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＜ Abstract ＞

In spite of managers’ strong preference for smooth earnings pattern, our knowledge of income smoothing activity is very limited. Our study attempts to fill this void by examining how wealth transfer via RPTs affect income smoothing because the effect of RPT on income smoothing can be tested more meaningfully in Korean’s economic circumstances than in other countries.

Using 4,807 firm-year observations of listed companies from 2001 to 2010 in Korea, we first find that the magnitude of RPTs is positively associated with the level of income smoothing, suggesting that wealth transfer via RPTs is, on average, positively associated with income smoothing of both sides in RPTs. Second, we find that the different types of RPTs have a differentiated impact on income smoothing. Specifically, operating RPTs is positively associated with the level of income smoothing, suggesting that operating RPTs based on business partnership is mainly associated with income smoothing. Finally, we find that the positive association between RPTs and income smoothing is more pronounced in groups where the level of government regulation is low. We confirmed the robustness of our results through a battery of additional analyses.

This study makes several contributions to the existing literature. First, our paper aims to enhance our understanding of income smoothing incentives by

Related Party Transactions and Income Smoothing

: Evidence from Korea

Ilhang Shin

Yonsei University

jayshih00@yonsei.ac.kr

Sungkyu Sohn

Yonsei University

sksohn@yonsei.ac.kr

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providing fresh evidence that RPTs significantly affects smooth earnings. Second, our paper compliment the perspective of prior literature related to the relation between RPTs and earnings management. While prior studies mainly focus on the party which receives profit through RPTs, our study focuses on both sides in RPTs, namely, both the party which grant profit and the party which receive profit and suggests that wealth transfer of in-business group via RPTs have, on average, a positive impact on income smoothing of both sides in RPTs. Finally, this study suggest that RPTs play a role in providing private information on earnings potential. Our paper suggest that information on income of both side in RPTs includes earnings potential in the medium and long term because wealth transfer via RPTs affect the mitigation of earnings volatility in both side in RPTs, thereby adding new findings to academic research in the area.

Key Words: Earnings Potential, Earnings Volatility, Income Smoothing, Regulatory Agency,

Related Party Transactions

Ⅰ. Introduction

In this study, we examine the effect of related party transactions (RPTs,

hereafter) on income smoothing. Specifically, we examine how the magnitude of

RPTs affect income smoothing, and examine how the different types of RPTs by

disaggregating firm-level RPTs into operating (e.g., products/services sales and

materials/merchandise purchases) and non-operating RPTs (e.g., sales and

purchases of property, plant and equipment and investment assets) affect income

smoothing. Finally, we examine how government regulation affect the relation

between RPTs and income smoothing.

Fudenberg and Tirole (1995) define income smoothing as the process of

managing earnings to be less volatile in the long run. Schipper (1989) define

earnings management as an intentional intervention about external financial reporting

process to be conducted for private gains. Numerous prior studies investigated the

incentive for earnings management. The greater part of these areas have the same

interests in the level of earnings; Bonus Plan Hypothesis, Debt Covenant Hypothesis,

Capital Market related incentive(e.g., Capital cost, stock price) and etc. On the other

hand, income smoothing we examine is differentiated from the point that it focuses on

the earnings volatility.

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Recent prior studies on income smoothing mainly investigate the economic

consequences of income smoothing. If income smoothing activities are used for the

opportunistic purpose, for example, the maximization for the utilization of manager,

market reaction will appears negative because income smoothing activities could lower

the level of earnings quality. But, the results of recent studies show that capital market

evaluate income smoothing positively because of its benefits. DeFond and Park(1997)

claim that manager manage earnings upward in case that he expect future performance

excels current performance and manage earnings downward in case that he expect

current performance excels future performance. Income smoothing activities reduce

earnings volatility and information risk and finally have a positive impact on firm

value(Tucker and Zarowin 2006; Li and Richie 2009). These prior studies shows why

managers prefer income smoothing to bumpy earnings paths.

The survey conducted by Graham et al. (2005) suggests that understanding the

determinants of income smoothing is important because of managers’ strong

preference for smooth earnings paths. About 97% of their survey respondents—404

business executives—prefer smooth earnings paths. But, in spite of this important

impact on managers’ behaviors, our knowledge of income smoothing activity is very

limited. Our study attempts to fill this void by examining the influence of RPT

which is regarded as a potential determinant of income smoothing because the

effect of RPT on income smoothing can be tested more meaningfully in Korean’s

economic circumstances other than in other countries1).

RPTs are defined as transactions with related entities such as shareholders,

members of the board of directors, and affiliated companies2). Namely, RPTs mean

the transfer of resource, service or obligation between reporting company and

related entities. The Korean market has several characteristics that make it

particularly suited to our investigation. Many Korean listed firms belong to business

groups (conglomerates) which links their affiliated firms via cross and/or

circular-shareholdings (Kim and Yi, 2006). Thus, wealth transfer between related

entities via RPTs is likely to be more apparent in Korea than other countries

because Korea has relatively weak protections for outside minority shareholders (La

Porta et al., 1999; Bae et al., 2002). The wealth transfer between related entities

1) In 2010, 92% of listed companies were investigated to execute RPTs.2) In this paper, we define a related party following the International Accounting Standard

No. 24 (IAS 24). According to IAS 24, a related party is a person or entity that is related to the entity that is preparing its financial statements. Specifically, a person or a close member of that person’s family is related to a reporting entity if that person (i) has control or joint control of the reporting entity; (ii) has significant influence over the reporting entity; or (iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.

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via RPTs can be observed like the following news.

Shinsegae SVN, escape from crisis via B2B transactions between related entities? [CEO

scoredaily 9.04.2014]

Shinsegae SVN which is getting the short end of the stick was reveled to overcome

decrease in sales via B2B transactions, namely related party transactions. (omitted)

Korea Fair Trade Commission (KFTC) focuses on the Unfair supports to Shinsegae SVN.

