a framework for the classification of accounts manipulations
TRANSCRIPT
A FRAMEWORK FOR THE CLASSIFICATION OF ACCOUNTS
MANIPULATIONS
Hervé Stolowy
HEC School of Management (Groupe HEC)Department of Accounting and Management
Control1, rue de la Libération
78351 - Jouy en Josas CedexFrance
Tel: +331 39 67 94 42Fax: +331 39 67 70 86E-mail: [email protected]
Gaétan Breton
University du Québec à MontrealDepartment of Accounting Sciences
P.O.B. 8888Succursale Centre-Ville
Montréal (Québec)H3C 3P8 - Canada
Tel: +1 514 987 3000 (4774)Fax: +1 514 987 6629
E-mail: [email protected]
June 28, 2000
This paper is a review of the literature on accounts manipulations in the U.S., but also in several other countries,including Canada, UK, and France. Although we tried to follow a comprehensive approach of this topic, wemight have forgotten some references. We make our apologies to the authors who have not been cited. We wishto thank participants of the 2000 EAA Annual Meeting (Munich). Hervé Stolowy would like to acknowledge thefinancial support of the Research Center of the HEC School of Management and thanks Etienne Lacam for hisresearch assistance.
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Résumé/Abstract
Proposition d’un cadre conceptuel pour une
classification des manipulations comptables
A Framework for the Classification of Accounts
Manipulations
Les manipulations comptables ont fait l’objet de
recherche, discussion et même controverse dans
plusieurs pays, comme les Etats-Unis, le Canada, le
Royaume Uni, l’Australie et la France. L’objectif de
ce cachier de recherche est de proposer un cadre
conceptuel permettant la classification des
manipulations comptables à travers une revue
approfondie de la littérature. Ce cadre est fondé sur le
désir d’influencer la perception par les marchés
financiers du risque associé à l’entreprise. Le risque
se matérialise à deux niveaux : le bénéfice par action
et le ratio dettes/capitaux propres. La littérature sur ce
sujet est extrêmement riche. Cependant, plusieurs
domaines mériteraient de faire l’objet de recherches
complémentaires.
Accounts manipulations have been a matter of
research, discussion and, even, controversy in
several countries such as the United States, Canada,
the United Kingdom, Australia and France. The
objective of this paper is to elaborate a general
framework for classifying accounts manipulations
through a thorough review of the literature. This
framework is based on the desire to influence the
market participants’ perception of the risk associated
to the firm. The risk is materialized through the
earnings per share and the debt/equity ratio. The
literature on this topic is already very rich, although
we have identified series of areas in need for further
research.
MOTS CLÉS . – MANIPULATIONS COMPTABLES _
GESTION DU RÉSULTAT – LISSAGE DU RÉSULTAT –
NETTOYAGE DES COMPTES - COMPTABILITÉ CRÉATIVE
KEYWORDS. – ACCOUNTS MANIPULATIONS – EARNINGS
MANAGEMENT – INCOME SMOOTHING – BIG BATH
ACCOUNTING – CREATIVE ACCOUNTING
2
1.0 INTRODUCTION
This article examines the literature on accounts manipulations (AM): earnings management
including income smoothing and big bath accounting, and creative accounting. This literature
studied most of the time some specific aspects of AM. It failed to develop a general model
encompassing all the activities included in the domain. Also, most reviews address only one
category at a time. This review elaborates a general framework and takes into account the
various components of AM.
AM are mainly based on the desire to influence the market participants’ perception of the risk
associated with the firm. On this basis, we develop a model dividing the risk into two
components and identify the related targets in the financial statements. The first component of
the risk is associated with the variance of return, measured through the earnings per share
(EPS). The second component relates to risk associated with the financial structure of the
company, measured by the debt/equity ratio. Our framework classifies the activities of AM in
relationship with the two aspects of risk.
This review is realized at a time when AM are highly criticized. For instance, SEC Chair,
Arthur Levitt, in his September 28, 1998 speech “The Numbers Game”, attacked the earnings
management and income smoothing practices of some public companies [Loomis, 1999].
Turner and Godwin [1999] reported some of the efforts that are underway in the Office of the
SEC Chief Accountant to help achieve objectives laid out in Chairman Levitt’s speech.
The remainder of our paper proceeds as follows. In the next section (2), we present our
framework for understanding AM. That is followed by a review of the literature on each AM
activity: earnings management (section 3), income smoothing (section 4), big bath accounting
(section 5) and creative accounting (section 6). Then we discuss directions for future research
(section 7). The final section (8) presents the conclusions.
2.0 THE FUNDAMENTAL OBJECTIVES OF ACCOUNTS MANIPULATIONS
Copeland [1968, p. 101] defined manipulation as some ability to increase or decrease reported
net income at will. At the same time, he implicitly acknowledged [p. 110] that the notion of
manipulation had several meanings, recognizing that “maximizers”, “minimizers”, or other
“manipulators” will not follow a pattern of behavior, which approximates that of “smoothers”.
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However, we believe that AM have a broader sense than the one given by Copeland. They
include the income statement classificatory practices, presented by Barnea et al. [1975, 1976]
and Ronen and Sadan [1975a, 1981], but also those related to the balance sheet, far less well
described in the literature [Black et al., 1998]. Actually, these practices represent a more
important phenomenon now than when Copeland published his article. Moreover, the
motivations for and the timing for the AM should be considered. Such AM practices share a
conception of accounting as a tool to pursue the general strategy of the firm or of its
management and the idea that the practices will reduce its perceived risk.
Our framework is based on the fundamental principle that the provision of financial
information aims at reducing the cost of financing firms’ projects. This reduction is related to
the perception of the firm’s risk by investors. The risk is technically measured by the beta,
which is based on the relative variance of earnings. Moreover, there is a structural risk
revealed by the equilibrium between debt and equity. As a consequence, the objectives of AM
are to alter these two measures of risk: the variance of earnings per share and the debt/equity
ratio. Earnings per-share can be modified in two ways: firstly, by adding or removing some
revenues or expenses (modification of net income) and secondly, by presenting an item before
or after the profit used to calculate the earnings per-share (classificatory manipulations).
Figure 1 presents our framework for classifying AM.
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Figure 1A Framework for Classifying Accounts Manipulations
Accountsmanipulations
Modification of investors’perception of the risk
Return:Earnings per share (EPS)
Structural risk:Debt/equity ratio
Earnings management(broad sense)
Creative accounting(window dressing)
Earningsmanagement
Incomesmoothing
Big bathaccounting
Academicperspective
Professionalperspective
Level of EPS Variance ofEPS
Reduction ofcurrent EPSto increasefuture EPS
EPSDebt/equity
ratio
Fair amountof empirical
research
Fairamount ofempiricalresearch
Few realempiricalresearch
Few realempiricalresearch
No empiricalresearch.
Professionalopinion
Schipper[1989]
Jones [1991]DeAngelo etal. [1994]
Copeland[1968]Imhoff
[1977, 1981]Eckel [1981]Ronen and
Sadan [1981]Albrecht andRichardson
[1990]
Dye [1987]Walsh etal. [1991]Pourciau[1993]
Tweedie andWhittington
[1990]Naser [1993]Breton and
Taffler[1995]Pierce-
Brown andSteele [1999]
Griffiths[1986, 1995]Smith [1992]
Schilit[1992]
Stolowy[2000]
Interpretations Transactions
Main researchstreams
Name of theresearchstream
Mainobjective
Type ,ofresearch
Representativeauthors
5
Regarding the nature of the practices, the literature has mainly discussed manipulations that
are interpretations of standards, for instance decisions on the level of accruals. But
manipulation can also be premeditated, i.e. transactions can be designed in order to allow a
desired accounting treatment. For instance, a leasing contract will be written in such a way
that the leased equipment is not capitalized.
We will now review the different categories of AM identified in our general framework.
3.0 EARNINGS MANAGEMENT
3.1 Definition
Management artificially manipulates earnings to achieve some preconceived notion of
“expected” earnings (e.g., analyst forecasts, management’s prior estimates or continuation of
some earnings trend) [Fern et al., 1994]. Manipulations are done to manage investors’
impression of the firm [Degeorge, Patel and Zeckhauser, 1999]. This position is detailed by
Kellog and Kellog [1991] who see two main motivations for earnings management (EM): to
encourage investors to buy company’s stocks and to increase the market value of the firm.
Dye [1988], in a completely theoretical paper, brings interesting arguments in the debate. EM
is generally seen as coming from the managers taking advantage of an asymmetry of
information with shareholders. This was the center of the definition provided by Scott [1997].
However, Dye brings at least two considerations in the debate. Firstly, the manipulations done
to increase the remuneration of the executive are likely to be provided for by investors.
Secondly, actual shareholders have an interest in the value of the firm to be better perceived
by the market. Therefore, there is a potential transfer of wealth from the new shareholders to
the old ones creating an external demand for EM [Schipper, 1989].
Accrual accounting differs from cash accounting by the timing. On the entire life of the firm
there may be no difference between both methods. In a long-term perspective, returns are
explained quite accurately by earnings [Degeorge, Patel and Zeckhauser, 1999; Lamont,
1998]. On the short term, the matching of revenues and expenses will create differences.
There is a standardized way of treating these differences. EM, as it is not forgery, is just
proposing another way of treating those differences, bringing the profits in the year in need
while pushing the expenses away. It is essentially gambling, hoping that the profit will be
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better in the future to cover those delayed expenses. Timing differences are recognized as the
basis of EM by Jones [1991], when she writes:
“Since the sum of a firm’s income over all years must equal the sum of its cash flows, managers must at
some point in time reverse any ‘excessive’ earnings-decreasing (or increasing) accruals made in the past”.
There are many reasons for managing earnings. Scott proposes the following definition:
“Earnings management is the choice by a firm of accounting policies so as to achieve some specific
manager objective” [1997, p. 352].
Healy and Wahlen [1998], in a review of the literature oriented towards standard-setters,
propose the following definition:
“Earnings management occurs when managers use judgment in financial reporting and in structuring
transactions to alter financial reports, to either mislead some stakeholders about the underlying economic
performance of the economy, or to influence contractual outcomes that depend on reported accounting
numbers”.
As Ayres [1994] states, there are three methods for managing earnings: (1) accruals
management, (2) the timing for the adoption of mandatory accounting policies and (3)
voluntary accounting changes. Most of the prior studies on EM have concentrated on how
accounts are manipulated through accruals. Accruals management refers to changing
estimates such as useful lives, the probability of recovering debtors and other year end
accruals to try to alter reported earnings in the direction of a desired target [Ayres, 1994]. The
timing for the adoption of mandatory accounting policies is a second form of EM, particularly
in relation to the possibility of an early adoption. Another method of managing earnings is to
switch from an accounting method to another one.
EM is also supposed to have a signaling effect [Schipper, 1989]. Managers, having privilege
information about future earnings, will take the opportunity to signal their confidence in the
level of those future earnings [Scott, 1997]. However, if managers have doubts about the level
of those future earnings, which incentive do they have to disclose it right away. We believe
that EM is about keeping the boat afloat for the current year hoping, with or without clues,
that the future will be better. Anyway, how readers would be able to discriminate between
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misleading or signaling accounts manipulations? And, in a manager’s perspective, if the
future is not better than the present, it will always be soon enough for signaling it.
Researches on EM have been developed without controversial statements about the efficient
market hypothesis, even if substantial manipulations have been described and investors strong
reactions after the manipulations are made public implying that investors have been misled.
3.2 Methodology
Studies on EM take mainly into consideration the accruals. Accruals are reputed to carry
information to the market [Schipper, 1989]. Accruals also form the difference between profit
and cash flow. Consequently, assuming the cash flows are not manipulated, the only way to
manipulate the profit remains to increase or decrease the accruals. But, the question then is: to
increase or decrease from which level? What is the normal level of accruals, the benchmark?
Many of the subsequent studies refer to Jones [1991] for the methodology. The first problem
is to determine which part of the accruals is normally related with the level of activity (non
discretionary) and which part is open to manipulation (discretionary). Previous studies have
focused on specific accruals as being more prone to be used for EM purposes. McNichols and
Wilson [1988] have studied only the bad debt provision adjustment. Jones decided to take all
the accruals (except those related to taxes) as more likely to express EM.
However, to take into consideration the difference in the level of activity of the firm, Jones
scaled the difference in accruals by total assets, not assuming that the level of discretionary
accruals is constant. There is also the inclusion of the level of tangible fixed assets in the
explanatory variables that control for the size. However, as we are going toward knowledge
based firms, using the quantity of tangible fixed assets as a measure is less accurate and,
following this logic, discretionary accruals will proportionally steadily increase in the
economy.
Different authors used different ways to define discretionary accruals. Table 1 presents a
selection of study.
8
Table 1
Discretionary accruals
Authors Measure of the discretionary accruals
Healy [1985] Non discretionary accruals are estimated by a mean value over a certain period
DeAngelo [1986] Total accruals
Dechow and Sloan [1991] Non discretionary accruals are measure by the mean of the industry sector
Jones [1991] Non discretionary accruals take into accounts the growth in revenues and fixed
assets by standardizing by total assets at the beginning
Friedlan [1994] DeAngelo’s model standardized by sales
Robb [1998] Loan loss provision
Francis, Maydew and
Sparks [1999]
Average discretionary accruals: difference between total accruals and estimated
nondiscretionary accruals
Navissi [1999] Total accruals
For a more detailed description and comparison of the models and their evolution we refer the
reader to Dechow, Sloan and Sweeney [1995]. Their paper compares the different model to
detect EM and therefore exposes the characteristics of each model with its forces and
weaknesses. The models studied are Healy [1985], DeAngelo [1986], Jones [1991], a
modified Jones model and the industry model. They conclude that the modified Jones model
is the best to detect EM.
