Optimal Smoothing of Profit Via Overhead Allocation

Income smoothing, as defined in Statistical Activity Cost Theory (SACT), is the rational statistical adjustment of periodic accounting earnings to reduce their time volatility around average long-term profit per period. This article demonstrates how overhead cost allocations can be applied to smooth accounting earnings optimally in accordance with this definition. Such an approach parallels earlier work, such as that by Lane and Willett (1997 , 1999 ), in which a depreciation formula was derived and applied for this purpose. In particular, it is shown that, to realize an income smoothing effect in profit making firms, the usual optimal strategy is to over-allocate costs, giving support to the accounting principle of conservatism.     

Earnings Smoothing,Cash Flow Volatility,and CEO Cash Bonus

Prior studies generally relate managers’ decisions to smooth earnings to their desire to maximize their overall compensation and to smooth their consumption. However, earnings smoothing could also be driven by the firm's expected benefits from reporting a smooth earnings stream. Our paper provides empirical support for the latter explanation of earnings smoothing. Specifically, we find that while CEO bonus on average increases with earnings smoothing, the increase is larger when the firm's cash flow volatility is higher. Further, CEO bonus is shielded from the negative effects of lower earnings arising from the need to report a smoother earnings stream.     

EXTRAORDINARY ITEMS AND INCOME SMOOTHING: A POSITIVE ACCOUNTING APPROACH

This is an empirical study of single-period income smoothing which uses an incentives-based model to explain classificatory choices. An index is constructed to measure the smoothing effect of these choices. Weighted least squares regression results indicate that classificatory choices consistent with smoothing are more likely to be observed in firms with high earnings variability, high dividend payout, substantial managerial holdings of share options and diffuse share ownership. The existence of material scope for smoothing strengthens these findings. The model as a whole is statistically significant and, although the proportion of variability in smoothing explained is modest, it compares very favourably with other accounting choice studies. The relationship between smoothing and alternative earnings management strategies, including big bath accounting, is explored.     

Depreciation Need Not Be Arbitrary

Following Thomas (1969, 1974) the depreciation adjustment charged against accounting earnings is nowadays commonly presumed to be entirely arbitrary when it is viewed from a measurement perspective. This paper develops a statistical interpretation of accounting measurement to show that the depreciation calculation need not necessarily be viewed as incorrigible in Thomas's sense. A probability modelling approach is adopted to illustrate how the depreciation adjustment can be used to smooth accounting earnings over time. Depreciation is thus shown to have potentially useful estimation properties. The results have obvious policy implications regarding the objectives that depreciation and other accounting allocations might serve. They also have a bearing on fundamental questions regarding the nature of accounting measurement.     

Do bank managers use securitization gains to smooth earnings in the post- FAS 166/167 period?

Previous literature has documented that securitization gains were used for income smoothing in the era before FAS 166 and FAS 167,¹ which tightened the requirements for sale accounting for securitizations. Using securitizing bank holding companies, we examine whether FAS 166/167 has reduced this income smoothing behavior. Our findings include two facets. First, at the aggregate level, time series statistics show that both the frequency of non-zero securitization gains reported and the magnitude of reported securitization gains are significantly reduced in the post- FAS 166/167 period. Second, at the firm level, our regression results indicate that even though the extent of this income smoothing behavior decreased after the issuance of FAS 166/167, securitization gains continue to be used to smooth earnings by securitizing banks in the post-FAS 166/167 period. Overall, our findings convey that FAS 166/167 has reduced the securitization gains recorded by banks but that after the regulation, banks still use securitization gains to smooth earnings.     

Earnings management and auditor specialization in the post-sox era: An examination of the banking industry

This study examines the impact of auditor specialization on bank loan loss provisions for a large cross-section of US banks for the period 2002-2006. We find a positive relationship between earning (before provision) and loan loss provision, suggesting that bank managers use LLP to smooth earnings in the post-SOX period. However, this relationship is significantly moderated by audit industry expertise, providing strong evidence that industry specialization constrains income smoothing. In further analysis, we find some evidence that auditor specialization is more effective in reducing potentially incoming-increasing earnings management. Our results hold after controlling for self-selection bias and are robust to alternative measures of industry specialization. Overall, our findings support the conclusion that audit industry expertise plays an effective monitoring role in constraining management’s discretionary accounting choices.     

