Income Smoothing

Topics: Income Pages: 9 (3021 words) Published: August 24, 2008

The income smoothing literature has been the centre of attention in the accounting world for the past few decades. When companies experience economic turbulence due to a poor performance year, they turn to the accounting management department to resolve the bottom line. A strategy that managers can approach is changing the true information content of the company. As a result this has led managers to resort to smoothing their income. Many questions have been raised whether or not it is common for companies to smooth their reported income, which many have argued whether if income smoothing is appropriate or ethical.

Income smoothing is defined as a technique to remove volatility in earnings by leveling off the peaks and valleys of earnings over a number of years. Its primary objective is to moderate income variability by reducing income during good successful years and as a result defer them for use during the bad years. (Beidleman, C.R. 1973) It is a process that is common in the accounting practice in which it can stretch over many periods. The application of income smoothing is often referred to earnings management. Earnings management is perceived as a strategy tool that is applied in companies in order for managers to manipulate accounting information. It is defined as, “a purposeful intervention by management in the earnings determination process, usually to satisfy self objectives.” (Wild, J. et al, 2001, p.1052)

It has been proven in studies that it is common for company managers to manipulate reported profits for their company’s interests. Managers can accomplish this by simply selecting certain accounting policies, changing accounting estimates, and manipulating accruals. (Yoon, S.S. & Miller, G. 2002). However, when profits are manipulated for self-interests or incentive schemes, their integrity is at risk. To prevent managers from misrepresenting their company’s prospects, regulators have advocated a reduction in accounting discretion. (Hwee-Cheng, T & Karim, J. 2006)

The remainder of this essay is composed of three sections, (1) to evaluate earlier investigations and research background, (2) to report on the reasons and motivations behind income smoothing and (3) to report on empirical testing and investigations from other accounting researchers

Background of Income Smoothing

Income literature originated from the work of Samual R. Hepworth in 1953, which his studies revealed to the accounting world the application of income smoothing in accounting literature. Hepworth’s article was evidently the first publication on income smoothing and is one of the primary reasons of the sudden influx of other accounting researchers to publish literature that had not previously been mentioned. In Hepworth article he first discusses the motivation for income smoothing and more importantly indicates several tactics that managers were able implement in order to smooth income due to the way in which income volatility can negatively affect company

Afterwards there were several accounting researchers that attempted to continue Hepworth’s theories based on income smoothing. This included Charles E. Johnson in the following year of 1954 who argued in his article that regulators should use the income smoothing accounting method as a criterion for the selection of regulatory accounting requirements. However, Robert L. Dickens and John O. Blackburn in 1964 disagreed with Johnson’s article and thereby contradicted Johnson by stating that the criteria for accounting policy choice was, “To provide the best possible basis for the stockholders to project the earnings and financial condition of the corporation.” (Dickens, R.L & Blackburn J.O. 1964, p.314)

The idea of using income smoothing as an accounting method in order obtain less fluctuation in reported earnings gained a lot support from the accounting world. However it was never really accepted by the wider community. For instance Eldon S....
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