More recent models refine the Jones Model. The problem is the degree of sophistication in the
separation of discretionary and non discretionary accruals. Jones introduced some good
amelioration in deflating both sides of the equation by the total assets. This was to take into
consideration the change in firm size during the period. However, assets are nor necessarily
the best measure, mostly when firms are not involved in a manufacturing activity. Teoh,
Welsh and Wong [1998] proposed to separate short term and long term accruals as not
behaving in the same way. Some studies have taken the difference in cash flow movements as
being a good measure of the real evolution of the firm. In the absence of natural income
manipulation (playing with the timing of transaction) this measure appears to be the best. The
main purpose of the modifications is to provide for the normal growth of the accruals
produced by the growth of the firm. However, the use of total assets to do that is influenced
by the old industrial model of the firm. Friedlan [1994] used the sales in the same purpose,
which is more in line with the characteristics of non industrial firms.
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3.3 Motivations and Findings
Many motivations have been put forward in the literature, focusing a lot on the incentives
managers have to manipulate earnings or on the consequences of their actions [Merchant and
Rockness, 1992].
3.3.1 Remuneration
One good reason for managers to enter into EM would be their remuneration package. Healy
[1985] is among the first to propose this explanation, recalling that earnings-based bonus
scheme is a popular mean of rewarding corporate executives. It is logical to believe that
managers receiving a remuneration partially based on the level of profit will manipulate this
profit to smooth their remuneration. Such a view is consistent with the big bath accounting
discussed later. Healy [see comments by Kaplan 1985] tests the association between
managers’ decisions about accruals, accounting procedures and their income-reporting related
to the incentives coming from their compensation packages. Two classes of tests are
presented: accrual tests and tests of changes in accounting procedures. As a result, managers
are more likely to choose income-decreasing accruals when their bonus plans upper or lower
bounds are binding, and income-increasing accruals when these bounds are not binding.
However, managers do not change accounting procedures to decrease earnings when the
bonus plan upper or lower bounds are binding. In summary, Healy found a significantly
higher number of accounting changes in companies having such bonus schemes.
Gaver, Gaver and Austin [1995] examined the relationship between discretionary accruals and
bonus plans bounds for a sample of 102 firms over the 1980-1990 period. Contrary to Healy
[1985], they found that when earnings before discretionary accruals fall below the lower
bounds, managers select income-increasing discretionary accruals (and vice versa). They
believe that these results are more consistent with the income smoothing hypothesis that with
Healy’s bonus hypothesis.
McNichols and Wilson [1988] reached results similar to Healy through studying the bad debt
provision. Guidry, Leone and Rock [1999] tested and validated the Healy hypothesis for
business-unit managers (see comments by Healy 1999).
10
Holthausen, Larcker and Sloan [1995], using more sophisticated data, were able to find that
managers having reached the top of their compensation possibilities decrease reported
earnings.
3.3.2 Compliance with Debt Covenants Clauses
Another motivation, also contained in the positive accounting theory [Watts and Zimmerman,
1986] would be the compliance of the firm with debt covenant clauses. Sweeney [1994] found
significant manipulations for firms having defaulted the conditions of their contract. Defond
and Jiambalvo [1994] obtained similar results for comparable firms for the years preceding
the disclosure of a default. To the contrary, DeAngelo, DeAngelo and Skinner [1994] took a
sample of firm having done some actions to conform to their debt contract (dividend cut).
They found no evidence of EM.
3.3.3 Official Examination
A third motivation is official examination following some allegations of ill behavior from a
firm or a sector. Often it is a sector event like having exaggerated average profits in average
for a sector, repetitive accidents like tanker breaks, dumping or the possible existence of a
cartel. The normal behavior during such a period will be to decrease profits as huge profits are
a signal of a monopolistic situation, illicit operations or the ability to repay for the damages
caused. Profit-decreasing accruals were found by Jones [1991] during official investigations.
Obviously, this motivation will have a reverse effect on earnings compared with the two
preceding ones. Most likely, the situations demanding opposite moves will not happened at
the same time. If they do happen together, the manager will have to make a trade off.
In a recent study in the oil industry, over a period of 19 years, Hall and Stammerjohan [1997]
reached similar results, showing that EM may be performed in response to firm and industry
specific factors such as high debt levels, pending legal damage rewards and foreign
competition. In the context of anti-dumping complaints against foreign competitors, Magnan,
Nadeau and Cormier [1999] showed that Canadian firms reduce their reported earnings by a
significant amount during the year in which they are under investigation.
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3.3.4 Initial Public Offerings
Initial public offerings seem to be a good opportunity to manage earnings. The firm has no
previous price on the market, so manipulating earnings would increase the introductory price.
This reasoning however is contradicted by studies finding a systematic initial underpricing of
these issues.
The case of IPOs is a little different than for seasoned issues. For new issues there is no
settled value and a shortage of information, therefore investors will rely more heavily on
financial statements information [Friedlan, 1994; Neill, Pourciau and Schaefer, 1995].
Earnings manipulations then appear as an opportunity for initial shareholders to increase their
wealth [Aharony, Lin and Loeb, 1993] through possibilities of biasing information [Titman
and Trueman, 1986; Datar et al., 1991]
Testing these hypotheses Friedlan [1994] found that firms increase their income just before
going public. However, he pointed out that firms are often going public in a period of growth
implying a natural increase in earnings. But, he also found that accruals have turned losses
into profits in 94% of the cases, which seems too high to be obtained by chance only.
Aharony, Lin and Loeb [1993], on the other side, found no evidence of manipulation by the
accruals. They believe to have two groups in their sample. One group employs high quality
underwriter and auditor and the other does not. Companies using EM are in the second group
and are smaller and more heavily leveraged.
Teoh, Welsh and Wong [1998] compared the level of accruals of IPO and non IPO firms.
They found a significant difference that is disappearing through time after the issuing. Neill,
Pourciau and Schaefer [1995] reported a relationship between the size of the proceeds and the
liberality of accounting policies.
3.3.5 Accounting Choices
Bremser [1975] contrasted the reported earnings (EPS) of a sample of 80 companies electing
to make accounting changes with those of 80 companies not disclosing changes. This study
revealed that companies reporting discretionary accounting changes in the period under
12
review exhibited a poorer pattern or trend of EPS than a random sample of companies with no
reported changes during the same period.
DeAngelo, DeAngelo and Skinner [1994] studied accounting choices in company
experiencing persistent problems with their level of profit. They took companies with losses
for three years in a row accompanied by a reduction of cash dividends. They also constructed
a control sample. At the end, on a ten-year period, they found very little difference in troubled
and untroubled companies.
Navissi [1999] provided evidence that New Zealand manufacturing firms made income-
decreasing discretionary accruals for the years during which they could apply for price
increases. Lim and Matolcsy [1999] carried out a similar study in Australia and showed that
firms subject to price controls adjust their discretionary accounting accruals downward to
reduce reported net income and to increase he likelihood of approval of the requested rice
increase.
Ahmed, Takeda and Thomas [1999] showed that the loan loss provision are used for capital
management but found no evidence of EM via loss provisions.
3.3.6 Minimization of Income Tax
Maydew [1997] investigated tax-induced intertemporal income shifting by firms with net
operating loss carrybacks. This research extends prior examinations of intertemporal income
shifting by profitable firms [Scholes, Wilson and Wolfson 1992; Guenther 1994].
Eilifsen, Knivsflå and Sættem [1999], following Chaney and Lewis [1995], showed that if
taxable income were linked to accounting income, there will exist an automatic safeguard
against manipulation of earnings within the analyzed framework (see comments by Hellman
[1999]).
3.3.7 Other Motivations
Copeland and Wojdak [1969] developed Gagnon’s work [1967] on the impact of the
purchase-pooling decision suggesting that corporate managers may account for mergers in a
13
manner which maximizes or smooths reported income. They found strong support of the
income maximization hypothesis.
Dempsey, Hunt and Schroeder [1993] found significant levels of EM with extraordinary items
when managers are not also owners, which is consistent with the predictions coming from the
agency theory.
McNichols and Wilson [1988] proposed as motivation for EM the elimination of extreme
values for profit. They found evidence that the profit is decreased when reaching too high
values. To a degree, they made a test of income smoothing using the provision for bad debts.
Han and Wang [1998] found evidence that oil companies used income decreasing accounting
policies during the Gulf War to avoid the political consequences of a higher profit coming
from increased retail prices.
Bartov [1993] provided evidence that US firms manage earnings through the timing of
income recognition from disposal of long-life assets and investments. In the same area, Black,
Sellers and Manly [1998] examined the effects of accounting regulation on EM behavior in an
international setting (Australia, New Zealand UK). They found no evidence of EM in the
Australia-New Zealand sample and, in contrast, strong evidence of EM in the UK sample
(before the change in the accounting standard on asset revaluation).
Burgstahler and Dichev [1997] examined incentives to manage earnings around the zero
values and to avoid losses.
Cormier, Magnan and Morard [1998] recalled that three reasons motivate EM: political cost
minimization, financing cost minimization and manager wealth maximization. They
addressed issues related to regulatory bodies, enterprises in financial difficulty and takeover
attempts. They presented an EM model based on a sample of Swiss companies and their
results generally support hypotheses found in the literature.
Cahan, Chavis and Elemendorf [1997] examined the earnings management of chemical firms
at a time when US Government was reforming the legislation. They showed that the
companies tookincome-decreasing accruals t the height of the debate. Labelle and Thibault
[1998] used the political costs related to 10 major environmental crises and a model similar to
14
those of Jones [1991] and DeAngelo et al. [1994], to conduct on a longitudinal and cross-
sectional bases an empirical test of the political-cost hypothesis where size is replaced by the
occurrence of the environmental crisis. The signs of all variables in the model match the
predicted sign and are significant except for the proxy for environmental crises. As a
consequence, results do not support the hypothesis of EM following an environmental crisis.
Visvanathan [1998] concluded that deferred tax valuation allowances are not subject to
widespread EM as some critics suggest.
Wu [1997] showed that managers manipulated earnings downward prior to an MBO proposal.
Table 2 synthesizes the issue of the motivation for earnings management.
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Table 2
Objectives of Earnings Management and their Contexts1
Objectives Contexts Examples
Minimization of
political costs
Inquiries or
surveillance by
regulatory bodies
Jones [1991]; Rayburn and Lenway [1992]: US International
Trade Commission; Cahan [1992]: Anti-Trust Division of
the Ministry of Justice; Key [1997]: cable television industry
during periods of Congressional scrutiny; Makar and Pervaiz
[1998]: antitrust investigations; Magnan, Nadeau and
Cormier [1999]: anti-dumping complaints
Environmental
regulation
Cahan, Chavis and Elemendorf [1997]; Labelle and Thibault
[1998]
Minimizing income
tax
Warfield and Linsmeir [1992]; Boynton et al. [1992];
Guenther [1994]; Maydew [1997]
Negotiation: labor
contract
Liberty and Zimmerman [1986]
Minimization of
the cost of capital
IPO’s Aharony et al. [1993]; Friedlan [1994]; Teoh et al. [1994];
Cormier et Magnan [1995]; Magnan et Cormier [1997]
Renewal of debt
contracts and
financial distress
DeAngelo et al. [1994]; Sweeney [1994]; DeFond and
Jiambalvo [1994]
Violation of debt
covenants and
restrictions on
dividend payments
McNichols and Wilson [1988]; Press and Weintrop [1990];
Healy and Palepu [1990]; Beneish and Press [1993]; Hall
[1994]
Maximization of
managers wealth
Maximizing short
term total
compensation
Healy [1985]; Holthausen et al. [1995]; Gaver et al. [1995];
Clinch and Margliolo [1993]
Changing of control DeAngelo [1986]; Perry and Williams [1994]; DeAngelo
[1988]
Non routine CEO
changes
Murphy and Zimmerman [1993]; Pourciau [1993]; Dechow
and Sloan [1991].
3.3.8. Earnings management and auditing
Becker et al. [1998] examined the relation between audit quality and EM and showed that
clients of non-Big Six auditors report discretionary accruals that increase income relatively
more than the discretionary accruals reported by clients of Big Six auditors.
16
Francis, Maydew and Sparks [1999] found that the likelihood of using a Big 6 auditor is
increasing in firms’ endogenous propensity for accruals. Even though Big 6-audited firms
have higher levels of total accruals, it is also found that they have lower amounts of estimated
discretionary accruals. This finding is consistent with Big 6 auditors constraining aggressive
and potentially opportunistic reporting of accruals.
3.3.9 The Role of Financial Analysts and Financial Statement Analysis – The Detection
of Earnings Manipulation
Robb [1998] tested the hypothesis that bank managers have an incentive to manage earnings
through discretionary accruals to achieve market expectations. The results suggest that
managers make greater use of the loan loss provision to manipulate earnings when analysts
have reached a consensus in their earnings forecasts.
The implication of the work performed by Mozes [1997] on LIFO liquidation relates to the
way analysts should deal with suspicions of income manipulation. If the observed income
manipulation does not involve behavior inconsistent with sound business practice, it can be
argued that analysts should not attempt to correct for the effects of such manipulations. The
manipulation may be management’s method of signaling its expectation of future results. As a
consequence, for this author, manipulated financial statements can measure firm’s
performance as well as straight ones. The results of this study suggest that it may be more
useful to analyze the forecasting implication of EM.