Shinsegae SVN is known as the so-called 'Chaebol Bakery' which Jung U Kyung, one of

the family members, owns. The prosecutory authorities reasoned that HurInChul, the

former CEO of E-MART was guilty for the Unfair supports to Shinsegae SVN through

appropriating lower fee than usual fee.

Management Support Team of Shinsegae Business Group says like the followings

in the process of the investigation conducted by Korea Fair Trade Commission

(KFTC).

The statement of Management Support Team of Shinsegae Business Group

The person in charge of Shinsegae SVN requested for cutting down sales fee based on

the increase in cost of labor and cost of materials several times and at that time,

sales fee was revised downwards to 15 %. During the renewal of contracts with the

existing enterprise, such reduction of sales fee is unusual.

Like the above case, RPTs are executed to support the related entities through

the discretional adjustment for the size, amount and timing of RPTs. Our paper

focus on the effect of discretional RPTs on income smoothing.

Using 4,807 firm-year observations of listed companies from 2001 to 2010 in Korea,

we first find that the magnitude of RPTs is positively associated with the level of

income smoothing, suggesting that wealth transfer via RPTs is, on average, positively

associated with income smoothing of both sides in RPTs. Second, we find that the

different types of RPTs have a differentiated impact on income smoothing. Specifically,

operating RPTs is positively associated with the level of income smoothing, suggesting

that operating RPTs based on business partnership is mainly associated with income

smoothing. Finally, we find that the positive association between RPTs and income

smoothing is more pronounced in groups where the level of government regulation is

low. We confirmed the robustness of our results through a battery of additional

analyses.

This study makes several contributions to the existing literature. First, our paper

aims to enhance our understanding of income smoothing incentives by providing

fresh evidence that RPTs significantly affects smooth earnings. The strong

preference of managers on a smooth earnings path surveyed by Graham et al.

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(2005) suggests that it is important to understand the determinants of earnings

smoothing, but, prior literature on the determinant of income smoothing is limited

compared with other types of earnings management focusing on earning’s level.

Second, our paper compliment the perspective of prior literature related to the

relation between RPTs and earnings management. Prior literatures mainly focus on the

effect of RPTs on earning’s level(e.g., profit maximization) via earnings management.

For example, Kim and Woo(2008) suggest that RPTs is positively associated with

discretional accruals. This results seems to be dominated by the party which receives

profit through RPTs, and does not consider the possibility of income-decreasing earnings

management of the counterparty in RPTs. On the other hand, our study focuses on

both sides in RPTs, namely, both the party which grant profit and the party which

receive profit and suggests that RPTs and suggest that wealth transfer of in-business

group via RPTs have, on average, an impact on income smoothing of both sides in

RPTs.

Finally, this study suggest that RPTs have a chance of providing private

information on earnings potential. Prior studies shows that income smoothing plays

a role for a vehicle for managers to reveal their private information about future

earnings3). Our paper suggest that information on income of both side in RPTs

includes earnings potential in the medium and long term because wealth transfer via

RPTs affect the mitigation of earnings volatility in both side in RPTs.

The remainder of this paper is organized as follows. Section 2 reviews prior

studies and develops our hypotheses. Section 3 presents our research methods and

sample selection. Section 4 shows the results of empirical analyses, and Section 5

concludes this study.

Ⅱ. Related literature and hypotheses development

2.1 Income smoothing

Income smoothing is one of ways for manager’s earnings management and

regarded as the process of managing earnings to be less volatile in the long

run(Fudenberg and Tirole 1995). Namely, income smoothing has been studied as

3) For example, Kirschenheiter and Melumad (2002) claim that reported earnings have dual roles. The first role is that the level of reported earnings allows investors to infer the level of permanent future cash flows. The second role is that the fluctuations of reported earnings reduce investors’ confidence in the inferred permanent component.

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one of earnings management since 1970’s. Recent research has enriched our

understanding of managers’ use of their reporting discretion, categorizing it as

either (1) garbling or (2) efficient communication of private information(Tucker and

Zarowin 2006).

On one hand, income smoothing was regarded as manager’s opportunistic

behavior because managers may smooth reported income to meet the bonus target

(Healy 1985) or to protect their job (Fudenberg and Tirole 1995; Arya et al. 1998).

In these circumstances, reported net income has been garbled and thus the

reported earnings are less informative about a firm’s future earnings and cash

flows, because under the contracting theory, income garbling is an equilibrium

solution (Lambert 1984; Demski and Frimor 1999; Tucker and Zarowin 2006).

But, on the other hand, there also exist diametrically opposed views on income

smoothing. Such studies focus on income smoothing as a vehicle for managers to

reveal their private information about future earnings. Healy and Wahlen(1999) claim

that manager convey credible private information on optimistic future prospect by

smoothing earnings. Dichev and Tang(2009) claim that the mitigation of earnings

volatility could increase the predictability of future earnings. Following this,

earnings volatility is negatively associated with he predictability of future earnings.

Truman and Titman(1988) claim that high earnings volatility increases the

possibility of bankruptcy risk and has a negative impact on stock price. Thus,

Truman and Titman(1988) claim that additional fund-raising and the lowering of

bankruptcy risk could be feasible if income smoothing increase the predictability of

future earnings and encourage investors to perceive firm risk low.

Recent studies on market reaction for income smoothing shows that income

smoothing decrease the fluctuations of reported earnings and increase earnings

persistence and the predictability of future earnings and finally lead to positive

market reaction. For example, prior studies propose several benefits of income

smoothing that might induce firms’ income smoothing behavior, such as high Credit

Ratings(Gu and Zhao 2006; Li and Richie 2009; Yang et al. 2007; Park et al. 2011),

high analyst’s forecast accuracy(Beidleman 1973)4), low implied cost of

equity(Francis et al. 2004), high earnings response coefficient(Barth et al. 1999;

Ghosh et al. 2005), high informativeness of earnings(Tucker and Zarowin, 2006),

low cost of debt(Li and Richie 2009) and low weighted average cost of capital(Park

et al. 2012).

