) further showed that in balancing his portfolio, the investor will reduce his holdings in firms whose returns are positively related to his
Y. Amihud et al., 'Managerialism', "ownerism' and risk
191
own income. This may imply that the manager should sell 'short' the stocks of his firm; but such an act will certainly not be tolerated by the firm's shareholders. In light of the difficulty within the capital market to reduce his risk, our risk averse manager, blocked from diversification of his job income in outside markets, would be expected to attempt to diversify his 'employment' risk internally by project selection or by 'income smoothing', intended to stabilize the firm's income stream and thus, in turn, his employment income. 2 3. The smoothing of accounting income as a means to reduce risk
Our hypothesis regarding manager's tendency to stabilize the firm's income stream can be tested by observing the extent to which managers act as if they wish to smooth 'accounting income numbers', relative to the extent of smoothing in OC firms. Smoothing is defined here as the dampening of variations in the accounting number over time [Ronen and Sadan (1981)]. Schramm and Sherman (1974) suggested, but did not empirically test, the proposition that firm's management in general (without distinguishing between MC and OC) would tend to use its discretion in the timing of operating decisions to affect the standard deviation of the firm's period by period profit. 3 Lev and Kunitzky (1974) found the extent of smoothness of sales, production, capital expenditures, dividends, and earning series to be significantly correlated with both the overall and systematic common stock risk measures. Besides, the effect that income smoothing may have on the firm's risk, and thus on the manager's risk, it helps the manager in conveying to the job market the value of his human capital. 4 The job market may be unable to fully differentiate between outcomes which are due to the manager's efforts 2Amihud and Lev (1981) pointed at the possible conflict of interests between the manager and shareholders; since the risk-reduction activities may induce a wealth-transfer from shareholders to bondholders, and real resources are employed to reduce risk, shareholders are actually paying for the manager's increased job security. Thus, managerial risk-reduction activities may be viewed of forms of perquisite. 3Thus, 'expenditures for advertising and research actually can be used by the firm to reduce the standard deviation of these reported earnings. Because of accounting conventions, current research and advertising expenditures are treated fully as current expenses and charged against current revenue in calculating accounting profit to be reported for a given period, even though each of these expenditures is apt to have some of its effects felt as revenue in future periods. As a consequence the firm can affect the standard deviation of its period-to-period reported profit by altering these expenditures that have some of their effects in later periods. In a 'good' period, for instance, considerably more can be spent on expenditures that have future payoff, such as research, to prevent current profit from being extremely high and also to enhance expected profit in the future. Similarly in a 'bad' period the firm can reduce those same expenditures and prevent current profit from falling very low although expected profit in the future will be lower as a result.' Schramm and Sherman (1974, p. 356). 4See Fama (1980) on the managerial smoothing of his marginal product through time. J.B.F.-- B
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Y. Amihud et al., 'Managerialism ', ownerism" and risk
and outcomes which are due to noise, hence the manager's compensation will reflect the noise in the firm's performance. The manager, who has an inside knowledge of the firm's affairs, may thus try to reduce the noise in the firm's performance so that the product of his efforts may be signalled out more clearly and not confounded with the firm's noise. The owner-manager, who does not depend on the job market for the valuation of his human capital, does not need to employ this signalling device. It follows that we should expect that income smoothing, which does not change the trend of income but rather reduces the noise about it, will be more prevalent in MC firms than in OC firms. We shall test this hypothesis, applying the method used in Kamin and Ronen (1978a and b). An inference that a reported income series has been 'smoothed' over time could be consistent with two major types of smoothing: (1) accounting smoothing, which does not result from changing the operating decisions and their timing, but which affects income through accounting dimensions, notably the accounting recognition of economic events and the accounting allocation over fiscal years and/or classification of the events' effects; and (2) 'real' smoothing, that is, actual smoothing of the firm's input and output series through the making and timing of operating decisions [Ronen and Sadan (1981)]. The two types of smoothing result in the same manifestation a smoother trend of the resulting earnings series - - and thus it is impossible to identify which of the two types was resorted to in producing their joint result, particularly when utilizing data from published financial statements. In this paper, we hypothesize that managers use their ability to control the timing and the accounting treatment of discretionary expenses so as to provide a smooth income stream. We test, therefore, whether the behavior of the operating expenses series is consistent with the 'smoothing' of the operating income series as reported in the financial statements. We further hypothesize that managers of MC firms will exhibit such income smoothing behavior to a greater extent than will managers of OC firms. The specific test method consists of the following steps: First, we detrended the time series of the observed net operating income per share (the smoothing object) over fifteen years, 5 1957 to 1971, by eq. (1): -
-
Yjt = al j + bl jt + ~jt,
(1)
where Yjt is observed net operating income (NOI) for firm j in year t, t = 1,..., SSmoothing tests such as this must be based on the observation of the relevant variables over a long time span. Tests limited to a short span might reveal behavior consistent not only with smoothing (expost dampening of income variation) but also with non-smoothing behavior such as maximizing or merely the random occurrence of the discretionary variables and their accounting communication. [Ronen and Sadan (1981).]