Kasznik [1999] tested the relationship between earnings forecasts and EM. His hypothesis is
that managers will try to present a result in the neighborhood of the forecasted result to keep
their reputation and avoid legal actions. He found significant evidences supporting his
hypotheses.
Wiedman [1999; see comments by Beneish 1999c] presented a case study focusing on the use
of financial statement analysis in the detection of earnings manipulation. Students are required
to assess the probability that a set of financial statements contain fraud by analyzing excerpts
from the company’s financial and proxy statements, and applying the Beneish [1997] probit
model for detecting earnings manipulation. In the same area, Beneish [1999b] developed a
model for detecting manipulation. The model’s variables are designed to capture either the
1 Adapted and updated from Cormier, Magnan and Morard [1998].
17
financial statement distortions that can result from manipulation or preconditions that might
prompt companies to engage in such activity.
3.3.10 Studies Outside the Anglo-Saxon System
There are few studies on EM outside the Anglo-Saxon accounting system. Kinnunen,
Kasanen and Niskanen [1995] have done one on Finnish firms. Finnish accounting rules are
quite slacks and allow for far more accounting changes than American rules. Therefore, it is
difficult to take accounting changes as a basis. So, they used the IASC standards as a
benchmark to determine the range of a steady income. They also test for income smoothing.
Kasanen, Kinnunen and Niskanen [1996] provided evidence of dividend-based EM in
companies that have owners with preference for stable dividends.
In Finland again, Kallunki and Martikainen [1999] investigated the adjustment process of
theEM of a firm to industry-wide targets. Their results indicated that the management of a
firm takes into account the extent of EM of other firms operating in the same industry when
managing reported earnings.
However, playing with accruals has some limits. Sometimes reality must prevail and the
balance sheet must be cleared to allow a new start in capitalizing doubtful amounts or making
new provisions. That is the function of the big bath accounting. Table 3 and appendix 1
present most of the main studies in the EM literature, theoretical and empirical.
18
Table 3
Earnings Management - Theoretical papers
Authors Discussion
Dye [1988] 1. Manipulations done by managers to increase their overall compensation are
likely to be provided for by investors
2. Actual shareholders may benefit from a transfer of wealth from new
shareholders if earnings management lead to a mispricing on the market
Schipper [1989] 1. Can be a signaling device for managers
2. Assume that accounting numbers are input in the decision process
3. Make a distinction between real (timing of transactions) and artificial (timing of
presentation) EM
4. Recognize the intergenerational problem for shareholders as for bondholders
5. There must be a blocked communication condition
Ayres [1994] How earnings quality is perceived
1. Some accounting methods are perceived as high quality and other as low quality
2. Smoothed profits are perceived as low quality
3. Problems: GAAP adoption delay, accounting changes, etc
Mozes [1997] 1. Deal with EM and financial analysts
2. It would be interesting to study the forecasting implications of EM
3. There may be a signaling effect in EM
DePree and Grant
[1999]
Case study about the decision of managing earnings taking into account the interest
of managers, shareholders, other stakeholders and the GAAP. They conclude that it
is difficult to reconcile all interests involved and that it is necessary to use ethics to
find a solution.
4.0 INCOME SMOOTHING
The income smoothing (IS) manipulation has a clear objective, which is to produce a steadily
growing stream of profits. To exist this form of manipulation necessitates that the firm makes
large enough profits to create provisions in order to regulate the flow when necessary. It is
mainly a reduction of the variance of the profit.
Researches on IS proceed from the belief that market participants will be mislead by a steady
stream of profit. This belief is based on casual observations on the one hand, but also on the
method to estimate the risk. The variance of the profit is a measure of the risk associated with
this profit. So, if for a given total amount of profit we diminish the variance, we will modify
the perception the market will have of the risk associated with it.
19
The hypothesis that management smoothes income was mainly suggested by Hepworth
[1953] and elaborated on by Gordon [1964]. However, Buckmaster [1992, 1997] found earlier
references. Since Hepworth’s article, IS has been studied mostly in the US whether there had
been also some researches in Canada, UK and France2. Several reviews of the literature have
been realized: Ronen et al. [1977] (with comments by Horwitz [1977]), who discuss the
motivation for smoothing, the objects of smoothing, the smoothing instruments and
methodological problems in the tests; Imhoff [1977] and Ronen and Sadan [1981]. Table 5
presents a selection of studies on income smoothing.
The appendix 2 presents a selection of studies on income smoothing.
Michelson, Jordan-Wagner and Wooton [1995, p. 1179] explained that several studies have
focused on three issues: (a) the existence of the smoothing behavior; (b) the smoothing ability
of various accounting techniques; and (c) conditions under which smoothing is effective [Lev
and Kunitzky, 1974, p. 268]. Smoothing studies have also focused on (a) the objectives of
smoothing (management motivation), (b) the objects of smoothing (operating income, net
income), (c) the dimensions of smoothing (real or artificial), and (d) the smoothing variables
(i.e., extraordinary items, tax credits) [Ronen and Sadan, 1981, p. 6].
We will present our review on IS, along the following lines: (1) the concept; (2) the
technique, (3) the research methodologies of empirical studies and (4) the motivations for
smoothing.
4.1 The Concept of Income Smoothing
4.1.1 Numerous Definitions
The supposition that firms may intentionally smooth income was first suggested by Hepworth
[1953, pp. 32-33] and developed by Gordon [1964, pp. 261-262] with a series of propositions:
• Proposition 1: the criterion a corporate management uses in selecting among accounting
principles is the maximization of its utility or welfare.
2 The expression “income smoothing” has even been used in other contexts which will not be dealt with in thispaper: consumption smoothing and savings [Alessie and Lusardi, 1997], uses of formal savings and transfers forincome smoothing [Behrman et al. 1997].
20
• Proposition 2: the utility of a manager increases with (1) its job security, (2) the rate of
growth in his income, and (3) the rate of growth in the firm’s size.
• Proposition 3: the achievement of the management goals stated in proposition 2 is
dependent in part on the satisfaction of stockholders with the firm’s performance.
• Proposition 4: Stockholders satisfaction with a firm increasing the rate of growth of
income (or the average rate of return on equity) and the stability of the income, is essential
for managers to be free to pursue their own objectives.
The theorem was thus designed: “given that the above four propositions are accepted or found
to be true, it follows that a management should within the limits of its power, i.e., the latitude
allowed by accounting rules, (1) smooth reported income, and (2) smooth the rate of growth
in income”.
Copeland [1968], White [1970], Beidleman [1973], Lev and Kunitzky [1974], Ronen et Sadan
[1975, 1981], Barnea, Ronen et Sadan [1976], Imhoff [1977, 1981], Eckel [1981], Koch
[1981], Belkaoui and Picur [1984], Albrecht and Richardson [1990], and Michelson, Jordan-
Wagner and Wooton [1995] authored the main studies along those lines.
Some of these authors have proposed their own definition of “income smoothing”. Table 4
presents, in chronological order, several definitions.
21
Table 4
Principal Definitions of “Income Smoothing”
Copeland [1968, p.101]
“Smoothing moderates year-to-year fluctuations in income by shifting earningsfrom peak years to less successful periods”.
Beidleman [1973, p.653]
“Smoothing of reported earnings may be defined as the intentional dampening offluctuations about some level of earnings that is currently considered to be normalfor a firm”.
Ronen and Sadan[1975b, p. 62]
“By smoothing, we mean the dampening of the variations in income over time”.
Barnea, Ronen andSadan [1976, p. 111]
“Deliberate dampening of fluctuations about some level of earnings which isconsidered to be normal for the firm”
Imhoff [1977, p. 86] “IS has typically been defined as a relatively low degree of earnings variability”.
Imhoff [1981, p. 24] “IS is a special case of inadequate financial statement disclosure. The smoothingof income implies some deliberate effort to disclose the financial information insuch a way as to convey an artificially reduced variability of the income stream”.
Ronen and Sadan[1981, p. 2]
“IS can be defined as a deliberate attempt by management to signal information tofinancial users”.
Koch [1981, p. 574] “IS can be defined as a means used by management to diminish the variability ofstream of reported income numbers relative to some perceived target stream bythe manipulation of artificial (accounting) or real (transactional) variables”.
Givoly and Ronen[1981, p. 175]
“Smoothing can be viewed as a form of signaling whereby managers use theirdiscretion over the choice among accounting alternatives within generallyaccepted accounting principles so as to minimize fluctuations of earnings overtime around the trend they believe best reflects their view of investors’expectations of the company’s future performance”.
Moses [1987, p. 360] “Smoothing behavior is defined as an effort to reduce fluctuations in reportedearnings”.
Ma [1988, p. 487] “Smoothing reported earnings may be defined as the intentional reduction ofearnings fluctuations with respect to some normal level”.
Ashari, Koh, Tan andWong [1994]
“Deliberate voluntary acts by management to reduce income variation by usingcertain accounting devices”.
Beattie et al. [1994, p.793]
“Smoothing can be viewed in terms of the reduction in earnings variability over anumber of periods, or, within a single period, as the movement towards anexpected level of reported earnings”.
Fern, Brown andDickey [1994]
“Attempts to reduce earnings variability, especially behavior designed to dampenabnormal increases in reported earnings”.
Fudenberg and Tirole[1995]
“IS is the process of manipulating the time profile of earnings or earnings reportsto make the reported income stream less variable, while not increasing reportedearnings over the long run”.
Imhoff [1981] reviewed the empirical literature dealing with the definition of IS. The
inconsistencies of previous definitions are discussed and empirical evidence is presented
22
suggesting that the inconclusive results obtained by previous smoothing researchers are partly
attributable to their definition.
4.1.2 Types of Smoothing
Following previous studies of IS behavior (Dascher and Malcolm [1970, pp. 253-254], Shank
and Burnell [1974, p. 136], Imhoff [1977] and Horwitz [1977, p. 27]), Eckel [1981] showed
the necessity to distinguish between the potentially different types of smooth income streams
(see figure 2 adapted from Eckel [1981 p. 29]).
23
Figure 2
Different Types of Smooth Income Streams
Smooth Income Stream
Intentionally
Being Smoothed
by Management
(“Designed
Smoothing”)
Naturally Smooth
(“Natural Smoothing”)
Artificial Smoothing
(“Accounting Smoothing”)
Real Smoothing
(“Transactional or Economic
Smoothing”)
Accounting manipulations undertaken
by management to smooth income.
[Eckel, 1981, p. 29].
Accounting smoothing variety of
allocating over time the consequences
of decisions already made and the
classification of these consequences
within a period among different items
in the financial statements.
Accounting smoothing does not result
from changing the operating decisions
and their timing but affects income
through accounting dimensions,
notably events’ recognition and the
allocation and/or classification of the
effects of the recognized events
[Kamin and Ronen, 1978, p. 144].
Artificial variables represented by
accounting decisions (selection of a
depreciation method and the
selection, of a method for the
investment tax credit) [Koch, 1981, p.
576].
Management actions undertaken to
control underlying economic events
[Eckel, 1981, p. 29].
Actual selection of projects and
timing of operating decisions. Non-
accounting smoothing of the firm’s
input and output series through the
making and timing of operating
decisions [Kamin and Ronen, 1978,
p. 144].
Real variables represented by
business decisions (selection of an
advertising plan or of an R&D
project) [Koch, 1981, p. 576].
The management can smooth
earnings by altering the firm’s
production and/or investment
decisions at year-end based on its
knowledge of how the firm has
performed up to that time in the year
[Lambert, 1984, p. 606].
The income generating
process inherently
produces a smooth
income stream [Eckel,
1981, p. 28].
24
Imhoff [1977] focused on the problem of distinguishing natural smoothing (caused by the
economic events being reported) from designed smoothing. He recalled [p. 88] that Ball
[1972, p. 33] differentiated between “the real effects and the accounting effects” on income
and adds that a smooth earnings stream takes place by design, not as a result of some natural
sequence of events.
If we review this literature, we find many authors having given their definition of these
different concepts. Albrecht and Richardson [1990, p. 714] indicated that Imhoff [1977] was
the first researcher to attempt to separate management’s artificial smoothing behavior from
the confounding effects of real smoothing actions or naturally smooth income streams. For
Imhoff [1977, p. 89], it appears to be an impossible task to determine whether income has
been smoothed by design or as the result of some natural course of events. He believes that
the major assumption made in attempting to identify natural smoothers is that the level of
income is dependent, to some extent, on the level of sales. If the pattern of the income stream
is supported by a similar pattern for the sales stream, the smooth income stream might be
viewed as a natural result of operations.
Other solutions have been described in the literature. For instance, according to Wang and
Williams [1994], two slightly different approaches were employed empirically to separate real
IS from accounting IS. Under the first approach, a smooth income series is considered to be
more likely due to real IS than merely accounting IS, if the firm’s underlying cash flows are
also smoothed over the same period (i.e. the fluctuation in the firm’s cash flows from
operations is in the lower fifty percent). Under the second approach, a firm is considered to be
more likely engaged in accounting IS if its smooth income series is accompanied by
variations in cash flows and accruals (i.e. reporting a significant increase in cash flows and at
the same time a significant decrease in accruals, and vice versa). Within the framework of
intentional smoothing, some studies attempted to look at the difference between artificial and
real smoothing. For instance, Koch [1981, p. 576] demonstrated that smoothing is greater
with the use of artificial (accounting) variables than with real (transactional) variables.
Lambert [1984] used agency theory to examine the phenomenon of “real” IS.
Eckel proposed a categorization for analyzing the definitions already existing in the literature.
It must be remember that managers’ decisions are influenced by the environment of the firm
and a mode of functioning (which is related to natural smoothing) implying certain
25
operational practices (which are related to real smoothing) and some accounting choices
(which are related to artificial smoothing).