4) Beidleman(1973) suggest analysts prefer income smoothing because the mitigation of earnings volatility through income smoothing could decrease error in analysts’ earnings forecasts.

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2.2 Related party transactions (RPTs)

There are two competing views on RPTs based on extant academic literature : the

efficient transaction hypothesis and the conflict of interest hypothesis. First, the efficient

transaction hypothesis is that by reducing transaction costs, RPTs can be used as

efficient contracting mechanisms under incomplete information (Williamson, 1975; Stein,

1997; Khanna and Palepu, 1997; Shin and Park, 1999). Second, the conflict of interest

hypothesis is that RPTs can be used for the interest of controlling shareholders in order

to expropriate wealth from minority shareholders. (e.g., Johnson et al., 2000).

Prior studies investigating whether RPTs manage be used as efficient contracting

mechanisms or a vehicle for controlling shareholders to expropriate wealth from minority

shareholders, however, provide mixed evidence. Chang and Hong (2000) document that

affiliated firms within a business group share tangible and intangible resources and by

doing so, they enjoy the economies of scale and scope. Friedman et al. (2003) argue that

some RPTs such as cash receipts by the listed company are used as a means of

propping, not tunneling, and these RPTs are likely to benefit the listed firm’s minority

shareholders. These prior studies like the above show that the efficient transaction

hypothesis is effective.

On the other hand, there exist a few empirical evidence which show that RPTs arise

from the agency conflicts between controlling shareholders and minority shareholders,

especially in emerging markets where legal protection of minority shareholders is weak.

For example, La Porta et al. (1997, 1998, 1999, 2000), Johnson et al. (2000), Glaeser et al.

(2001), Jian and Wong (2004), and Claessens et al. (2006) have found that controlling

shareholders extract private benefits from minority shareholders through “tunneling.”

Cheung et al. (2009) also provide evidence that prices are arbitrarily set in asset sales

and purchases with related parties. Using 174 firms that disclosed RPTs in Hong Kong,

they find that firms purchase products at higher prices while selling them at lower

prices in RPTs. Similarly, Cheung et al. (2006) document that firms listed on the Hong

Kong stock market experience significant negative abnormal stock returns upon the

disclosure of RPTs; this indicates that such transactions have a negative effect on firm

value.

While there exist mixed evidences regarding the usefulness of RPTs from the

perspective of firm value, RPTs may, on the whole, have negative impact on the

usefulness of accounting information. Kim and Woo(2008) suggest that RPTs is

positively associated with discretional accruals and is negatively associated with

earnings response coefficient. Choi(2009) also suggest that RPTs is negatively associated

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with accruals quality. Choi(2009) measure accruals quality by accrual estimation errors

estimated using the industry-specific cross-sectional regressions of current accruals on

past, current, and future operating cash flows based on Dechow and Dichev(2002).

2.3 Hypotheses development

Based on the conflict of interest hypothesis, RPTs are used for cross subsidization

which means to support the financially unhealthy firms or the important firms from the

strategic standpoint. By the conflict of interest hypothesis, both sides in RPTs is

composed of one party which grant profit and the other party which receive profit

shown as <Figure 1>.

<Figure 1> The effect of wealth transfer via RPTs on earnings volatility of both sides in

RPTs.

Suppose there is RPT between firm A and firm B. Prior studies such as Johnson et

al.(2000) suggest that controlling shareholders of business group have incentives for wealth

transfer to maximize their wealth. In addition, Ferris et al(2003) claim the so-called "Profit

stability hypothesis". Profit stability hypothesis states that business group like Chaebol will

focus more on smooth earnings streams rather than profit maximization. Thus, firm volatility

is smaller for business group like Chaebol.

Based on these prior studies, we can predict that there is wealth transfer via RPT from

overperforming firm which show income-increasing trend to underperforming firm which

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show income-decreasing trend to share the wealth of in-business group via RPTs.

Namely, the allocation of the wealth of in-business group via RPTs can mitigate the

income-increasing trend of overperforming firm and the income-decreasing trend of

underperforming firm. Shown as <Figure 1>, firm A grant profit 20 to firm B through

RPT. This RPT cause to allocate profit 20 from firm A to firm B and lead to the

smooth earnings streams of both sides in RPTs5).

To sum up, many Korean firms belong to business groups, a collection of both public and

private companies in a pyramidal and circular ownership structure, that are typically

controlled by members of a founding family, controlling shareholders(Kang et al 2014).

Controlling shareholders of business group have incentives for wealth transfer siphoning off

corporate wealth to line the pockets of the siblings of owner families instead of

improving the efficiency of transactions to maximize their wealth using their controlling

power over business group. As a result, wealth transfer of in-business group via RPTs

have, on average, a positive impact on income smoothing of both sides in RPTs. Based on

the above discussion, Hypothesis 1 written in the alternative form is as follows:

Hypothesis 1: There is a positive association between the magnitude of RPTs and the

level of income smoothing.

Managers have incentives for income smoothing to lower cost of equity and enhance

firm value. Thus, managers note the effect of discretional RPTs on income smoothing of

both sides in RPTs.

RPTs can be disaggregated into either operating (e.g., products/services sales and

materials/merchandise purchases) or non-operating transactions (e.g., sales and

purchases of property, plant and equipment and investment assets). Operating

transactions occur throughout the accounting period in a frequent and recurring manner,

while nonoperating transactions tend to be infrequent and large in amount(Kang et al

2014). Therefore, managers is expected to prefer frequent and recurring operating RPTs

to infrequent non-operating transactions for income smoothing which is regarded as

5) Our study focuses on both sides in RPTs, namely, both the party which grant profit and the party which receive profit. Thus, it needs proper assumption to distinguish both sides in RPTs. To address this issue, we suppose that the party which grant profit is, on average, overperforming and have an income-increasing trend and that the party which receive profit is, on average, underperforming and have an income-decreasing trend. To confirm the properness of our assumption, we perform additional analysis using subsamples with positive or negative premanaged income changes from the last year to the current year. Panel with positive premanaged income changes show that RPTs is negatively associated with discretionary accruals, but panel with negative premanaged income changes show that RPTs is positively associated with discretionary accruals. Refer to the detailed results of [Additional analysis 5.1].