Y. Amihud et al., 'Managerialism', 'ownerism" and risk
193
15; a, b are parameters; and ejr is the deviation of the N O I from its trend. The N O I numbers were taken directly from the C O M P U S T A T tapes and computed on a per-share basis and adjusted based on the number of outstanding shares in 1957. The resulting ex-post trend was assumed to represent what management deemed to be desirable as 'normal'. We de-trended the time series of the actually reported operating expenses per share (the smoothing variable) over the same period of time by eq. (2):
E jr = a2j + b 2 j t + v jr,
(2)
where E j, are expenses of firm j in year t, and vjr is deviation of the reported expenses from their trend. Operating expenses were defined as expenses not included in cost of sales that are subtracted from the gross margin before determining operating income. These expenses were computed on a per-share basis and adjusted forward, based on the number of outstanding shares in 1957. It was assumed that the 'normal' magnitude of operating expenses lies on the time trend line of the observed expenses. The deviations e and v were used to test for smoothing behavior. If abovetrend N O I were associated with above-trend operating expenses, or if belowtrend N O I were associated with below-trend operating expenses, behavior that is consistent with the smoothing of N O I would be indicated. Under these situations, if the operating expenses were not increased or decreased from their 'normal' magnitudes, the time variations and the magnitudes of the N O I would have been observed to be greater. It could be argued that at least to a certain extent the positive correlation coefficients may be explained by an inherent functional relationship between income and expenses. However, notice that to minimize this problem, we excluded cost of sales from the operating expenses. Moreover, there is no a priori reason to believe that such functional relationship - - even though it may exist - - would systematically affect the difference between the observed coefficients of correlation between the N O I and the operating expenses. For each firm we computed the correlation coefficient, r~, between the deviations series ejr and vjr. The observation of such positive correlation coefficients would be consistent with the smoothing hypothesis. Data were obtained for 56 firms from Boudreaux's (1973) sample drawn from the United States' top 500 manufacturing firms in the period 19521963. Boudreaux's original sample included 12 industries, 6 firms in each, evenly divided between owner controlled and management controlled. The criterion is as follows: The owner controlled group includes firms where (i) one party owns 10~o or more of the voting stock and is represented on the board or in management or is otherwise known to control, or (ii) one party owns 209/0 or more of the voting stock. The management controlled group
194
Y. Amihus et al., "Managerialism', "ownerism' and risk
includes firms where no single block greater than 5~o of the voting stock exists and there is not recent evidence of control. The results show that income smoothing is prevalent in both OC and MC firms. To test for our hypothesis of differences in the extent of income smoothing between the two types of firms, we transformed the correlation coefficient rj into the variable Nj which is normally distributed: Nj=½1nl+rj 1
-
rj
and
N,,~N ~ l n ~ _ p j , n
3 '
where n is the number of observations (15 years) and p is the population correlation coefficient whose estimate is r. The average .N for MC is 0.986 as compared with R of 0.863 for OC, and the difference is significant at the 5Yo level (one-tailed test). This supports our hypothesis that income smoothing is exercised to a greater extent by MC firms than by OC firms.