In a practical sense, the three types of smoothing are often hardly distinguishable and,
moreover can be considered as interrelated. Smoothing practices are based on numerous
variables.
4.2 The Smoothing Techniques
The researchers have identified different components of IS: (1) the object of smoothing, (2)
the number of periods, (3) the smoothing variables, and (4) the smoothing dimensions. We
will add a description of their research methodologies (5).
4.2.1 The Smoothing Objects
The smoothing objects are the numbers whose series is presumed to be the target of the
smoothing attempts. They represent the variables whose variations over time are to be
dampened [Kamin and Ronen, 1978, p. 141 and 145].
Imhoff [1981, p. 24] wrote that the target of management’s smoothing efforts may vary across
firms. Empirical studies dealing with IS show that the concept of “income” has been
interpreted in different ways (see table 5).
26
Table 5
The Smoothing Objects
Authors Objects of smoothing Dopuch and Drake [1966] Net income Gordon, Horwitz and Meyers [1966] - Earnings per share
- Rate of return on stockholder’s equity Archibald [1967] Net income Gagnon [1967] Earnings (less preferred dividends) Copeland [1968] Net income Cushing [1969] Earnings per share (unclear which type)) White [1970, 1972] Earnings per share (unclear which type) Dascher and Malcolm [1970] Income (not clear which one) Barefield and Comiskey [1972] Before tax earnings (unclear which one) Beidleman [1973, 1975] Earnings (unclear which one) Ronen et Sadan [1975a, 1975b] - Ordinary income per share before extraordinary items
- Extraordinary income per share Barnea, Ronen and Sadan [1976, 1977] - Ordinary income (before extraordinary items) per share
- Operating income per share (before period charges and extraordinaryitems)
Kamin and Ronen [1978] - Operating income- Ordinary income
Givoly and Ronen [1981] Earnings per share (before extraordinary items), adjusted for stock splitsand dividends.
Imhoff [1981] - Fully diluted Earnings per share- Net income- Net income before extraordinary items- Operating income- Gross margin
Koch [1981] Earnings per share Amihud, Kamin and Ronen [1983] Net operating income per share Belkaoui and Picur [1984] - Operating income
- Ordinary income Moses [1987] Earnings (unclear which) Brayshaw and Eldin [1989] - Ordinary income before tax and extraordinary items
- Net income Craig and Walsh [1989] Reported consolidated net income after tax, minority interests and
extraordinary items. Albrecht and Richardson [1990] - Operating income
- Income from operations- Income before extraordinary items- Net income
Ashari, Koh, Tan and Wong [1994] - Income from operations- Income before extraordinary items- Net income after tax
Beattie et al. [1994] Reported profit after tax, but before extraordinary items Fern, Brown and Dickey [1994] Ordinary income (income before extraordinary items). Sheikholeslami [1994] - Pre-tax income
- Net income- Operating income
Michelson, Jordan-Wagner and Wooton [1995] - Operating income after depreciation- Pre-tax income- Income before extraordinary items- Net income
Bhat [1996] Earnings after taxes and before extraordinary itemsSaudagaran and Sepe [1996] Earnings (unclear which)Breton and Chenail [1997] Net incomeGodfrey and Jones [1999] Net operating profit
Imhoff indicated [1977, p. 86] that since no smoothing research study has considered more
than one form of income, and since it is unclear in some research which form of income was
used, it is impossible to infer how any particular form of income affects the research results
27
within or across studies. Since, several studies have included more than one smoothing object,
as it appears from table 5.
The choice of the smoothing object has to be discussed. For instance, Barnea, Ronen and
Sadan have suggested that financial statements users focus on “ordinary income per share”
which they feel “… should be the object of smoothing” [1976, p. 110]. Kamin and Ronen
[1978, p. 144], who were mostly interested in real smoothing, believed that since operating
income primarily reflects the operation inflow and outflow series, its potential for real
smoothing is likely to outweigh its potential for accounting smoothing.
White [1970, p. 260] selected Earnings Per Share (EPS) as an appropriate surrogate for
reported performance because of the heavy emphasis placed on this measure in the annual
report and traditional security analysis.
4.2.2 The Number of Periods Covered
Empirical studies on IS had to face the question of the optimal number of periods involved in
the research. Copeland [1968, p. 113] believes that investigating smoothing must be done on a
sufficiently long period, and that the length of the period may influence the results of the
study. His survey confirmed the hypothesis that classification of firms as smoothers and non
smoothers based on observations over six years is more valid that a classification based on a
two-year or a four-year observation period [p. 114].
A similar idea is developed by Beidleman [1973, p. 657] who states that an increase in the
lenght of the period tends to reduce errors of misclassification of firms as smoothers when,
based on another apparently “more valid” test, they appear to be nonsmoothers. As for Moses
[1987, p. 362], he suggested that multiperiod studies capture smoothing achievement,
whereas one period studies reflect attempts to smooth.
From a statistical point of view, we could remind that time-series analyses can be performed
for a variety of purposes including considerations of IS [Cogger 1981; Lorek, Kee and Vass,
1981].
28
4.2.3 The Smoothing Variables
The smoothing instruments, also known under the terminology “smoothing devices” [Moses,
1987, p. 360] are the variables used by managers in attempting to smooth particular
accounting figures [Kamin and Ronen, 1978, p. 145].
According to Copeland [1968 p. 102], an accounting practice or measurement rule must
possess certain properties before it may be used as a manipulative smoothing device. For this
author, a perfect smoothing device must possess all of the following characteristics:
A. Once used, it must not commit the firm to any particular future action. Effective smoothing devices
should not establish a precedent to which the “principle” of consistency may apply. Practices, which,
once used, commit the firm to report particular amounts in the future may smooth current income;
however, use of them may cause anti-smoothing in the future. Future freedom of action is vital for long-
term smoothing.
B. It must be based upon the exercise of professional judgment and be considered within the domain of
“generally accepted accounting principles.” A smoothing device should not force management to
disclose the fact of its manipulation and obviously must not cause the auditor to qualify his opinion.
C. It must lead to material shifts relative to year-to-year differences in income. In other words, to be
effective, the manipulation must be material. Effectiveness relates to accomplishing specific goals;
materiality refers to the net change in income caused by the alternative.
D. It must not require a “real” transaction with second parties, but only a reclassification of internal
account balances. This condition refers to the distinction between real and accounting smoothing. A
smoothing device ought to involve only accounting interpretation of an event, not the event itself.
E. It must be used, singularly or in conjunction with other practices, over consecutive periods of time. The
term “smoothing” implies adjustments to income in two or more consecutive periods.
In reaction to Copeland’s definition of the characteristics of a good smoothing instrument,
Beidleman [1973, p. 658] proposed less strict conditions:
1. It must permit management to reduce the variability in reported earnings as it strives to achieve its long-
run earnings (growth) objective.
2. Once used, it should not commit the firm to any particular future action.
29
Copeland’s specifications have been criticized by Schiff [1968], Kirchheimer [1968] and
Beidleman [1973] as being too restrictive. Thus, the inclusion of discretionary “management
decisions – and the timing of such decisions” [Schiff, 1968, p. 121] and “a wide range of
devices, some of which are of the accounting type” [Kirchheimer, 1968, p. 119] would have
provided a more complete compendium of techniques available to management to adjust
reported earnings [Beidleman, 1973, p. 658]. Moreover, the flexibility that was introduced
into characteristic A has been mitigated by the restraints implicit in B, C, D, and E
[Beidleman p. 658].
Imhoff [1981, p. 25] reminds us that one of the more popular methods of investigating
smoothing behavior has been to select certain key variables which are both observable and
capable of being influenced through management actions, and to observe their effect on
earnings. As shown in appendix 3 below, some of the hypothesized smoothing variables
which have been investigated include the investment tax credit [Gordon et al. 1966], the
classification of extraordinary items [Ronen and Sadan 1975; Godfrey and Jones 1999],
dividend income [Copeland, 1968; Copeland and Licastro, 1968], gains and losses on
securities [Dopuch and Drake, 1966], pensions, R&D, and sales and advertising expense
[Beidleman, 1973; Dascher and Malcolm, 1970], choice of the cost or equity method
[Barefield and Comiskey, 1972], and changes from accelerated to straight-line depreciation
[Archibald, 1967].
Most of the earlier empirical studies on IS have considered only one manipulative variable at
a time. However, the weakness of concentrating on one variable was acknowledged by both
Gordon, Horwitz and Meyers [1966] and Copeland and Licastro [1968]. Copeland [1968, p.
107], criticizing an article by Archibald [1967], explained that he had only one observation on
one manipulative variable, so that a pattern of behavior could not be determined. Thus, some
declining profit firms reported in the Archibald’s sample may have been maximizers or
randomly acting non manipulators.
More fundamentally, Copeland [1968] raised the question of whether the classification of
firms as smoothers and non smoothers differs substantially with the variables selected. His
results showed that increasing the number of variables reduces the number of classificatory
errors.
30
Eckel [1981] proposed a new conceptual framework to overcome the perceived weaknesses of
the existing ones. The proposed framework suggested that an IS firm is one that selects ‘n’
accounting variables such that their joint effect is to minimize the variability of its reported
income.
Zmijewski and Hagerman [1981] proposed that companies do not select accounting
procedures independently, but consider the overall effect of all accounting procedures on
income. Ma [1988, p. 490] assumed that the failure to find significant evidence of IS might
have been due to the difficulty of testing several smoothing variables simultaneously.
4.2.4 The Smoothing Dimensions
Smoothing dimensions are the methods through which smoothing is presumed to be
accomplished, such as allocation over time or classification [Kamin and Ronen, 1978, p. 145].
Barnea, Ronen and Sadan [1976, p. 110], Ronen and Sadan [1975a, pp. 133-134; 1975b, p.
62] and Ronen, Sadan and Snow [1977, p. 15] indicated that smoothing can be accomplished
along several smoothing dimensions
The dimensions are summarized in figure 3.
31
Figure 3
The Three Smoothing Dimensions
Smoothing
through an
event’s
occurrence
and/or
recognition
Management can schedule transactions so that their
effects on reported income tend to dampen its
variations over time. For example, the delivery of
goods can be included in, or excluded from, a
specific accounting period.
Inter-temporal
Smoothing
through
allocation
over time
Given that an event has occurred and has been
recognized in the firm’s accounting, management still
has partial discretion to determine the number of
future periods affected and the impact on each period
through depreciation or amortization, for instance.
Dimensions
of smoothing
Classificatory
Smoothing
through
classification
Depending on the classification of income statement
items, management can reduce the variance of
income figures other than net income. Classificatory
smoothing is effective only when the objects of
smoothing are income figures other than net income.
For example, by classifying income or expense
elements on the borderline between ordinary and
extraordinary items, management can give a
smoother appearance to the stream of ordinary
income (before extraordinary items).
As indicated in figure 3, classificatory smoothing is mainly based on borderline items, such
as, in the US accounting, material write-downs of inventories, provisions for loss on major
long-term contracts, and losses on dispositions of assets.
The classificatory dimension with extraordinary items had not been investigated before the
surveys carried out by Ronen and Sadan [1975a, 1975b] and Barnea, Ronen and Sadan
32
[1976]. These works showed strong support for the hypothesis that management behave as if
they smoothed income through the accounting manipulation of extraordinary items.
Gibbins [1977] studied the classificatory smoothing of income with extraordinary items. He
explained that Barnea, Ronen and Sadan [1976] investigated the IS hypothesis using
correlation analysis without data on management’s intentions. Doing so, they introduced the
concept of “as if” smoothing. Then, Gibbins suggested to clearly establish intent to smooth as
a cause of accounting adjustments. One approach would involve a search for behavioral
evidence regarding intention, motivation, opportunity, smoothing models, etc. A second
approach would involve the evaluation of alternative explanations and would require various
research techniques following the explanation to be studied. Godfrey and Jones [1999]
indicated that Australian managers of companies with highly unionized workforces, and
therefore subject to labor-related political costs, attempted smoothed reported net operating
profit via the classification of recurring gains and losses.
Smoothing dimensions and smoothing objects are closely associated. Ronen, Sadan and Snow
[1977, p. 16] investigated the interrelationships among the smoothing objects, dimensions and
variables.
4.3 Research Methodologies3
Copeland [1968, p. 105] suggested that empirical tests of IS can be of three types: (1) directly
ascertain from management by interview, questionnaire, or observation; (2) ask other parties
such as CPA’s; or (3) examination of financial statements and/or reports to governmental
agencies to verify, ex post, if smoothing had occurred.
Eckel [1981, p. 30] noticed that by far the great majority of researchers selected the last
method assuming the same conceptual framework: if the variability of normalized earnings
generated by a specified expectancy model is lessened by the inclusion of a potential
smoothing variable utilized by the firm, then the firm has “smoothed income”.
This is confirmed by Albrecht and Richardson [1990, p. 713] who indicated that early
empirical researchers in accounting examined ex post data to determine the existence of
smoothing behavior. The general assumption was that if smoothed earnings resulted from the
33
choice of a smoothing variable, then IS behavior must have occurred. A classical approach to
studying IS involves an examination of the relation between choice of smoothing variable and
its effect on reported income [p. 714].
Ronen, Sadan & Snow [1977] suggested an interesting approach to research on IS. According
to them, any researcher who wants to test for smoothing must simulate management’s
decision-making process. Specifically, they address four methodological questions the
researcher has to cope with:
1. What is management’s object of smoothing?
2. Through what dimension management is conducting smoothing?
3. What is management’s smoothing instrument?
4. What is the object of the smoothing behavior?
With regard to the earnings trend, Imhoff [1981, p. 31] explained that the model used to
assess the smoothness or the variance of the income varies through time (see table 6).