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long-term financial reporting strategy with long-term horizons.

Managers’ preference for operating RPTs as a means of income smoothing is shown

in the case of Shinsegae SVN. According to the investigation of Korea Fair Trade

Commission (KFTC), unfair supports to Shinsegae SVN by related entities was the part

of long-term business strategy from the perspective of Shinsegae Business Group6).

This case shows that in particular, the underperforming member firm of business group

try to draw the support of related entities appealing to both the level of each member

firm and the level of business group. As a result, the support for the underperforming

member firm of business group come to include the part of long-term business strategy

of Shinsegae Business Group.

To sum up, operating RPTs, the part of long-term business strategy of Business

Group Level, is mainly expect to enhance the level of income smoothing compared with

non-operating RPTs. Based on the above discussion, Hypothesis 2 written in the

alternative form is as follows:

Hypothesis 2: The positive association between the magnitude of RPTs and the level

of income smoothing is different between operating and non-operating RPTs.

(Hypothesis 2-1) The magnitude of operating RPTs is positively associated with

the level of income smoothing.

(Hypothesis 2-2) The magnitude of non-operating RPTs is not associated with

the level of income smoothing.

Unfair internal transactions are those with related parties or other companies who

provide goods, services, capital, assets, and personnel free of charge or on favorable

terms which might substantially interfere with fair deals(KFTC, Guidelines for

Reviewing Unfair Assistance, 2011).

By the way, business groups, specially "designated business groups7)", are under

6) According to the investigation of Korea Fair Trade Commission(KFTC), long-term business strategy of Shinsegae Business Group in 2011 to support Shinsegae SVN was as follows;○ long-term business strategy between related entities

· issue: growth dependent on Business Group Infrastructure (Food, Bakery, I&C, L&B)· support for long-term growth → enforce the Synergy effect

○ incubation strategy · World-level bakery firm· combination of Business Group Infrastructure and SPC growth model· active support for the enhancement of profitability of SVN

7) The Fair Trade Commission determines a business group as a group of firms in which “the same person virtually dominates the business decisions of a group” and specifies, among business groups, a large scale business group (chaebol) as having total assets of 5 trillion Won (2 trillion Won before 2009)[Fair Trade Act Decree 17 Article 9, amended 2008]. We

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strict discipline as for internal transactions through “Monopoly Regulations and Fair

Trade Law”. First, Chaebol firms which belong to designated business groups must

undergo a board decision and disclose relevant information when large internal

transactions with related parties (i.e., more than 10 percent of company capital stock or

more than a 10 billion Won deal) are made8). Second, Chaebol firms must disclose,

quarterly, the general status of business groups, shares, transactions with related parties,

etc9).

Therefore, wealth transfer between chaebol firms via RPTs could be hard compared

with non-chaebol firms because Korea Fair Trade Commission (KFTC) monitor whether

RPTs correspond to unfair internal transactions through various regulation like the aboves.

In addition, if one of both sides in RPTs is under other regulation conducted by Korea

Fair Trade Commission (KFTC), such as monopoly regulation or market-controlling

enterpriser regulation, the risk in the process of wealth transfer via RPTs have no choice

but to grow. As a result, we can predict that government regulation mitigate the

positive relation between RPTs and income smoothing. Based on the above discussion,

Hypothesis 3 written in the alternative form is as follows:

Hypothesis 3: The positive association between RPTs and income smoothing is

stronger under low government regulation than under high government regulation.

Ⅲ. Research design and sample selection

3.1. Measurement of income smoothing

We employ main measures of earnings income following the previous studies. The

measure of income smoothing, SMTH, is measured as the negative of the correlation

between the change in discretionary accruals (DA) and the change in pre-managed

earnings (PDI = earnings - DA), following Tucker and Zarowin (2006):

usually call designated business groups as Chaebol.8) KFTC, Regulation on Resolution of Board of Directors and Disclosures on Large-Scale

Intra-Group Transactions, 20129) Fair Trade Act Article 11, amended 2007 and Decree 11 Article 17, amended 2009

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Variable DefinitionsRPT = [RPTs (operating sales and purchases + non-operating

transactions)]/Beginning total assets;OPRPT = RPTs (operating sales and purchases)/Beginning total assets;NON_OPRPT = RPTs (non-operating transactions)/Beginning total assets;SMTH = the negative of the correlation between the change in discretionary

accruals (DA) and the change in pre-managed earnings (PDI = earnings - DA), following Tucker and Zarowin (2006)

NOA = Net operating assets;MB = Market-to-book ratio;ISSUE = Bond or equity issuance, 1 if the amount of net bond and equity

issuance is above zero, and 0 otherwise; LNMV = The logarithm of the market value of equity;ROA = NI/Beginning total assets;DIV = 1 if a firm pays dividends, and 0 otherwise;LEV = Leverage ratio, calculated as total debts divided by total assets;

or

SMTH is likely larger for firms that smooth earnings to a greater extent, because

their managers respond to changes in non-discretionary earnings by adjusting

discretionary accruals in the opposite direction, designed to capture how volatile

discretionary portions of earnings are given the fundamental and non-discretionary

earnings volatility10).

3.2. Research model

We use the following models to test our main hypotheses. Models (1) are used to

test Hypotheses 1 and Hypotheses 2.

(1)

The major variable of interest in model (1) is RPT, OPRPT and NON_OPRPT(i.e.,

the level of related party transactions). A significant positive sign of RPT would

suggest that RPTs can be used as a channel which leads to income smoothing. In

addition, to test our hypothesis 3, we classify government regulation into the following 3

aspects: regulation for Chaebol, monopoly regulation, market-controlling enterpriser

regulation. We measure the level of each government regulation like <Table 1>.

10) Following Tucker and Zarowin (2006), discretionary accruals is based on modified Jones modelbut, we employ discretionary accruals based on Kothari et al(2005).