The Use of Unsigned Earnings Quality Measures in Tests of Earnings Management

This paper examines the implications of using the absolute value of discretionary accruals when testing for earnings management. First, we analytically develop the mean and variance of the distribution of absolute discretionary accruals, and show that the expected value is an increasing function of the variance in the underlying error term from the first‐stage discretionary accrual estimation model. Second, we highlight several firm characteristics that are related to the error variance in discretionary accrual estimation models. Using simulations, we show that correlation between the earnings management partitioning variable and these firm characteristics leads to an overrejection of the null hypothesis of no earnings management. Third, we provide research design suggestions to help researchers mitigate the potential bias arising from the use of unsigned measures of earnings management. Using these suggestions, we replicate a recent study, and demonstrate that the inferences change after controlling for operating volatility.     

A Business Economics Foundation for Accounting: The Dutch Experience

In this paper, experimental, computer simulation methods are used to demonstrate how a depreciation-type adjustment influences the distributional form of accounting earnings. The results confirm conjectures that earnings distributions generally, with or without depreciation adjustments, tend towards a normal form as a function of increasing ‘activity’ levels. They also indicate that depreciation is likely to accelerate the transition towards a normal form as activity levels increase and to transform a non-normal form to one that is significantly closer to the normal at relatively low activity levels. The impact of the fixed asset ‘impairment’ rules is also investigated. The results reported in the paper have implications for standard-setting, risk analysis and inference using accounting earnings and related numbers, including ratios based upon earnings.     

Environmental uncertainty and the market pricing of earnings smoothness

Environmental uncertainty induces variability in an organization's reported earnings, and accentuates the information asymmetry between its managers and outside stakeholders. Managers operating in an environment of high uncertainty, therefore, have an incentive to reduce such variability by smoothing income numbers. We investigate the stock market response to earnings smoothness for firms operating in an environment of high uncertainty. We measure income smoothing by the negative correlation of a firm's change in discretionary accruals with its change in pre-managed earnings as per Tucker and Zarowin (2006). Using future earnings response coefficient (FERC) methodology to measure the informativeness of smoothed earnings, and two measures of environmental uncertainty, this paper documents that current stock price incorporates more information about future earnings for firms operating in high uncertain environments, thus supporting the informational value view of income smoothing.     

Using Available-for-sale Securities to Smooth Earnings: Evidence from China

Utilizing a large sample of non-financial public firms in China from 2009 to 2016, we find robust evidence that non-financial firms smooth their earnings through realized gains and losses on available-for-sale (AFS) securities. This effect is more pronounced for firms with weaker internal and external corporate governance. Firms with an incentive to manipulate up their earnings are also less likely to smooth earnings through AFS securities. Moreover, firms with more accrual earnings management or real earnings management tend to smooth earnings to a greater extent through AFS securities. Firms smooth earnings only when their net income is positive or when net income is negative and the gains from AFS securities are large enough to offset negative earnings. We do not find supporting evidence for engaging in big bath earnings management through the realization of losses on AFS securities. These findings suggest that gains and losses on AFS securities allow non-financial firms to actively smooth their earnings. Last, the accounting standards amendments in 2017 that essentially disable earnings smoothing through AFS securities increase price efficiency.     

Discussion of “Using accounting information for consumption planning and equity valuation”

This paper discusses Yee (2007), who investigates the role of accounting information for consumption planning and equity valuation. Higher earnings quality increases investor welfare and ex ante stock prices as well as the weight on earnings in valuation equations based on both cash flows and earnings. The former is due to improved consumption smoothing through more informed production choices, while the latter is due to the impact on the relative information content of current cash flows versus earnings about future cash flows.     