Researches using a two-periods model assume the target earnings number as equal to the
previous year’s earnings [Copeland and Licastro, 1968]. In other words, the measure of
smoothness is the magnitude of the change in income from one year to the next. The studies
which evaluated earnings using multi-period tests were based on the assumption that there
should be a smooth increasing trend [Gordon, Horwitz and Myers, 1966]. They have
employed exponential models [Dascher and Malcolm, 1970], linear time-series models
[Barefield and Comiskey, 1972], semilogarithmic time trend [Beidleman, 1973] and first-
difference market income index models [Ronen and Sadan, 1975], to mention a few. Dopuch
and Watts [1972] suggested that the Box and Jenkins techniques might be useful in
ascertaining which smoothing model to use.
Imhoff [1977], followed by Eckel [1981], developed a methodology based on the testing of
the variability of income against the variability of sales. They assumed that the level of
income is dependent to some extent on the level of sales. The basic idea is that a change in
sales, at the margin, must create a relatively larger effect on the profit. Therefore, if the
variance of the profit is less than the variance of the sales, we may conclude that the benefit
had been smoothed.
3 Breton and Chenail [1997, p. 55] presented a summary of the various methodologies used in several studies.
34
Gonedes [1972] considered the IS hypothesis within the context of two kinds of stochastic
processes: martingales and mean-reverting processes. A characterization of optimal
smoothing action for an N period horizon was derived via dynamic programming tools. The
smoothing object was formed by a series of rates of return: the rate of return on common
equity, the rate of return on total assets, etc. Table 6 provides some examples of
methodologies.
Table 6
Examples of Methodologies
Authors Methodology used or describedArchibald [1967], Copeland [1968],Copeland and Licastro [1968], White[1970]
Normal or target earnings equal the preceding year’searnings.
Gordon, Horwitz and Meyers [1966] • Exponential weighting of prior year normal earnings andcurrent year actual earnings to calculate current yearnormal earnings
• Adjusts “normal” earnings using an exponentiallyweighted one-year growth rate and compares it withactual earnings per share to determine the direction ofdeviations from normality
• Two-period exponentially smoothed rate of return onbook value per share. This is then multiplied by actualbook value to calculate “normal” earnings.
Cushing [1969]
Weighted average of the four prior years’ earnings.
Dascher and Malcolm [1970]
Exponential curve.
Imhoff [1977], Eckel [1981], Albrecht andRichardson [1990], Michelson et al. [1995]
Comparison of the variance of sales and profit..
4.4 The Motivations and Determinants for Income Smoothing
As Bitner and Dolan [1996, p. 16] indicated, the initial phase of the smoothing literature,
which has been presented in the paragraph 4.2 of this section, focused on detecting
smoothing. The empirical question was whether firms deliberately dampen fluctuations
around some expected earnings trend. While the results of early studies were inconclusive,
recent evidence generally has supported the hypothesis. This finding has prompted a second
era in the literature investigating the motivation for smoothing and the factors determining
this smoothing.
Belkaoui and Picur [1984, p. 528] repertoried various motivations for smoothing given in the
literature. Early smoothing studies hypothesized that management was motivated to reduce
35
earnings and cash flow variability in an attempt to reduce firm’s perceived risk [Cushing,
1969; Ronen and Sadan, 1975; Beidleman, 1973]. As mentioned by Fern et al. [1994], later
research suggested that capital markets were “efficient” and that investors would not be
fooled by mere accounting gimmicks [Imhoff, 1975, 1981; Copeland, 1968; Beaver and
Dukes, 1973]. However smoothing may survive through managers not believing in market
efficiency.
It seems interesting to refer to Ronen, Sadan and Snow’s opinion [1977, p. 12-13]: smoothing
could be destined to (1) external users of financial statements, such as investors and creditors,
and (2) management itself. More specifically, as far as management is concerned, it should be
noted that the motivation to smooth income is not confined to top management. Lower
management may attempt to smooth to look good to the top management. They may try to
meet predetermined budgets, which in addition to serving as forecasts, also act as
performance yardsticks.
Belkaoui [1983, pp. 306-307] showed that the variability of income numbers exceeds, in
many firms, the cash accounting based numbers. That would be a sign that some smoothing
had been done. Such a measure can be used to detect natural income smoothing as differences
in the variation of income and cash flows may indicate an aggressive policy for revenue
recognition. The table 7 presents some motivations advanced by the literature.
36
Table 7
Examples of Motivations for Smoothing
Authors Motivations
Hepworth [1953] Managers are motivated to smooth income
- to gain tax advantages
- to improve relations with creditors, employees and investors.
Stable earnings give owners and creditors a more confident feeling toward management.
Beidleman [1973],
Lev and Kunitzky
[1974]
- To reduce the uncertainty resulting from the fluctuations of income numbers in general and
- To reduce systematic risk in particular by reducing the co-variance of the firm’s returns with
the market returns.
Barnea et al. [1976] Management may attempt to smooth income number to convey their expectations of future cash
flows
Ronen, Sadan and
Snow [1977]
Smoothing could be aimed at
- external users of financial statements, such as investors and creditors, and
- management itself.
Brawshaw and Eldin
[1989]
- Management compensation schemes are normally linked to firm performance represented by
reported income. Hence, any variability in this income will affect management compensation.
- The threat of management displacement: variations in the firm performance might result in the
intervention by owners to displace management by means of, for example, amalgamations,
takeovers or direct replacement.
Fern, Brown and
Dickey [1994]
- To affect a firm’s stock prices and risk
- To manipulate management compensation
- To escape restrictive debt covenant
- To avoid political costs.
Fudenberg and Tirole
[1995]
The paper builds a theory of IS based on the managers’ concern about keeping their position or
avoiding interference, and on the idea that current performance receives more weight than past
performance when one is assessing the future.
Bhat [1996] - IS improves investors’ perception of the risk of the firm.
- It helps to maintain a steady compensation scheme over time for managers.
- Since it is hard for investors to gauge the quality of the management of a bank, IS provides an
excellent alternative for low quality management to project an image of high quality
management.
- IS improves price stability of a stock by reducing its perceived earnings volatility.
37
4.4.1 Is Income Smoothing “Bad”?
For Imhoff [1977, p. 85], there is no strong empirical evidence indicating that a smoothed
income stream is either advantageous or disadvantageous to a firm or its equity holders. Ball
and Watts [1972], and earlier Kennelly et al. [1971] interpreted their research findings as
indicating that the market is efficient with respect to smoothing techniques. Yet, Gonedes
[1972] has challenged this contention and Beidleman [1973] has further asserted that
smoothing income is advantageous to both investors and market analysts.
Whereas income smoothing has long been regarded as an opportunistic management move to
“manipulate” financial statements, Ronen and Sadan [1980] proposed that IS may not be as
evil as one might think. Specifically, they argued that the smoothing of income could enhance
the ability of external users to predict future income numbers.
In the same area, Wang and Williams [1994] demonstrated that, contrary to the widespread
view that the accounting IS consists of cheating and misleading, it enhances the informational
value of reported earnings. Their study provides consistent evidence indicating that smoothed
income numbers are viewed favorably by the markets, and firms with smoother income series
are perceived as being less risky. The findings suggested that IS can be beneficial to both
existing stockholders and prospective investors. The study examines the relationship between
accounting IS and stockholder wealth. Suh [1990, p. 704] also recalled that IS is often viewed
as an attempt to fool the shareholders and investors.
In contrast to these negative views on strategic accounting choice or IS, recent agency
research in accounting has provided models in which these practices arise as rational
equilibrium behavior. Hunt, Moyer and Shevlin [1995] reported that market value is
positively associated with the magnitude of reduction in earnings volatility through
discretionary IS. While IS has an opportunistic connotation, not all smoothing is necessarily
opportunistic. Hand [1989] observed that managers may smooth earnings to align results with
market expectations, and even to increase the persistence of earnings. If earnings are
smoothed to mitigate the effects of transitory cash flows and adjust reported earnings towards
a more stable trend, then IS can enhance the value relevance of earnings. Subramanyam
[1996, p. 267] shows that discretionary accruals are priced by the market and that there is an
evidence of pervasive IS improving the persistence and predictability of earnings.
38
Bitner and Dolan [1996] expanded upon the Trueman and Titman [1988] rationale, albeit in a
non-agency setting, to propose equity market valuation as a motivation for smoothing. This
study has suggested a theoretical link between income smoothness and market valuation as
measured by the Tobin’s q. From this theoretical basis, they develop two testable hypotheses.
Does the financial market show a preference for smooth income streams? And does it
distinguish between naturally versus managed smoothness? The results indicated that, along
with growth, the market does value smoothed income. But the market also appears to be
sensitive to how smoothing is achieved, thus supporting semi-strong form of market
efficiency. The empirical results reveal that equity market valuations discount for both
artificial and real smoothing.
In some studies, IS may not be anymore the object of studies, but a variable. For instance,
Booth, Kallunki and Martikainen [1996] investigated whether the post-announcement
unexpected return behavior differs between Finnish firms that naturally smooth and do not
smooth their income.
4.4.2 Income Smoothing and Compensation
Some researchers have argued that managers benefit from smoothing due to the structure of
their compensation packages. Watts and Zimmerman [1978] and Ronen and Sadan [1981]
provided the earliest theory of how income-related compensation schemes can induce
smoothing behavior. Moses [1987] supported this theory empirically by linking smoothing
behavior with the existence of bonus compensation schemes. Other researchers have sought to
explain the rationale for smoothing in an agency setting. Lambert [1984] applied agency
theory to show that optimal compensation agreements offered by principals may cause agents
(managers) to smooth income (see below). Trueman and Titman [1988] also used an agency
framework to demonstrate that managers have an incentive to present future debt holders with
low variance income streams, thus lowering the required return of the debt holders and
thereby the firm’s long-term cost of capital.
4.4.3 Determinants of Smoothing
Ball and Foster [1982] have criticized the smoothing literature for not factoring motivations
into the research design. Lambert [1984] suggested that the proper test for smoothing is to
determine whether smoothing is more in evidence when there is relatively greater incentive
39
for it to exist. Moses [1987] added that studies of the economic consequences of accounting
choices ([Kelly, 1983] and [Holthausen and Leftwich, 1983]) have developed factors to
explain different accounting preferences across firms. The examples include taxes, political
costs, contractual relationships, and ownership control.
Beattie et al. [1994, p. 793] wrote that IS emerges as rational behavior based on the
assumptions that (1) managers act to maximize their utility, (2) fluctuations in income and
unpredictability of earnings are causal determinants of market risk measures, (3) the dividend
ratio is a causal determinant of share values, and (4) managers’ utility depend on the firm’s
share value [Beidleman, 1973; Watts and Zimmerman, 1986, p. 134].
Koch [1981] conducted a laboratory experiment to investigate the following determinants of
IS: (1) the organizational structure that is likely to induce smoothing behavior, (2) the trade-
off which a manager is willing to make to smooth income, and (3) the manner in which a
manager prefers to smooth income.
Carlson and Bathala [1997] examined the association between differences in ownership
structure and IS behavior. Several factors are identified: manager versus owner control, debt
financing, institutional ownership, dispersion of stock ownership, profitability and firm size.
As a result, dimensions reflecting differences in the ownership structure, executive’s incentive
structure and firm profitability are important in explaining IS smoothing.
4.4.4 Agency Theory
Lambert [1984] used agency theory to construct a simple economic model of the stockholder-
manager relationship. He elaborated a two-period agency model where the principal chooses
the manager’s compensation scheme to motivate the manager to engage in real IS activities,
thus allowing the agent to smooth his compensation.
Consistently with the agency hypothesis, Ma [1988, p. 488] showed that the degree of control
which management has over the conduct of firm’s affairs will influence its smoothing
behavior. On this aspect, various studies [Monsen, Chiu and Cooley, 1968; Larner, 1971;
Smith 1976; Koch, 1981; Amihud, Kamin and Ronen, 1983] have provided evidence that
management-controlled firms reported relatively smoother income series and have a lower
systematic market risk than owner-controlled firms.
40
Dye [1988], following Lambert [1984], demonstrated, in an agency setting that a risk-averse
manager who is precluded from borrowing in the capital markets has an incentive to smooth
reported income. In contrast, Trueman and Titman [1988] showed that within a market setting
an incentive exists for a manager to smooth income independently of either risk aversion or
restricted access to capital markets. They have provided an explanation for corporate
managers smoothing behavior, i.e., to lower claim holders’ perception of the variance of the
firm’s underlying economic earnings [see comments by Newman 1988].
The purpose of Suh’s paper [1990] is to focus on accounting IS rather than real IS by
incorporating information asymmetry regarding production technology into the model. The
paper develops a two-period agency model in which an agent obtains, after the first period of
operation, private information regarding future productivity of these operations. The agent’s
private information and the multi-period nature of the agency relationship are two essential
elements for explaining signal-contingent inter-period smoothing (through the choice of his
report) as a rational equilibrium behavior.
Demski [1998] proposed a new type of research. A two-period principal-agent formulation in
which the manager has an option to misreport first-period performance is presented. The
underlying model is a streamlined agency setting in which accounting recognition is an issue.