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<Table 1> Measurement of the level of government regulationClassification Proxy Variable Contents

Regulation for Chaebol Chaebol

- If a firm belongs to designated business groups, a firm is under high regulation.- If a firm doesn't belong to designated business groups, a firm is under low regulation.

Monopoly regulation Herfindahl-Herschman Index(HHI)

- If HHI >= Median, a firm is under high regulation.- If HHI < Median, a firm is under low regulation.

Market-controlling enterpriser regulation Market Share (MS)

- If MS >= Median, a firm is under high regulation.- If MS < Median, a firm is under low regulation.

Control variables used in Models (1) are taken from prior studies. NOA, the amount

of net operating assets represents firms’ accounting discretion flexibility(Barton and

Simko, 2002). MB, market-to-book ratio is negatively related to the extent of earnings

smoothing activities, suggesting that these activities are less prevalent for growing firms

than for mature firms. ISSUE proxies for managers’ incentives to smooth earnings

associated with equity or bond issuance. LNMV proxies for firm size and is positively

related to earnings smoothing, consistent with the literature (e.g., Watts and

Zimmerman, 1990) in that larger firms are more involved in earnings smoothing to

reduce political costs. DIV indicates more earnings smoothing for dividend-paying firms.

Firms with higher leverage are more likely to smooth earnings to reduce their cost of

debts. Thus, we included LEV as control variable(Jung et al. 2013). We also add

industry dummies and year dummies to control for variations in earnings smoothing

activities over time and across industry.

3.3. Sample selection

This study covers publicly listed firms in Korea from 2001 to 2010. Financial firms

and non-December year-end firms are excluded to make the sample comparable. This

study also excludes deficit firms and delisted firms. Financial and stock market data

used in this study are extracted from the Data Guide Pro database provided by FnGuide

Co., and related-party transaction data are from the Kis-value database provided by

NICE Information Service Co., Ltd. Data Guide Pro and Kis-value is equivalent to CRSP

and Compustat in US, respectively covering all publicly listed firms in Korea. These

procedures leave the final sample of 4,807 firm-year observations. <Table 2> provides

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<Table 2> Descriptive Statistics (N= 4,807)Variable Mean StdDev Q1 Median Q3

RPT 0.2627 0.3659 0.0352 0.1274 0.3357 OPRPT 0.2418 0.3625 0.0144 0.1009 0.3090 NON_OPRPT 0.0177 0.0439 0.0000 0.0000 0.0111 SMTH 0.5575 0.3417 0.4997 0.7157 0.7763 NOA 0.9558 0.1980 0.8487 0.9515 1.0409 MB 1.8377 1.4479 0.8302 1.4501 2.4057 ISSUE 0.2773 0.4477 0.0000 0.0000 1.0000 LNMV 25.3938 1.7368 24.1559 25.0517 26.3055 ROA 0.0568 0.0675 0.0211 0.0510 0.0894 DIV 0.7306 0.4437 0.0000 1.0000 1.0000 LEV 0.4581 0.1949 0.3112 0.4589 0.5975

Variable DefinitionsRPT = [RPTs (operating sales and purchases + non-operating

transactions)]/Beginning total assets;OPRPT = RPTs (operating sales and purchases)/Beginning total assets;NON_OPRPT = RPTs (non-operating transactions)/Beginning total assets;SMTH = the negative of the correlation between the change in discretionary

<Table 2> Sample Selection

Criteria Number of Firm-Years

Total sample 2001～2010 5,832

Less: Financial institutions 374

Less: Non-December 31 fiscal year end firms 174

Less: Deficit firms 12

Less: firms without necessary financial data 465

Total 4,807

the summary of sample selection procedures.

Ⅳ. Empirical analyses and results

4.1. Descriptive statistics

<Table 3> presents descriptive statistics of variables used in this study11).

11) To reduce the effect of extreme values on the results, we winsorize all variables except for dummy variables at the top and bottom 1% of their distributions.

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accruals (DA) and the change in pre-managed earnings (PDI = earnings - DA), following Tucker and Zarowin (2006)

NOA = Net operating assets;MB = Market-to-book ratio;ISSUE = Bond or equity issuance, 1 if the amount of net bond and equity

issuance is above zero, and 0 otherwise; LNMV = The logarithm of the market value of equity;ROA = NI/Beginning total assets;DIV = 1 if a firm pays dividends, and 0 otherwise;LEV = Leverage ratio, calculated as total debts divided by total assets;

The test variable of this study (RPT) represents the proportion of RPTs to the

beginning total assets. RPTs has mean values of 0.2627. OPRPT and NON_OPRPT have

mean values of 0.2418 and 0.0177, respectively. It is noteworthy that the magnitude of

operating RPTs is greater than the magnitude of non-operating RPTs. This means that

a greater part of RPTs is composed of operating RPTs.

Among control variables, the mean value of the logarithm of the market value of

equity (LNMV) is 25.3938; the mean value of ROA is 0.0568, indicating that firms make

about 5.68 percent of total assets as net income during the sample period.

<Table 4> contains Pearson correlations among variables.

We find that RPT and OPRPT are positively correlated with SMTH, consistent with

our prediction. The correlation coefficient between RPT and SMTH is 0.048 (p-value =

0.001), and the coefficient coefficient between OPRPT and SMTH is also 0.048 (p-value

= 0.001) indicating that a greater part of RPTs is composed of operating RPTs. On the

other hand, the coefficient coefficient between NON_OPRPT and SMTH is insignificant,

consistent with our multivariate test results.

Variance Inflation Factor (VIF) values in all empirical models do not exceed 10,

suggesting the multicollinearity is not severe.