Legal Costs and Accounting Choices: Another Test of the Litigation Hypothesis

This paper provides another test of the litigation hypothesis proposed by Hall and Stammerjohan (1997) and provides evidence that subtle differences in the underlying business environment may be very important in predicting the accounting reaction of management to major events. The litigation hypothesis predicts that firms that are defendants in litigation with potentially large damage awards (major litigation) will attempt to reduce the size of those damage awards by making income‐decreasing accounting choices. The oil firms in the Hall and Stammerjohan study appeared to systematically reduce reported earnings during the litigation periods by under‐reporting new reserves. The fourteen chemical and pharmaceutical firms, involved in fifteen litigation events, examined by this study produce a very different result. The chemical and pharmaceutical firms faced a different business environment during their litigation periods and appear to have made income‐increasing accounting choices. These firms appear to have been able to perpetuate earnings growth without corresponding sales revenue growth during the litigation periods through unexpected reversals in deferred income tax expense.     

Classificatory income smoothing: The impact of a change in regime of reporting financial performance

Financial Reporting Standard No. 3 (FRS3) regulated the reporting of financial performance by UK firms from 1993 until the adoption of International Financial Reporting Standards in 2005. FRS3 outlawed extraordinary items, but allowed a clearer distinction between recurring and transitory income by giving firms discretion over the classifications of unusual (i.e. exceptional) items and the option to disclose alternative EPS. Through these provisions FRS3 increased the scope for classificatory choices as a means to highlight persistent profitability. We examine the impact of FRS3 on classificatory smoothing by UK firms and document a significant rise in this practice post-FRS3. We find that this increase is due mainly to deviations of net income from expected earnings inducing a significantly higher level of classificatory smoothing post-FRS3. Additional analysis shows that earnings are substantially more persistent at the pre-exceptional level post-FRS3. Overall, our results suggest greater use of classificatory choices to highlight sustainable profitability after the change in performance reporting regime.     

Evidence on the Usefulness of Capital Expenditures as an Alternative Measure of Depreciation

Investment professionals often suggest that accounting earnings is a more useful indicator of share value if adjusted by substituting current capital expenditures for reported depreciation. We investigate the usefulness of this alternative depreciation measure by comparing the ability of reported earnings and adjusted earnings to explain the cross-sectional distribution of stock prices for a large sample of manufacturing firms. We find that adjusted earnings explains a much smaller fraction of the variation in share prices than earnings based on reported depreciation, and provide evidence on the reasons for this difference.     

Earnings Volatility, Cash Flow Volatility, and Informed Trading

I examine whether earnings that are smoother or more volatile than cash flows provide or garble information. Consistent with theories that predict more informed trading when public information is less informative, I find that bid-ask spreads and the probability of informed trading are higher both when earnings are smoother than cash flows and also when earnings are more volatile than cash flows. Additional tests suggest that managers' discretionary choices that lead to smoother or more volatile earnings than cash flows garble information, on average. However, I find that informed trading is attenuated in settings in which theory suggests that discretionary smoothing or volatizing of earnings is likely to be informative.     

US Managers' Use of 'Pro Forma' Adjustments to Meet Strategic Earnings Targets

Abstract:  The practice of reporting manager-adjusted 'pro forma' earnings numbers in quarterly earnings press releases has attracted considerable attention in recent years in the United States. Prior research suggests that while some managers report these adjusted numbers to better reflect core earnings, others may use these earnings adjustments to meet strategic earnings targets on a pro forma basis when they fall short based on GAAP reporting standards. Assuming the latter motivation could potentially mislead investors, the difficulty lies in distinguishing the 'good guys' from the 'bad guys.' Using hand-collected pro forma earnings data, we investigate the extent to which different types of earnings adjustments affect the spread between pro forma earnings and GAAP earnings from continuing operations. Moreover, we investigate which types of adjustments managers use to meet strategic earnings targets. In addition to the exclusion of one-time items like restructuring charges, the results indicate that managers often exclude recurring expenses such as depreciation, research and development, and stock-based compensation to meet these strategic targets. The exclusion of recurring items is especially indicative of aggressive pro forma reporting. Finally, we find that firms that report adjusted earnings numbers only sporadically are more likely than firms that adjust earnings figures on a regular basis to use pro forma reporting to achieve strategic earnings targets by excluding recurring items.     