4.4.5 Sector Analysis
The activity sector has been an area of research, on the basis of a dual economy perspective:
core and periphery [Averitt, 1968, pp. 6-7]. Using this classification, Belkaoui and Picur
[1984] hypothesized that companies in the core sectors would exhibit a lesser degree of
smoothing behavior than companies in the periphery sectors because “firms in the periphery
sectors have more opportunity and more predisposition to smooth both their operating flows
and reported income measures than firms in the core sector” [p. 530]. Their method was to
compare the change in operating income and the change in the profit before extraordinary
items figure to the change in expenses. Their findings confirm their hypothesis.
Albrecht and Richardson [1990] and Breton and Chenail [1997] found interesting to adopt the
Imhoff-Eckel [1977-1981] income variability method of analysis to detect the relative
incidence of IS in the core and periphery sectors of the economy. Both studies do not support
41
the Belkaoui-Picur hypothesis of differences in corporate behavior between core and
peripheral activity sectors.
Kinnunen, Kasanen and Niskanen [1995] tested a sample separated into core and periphery
industries following the Belkaoui and Picur [1984] distinction. They found that core
companies were more incline to practice IS which they explained by the international
situation of the core sectors compared with the relatively more local statute of the periphery
sectors.
Besides that, several studies focus on one particular sector, namely the bank industry. For
instance, Scheiner [1981] analyzed IS in the banking industry, with the loan loss provision as
a smoothing instrument. He rejected the position that commercial banks use loan loss
provisions to smooth income.
Genay [1998] examined the performance of Japanese banks in recent years related to
variables used by regulators and analysts to assess their situation. This paper showed that
accounting profits are correlated with some bank characteristics and economic variables in
puzzling ways. Additional evidence suggested that these puzzling or inconsistent results may
be due to IS by banks. Specifically, Japanese banks appear to increase their loan loss
provisions when their core earnings and the returns on the market are high.
Westmore and Brick [1994] studied the Circular number 201, from the Comptroller of the
Currency, which states that bank managers should follow relevant criteria when determining
loan-loss provisions. An analysis estimates the tie between relevant criteria to the actual
provision. Contrary to results of recent past studies, they found no evidence of IS.
Grace [1990] studied the hypothesis that an insurer maximizes discounted cash flow subject
to estimation errors and IS constraints. He provided evidence to support this hypothesis for
the periods 1966-1971 and 1972-1979. Regression results for the latter period show that the
level of reserves helped reduce tax bills and smooth earnings volatility, subject to uncertain
future claim costs. Results for the period 1966-1971 indicated that reserve errors are unrelated
to smoothing measures.
Table 8 presents a listing of IS studies focusing on a specific sector or country (except from
the US).
42
Table 8
Income Smoothing in a Specific Sector or Country
Authors Sector and/or Country
Scheiner [1981] Banking industry
Ma [1988] Banking industry.
Greenwalt and Sinkey [1988] Banks
Wetmore and Brick [1994] Commercial banks
Bhat [1996] Banks
Genay [1998] Japanese banks
Hasan and Hunter [1994] Thrift industry
Grace [1990] Insurance
Fern, Brown and Dickey [1994] Oil refining industry
Gordon, Horwitz and Meyers [1966] Chemical industry
Dascher and Malcolm [1970] Chemical and chemical preparations industries
White [1970] Chemical industry and building materials industry
White [1972] Chemical, retail and electrical and electronics companies
Ronen and Sadan [1975a, 1975b] Paper, chemicals, rubber and airlines industries
Barnea, Ronen and Sadan [1976] Paper, chemicals, rubber and airlines industries
Brayshaw and Eldin [1989] UK companies
Craig and Walsh [1989] Australian companies
Chalayer [1994, 1995] French companies
Sheikholeslami [1994] Japanese firms
Ashari, Koh, Tan and Wong [1994] Listed companies in Singapore
Beattie et al. [1994] UK companies
Booth, Kallunki and Martikainen [1996] Finnish firms
Saudagaran and Sepe [1996] UK and Canadian companies
Breton and Chenail [1997] Canadian companies
4.4.6 Income Smoothing in Special Contexts
Sheikholeslami [1994] hypothesized that IS practices are altered when firms list their stocks
on foreign stock exchanges with more stringent accounting requirements than local stock
exchanges. Comparing IS practices of a sample of Japanese firms listed on New York,
43
London, and Amsterdam stock exchanges with a comparable sample of locally listed Japanese
firms, over the 1982-1987 period, results do not support the hypothesis.
5.0 BIG BATH ACCOUNTING
Intuitively, big bath accounting is easy to understand. Every time we change the Minister of
finance and the Government, the new one announces that the expected deficit will be higher
than claimed by his predecessor because he found many hidden expenses in the closets.
Briefly, he is taking the opportunity given by his arrival to clean the balance sheet and blame
the poor result on his predecessor. It is working the same way in a firm. When a new CEO is
appointed, an the turnover is quite high in the profession, he will clean the accounts to be able
to use it in the future to smooth the earnings, reassuring the shareholders and making a
constant stream of revenues for himself.
Healy [1985, p. 86] explained that the reduction of current earnings by deferring revenues or
accelerating write-offs is a strategy known as ‘taking a bath”. He described the situations that
will influence income increasing or income decreasing accounting policies. The rationale is
that when the lower limit of the bonus window cannot be reached efficiently, it is better to go
as low as possible to clear the sky for future periods. Healy [1985] refined the explanation
given in the above paragraph by adding situations that are not implying a change of managers.
One of the oldest papers investigating the “big bath” accounting hypothesis was from Moore
[1973] who noticed that new management has a tendency to be very pessimistic about the
values of certain assets with the result that these values are often adjusted. Moore studied the
income reducing discretionary accounting decisions, which were made after a change in
management. The objective was to determine whether discretionary accounting changes were
relatively more prevalent after management changes occurred than they are in a random
sample of annual reports. New management can benefit from discretionary accounting
decisions, which reduces current income in at least two ways. First, the reported low earnings
may be blamed on the old management, and the historical bases for future comparison will be
reduced. Second, future income would be relieved of these charges, so that improved earnings
trends could be reported. As a result of this study, he found that the proportion of income
reducing discretionary accounting decisions made by companies with management changes
was significantly greater than the proportion in samples chosen from companies with no
management turnover.
44
Without naming it directly, Pourciau [1993] tested the level of earnings management when
non-routine executive changes occur which is a typical big bath accounting context. She
found evidence that the incoming executive adopt income decreasing policies in the first year
to better increase earnings in the following years, consistent with the big bath accounting
hypothesis. The retained changes are those happening when there was few signs before the
resignation which comes unplanned.
The results after a big bath will depart significantly from casual results. The big bath is
supposed to be used to open the door to a subsequent smoothed steady profit for years.
Therefore, Walsh, Craig and Clarke [1991] analyzed a series of revenues (39 years, in the best
cases) looking for outliers. Although they had a limited sample (23 companies), they found
strong evidence of such behavior. Before that, Copeland and Moore [1972] looked at the
frequency of such behavior.
The practitioners world is also sporadically interested in this issue. Newsweek, as far as 1970
had something on big bath accounting4 and Forbes in 1986, for instance, had an article
entitled Big Bath? Or a Little One?
6.0 CREATIVE ACCOUNTING
In contrast with earnings management and income smoothing, which have mainly given rise
to developments by academics, creative accounting is a concept dealt with by professionals
(particularly journalists) and academics, to a lesser extent.
6.1 Creative Accounting in a Professional Perspective
Creative accounting is an expression that has been developed mainly by practitioners and
commentators (journalist) of the market activity. Their concern came from their observation
of the market and not from any theory. They understood the motivations of such an activity to
be misleading investors by presenting what they want to see, like a nice steadily increasing
profit figure. So this term of creative accounting is quite general and refers to the work of
4 See, for example, The big bath. Newsweek (July 27, 1970): 54-59; The year of the big bath, Forbes (March 1,1971): 1.
45
British people like Griffiths [1986, 19955], Jameson [1988], a financial journalist, who takes
the accountant’s perspective and talks of “manipulation, deceit and misrepresentation”, Smith
[1992], an investment analyst, who refers to “accounting sleight of hand”, and Pijper [1994;
see comments by Peter 1994], an accountant who contrats and compares the initial successes
and failures of the Accounting Standards Board. Mathews and Perera [1991, p. 228] include
under the term such activity as “ ‘fiddling the books’, ‘cosmetic reporting’ and ‘window
dressing the accounts’ (...)”. Griffiths [1986] begins his introduction assuming that “every
company in the country is fiddling its profits. Every set of accounts is based on books, which
have been gently cooked or completely roasted”.
Taking into consideration the number of books published on the topic of “creative
accounting” in the UK, one might think that this country is maybe the only one (or the “best”
one) to develop creative accounting. In order to deny this assertion, Blake and Amat [1996]
presented the results of a survey on the extent of creative accounting in Spain (see below).
In France, the journalists compared several times financial accounting to an art: “the art of
cooking the books” [Bertolus, 1988], “the art of computing its profits” [Lignon, 1989], “the
art of presenting a balance sheet” [Gounin, 1991], “the provisions or the art of saving money”
[Pourquery, 1991]. Ledouble [1993] did not hesitate to assimilate financial accounting to a
“fine art”. Other journalists assimilated financial accounting to human beings. The accounts
(financial statements) must be “dressed” [Audas, 1993; Agède, 1994], after having been
“cleaned” [Feitz, 1994a et b; Silbert, 1994; Polo, 1994]. They can be make up [Agède, 1994],
they may have their look improved [Loubière, 1992], or have a fiscal facelift [Agède, 1994].
Depreciation can be muscled and the provisions plumped [Agède, 1994].
According to Craig and Walsh [1989], disparaging references to “creative accounting
practices” by Australian companies have appeared in the Australian financial press in recent
years [e.g. Rennie, 1985]. Concern regarding the calculation of reported profit figures is
neither merely a recent phenomenon, nor a phenomenon restricted solely to the financial
reporting practices of Australian companies. Chambers [1973, Ch. 8], for example, cites
numerous instances of the ways in which companies in the UK, USA and Australia “tinker
with” reported profit figures and “cook the books”. This group may also include the book of
Schilit [1993], Financial Shenanigans, that is doing in the US what the other authors quoted
above have done in the UK.
5 See comments by Paterson [1995]
46
These works build on the presence of a fundamental asymmetry of information between
managers, actual controlling shareholders and other actual or potential shareholders.
Managers and controlling shareholders are taking advantage of this asymmetry to mislead
other investors and decrease the capital cost of the firm, which, incidentally, is also the goal of
every provision of honest accounting information to the market. So, in this category, here, we
have no real theory, and no real method although a richness of observation and description of
real situations, i.e., many interesting anecdotal evidence.
Ronen and Sadan [1981] stated, about IS, that its perceived manifestation are in most cases
negative. For example, the press, which is an agent of public opinion and feeling, views the
smoothing phenomenon as revelations of “cheating”, of “misleading”, and of other “immoral”
deeds on the part of managers of corporations. This opinion may easily be transposed to
creative accounting.
6.2 Creative Accounting in an Academic Perspective
Creative accounting enters in the academic literature, in the UK, under the label of window-
dressing. Manipulations of such amplitude are hardly market anomaly. The behavior of
market participants must be described differently than by the efficient market hypothesis. In
fact, the functional fixation hypothesis would fit better a system where manipulations are
widely spread and have dramatic effects on the investors understanding of the potential risk
and return of the firms. Naser [1993] published a book entitled Creative Financial
Accounting. Although including no empirical work, Naser synthesized many researches on the
subject and try to determine the causes and consequences of the phenomenon.
These studies goes over the effect on the earnings to consider also the effects on the gearing,
which is the relationship between the debt and the equity and an expression of the structural
risk of the firm that is not necessarily perceived through the variance of the profit.
The methodology used by researchers in this stream is in depth analysis of accounts in order
to find the doubtful applications of accounting procedures and standards. So, their analyses
rely on the experience and knowledge of the researcher to discriminate between acceptable
and unacceptable practices. The results of these studies suggested that accounts are effectively
47
manipulated to produce a better image of the firm and convince investors to accept a lower
rate of return.
Simpson [1969], before the first studies on earnings management, which imply a specific
object and also a specific methodology, studied income manipulation. He repertoried
situations where there had been a choice without any difference in the situations. After having
determined which alternative produce the best image of the financial situation of the firm, he
was able to determine if there had been manipulation. Obviously, such study depend very
much on the expertise of the author to determine what would have been the best treatment
under the circumstances and which produce the truest and fairest view. His results showed
that managers make accounting choices to produce the desired results and that investors are
not provided with the accounting information they are entitled to receive.
In 1990, Tweedie and Whittington, in a standard setting perspective, examine some creative
accounting schemes as reporting problems and found a large potential for misleading uses of
accounting information taking advantage of vague standards
Blake and Amat [1996] showed that creative accounting is as significant an issue in Spain as
in the UK. This finding challenges the view that the prescriptive continental European
accounting model is less open to manipulation than the flexible Anglo-American model.
Shah [1996], taking another perspective, showed how creative accounting is not a solitary
activity but that many participants join forces to by pass laws and standards. Among them,
bankers and lawyers are featuring actors. He also showed how firms are ready to pay large
bankers and lawyers fees to organize schemes presenting bonds as equity and avoiding
amortization of goodwill, for instance. Therefore, there must be a strong belief that
accounting presentation can modify the market perception of the value of the firm.
Breton and Taffler [1995] conducted a laboratory experiment with 63 City stockbroking
analysts to test their reactions to accounts manipulations. They proposed two sets of accounts;
one heavily window dressed and the other clean. They found no evidence of corrections for
window dressing made by analysts in their assessment of the firms.