- 16 -

<Table 4> Pearson Correlation (N= 4,807)

RPT OPRPT NON_OPRPT SMTH NOA MB ISSUE LNMV

RPT 1.000 0.978 0.100 0.048 0.112 -0.152 0.049 0.189　 　 <.0001 <.0001 (0.001) <.0001 <.0001 (0.001) <.0001OPRPT 　 1.000 -0.070 0.048 0.101 -0.145 0.039 0.173　 　 　 <.0001 (0.001) <.0001 <.0001 (0.007) <.0001NON_OPRPT 　 　 1.000 0.010 0.054 -0.041 0.056 0.076　 　 　 　 (0.493) (0.000) (0.004) <.0001 <.0001SMTH 　 　 　 1.000 0.060 0.052 -0.014 0.111　 　 　 　 　 <.0001 (0.000) (0.339) <.0001NOA 　 　 　 　 1.000 -0.021 0.190 0.142　 　 　 　 　 　 (0.141) <.0001 <.0001MB 　 　 　 　 　 1.000 -0.086 -0.450　 　 　 　 　 　 　 <.0001 <.0001ISSUE 　 　 　 　 　 　 1.000 0.207　 　 　 　 　 　 　 　 <.0001LNMV 　 　 　 　 　 　 　 1.000　 　 　 　 　 　 　 　 　

ROA 　 　 　 　 　 　 　 　

　 　 　 　 　 　 　 　 　

DIV 　 　 　 　 　 　 　 　

　 　 　 　 　 　 　 　 　

LEV 　 　 　 　 　 　 　 　

　 　 　 　 　 　 　 　 　

1) *, **, *** indicate significance levels at 10%, 5%, 1%, two-tailed, respectively.2) Variable definitions are presented in <Table 1>.

- 17 -

<Table 5> RPTs and income smoothing

VariablesTest variable = RPT

Coef. t-valueIntercept 0.142 　 1.59 　

RPT 0.035 　 2.68 ***NOA 0.018 　 0.69 　

MB 0.018 　 4.56 ***ISSUE 0.000 　 -0.02 　

LNMV 0.006 　 1.68 *ROA 0.123 　 1.55 　

DIV 0.268 　 21.44 ***LEV -0.006 　 -0.23 　

Yeardummies Yes

Industrydummies Yes

F-value 34.47 Adj. R² 0.1533

N 48071) *, **, *** indicate significance levels at 10%, 5%, 1%, two-tailed, respectively.2) Variable definitions are presented in <Table 1>.

4.2. The results of empirical analyses

4.2.1. The association between the magnitude of RPTs and the level of

income smoothing

<Table 5> presents our empirical results of estimating the association between the

magnitude of RPTs and the level of income smoothing.

Consistent with our prediction, coefficient estimate of RPT is 0.035, significant at the

1 percent level(t-value=2.68), suggesting that there is a positive association between the

magnitude of RPTs and the level of income smoothing. This empirical result show that

wealth transfer of in-business group via RPTs is, on average, positively associated with

income smoothing of both sides in RPTs.

Overall, our evidence in <Table 5> reveal that there is a positive association between

RPTs and income smoothing supporting Hypothesis 1.

- 18 -

<Table 6> Types of RPTs and income smoothing

VariablesPanel A : Test variable = OPRPT Panel B : Test variable =

NON_OPRPTCoef. t-value Coef. t-value

Intercept 0.141 　 1.57 　 0.122 　 1.36 　

OPRPT 0.036 　 2.74 ***NON_OPRPT 0.080 　 0.77 　

NOA 0.018 　 0.71 　 0.021 　 0.83 　

MB 0.019 　 4.58 *** 0.018 　 4.48 ***ISSUE 0.000 　 0.00 　 -0.001 　 -0.06 　

LNMV 0.006 　 1.70 * 0.006 　 1.96 *ROA 0.123 　 1.55 　 0.136 　 1.71 *DIV 0.268 　 21.44 *** 0.269 　 21.55 ***LEV -0.006 　 -0.22 　 0.002 　 0.06 　

Yeardummies Yes Yes

Industrydummies Yes Yes

F-value 34.48 34.16 Adj. R² 0.1533 0.1521

N 4807 48071) *, **, *** indicate significance levels at 10%, 5%, 1%, two-tailed, respectively.2) Variable definitions are presented in <Table 1>.

4.2.2. The association between types of RPTs and the level of income

smoothing

<Table 6> presents our empirical results of estimating the association between types

of RPTs and the level of income smoothing.

Consistent with our prediction, coefficient estimate of OPRPT is 0.036, significant at

the 1 percent level(t-value=2.74), suggesting that there is, on average, a positive

association between the magnitude of operating RPTs and the level of income

smoothing. This empirical result show that the effect of wealth transfer of in-business

group via RPTs on income smoothing is, on average, mainly dominated with operating

RPTs. On the other hand, coefficient estimate of NON_OPRPT is insignificant

suggesting that non-operating RPTs don't affect the level of income smoothing

significantly.

Overall, our evidence in <Table 6> reveal that there is a positive association between

only operating RPTs and income smoothing supporting Hypothesis 2.

- 19 -

<Table 7> the effect of government regulation on the relation between RPTs andincome smoothing

Variables

Panel A : Designated Business Group(DBG) Panel B : Top 30 Business Group

High Regulation(Sub-sample

belonging to DBG)

Low Regulation(Sub-sample not

belonging to DBG)

High Regulation(Sub-sample

belonging to Top 30)

Low Regulation(Sub-sample not

belonging to Top 30)

Coef. t-value Coef. t-value Coef. t-value Coef. t-valueIntercept -0.312 　 -1.67 * 0.401 　 2.80 *** -0.376 　 -1.85 * 0.422 　 3.15 ***RPT -0.002 　 -0.10 　 0.048 　 2.64 *** 0.004 　 0.20 　 0.050 　 2.95 ***NOA -0.015 　 -0.28 　 0.034 　 1.15 　 0.036 　 0.65 　 0.023 　 0.82 　MB 0.004 　 0.38 　 0.021 　 4.51 *** 0.006 　 0.62 　 0.020 　 4.30 ***ISSUE -0.036 　 -1.83 * 0.014 　 1.11 　 -0.054 　 -2.64 *** 0.018 　 1.47 　LNMV 0.018 　 2.74 *** -0.004 　 -0.69 　 0.022 　 3.11 *** -0.005 　 -1.00 　ROA 0.525 　 3.08 *** 0.038 　 0.42 　 0.603 　 3.39 *** 0.041 　 0.46 　DIV 0.217 　 8.15 *** 0.280 　 19.79 *** 0.200 　 7.07 *** 0.281 　 20.18 ***LEV 0.151 　 2.64 *** -0.061 　 -1.86 * 0.138 　 2.22 ** -0.048 　 -1.49 　Yeardummies Yes Yes Yes Yes

Industrydummies Yes Yes Yes Yes

Adj. R² 0.1579 0.1642 0.142 0.1616N 1122 3685 968 3839

1) *, **, *** indicate significance levels at 10%, 5%, 1%, two-tailed, respectively.2) Variable definitions are presented in <Table 1>.