4. The market-based measures of risk If the risk-reduction activities of the manager of a MC firm are successful, they will be reflected in the behavior of the firm's equity returns. Consider the market model:
R jr = o~j+ t~jRmt + e~t,
(4)
where Rit and R,,,t are the returns on securityj and on the market, respectively, ej, is a residual and ~j and/~j are constant coefficients. Here,/~j= coy (Rj,R,,)/ var(R,.) is the measure of the systematic risk, while var(ej) gives the unique risk of firm j. The coefficient of determination from this regression is R 2 = 1-var(ej)/var(R~), which is increasing when the extent of the unique risk in the firms' equity returns is smaller. The greater is R 2, the smaller is the weight of firm-specific factors in the total risk of the firm. It follows that risk-reduction activities which reduce the firm's unique risk should lead to an increase in R 2. Another important interpretation of R e is as a measure of diversification. Barnea and Logue (1973) showed that the greater is the diversification of the firm's business activity, the greater is its R 2. Hence, if the manager diversifies the firm's activity to reduce its risk, it should be reflected by a higher R2. 6 Another component of risk is the systematic risk, measured by the /~ coefficient. Again, it may be of interest to observe whether the manager's risk-reduction activities affect the systematic risk of the firm. 6See Amihud and Lev (1981) who tested this hypothesis, using income numbers.
Y. Amihud et al., 'Managerialism', 'ownerism' and risk
195
We thus have another test on the difference in behavior between OC and MC firms. Unlike the earlier studies by Boudreaux (1973) and Palmer (1973) who looked at the total variance of firms' income, we present a finer look at the firm's risk, separating between its systematic and unsystematic components. Further, we use market-based measures of risk, derived from securities' returns, rather than from accounting income. Estimates of R 2 and fl were obtained for 61 firms from Boudreaux's (1973) list from Merrill-Lynch's reported results of regressions of monthly data for the period 7/66-6/71. Then, we transformed the R2'S into the normal variables N as in (3), and regressed them on CON, the type of control - - 1 for MC and 0 for OC firm - - and on eleven dummy variables (taking values of 0 and 1) to account for the industry effect. We obtained Nj = 1.14-0.153 CON + 11 industry dummy variables. The t statistic of the CON coefficient was 1.85, significant at better than 5~ (one tail test). 7 This supports our hypothesis that the weight of the firm's specific risk in MC firms is lower than in OC firms, and that MC firms seem to be more diversified. The next test is on the effect of_the firm's type of control on its systematic risk. We estimated the following regression: flj = 1.12 - 0.107 CON + 11 industry dummy variables, where, again, CON= 1 for MC and 0 for OC, and the dummy variables capture the industry effect. Here, the coefficient of CON had the predicted sign but had a t statistic of 1.28, which is significant only at the 10~ level (one tail test). 5. Conclusions
In this paper we presented several new tests of the hypothesis that managers in MC firms undertake policies which result in a lower risk than in OC firms. We found that in MC firms, smoothing of income is more prevalent, the firm's unique risk is relatively smaller and the systematic risk is lower than in OC firms. These results are consistent with the view that when managerial discretion is feasible, as it is in MC firms, managers would strive to reduce their undiversifyable human capital risk by directly affecting their own firms' policies. We are hopeful that our results will add an impetus to a further study of the determinants of differences in preference by different firms for risk-return combination. 7Using R~ instead of Nj, we obtained that the coefficient of CONj is - 0.30, with t = 1.92.