Pierce-Brown and Steele [1999] carried out a study of the accounting policies of the leading
UK companies analyzed by Smith [1992]. They used agency theory variables to predict the
48
individual accounting policy choices and combinations of policies. They showed that size,
gearing, the presence of an industry regulator and industry classification are good predictors
of accounting policy choices.
6.3 Creative Accounting and Creativity
Finally, we would like to add that “creative accounting”, as it is dealt with in a professional
perspective, has almost nothing to do with “creativity”. For instance, even the twelve
techniques listed by Smith in his much-debated book [1992]6 (including accounting for
pensions, capitalization of certain costs or brand accounting) are much more related to
accounting alternatives than to creativity.
More recently, Naser [1993] who, however makes a very interesting historical analysis of the
concept of creative accounting, deals with very classical topics: accounting for short-term
investments and accounts receivable (chapter 5), accounting for inventories (chapter 6),
accounting for tangible fixed assets (chapter 7) and intangible assets (chapter 8), accounting
for long-term debts (chapter 9)…
To summarize our opinion, there is a harmful confusion between a so-called “creative”
accounting and the existence of numerous accounting choices, which have always been
known. These choices are based on real alternatives, but also on the relative freedom with
regards to valuation.
However, there is one circumstance when accounting will have been “creative”: when a legal,
economic or financial innovation appears without any existing accounting standard to regulate
it. In this case, creative accounting will be necessary and will translate legal or financial
creativity. However, the vacuum created by the accounting standards may lead to reverse the
reasoning: a legal or financial operation (scheme) would be organized because of its impact
on financial statements. In-substance defeasance constitutes a good example of such an
operation. In this context, Pasqualini and Castel [1993] have used the term “financial
creativity with accounting objectives”. Some authors refer to “balance sheet management”
[e.g., Black, Sellers and Manly, 1998, p. 1287] which includes, for instance, the need to
reduce debt/equity ratio. These authors conducted a study, in order to extend prior research on
asset revaluation, by demonstrating that UK firms that are doing asset revaluation differ from
49
those who do not, in terms of debt/equity ratio, market-to-book ratio and liquidity. They
found their results difficult to interpret.
7.0 DIRECTIONS FOR FUTURE RESEARCH
Before concluding this paper, some directions for future research can to be mentioned.
7.1 Manipulations, Law, and the Concept of True and Fair View
Is accounts manipulation legal? What is the link between accounts manipulation, law, fraud,
and true and fair view? Although discussed by Merchant [1987], Belkaoui [1989], Brown
[1999], and Jameson [1988], these questions have not received sufficient attention in the
literature.
New concepts have been proposed to study these questions: (1) creative compliance [Shah,
1996], describing the capacity of creative accounting to remain within the limits of the law
although bending its spirit; (2) misrepresentation hypothesis [Revsine, 1991], stating that
foggy accounting standards are useful for everybody. In the accounting education area, case
studies started to be developed [Cohen et al., 2000].
Finally, the notion of true and fair view is not understood in the same way by every interested
parties [Parker and Nobes, 1991; Rutherford, 1985]. Before, following the law was reputed to
produce a true and fair view. Recently, these concepts tend to be separated [Briloff, 1976, p.
12]. More studies are necessary to clarify the relationship between accounts manipulation, law
and true and fair view.
7.2 The Social Aspect of Accounts Manipulation
Accounts’ first justification will be to report on the use of collective resources by individuals
and firms. This reporting is assumed to be done by the reporting to shareholders. So, in a
perspective where the firm exists to generate and disseminate wealth in a society, cheating
with accounts is cheating with society in general.
6 See comments by Swinson [1992] and Cassidy et al. [1992].
50
7.3 Economic Impact of Accounts Manipulation
Hand [1989] observed that managers may smooth earnings to align results with market
expectations, and even to increase the persistence of earnings. If earnings are smoothed to
mitigate the effects of transitory cash flows and adjust reported earnings towards a more
stable trend, then IS can enhance the value relevance of earnings. Subramanyam [1996, p.
267] showed that discretionary accruals are priced by the market and that there is an evidence
of pervasive IS improving the persistence and predictability of earnings.
In this context, we could remind that, in the classical version of the liberal economics,
accounting information lead to better decision, i.e., to a better resources allocation. An
efficient allocation of resources is the ultimate goal of any economic system. In that logic,
biasing the accounts may lead to a sub-optimal allocation and consequently the spoiling of
resources. This idea could be investigated further.
8.0 SUMMARY AND CONCLUSIONS
One objective of this paper was to distinguish between the different characterizations of
accounts manipulation. In this context, several ideas, of course debatable, could be put
forward.
1 – Income smoothing is one type of earnings management
Whereas earnings management has been defined as “a process of taking deliberate steps
within the constraints of generally accepted accounting principles to bring about a desired
level of reported earnings” [Davidson et al., 1987] and called “disclosure management” by
Schipper [1989], several authors believe that income smoothing is one part of earnings
management: “A specific example of earnings management … is income smoothing” [Beattie
et al., 1994, p. 793]; “A significant portion of this work (earnings management) has examined
income smoothing, a special case of disclosure management” [Bitner and Dolan, 1996]; “One
motivation of earnings management is to smooth earnings” [Ronen and Sadan, 1981].
51
2 – Earnings management relates to income maximization (or minimization) and income
smoothing refers to the trend of earnings
More precisely, the smoothing behavior is defined as an effort to “reduce fluctuations in
reported earnings” [Moses, 1987, p. 360], “rather than to maximize or minimize reported
earnings” [Moses, 1987, p. 358; Ronen and Sadan, 1981]. Moreover, to smooth income, a
manager takes actions that increase reported income when income is low and takes actions
that decrease reported income when income is relatively high. This latter aspect is what
differentiates income smoothing from the related process of trying to exaggerate earnings in
all states [Fudenberg and Tirole, 1995].
3 – Extreme earnings management performed by new management is referred to as “big bath
accounting”
As Moore [1973, p. 100] explained, new management has a tendency to be very pessimistic
about the values of certain assets with the result that these values are often adjusted. This type
of behavior is commonly known as “taking a bath”. Such a definition obviously expresses the
positive way of seeing the situation.
4 – Creative accounting is a mixture of the other mechanisms
Creative accounting has been used with various meanings and brings some confusion into the
field of accounts manipulation. It mainly includes earnings management (without any
reference to income smoothing) and focuses a lot on classificatory manipulations (either
related to income statement or to balance sheet).
We may believe that accounts manipulation is a sorry business. However, if we compare with
all other activities in the world, we may wonder why accounts would not be manipulated. Not
that far from accounting (normally taught in the same business schools) is the marketing,
where cheating seems to be the rule and where they believe to be able to easily mislead
people. The people targeted by the marketing are also market participants. Why would they be
easy to mislead or, at least, to influence when they buy products and impossible to influence
when they buy share?
52
The market may be efficient to a degree, but efficiency is not given. It is constructed every
day by the accumulated work of analysts and journalists and other providers of information.
In such a context, manipulations are possible and probably sometimes efficient and,
consequently, they constitute an important object to study.
53
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75
Appendix 1
Empirical Studies of Earnings Management – A Selected List
Authors Motivations Sample Methodology Results
Copeland and Wojdak
[1969]
Accounting for merger to
maximize future income
Gagnon’s 55-58 data, plus 118
recent NYSE mergers
Changes in accounting
treatments
Strong support for the hypothesis of
income maximization through a massive
use of the pooling method
Anderson and Louderback III
[1975]
Purchase-pooling decision 114 mergers of the NYSE (pre-
Opinion 16 period) and 64 mergers
(post-opinion period): 1967-70.
1970-74
Test for significnce of the difference
between proportions: Z statistic.
No significant decline of the maximazing
behavior after APB 16.
Bremser [1975] Use of accounting changes for
EM
80 firms with changes compared
to 80 without
Comparison of both groups on
EPS and ROI
Changing firms have a poorer pattern of
profit
Healy [1985] Effects of bonus plans on
accounting choices
Population = 250 largest US
firms from Fortune
Sample = 94 firms for 239 firm-
years
Non discretionary accruals = a
mean value over a period
If the profit is too low, managers will take
a bath otherwise they will pick income -
increasing or decreasing procedures
DeAngelo [1986] Proxy contest and
management buyout
64 NYSE and American SE
proposing a management buyout
(73-82)
Discretionary accruals = total
accruals
The empirical evidence does not support
the hypotheses
McNichols and Wilson
[1988]
Decrease the variance of
earnings
When the profit is too low,
managers will choose to take a
bath
138 firms from the printing and
publishing industry giving a
total of 2038 firm-years
Test of the change on bad
discretionary bad debt
provision, the discretionary
portion being estimated with 4
benchmarks
Results are consistent with the income
decreasing hypothesis although not with
the smoothing hypothesis
76
Dechow and Sloan [1991] CEO situation and R&D
expenditure
Compustat firms in specific SIC
codes - 405 firms
Non discretionary accruals =
the mean of the industry sector
Positive evidence of income -increasing
accounting choices by CEO
Jones [1991] EM during an inquiry of the
International Trade
Commission
23 firms in 5 industrial sectors Non discretionary accruals are
established by providing for
the normal growth of the firm
(revenues and assets) by
normalizing with total assets
at the beginning
Managers make income-decreasing
accounting choices during investigations
Aharony, Lin and Loeb
[1993]
EM in an IPO context 229 industrial firms (1985-87)
on a population of 1162 US
firms
DeAngelo’s model; total
accruals standardized by
average total assets
No evidence of manipulation through the
accruals
Bartov [1993] EM from specific items
manipulation: income
recognition from disposals
653 firm-year observations from
Compustat, classified by
industrial sector
Through a regression, the
income from asset sales is
explained by the variation of
earnings per share and the
book value of the debt/equity
ratio
Highly geared and low income firms have
significantly higher revenues from asset
sales
Dempsey, Hunt and
Schroeder [1993]
Effect of ownership structure
on EM
Compustat firms with at least
one extraordinary item between
1960 and 1966. Total 248 firms
3 groups: 1 - owner managed,
2 - externally controlled, 3 -
management controlled.
Classification into
extraordinary items and
ownership structure
When management and ownership are
separated, high level of EM through
extraordinary items
Pourciau [1993] The effect of nonroutine top
executive changes on
accounting choices
73 firms from Disclosure having
experience a nonroutine CEO
change
Examination of unexpected
earnings, accruals and cash
flows and special items
As expected new CEO decrease income in
their first year (big bath), unexpectedly
leaving CEO do the same in their last year
77
DeAngelo, DeAngelo and
Skinner [1994]
Potential problems to comply
with debt covenant dealt
through dividend cuts
76 firms from the NYSE with
three years of losses within
1980-85
Looked for a movement in the
accruals around the dividend
reduction date
Accruals = net income - cash
flows
No real significant income increasing
procedures
DeFond and Jiambalvo
[1994]
Possibility of a default of the
debt covenant
94 firms from the NAARS
database disclosing a violation
between 1985 and 1988
2 measures: total accruals and
working capital accruals
EM occurs the year before the default
becomes publicly known
Friedlan [1994] EM in a IPO context 277 IPO firms from 1981 to
1984
DeAngelo’s model modified
through standardizing by sales
Income increasing procedures just before
the IPO
Sweeney [1994] Debt covenants default
possibilities
130 firms first time violators
(1980-89) with data on
Compustat
Direct test of the use of certain
accounting methods, e.g.
LIFO vs FIFO
Significant manipulations when in danger
of defaulting
Dechow, Sloan and
Sweeney [1995]
To test the validity of
available models in detecting
EM
4 samples: 2 randoms of 1000
each, 1 from firms having
extreme performances, and 1 of
36 firms prosecuted by the SEC
Models tested: Jones original,
Jones modified, Healy,
DeAngelo and the industry
model
Jones modified is the best model although
none is really complete
Gaver, Gaver and Austin
[1995]
Effects of bonus plans on
accounting choices
102 firms, between 1980 and
1990
Replication of Healy’s study
using Jones’ model
No big bath. They increase the profit
when too low and decrease it when too
high
Holthausen, Larcker and
Sloan [1995]
Effects of bonus plans on
accounting choices
Income-reducing procedures at the top
Kinnunen, Kasanen and
Niskanen [1995]
EM and economy sectors 37 listed firms, 17 core and 20
peripheric
Total EM = profit from IASC
standards less profit presented
in Finnish standards
Opportunity for and use of EM is greater
in the core sector, and the sector is
making a difference
78
Neil, Pourciau et Schaefer
[1995]
EM in an IPO context Population = 2609 IPOs (1975-
84). Sample = 505 following
data availability
Classification of accounting
methods: depreciation and
stock valuation, as
conservative or liberal
Relationship between the size of the
proceeds and the liberality of accounting
policies
Beneish [1997] Firms experiencing extreme
financial performance.
Distinguish GAAP violaters
from simply aggressive
accruers
Experimental: 64 firms charged
by the SEC
Control group: firms with high
accruals - 2118 firms
The Jones model for selecting
the aggressive accruers
(control)
A regression to explain the
differences between violators
and non violators through a set
of variables
The model can detect the possibility of
opportunistic reporting among firms with
large accruals
Recommendations to improve Jones
model
Burgstahler and Dichev
[1997]
EM around profit = 0 or a
negative value
64466 observation-years (1977-
94)
Gaps in the density of the
distribution of earnings
Strong evidence of EM when earnings
decrease or are negative
Black, Sellers and Manly
[1998]; Peasnell [1998]
EM through asset disposals
and accounting regulation in
an international context
From data available in Global
Vantage. 750 firms from
Australia, New-Zealand and
UK, for a total of 1199 firm-
years
Comparison of the
characteristics of the revaluers
and non revaluers
Testing for asset revaluation
No evidence of EM in Australia and New-
Zealand but strong one in the UK
Cormier, Magnan and
Morard [1998]
Firms in financial distress and
takeover attempts
60 Swiss firms on 5 years on the
total of 172 listed Swiss firms
Explain the level of total
accruals by a list of variables
like the Beta, the cash flow,
structure of ownership, etc.
