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

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:

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  Aggressive accounting policies, aimed at improving income;

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  Conservative accounting policies, aimed at reducing income; and

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  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.