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References Amihud, Y. and B. Lev, 1981, Risk reduction as a managerial motive for 1982 conglomerate mergers, The Bell Journal of Economics, Autumn, 605-617. Barnea, A. and D.E. Logue, 1973, Stock-market based measure of corporate diversification, Journal of Industrial Economics, Sept., 51-60. Baumol, W.J., 1967, Business behavior, value and growth, revised ed. (Harcourt, Brace and World). Boudreaux, K.J., 1973, Managerialism and risk-return performance, Southern Economic Journal, 366-372. Donaldson, G., Financial goals: Management versus stockholders, Harvard Business Review, May-June, 116-129. Fama, E.F., 1980, Agency problems and the theory of the firm, Journal of Political Economy, April, 288-307. Holl, P., 1975, effect of control type on the performance of the firm in the U.K., Journal of Industrial Economics, 257-271. Kamin, J.Y. and J. Ronen, 1978a, The effect of corporate control on apparent profit performance, Southern Economic Journal, July. Kamin, J.Y. and J. Ronen, 1978b, The smoothing of income numbers: Some empirical evidence on systematic differences among management-controlled and owner-controlled firms, Accounting, Organizations and Society, 141-153. Lev, B. and S. Kunitzky, 1974, On the association between smoothing measures and the risk of common stocks, The Accounting Review, April, 259-270. Marris, R., 1964, The economic theory of managerial capitalism (McMillan, New York). Mayers, D., 1972, Nonmarketable assets and capital market equilibrium under uncertainty, in: M. Jensen, ed., Studies in the theory of capital markets (Praeger, New York) 223-249. Merrill Lynch, Pierce, Fenner and Co., 1972, Security risk evaluation. Monsen, R. and A. Downs, 1965, A theory of large managerial firms, Journal of Political Economy, June, 221-236. Palmer, J., 1973, The profit-performance effects of the separation of ownership from control in large U.S. industrial corporations, The Bell Journal of Economics and Management Science, Spring, 293-303. Ronen, J. and S. Sadan, 1981, Smoothing accounting numbers (Addison-Wesley, Reading, MA). Schramm, R. and R. Sherman, 1974, Profit risk management and the theory of the firm, Southern Economic Journal, Jan., 353-363.
'MANAGERIALISM', 'OWNERISM' AND RISK Yakov AMIHUD Tel Aviv University, Tel Aviv, Israel New York University, New York, N Y 10003, USA
Jacob Y. KAMIN University of California, Los Angeles, CA 90024, USA
Joshua RONEN New York University, New York, N Y 10003, USA Received September 1978, final version received July 1982 This paper proposes that managers, having the value of their human capital dependent on the performance of the firm they manage, and being unable to diversify away this risk, are expected to attempt to reduce their employment risk internally by project selection or by income smoothing, intended to stabilize the firm's income stream. An empirical investigation shows that manager-controlled firms exercise 'income smoothing' to a greater extent than owner-controlled firms, have relatively lower unsystematic risk and perhaps lower systematic risk.
I. Introduction
It has been noted that 'since the professional manager finds his own present and future intimately bound up with that of the corporation, any desire to reduce the riskiness of his own position must be accomplished by changing the specific corporate environment he works in' [Donaldson (1963, p. 128)]. While the owners-shareholders of the corporation can reduce their risk by diversifying their portfolio holdings, the manager must act within the firm he manages to reduce its risk. Managerial theories of the firm by Monsen and Downs (1965) and Baumol (1967) led to the conclusion that the income streams in manager-controlled (MC) firms will be less variable than those in owner-controlled (OC) firms. This prediction was later supported by empirical studies by Boudreaux (1973), Palmer (1973) and Holl (1975). 1 This paper extends these empirical investigations to test for the differences between OC (owner-controlled) and MC (manager-controlled) firms with respect to their risk. We examine income statements to detect methods managers could possibly employ to reduce risk and find that 'income 1Recently, Amihud and Lev (1981) analyzed the manager's problem in the context of agency theory, and suggested that he attains risk-reduction by internal diversification, e.g., by performing conglomerate mergers. 0378-4266/83/$3.00 © Elsevier Science Publishers B.V. (North-Holland)
190
Y. Amihud et al., 'Managerialism ', "ownerism' and risk
smoothing' techniques, while used by most firms, are exercised to a greater extent by MC firms than by OC firms. The importance of this test lies in the fact that income smoothing is controlled by the firm and points to the explicit managerial intention to reduce risk. Then, we test for differences in risk between OC and MC firms, using risk measures which are derived from the firms' equity returns. These risk measures have not yet been examined in this context, inasmuch all studies on the subject employed data from the firms' financial statements. Since the manager's rewards are related to the performance of his firm's stocks, it stands to reason that his effort to reduce his risk will be reflected in the risk of his firm's stocks returns. In addition, these measures show evidence that MC firms tend to be more diversified in their operations than OC firms.
