Transitioning from a Bank-Based Toward an Equity-Outsider Financing System in Japan: The Impact on Income Smoothing Practice over 45 Years

Synopsis The research problem We investigated how income smoothing in Japan has changed over time and whether this change is associated with changes in its financing system. Motivation International accounting research predicts that a country’s financing system determines its accounting practice—that is, as a country changes its financing system, especially from an insider to an equity-outsider financing system, its accounting practice changes accordingly. In Japan, the financing system has traditionally been bank-oriented (an insider system). After the collapse of the bubble economy starting around 1990, it moved toward an equity-outsider system, open to international investment with the introduction of more transparent accounting standards similar to U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. We exploit the setting of Japan to examine our prediction regarding accounting changes. The test hypothesis We hypothesized that the degree of income smoothing in Japan has decreased in response to the change from a bank-based toward an equity-outsider financing system. Target population This study is relevant to researchers evaluating the impact of country-level financing system transitions on financial reporting practices and other firm behaviors. It is also of interest to policymakers facing such transitions and considering a reform of economic regulations. Adopted methodology We performed multivariate analyses using ordinary least squares regressions. Analyses The sample period is from 1976 to 2020 (45 years). The main proxy for the insider system is country-level bank ownership, which is complemented by country-level foreign ownership (i.e., a proxy for the equity-outsider system). Findings The degree of income smoothing decreased through the 1990s and early 2000s. This change is associated with lower levels of bank ownership, a proxy for an insider system, and higher levels of foreign ownership, which reflect arm’s-length investment forces. Together, these findings provide evidence of the impact of Japan’s transition from a bank-based toward an equity-outsider financing system on accounting practices.