An Overall Perspective of Income Smoothing as a Strategy of Earnings Management

An Overall Perspective of Income Smoothing as a Strategy of Earnings Management

Cláudia Araújo Mendes (Polytechnic Institute of Cávado and Ave, Portugal), Lúcia Lima Rodrigues (University of Minho, Portugal) and Laura Parte (Universidad Nacional de Educación a Distancia (UNED), Spain)
DOI: 10.4018/978-1-5225-7817-8.ch003

Abstract

This chapter provides insights on earnings management (EM) explanatory factors. These factors are analyzed within the framework of a specific strategy of EM: income smoothing (IS). This strategy is often used to report earnings with an artificially reduced variability. Thereby, the purpose of the chapter is to explore the motivations, the determinants (anticipated by the positive accounting theory), and some firm-specific factors that might explain IS practices. The relevance of this chapter is justified essentially by two reasons. First, it highlights the contemporary importance of this research line. The academic community, professionals, and regulatory bodies have expressed publicly the concern about the quality of financial reporting. Consequently, a deep knowledge of the factors that possibly explain these accounting discretionary practices is crucial. Second, the extensive literature on EM also justifies this chapter. Thereby, the systematization of the literature on the IS explanatory factors can help researchers and increase future empirical research focused on this area.
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Introduction

Stakeholders in general (e.g. academic community, professionals, regulatory bodies) have expressed publicly the concern about the quality of financial reporting. Investors and other accounting information users only can make more accurate decisions if financial reporting has certain quality levels.

Generally, according to the literature (e.g. Monterrey, 1998; Albornoz, 2003), it is possible to identify three earnings management strategies:

  • Aggressive accounting policies, aimed at improving income;

  • Conservative accounting policies, aimed at reducing income; and

  • Income smoothing policies, aimed at increasing income in some fiscal exercises and at decreasing it in others, in order to minimize its long-term fluctuations.

Unlike the other hypotheses of earnings management, income smoothing is a general strategy that can be tested in samples of heterogeneous companies, without requiring the presence of strong incentives to manipulate income in a specific direction (e.g. Porciau, 1993; Perry & Williams, 1994; Teoh et al., 1998). Income smoothing seems, thereby, more rational on the long-term (Chaney et al., 1998), being, also for these reasons, the object of this chapter.

Although, income smoothing is a topic widely analysed in the literature since the 1970s, there is still a long-run debate about the positive or negative effects of income smoothing in the academia. One stream of research suggests that income smoothing is an efficient vehicle for managers to provide private information and, consequently, it is positive for both managers and investors (Ronen & Sadan, 1981; Chaney & Lewis, 1995; Kirschenheiter & Melumad, 2002; Gassen & Fuelbier, 2015; Li & Richie, 2016; Demerjian et al., 2018). However, other stream considers that managers opportunistically smooth income and, as a result, this practice is a vehicle to mislead investors and other users (Fudenberg & Tirole, 1995; Leuz et al., 2003).

The chapter provides insights on income smoothing explanatory factors and its relevance is justified essentially by two reasons. Firstly, it highlights the contemporary importance of this research line, and, consequently, offers a deep knowledge of the factors that possibly explain income smoothing discretionary practices. Second, there is an extensive literature on income smoothing explanatory factors, since its systematization can help researchers and increase future empirical research focused on this subject. Finally, the chapter provides the conclusions and future avenues.

Key Terms in this Chapter

Earnings Management: Any practice undertaken deliberately by managers to alter reported earnings, with the purpose of obtaining some specific gain.

Income Smoothing Determinants: Motivations anticipated by the positive accounting theory which can lead managers to engage in income smoothing practices.

Income Smoothing Motivations: General motivations which lead managers to engage in income smoothing practices.

Positive Accounting Theory: Hypotheses developed by Watts and Zimmerman to justify the companies’ accounting choices and, in parallel, to understand the earnings management strategies undertaken deliberately by managers.

Income Smoothing: Practices aimed at increasing income in some fiscal years and at decreasing it in others, in order to minimize its long-term fluctuations.

Income Smoothing Firm-Specific Factors: Firm features that might explain the adoption of income smoothing practices.

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