Comparing the effects of income smoothing practices on the earnings-price ratios of Japanese and United States firms

This study examines the variation in earnings-price ratios across Japanese and U.S firms. Japanese firms have consistently lower earnings-price ratios than U.S. firms. The differences in earnings-price ratios have been primarily attributed to differences in Japanese and U.S. accounting standards. The objective of this study is to show that Japanese firms engage in income smoothing practices that stabilize earnings, thereby increasing Japanese investors' willingness to pay higher prices for Japanese stocks.;Consistent with the results of French and Poterba's (1991) study, adjusting Japanese earnings does not entirely eliminate the differences in the earnings-price ratios between Japanese and U.S. firms. On the average, the accounting standard differences explain 52 percent of the differences in the average earnings-price ratios of Japanese and U.S. firms.;Comparing the income smoothing index and proportion of firms identified as smoothers show that the intensity of Japanese firms practicing income-smoothing is greater than that of U.S. firms. The results also show that income-smoothing index is significant in explaining the cross-sectional variation of earnings-price ratios for Japanese firms but it is not significant for U.S. firms. Two potential explanations for the results of U.S. firms are as follows. First, income smoothing is not practiced widely across firms in the U.S. Hence, the variation of income smoothing does not explain the variation in the cross-sectional earnings-price ratios. Second, even if U.S. firms practice income smoothing, investors are aware of it and take it into account.;Controlling for income smoothing does not completely eliminate the differences in the earnings-price ratios of Japanese and U.S. firms. That is, although income smoothing plays a role in explaining the variations of earnings-price ratios across Japanese firms, it is not the only factor that contributes to the differences in the earnings-price ratios of Japanese and U.S. firms. Other factors may play a role which is either country-specific (such as inflationary expectations, tax regimes) or firm-specific (such as quality of earnings, real returns) as suggested by Brown (1989).