2. The manager's motivation in reducing risk Like any person, the manager's wealth consists of his portfolio of tangible and financial assets and of his human capital. Unlike other persons, however, the manager's 'investment' is concentrated mostly in the firm he manages. Hence, any activity in the firm the manager selects,~ affects the risk he bears in two ways: first, it affects the risk of his financial portfolio, which consists of 'his' firm's shares as well as other firm's shares. In this respect, he is similar to any other well-diversified owner of his firm. Second, it affects the risk of his income from his job with the company, which is assumed to be positively related to the firm's income. It follows that any chosen activity affects the manager's own risk more than it does to that of the owner. This argument can be applied to Mayer's (1972) capital market equilibrium model where investors have non-marketable assets. There he showed that the actual risk perceived by an investor in a firm is composed of two components: First, the covariance of the firm's returns with those of the market, and second, the covariance of his dollar return on his 'human capital' with that of the firm's returns. Obviously, this second component is particularly large for the firm's manager, whose compensation is usually a well-defined increasing function of his firm's returns. In addition, in case the firm's performance seems unsatisfactory, the manager may loose his job, and the value of his human capital in the job market will be reduced (due to the effect on future job opportunities). Thus, the riskiness of the firm to the manager is perceived to be far greater than it is to its investor-owner. An owner's portfolio does not require a job investment as a necessary ingredient; and if he holds a job in his OC firm, little risk will be added to his portfolio as a result, since the owner also controls his job security (he is not likely to fire himself), and he does not depend on the job market for employment. Mayers (1972) further showed that in balancing his portfolio, the investor will reduce his holdings in firms whose returns are positively related to his
Y. Amihud et al., 'Managerialism', "ownerism' and risk
191
own income. This may imply that the manager should sell 'short' the stocks of his firm; but such an act will certainly not be tolerated by the firm's shareholders. In light of the difficulty within the capital market to reduce his risk, our risk averse manager, blocked from diversification of his job income in outside markets, would be expected to attempt to diversify his 'employment' risk internally by project selection or by 'income smoothing', intended to stabilize the firm's income stream and thus, in turn, his employment income. 2 3. The smoothing of accounting income as a means to reduce risk
Our hypothesis regarding manager's tendency to stabilize the firm's income stream can be tested by observing the extent to which managers act as if they wish to smooth 'accounting income numbers', relative to the extent of smoothing in OC firms. Smoothing is defined here as the dampening of variations in the accounting number over time [Ronen and Sadan (1981)]. Schramm and Sherman (1974) suggested, but did not empirically test, the proposition that firm's management in general (without distinguishing between MC and OC) would tend to use its discretion in the timing of operating decisions to affect the standard deviation of the firm's period by period profit. 3 Lev and Kunitzky (1974) found the extent of smoothness of sales, production, capital expenditures, dividends, and earning series to be significantly correlated with both the overall and systematic common stock risk measures. Besides, the effect that income smoothing may have on the firm's risk, and thus on the manager's risk, it helps the manager in conveying to the job market the value of his human capital. 4 The job market may be unable to fully differentiate between outcomes which are due to the manager's efforts 2Amihud and Lev (1981) pointed at the possible conflict of interests between the manager and shareholders; since the risk-reduction activities may induce a wealth-transfer from shareholders to bondholders, and real resources are employed to reduce risk, shareholders are actually paying for the manager's increased job security. Thus, managerial risk-reduction activities may be viewed of forms of perquisite. 3Thus, 'expenditures for advertising and research actually can be used by the firm to reduce the standard deviation of these reported earnings. Because of accounting conventions, current research and advertising expenditures are treated fully as current expenses and charged against current revenue in calculating accounting profit to be reported for a given period, even though each of these expenditures is apt to have some of its effects felt as revenue in future periods. As a consequence the firm can affect the standard deviation of its period-to-period reported profit by altering these expenditures that have some of their effects in later periods. In a 'good' period, for instance, considerably more can be spent on expenditures that have future payoff, such as research, to prevent current profit from being extremely high and also to enhance expected profit in the future. Similarly in a 'bad' period the firm can reduce those same expenditures and prevent current profit from falling very low although expected profit in the future will be lower as a result.' Schramm and Sherman (1974, p. 356). 4See Fama (1980) on the managerial smoothing of his marginal product through time. J.B.F.-- B
192
Y. Amihud et al., 'Managerialism ', ownerism" and risk