Testing for Income Smoothing Using the Backing Out Method: A Review of Specification Issues

This study investigates potentially spurious correlation in prior studies of income smoothing which use a research method that we call backing out. If E is reported income, Y a discretionary earnings component hypothesized to smooth income, and T the smoothing target, the backing out method consists of regressing Y on E – Y – T. A negative regression coefficient is interpreted as evidence that Y is being managed to smooth earnings. We argue that the negative regression coefficient may simply reflect the positive correlation between E and T, which may or may not be the result of manipulating Y. If E is not manipulated by Y, the negative regression coefficient reflects measurement errors in E – Y as an estimate of unmanaged earnings.We replicate the backing out method of prior studies and use each of the accrual and cash flow components of earnings in the Statement of Cash Flows for Y. We find that the regression coefficient, hypothesized to be negative because of smoothing with Y, is always negative and its magnitude depends on the variances of Y and E – T (smoothing error) independent of the nature of Y (discretionary or nondiscretionary). We conclude that the negative coefficient on E – Y – T is equally consistent with three possibilities: (1) managers smooth earnings with Y, (2) managers smooth earnings with something other than Y, and (3) managers do not smooth earnings at all.     

中国上市公司收益透明度实证研究

本文运用收益激进度和收益平滑度这两项指标 ,对 2 0 0 0年 12月 31日前在沪深两市上市的公司从 1994年到 2 0 0 2年的收益透明度变化趋势进行了系统的实证分析。分析结果表明 :A股上市公司从 1994到 2 0 0 2年收益透明度的总体趋势是上升的 ,只是在 1997年附近和 2 0 0 0年附近出现偏离情况 (即略为下降 )。论文还对我国上市公司IPO前后收益透明度 ,分行业以及分股票类型的收益透明度进行了分析 ,并完成了各种稳健性检验。     

Stable Shareholdings,the Decision Horizon Problem and Earnings Smoothing

Prior studies argue that stable shareholders do not encourage firm managers to manage their earnings to achieve short‐term earnings goals. They also state that firm managers with stable shareholders have an incentive to report smooth earnings to maintain long‐term relationships with such shareholders. We focus on cross‐shareholdings and stable shareholdings owned by financial institutions as stable shareholdings in Japan, and investigate the effect of these ownership structures on earnings management patterns. Specifically, we hypothesize that stable shareholdings are positively associated with the informational components of earnings smoothing. Consistent with our hypothesis, we first find that as stable shareholdings increase, managers are more likely to conduct earnings smoothing that provides useful information to stable shareholders. Further, our additional analysis shows that stable shareholdings reduce incentives for managers to cut discretionary expenditures to meet short‐term earnings benchmarks, implying that stable shareholdings could reduce the possibility of a myopic problem. These results suggest that managers with stable shareholdings tend to report smoother and less volatile earnings, and do not tend to pursue earnings management to attain short‐term earnings targets.     

亏损上市公司是否会在第四季度平滑利润?

西方学者认为企业管理人员有平滑利润、降低收益波动性以此来取悦股东的动机,我们选取中国亏损上市公司作为样本,对其是否在第四季度平滑利润进行实证研究,结果发现这些亏损公司并未在第四季度平滑利润,相反他们更倾向于在第四季度“洗一个大澡“,大亏一把,这样为下一年度扭亏为盈做好准备,进一步的研究同时表明,亏损越严重的企业在第四季度越倾向于“洗大澡“,这与中国上市公司目前的公司治理、资本市场的运作效率以及证监会对亏损公司的管理规定不无关系。