4.2.3. The effect of government regulation on the relation between RPTs and

income smoothing

<Table 7> presents our empirical results of estimating the effect of government

regulation regarding regulation for chaebol on the relation between RPTs and income

smoothing.

Subsample tests in Panel A, <Table 7> shows that only for low regulation

groups(i.e., non-DBG group), the coefficient of RPTs is significantly positive. These

results suggest that Chaebol regulation of government mitigate the relation between

RPTs and income smoothing. That is, for high regulation groups(i.e., DBG group), RPTs

is not significantly associated with income smoothing, because wealth transfer via RPTs

could be hard due to the various regulation conducted by Korea Fair Trade Commission

(KFTC) on unfair internal transactions. Subsample tests in Panel B, <Table 7> using

Top 30 Business Group as the definition of chaebol also shows qualitatively the same

results as subsample tests in Panel A.

Overall, our evidence in <Table 7> reveal that a positive association between RPTs

and income smoothing is more pronounced in the low regulation groups(i.e., non-DBG

- 20 -

<Table 8> The effect of government regulation on the relation between RPTs and income smoothing

Variables

Panel A : Monopoly regulation Panel B : Market-controlling enterpriser regulation

High Regulation(HHI >= Median)

Low Regulation(HHI < Median)

High Regulation(MS >= Median)

Low Regulation(MS < Median)

Coef. t-value Coef. t-value Coef. t-value Coef. t-valueIntercept 0.008 　 0.07 　 0.255 　 1.63 　 -0.302 　 -2.23 ** 0.253 　 1.26 　RPT -0.017 　 -1.03 　 0.068 　 2.99 *** 0.017 　 1.00 　 0.054 　 2.58 ***NOA -0.055 　 -1.48 　 0.080 　 2.32 ** 0.102 　 2.61 *** -0.038 　 -1.14 　MB 0.011 　 1.90 * 0.025 　 4.35 *** 0.016 　 2.75 *** 0.029 　 4.64 ***ISSUE 0.011 　 0.76 　 -0.012 　 -0.73 　 -0.027 　 -1.86 * 0.031 　 1.95 *LNMV 0.010 　 2.50 ** 0.000 　 -0.03 　 0.021 　 4.45 *** 0.002 　 0.24 　ROA -0.001 　 -0.01 　 0.346 　 3.01 *** -0.123 　 -1.05 　 0.331 　 3.00 ***DIV 0.282 　 16.03 *** 0.246 　 13.73 *** 0.274 　 15.23 *** 0.260 　 14.82 ***LEV 0.035 　 0.88 　 -0.040 　 -1.03 　 -0.012 　 -0.28 　 0.040 　 0.99 　Yeardummies Yes Yes Yes Yes

Industrydummies Yes Yes Yes Yes

Adj. R² 0.1688 0.1594 0.163 0.1537N 2405 2402 2402 2405

1) *, **, *** indicate significance levels at 10%, 5%, 1%, two-tailed, respectively.2) Variable definitions are presented in <Table 1> and are as follows.

group) supporting Hypothesis 3.

<Table 8> also presents our empirical results of estimating the effect of government

regulation regarding monopoly regulation and market-controlling enterpriser regulation

on the relation between RPTs and income smoothing.

Subsample tests in Panel A, <Table 8> shows that only for low regulation groups

regarding monopoly regulation, the coefficient of RPTs is significantly positive. These

results suggest that monopoly regulation of government mitigate the relation between

RPTs and income smoothing. That is, for high regulation groups with HHI over median

value, RPTs is not significantly associated with income smoothing, because wealth

transfer via RPTs could be hard due to the monitoring of Korea Fair Trade Commission

(KFTC). Subsample tests in Panel B, <Table 8> regarding market-controlling

enterpriser regulation also shows qualitatively the same results as subsample tests in

Panel A.

Overall, our evidence in <Table 8> reveal that a positive association between RPTs

and income smoothing is more pronounced in the low regulation groups for both

monopoly regulation and market-controlling enterpriser regulation supporting Hypothesis

- 21 -

3.

4.3. Further analyses

4.3.1. Changes in premanaged income and the relation between RPTs and

earnings management

So far we provide evidence that there is a positive association between RPTs and

income smoothing arguing that RPTs in in-business group is, on average, positively

associated with income smoothing of both sides in RPTs.

By the way, income smoothing means managers attempt to manage earnings

downwards (or upwards) when managers expect an increase (or decrease) in earnings

from the last year to the current year, Thus, the positive relation between RPTs and

income smoothing means, in other words, that RPTs is associated with

income-decreasing earnings management in subsamples with positive premanaged income

changes from the last year to the current year and RPTs is associated with

income-increasing earnings management in subsamples with negative premanaged

income changes from the last year to the current year.

Therefore, to check the robustness of our test results, we split entire samples into

the following 2 subsamples: subsamples with positive premanaged income changes from

the last year to the current year, subsamples with negative premanaged income changes

from the last year to the current year. In each of groups, we confirmed the relation

between RPTs and discretionary accruals.