and outcomes which are due to noise, hence the manager's compensation will reflect the noise in the firm's performance. The manager, who has an inside knowledge of the firm's affairs, may thus try to reduce the noise in the firm's performance so that the product of his efforts may be signalled out more clearly and not confounded with the firm's noise. The owner-manager, who does not depend on the job market for the valuation of his human capital, does not need to employ this signalling device. It follows that we should expect that income smoothing, which does not change the trend of income but rather reduces the noise about it, will be more prevalent in MC firms than in OC firms. We shall test this hypothesis, applying the method used in Kamin and Ronen (1978a and b). An inference that a reported income series has been 'smoothed' over time could be consistent with two major types of smoothing: (1) accounting smoothing, which does not result from changing the operating decisions and their timing, but which affects income through accounting dimensions, notably the accounting recognition of economic events and the accounting allocation over fiscal years and/or classification of the events' effects; and (2) 'real' smoothing, that is, actual smoothing of the firm's input and output series through the making and timing of operating decisions [Ronen and Sadan (1981)]. The two types of smoothing result in the same manifestation a smoother trend of the resulting earnings series - - and thus it is impossible to identify which of the two types was resorted to in producing their joint result, particularly when utilizing data from published financial statements. In this paper, we hypothesize that managers use their ability to control the timing and the accounting treatment of discretionary expenses so as to provide a smooth income stream. We test, therefore, whether the behavior of the operating expenses series is consistent with the 'smoothing' of the operating income series as reported in the financial statements. We further hypothesize that managers of MC firms will exhibit such income smoothing behavior to a greater extent than will managers of OC firms. The specific test method consists of the following steps: First, we detrended the time series of the observed net operating income per share (the smoothing object) over fifteen years, 5 1957 to 1971, by eq. (1): -
-
Yjt = al j + bl jt + ~jt,
(1)
where Yjt is observed net operating income (NOI) for firm j in year t, t = 1,..., SSmoothing tests such as this must be based on the observation of the relevant variables over a long time span. Tests limited to a short span might reveal behavior consistent not only with smoothing (expost dampening of income variation) but also with non-smoothing behavior such as maximizing or merely the random occurrence of the discretionary variables and their accounting communication. [Ronen and Sadan (1981).]
Y. Amihud et al., 'Managerialism', 'ownerism" and risk
193
15; a, b are parameters; and ejr is the deviation of the N O I from its trend. The N O I numbers were taken directly from the C O M P U S T A T tapes and computed on a per-share basis and adjusted based on the number of outstanding shares in 1957. The resulting ex-post trend was assumed to represent what management deemed to be desirable as 'normal'. We de-trended the time series of the actually reported operating expenses per share (the smoothing variable) over the same period of time by eq. (2):
E jr = a2j + b 2 j t + v jr,
(2)
where E j, are expenses of firm j in year t, and vjr is deviation of the reported expenses from their trend. Operating expenses were defined as expenses not included in cost of sales that are subtracted from the gross margin before determining operating income. These expenses were computed on a per-share basis and adjusted forward, based on the number of outstanding shares in 1957. It was assumed that the 'normal' magnitude of operating expenses lies on the time trend line of the observed expenses. The deviations e and v were used to test for smoothing behavior. If abovetrend N O I were associated with above-trend operating expenses, or if belowtrend N O I were associated with below-trend operating expenses, behavior that is consistent with the smoothing of N O I would be indicated. Under these situations, if the operating expenses were not increased or decreased from their 'normal' magnitudes, the time variations and the magnitudes of the N O I would have been observed to be greater. It could be argued that at least to a certain extent the positive correlation coefficients may be explained by an inherent functional relationship between income and expenses. However, notice that to minimize this problem, we excluded cost of sales from the operating expenses. Moreover, there is no a priori reason to believe that such functional relationship - - even though it may exist - - would systematically affect the difference between the observed coefficients of correlation between the N O I and the operating expenses. For each firm we computed the correlation coefficient, r~, between the deviations series ejr and vjr. The observation of such positive correlation coefficients would be consistent with the smoothing hypothesis. Data were obtained for 56 firms from Boudreaux's (1973) sample drawn from the United States' top 500 manufacturing firms in the period 19521963. Boudreaux's original sample included 12 industries, 6 firms in each, evenly divided between owner controlled and management controlled. The criterion is as follows: The owner controlled group includes firms where (i) one party owns 10~o or more of the voting stock and is represented on the board or in management or is otherwise known to control, or (ii) one party owns 209/0 or more of the voting stock. The management controlled group
194
Y. Amihus et al., "Managerialism', "ownerism' and risk
includes firms where no single block greater than 5~o of the voting stock exists and there is not recent evidence of control. The results show that income smoothing is prevalent in both OC and MC firms. To test for our hypothesis of differences in the extent of income smoothing between the two types of firms, we transformed the correlation coefficient rj into the variable Nj which is normally distributed: Nj=½1nl+rj 1
-
rj
and
N,,~N ~ l n ~ _ p j , n
3 '
where n is the number of observations (15 years) and p is the population correlation coefficient whose estimate is r. The average .N for MC is 0.986 as compared with R of 0.863 for OC, and the difference is significant at the 5Yo level (one-tailed test). This supports our hypothesis that income smoothing is exercised to a greater extent by MC firms than by OC firms.
4. The market-based measures of risk If the risk-reduction activities of the manager of a MC firm are successful, they will be reflected in the behavior of the firm's equity returns. Consider the market model:
R jr = o~j+ t~jRmt + e~t,
(4)
where Rit and R,,,t are the returns on securityj and on the market, respectively, ej, is a residual and ~j and/~j are constant coefficients. Here,/~j= coy (Rj,R,,)/ var(R,.) is the measure of the systematic risk, while var(ej) gives the unique risk of firm j. The coefficient of determination from this regression is R 2 = 1-var(ej)/var(R~), which is increasing when the extent of the unique risk in the firms' equity returns is smaller. The greater is R 2, the smaller is the weight of firm-specific factors in the total risk of the firm. It follows that risk-reduction activities which reduce the firm's unique risk should lead to an increase in R 2. Another important interpretation of R e is as a measure of diversification. Barnea and Logue (1973) showed that the greater is the diversification of the firm's business activity, the greater is its R 2. Hence, if the manager diversifies the firm's activity to reduce its risk, it should be reflected by a higher R2. 6 Another component of risk is the systematic risk, measured by the /~ coefficient. Again, it may be of interest to observe whether the manager's risk-reduction activities affect the systematic risk of the firm. 6See Amihud and Lev (1981) who tested this hypothesis, using income numbers.
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We thus have another test on the difference in behavior between OC and MC firms. Unlike the earlier studies by Boudreaux (1973) and Palmer (1973) who looked at the total variance of firms' income, we present a finer look at the firm's risk, separating between its systematic and unsystematic components. Further, we use market-based measures of risk, derived from securities' returns, rather than from accounting income. Estimates of R 2 and fl were obtained for 61 firms from Boudreaux's (1973) list from Merrill-Lynch's reported results of regressions of monthly data for the period 7/66-6/71. Then, we transformed the R2'S into the normal variables N as in (3), and regressed them on CON, the type of control - - 1 for MC and 0 for OC firm - - and on eleven dummy variables (taking values of 0 and 1) to account for the industry effect. We obtained Nj = 1.14-0.153 CON + 11 industry dummy variables. The t statistic of the CON coefficient was 1.85, significant at better than 5~ (one tail test). 7 This supports our hypothesis that the weight of the firm's specific risk in MC firms is lower than in OC firms, and that MC firms seem to be more diversified. The next test is on the effect of_the firm's type of control on its systematic risk. We estimated the following regression: flj = 1.12 - 0.107 CON + 11 industry dummy variables, where, again, CON= 1 for MC and 0 for OC, and the dummy variables capture the industry effect. Here, the coefficient of CON had the predicted sign but had a t statistic of 1.28, which is significant only at the 10~ level (one tail test). 5. Conclusions
In this paper we presented several new tests of the hypothesis that managers in MC firms undertake policies which result in a lower risk than in OC firms. We found that in MC firms, smoothing of income is more prevalent, the firm's unique risk is relatively smaller and the systematic risk is lower than in OC firms. These results are consistent with the view that when managerial discretion is feasible, as it is in MC firms, managers would strive to reduce their undiversifyable human capital risk by directly affecting their own firms' policies. We are hopeful that our results will add an impetus to a further study of the determinants of differences in preference by different firms for risk-return combination. 7Using R~ instead of Nj, we obtained that the coefficient of CONj is - 0.30, with t = 1.92.
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