Subsample tests in Panel A, <Table 9> presents our empirical results of estimating

the relation between RPTs and discretionary accruals. For the sub-sample of

observations with the changes in premanaged income>=0, the coefficient estimate of

RPT is -0.008, significant at the 5 percent level(t-value=-2.11), suggesting that

managers manage earnings downwards through RPTs when managers expect an

increase in earnings from the last year to the current year. For the sub-sample of

observations with the changes in premanaged income<0, the coefficient estimate of RPT

is 0.011, significant at the 1 percent level(t-value=2.95), suggesting that managers

manage earnings upwards through RPTs when managers expect a decrease in earnings

from the last year to the current year. This is consistent with our main result for

Hypothesis 1.

Subsample tests in Panel B, <Table 9> also support our main result for Hypothesis

2. For the sub-sample of observations with the changes in premanaged income>=0, the

- 22 -

coefficient estimate of OPRPT is -0.010, significant at the 1 percent level(t-value=-2.58),

suggesting that managers manage earnings downwards through operating RPTs when

managers expect an increase in earnings from the last year to the current year. For the

sub-sample of observations with the changes in premanaged income<0, the coefficient

estimate of RPT is 0.011, significant at the 1 percent level(t-value=2.95), suggesting that

managers attempt to manage earnings upwards through operating RPTs when managers

expect a decrease in earnings from the last year to the current year. This is consistent

with our main result for Hypothesis 2.

On the other hand, subsample tests in Panel C, <Table 9> support our main result

for Hypothesis 3 showing that non-operating RPTs is not significantly associated with

income smoothing. For the sub-sample of observations with the changes in premanaged

income>=0, the coefficient estimate of NON_OPRPT is 0.049, significant at the 10

percent level(t-value=1.69), but, for the sub-sample of observations with the changes in

premanaged income<0, the coefficient estimate of RPT is insignificant. This is consistent

with our main result for Hypothesis 3.

- 23 -

<Table 9> The effect of changes in premanaged income on the relation between RPTs and earnings management

Variables

Panel A : Test variable = RPT Panel B : Test variable = OPRPT Panel C : Test variable = NON_OPRPT

Sub-sample of observations with the

changes in premanaged income >=0

Sub-sample of observations with the

changes in premanaged income

<0

Sub-sample of observations with the

changes in premanaged income >=0

Sub-sample of observations with the

changes in premanaged income

<0

Sub-sample of observations with the

changes in premanaged income >=0

Coef. t-value Coef. t-value Coef. t-value Coef. t-value Coef.

RPT -0.008 　 -2.11 ** 0.011 　 2.78 ***

OPRPT -0.010 　 -2.58 *** 0.011 　 2.95 ***

NON_OPRPT 0.049 　

Intercept & control variables

Yes Yes Yes Yes Yes

Year dummies Yes Yes Yes Yes Yes

Industry dummies Yes Yes Yes Yes Yes

Adj. R² 0.1715 0.1443 0.1723 0.1447 0.172N 2404 2403 2404 2403 2404

1) *, **, *** indicate significance levels at 10%, 5%, 1%, two-tailed, respectively.2) Variable definitions are presented in <Table 1>.

- 24 -

4.3.2. Alternative measure of income smoothing: Leuz et al.(2003)

To check the robustness of our test results, we employ alternative measure of

income smoothing: Leuz et al.(2003). Alternative measure captures the relative

volatility of earnings to the volatility of cash flows from operation (Francis et al., 2004;

LaFond et al., 2007; Leuz et al., 2003), calculated as follows:

, where earnings is calculated as net income scaled by average total assets and CFO is

cash flow from operations scaled by average total assets. Larger values of alternative

measure represent more earnings smoothing activities. Note that deflating earnings

volatility by cash flow volatility controls for differences in the variability of fundamental

economic performance across firms (Leuz et al., 2003). In other words, scaling by cash

flow volatility helps us capture the discretionary portion of earnings smoothing through

accruals management. We require 5 consecutive firm-year observations to calculate the

standard deviations on rolling basis.

We confirm that the results with alternative measure of income smoothing are

qualitatively the same as those with main measure of income smoothing, though we do

not suggest additional empirical result.

Ⅴ. Conclusion

In this study, we examine the effect of related party transactions (RPTs, hereafter)

on income smoothing. Specifically, we examine how the magnitude of RPTs affect

income smoothing, and examine how the different types of RPTs by disaggregating

firm-level RPTs into operating (e.g., products/services sales and materials/merchandise

purchases) and non-operating RPTs (e.g., sales and purchases of property, plant and

equipment and investment assets) affect income smoothing. Finally, we examine how

government regulation affect the relation between RPTs and income smoothing.

Using 4,807 firm-year observations of listed companies in Korea, we first find that

the magnitude of RPTs is positively associated with the level of income smoothing,

suggesting that wealth transfer via RPTs has a positive impact on income

smoothing. Second, we find that the different types of RPTs have a differentiated

- 25 -

impact on income smoothing. Specifically, operating RPTs is positively associated

with the level of income smoothing, suggesting that operating RPTs based on

business partnership is mainly associated with income smoothing. Finally, we find

that the positive association between RPTs and income smoothing is more

pronounced in groups where the level of government regulation is low. We

confirmed the robustness of our results through a battery of additional analyses.

This study makes several contributions to the existing literature. First, our paper

aims to enhance our understanding of income smoothing incentives by providing fresh

evidence that RPTs significantly affects smooth earnings. Second, our paper compliment

the perspective of prior literature related to the relation between RPTs and earnings

management. Our study focuses on both sides in RPTs, namely, both the party which

grant profit and the party which receive profit and suggests that RPTs and suggest

that wealth transfer of in-business group via RPTs have, on average, an impact on

income smoothing of both sides in RPTs. Finally, this study suggest that RPTs have a

chance of providing private information on earnings potential. Our paper suggest that

information on income of both side in RPTs includes earnings potential in the medium

and long term because wealth transfer via RPTs affect the mitigation of earnings

volatility in both side in RPTs.

But, if measurement error of income smoothing is systematically related to the

income smoothing proxies, then the reported regression coefficients may be biased. We

expect these limitations to be resolved in future studies.

“This manuscript has not been published and is not under consideration

elsewhere.”

- 26 -

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