Principles of the agency theory (or
positive accounting theory) are applicable
in Switzerland as well as in anglo-saxon
countries
Han and Wang [1998] EM to decrease political
visibility
76 firms in predetermined Sic
codes
DeAngelo’s model adjusted
by total assets
Evidence that oil companies used income
decreasing procedures during the Gulf
war
79
Labelle and Thibault [1998] Environmental crises Sample of 10 firms having
known an environmental crisis
reported on the front page of the
New-York Times
Jones model modified,
adjusted for the differences in
cash flows
No evidence of earnings management
following an environmental crisis
Teoh, Welsh and Wong
[1998]
IPOs, increased asymmetry of
information
1649 IPO firms (1980-92) Four types of accruals
discretionary and non, short
term and long term
Positive evidence of earnings
management immediately after the issuing
Beneish [1999a] Consequences of earnings
overstatement
Same sample than in 1997 Managers are more likely to sell their
holdings and exercise stock appreciation
rights in the period when earnings are
overstated than are managers in control
firms
Beneish [1999b] Detection of earnings
manipulation
74 companies and all Compustat
companies matched by two-digit
SIC numbers. Data available for
1982-92 period.
8 variables. Identification of half of the companies
involved in earnings manipulation
Degeorge, Patel and
Zeckhauser [1999]
Manage investors impression Quarterly data on 5387 firms
from 1974 to 1996
Analysts’ expectations = a
mean of forecasts. They study
the distribution of changes in
EPS and earnings forecasts to
identify discontinuities
Firms are using EM to avoid reporting
earnings below some threshold identified
empirically in the study
Erickson and Wang [1999] Increasing stock value prior to
a stock for stock merger
55 firms from 24 industries Total accruals = net income
less operating cash flows.
Jones model to determine
discretionary accruals
Income increasing procedures are found
just before the merger
80
Jeter and Shevakumar
[1999]
Improve the methodology to
detect event-specific EM
1000 firms-periods in each cash
flow quartile
Modified Jones model to take
into account the level of cash
flow
The Jones model is not well specified for
extreme cash flow
Kasznik [1999] Managers will try to present
earnings in the neighborhood
of analysts forecasts
499 management earnings
forecasts from Lexis news
Jones model as modified by
Dechow, Sloan and Sweeney
Found evidence of EM to align the
presented and the forecasted earnings
Lim and Matolcsy [1999] EM facing price control in
Australia
3 groups: 1. 32 investigated, 2.
34 subject to be inquired, 3- not
subject to be inquired
Jones model Evidence of EM for the category 1 in year
0
Magnan, Nadeau and
Cormier [1999]
EM by firms participating as
plaintiffs in antidumping
investigations
17 Canadian firms (1976-92
period)
Model relating accruals to
return, cash flow, PPE, control
and tribunal
Evidence of reduction of earnings to
obtain favorable rulings from the tribunal
Navissi [1999] EM under price regulation 62 firms from New Zealand (2
samples). One control sample.
Dechow, Sloan and Sweeney
model adjusted for the impact
of general price inflation
Evidence of EM
Young [1999] To test the robustness of 5 modelsto measurement error
158 firms distributed over3 years Mode tested: Healy, DeAngelo,modified DeAngelo, Jones,modified Jones
Jones and modified Jones are the best models
81
Appendix 2
Studies of Income Smoothing (IS) – A Selected List7
Authors Purpose of the paper Object of smoothing Variable (instrument) of
smoothing
Sample
Period of analysis
Methodology – Expectancy
model
Results - comments
Dopuch and
Drake [1966],
Gordon [1966],
Savoie [1966]
To investigate the effects
of alternative accounting
rules for valuing non
subsidiary investments.
Net income. Gains and losses on sale of
securities.
Dividends of non-subsidiary
investments.
12 firms.
1955-64.
Time series regression
techniques on net income.
No expectancy model specified.
No evidence of smoothing with
gain or loss of securities.
Some evidence with dividend
income.
Gordon, Horwitz
and Meyers
[1966]
To test the hypothesis
that firms attempt to
smooth income.
Earnings per share.
Rate of return on
stockholder’s equity.
Income (unclear which).
Investment tax credit. 21 firms in the
chemical industry.
1962-63.
Exponential weighting of prior
years normal earnings and
current year actual earnings.
Exponentially weighted one-
year growth rate.
Two-period exponentially
smoothed rate of return.
Inconclusive results.
Archibald
[1967], Sprouse
[1967],
Cummings
[1967]
To discover how and
why an accounting
change is made.
Net income. Change from accelerated
depreciation to straight-line
depreciation.
Investment credit.
53 firms.
1962-64.
Target earnings are the
reproduction of the preceding
year’s earnings. Descriptive
statistics (ratios).
Mitigated results. A high
proportion of companies
smoothes income when their
profitability is relatively low.
7 This table is based on an idea taken from Ronen, Sadan and Snow [1977], Ronen and Sadan [1981], Brayshaw and Edlin [1989] and Chalayer [1994]. The studies are presented inchronological order. For each study, the references following the first one, when mentioned, is related to comments or discussions.
82
Gagnon [1967],
Sapienza [1967],
Wyatt [1967]
To find out whether there
is any empirical basis for
assuming that managers
seek to smooth reported
income.
Earnings (less preferred
dividends).
Purchase-pooling decision. 500 mergers from the
NYSE.
1955-58.
Discriminant function. Management’s choice is more
consistent with income
maximization than with
income normalization.
Copeland [1968],
Schiff [1968],
Kirchheimer
[1968]
To specify some
attributes of accounting
variables which have a
capacity for smoothing.
To evaluate earlier
investigations in terms of
criteria so developed.
To report on empirical
investigations of three
hypotheses which have
implications for further
research on income
smoothing.
Net income. Dividend income received
from unconsolidated
subsidiaries reported by
parent at cost.
Other smoothing variables
(extraordinary charges or
credits, write-offs of fixed
assets or intangibles,
cessation or unusual changes
in pension charges, changes
in accounting methods or
procedures, fluctuations in
contingency or self-
insurance reserves, changes
in deferred charge or credit
accounts…).
19 companies from
the NYSE.
From 4 to 20 years.
Target earnings were the
reproduction of the preceding
year’s earnings.
Defines what a good
smoothing device must
possess.
Increasing the number of
variables and the length of the
time series reduces the error
involved in classifying firms as
smoothers or non-smoothers.
Copeland and
Licastro [1968]
Study of accounting for
unconsolidated
subsidiaries reported by
the parent at cost.
Net income. Dividend income. 20 companies from
the NYSE.
Periods from 5 to 12
years (1954-65).
Year-to-year changes.
Chi-square statistics.
No evidence of IS.
83
Cushing [1969] To study the effects of
changes in accounting
policy on the reporting
earnings with emphasis
on the IS effects of such
changes.
Earnings per share
(unclear what type of
EPS).
Reported changes in
accounting policies
(consistency qualifications
variables in the auditor’s
report).
249 cases of changes.
1955-66.
A $0.01 increase in earnings per
share over the preceding year; a
distributed lag model.
Weighted straight-line
projection based on the five
previous years.
Evidence that management
chooses the periods in which to
implement a change so as to
report favorable effects on
current earnings per share.
White [1970] Study of discretionary
accounting decisions.
Earnings per share
(unclear which type).
Discretionary accounting
decisions.
42 firms (chemical
industry) and 54
firms (building
materials industry).
1957-66.
Target earnings were the
reproduction of the preceding
year’s earnings.
Evidence that companies faced
with highly variable
performance pattern and
declining earnings smooth
income.
However, those faced with
variability in positive earnings
do not smooth income.
Dascher and
Malcolm [1970]
Examine companies in
the chemical and
chemical preparations
industries.
Income (not clear
which).
Pension costs.
Dividend from
unconsolidated subsidiaries
reported by the parent at
cost.
Extraordinary charges and
credits.
R&D costs.
52 firms.
1955-66 and 1961-
66.
Time series regression
techniques on net income.
Exponential of the form y = abx.
Results considered being
consistent with the smoothing
assumption.
Barefield and
Comiskey [1972]
Differential impact of the
cost versus the equity
method of accounting for
unconsolidated
subsidiaries.
Before tax earnings
(unclear which).
Cost or equity method. 30 firms. 10 (cost
basis); 14 (equity); 6
(both methods).
1959-68.
Linear relationship between
earnings and time. Parametric
two factor analysis of variance
design with repeated measures
on one factor.
Modest support for the
hypothesis that firms select
that method which produces
smoother earnings.
84
White [1972] Study of discretionary
accounting decisions
(other companies than in
the previous study).
Earnings per share
(unclear which type).
Discretionary accounting
decisions.
42 chemical
companies, 39 retail
companies and 41
electrical and
electronics
companies.
1957-66 or 1959-68.
Target earnings were the
reproduction of the preceding
year’s earnings.
Mixed results with companies
faced with highly variable
performance pattern and
declining earnings smooth
income.
Beidleman
[1973, 1975],
Imhoff [1975]
The paper addresses 3
questions:
Is it desirable for
management to have
smooth earnings?
If desirable, can
management create the
appearance of smooth
earnings?
If desirable and possible,
do firms succeed in their
attempt to normalize
reported income?
Earnings (unclear
which).
Pension and retirement
expense.
Incentive compensation.
R&D expense.
Remitted earnings from
unconsolidated subsidiaries.
Sales and advertising
expense.
Plan retirements.
43 firms.
1951-70.
Linear time trend.
Semi logarithmic time trend.
Correlation of residuals from
time-series regressions of
reported income with similarly
derived residuals of variables
which have smoothing
potential.
Many firms employ certain
devices to normalize reported
earnings.
Evidence of smoothing with
the instruments: pension costs,
incentive compensation, R&D
and sales and advertising
expense.
Lev and
Kunitzky [1974]
To suggest that firms
actively engage in the
smoothing of various
input and output series,
such as sales and capital
expenditure, in order to
decrease environmental
uncertainty.
No object. No instrument. 260 firms.
1949-68 (15 years of
continuous annual
data).
Mean-standard deviation
portfolio model.
Overall risk and systematic risk.
Reveal a significant
association between the extent
of smoothness of sales, capital
expenditures, dividends, and
earnings series and the risk of
common stock.
85
Ronen et Sadan
[1975a, 1975b]
To report the results of a
test for classificatory
smoothing with
extraordinary items.
To present evidence that
firms make use of
whatever discretion they
have to “smooth”
income.
Firms from four
industries: paper,
chemicals, rubber and
airlines.
Ordinary income per
share before
extraordinary items.
Extraordinary income
per share.
Extraordinary items
(classificatory smoothing).
62 firms.
1951-70.
Correlation coefficient between
the ordinary income series and
the extraordinary income (or
expense) series.
First differences income market
index.
Submartingale.
Strong support of the
smoothing hypothesis.
Barnea, Ronen
and Sadan [1976,
1977]
Tests of whether
extraordinary revenues
and expenses are used to
smooth ordinary or
operating income over
time.
Ordinary income
(before extraordinary
items) per share.
Operating income
(before period charges
and extraordinary items)
per share.
Classification of non
recurring items as either
ordinary or extraordinary.
62 firms from 4
industries: paper,
chemicals, rubber
and airlines.
1951-70
Regression of the extraordinary
items deviations on the
smoothed variables deviations.
Linear time trend. Industry
leader trend.
Strong support for the
hypothesis that management
behave as if they smoothed
income before extraordinary
items through the accounting
manipulation of extraordinary
items
Imhoff [1977] To question the
definition of what
constitutes IS and to
suggest an alternative
definition.
Empirical study on the
possible existence of
smoothing.
No object. No instrument. 94 industrial firms.
1962-72 (or 1961-
71).
Suggested that IS can be studied
by comparing the variance of
sales to the variance of income.
Regressions for the net income
and sales time –series as well as
the association between net
income and sales.
No evidence of IS.
86
Kamin and
Ronen [1978]
Factors associated with
IS. Examined the effects
of the separation of
ownership and control on
IS under the hypothesis
that management-
controlled firms are more
likely to be engaged in
smoothing as a
manifestation of
managerial discretion
and budgetary slack.
Operating income.
Ordinary income.
Discretionary items:
Operating expenses (not
included in the cost of sales).
Ordinary expenses including
non-manufacturing
depreciation and fixed
charges.
310 U.S. industrial
firms.
1957-71.
Time trend.
Market trend.
Compared to owner-controlled
companies, manager-controlled
ones tend to smooth income.
Barrier entry have an effect on
IS.
Eckel [1981] To offer an alternative
conceptual framework
for identifying IS
behavior.
Net income.
(Artificial smoothing).
No instrument. 62 industrial
companies.
1951-70.
To compare the variability of
sales and the variability of
income.
Finds only two firms that
appeared as if they smoothed
income.
Givoly and
Ronen [1981]
To test the hypothesis
that the observed first
three quarters’ results
trigger actions by
management during the
fourth quarter that appear
as smoothing behavior.
Earnings per share
(before extraordinary
items), adjusted for
stock splits and
dividends.
Sales (real smoothing). 50 companies and 42
companies.
1947-72.
Submartingale.
Polynomial regression.
The manifestations of end-of-
year actions by managers are
consistent with the possible
attempt on their part to alter
fourth quarter reported.
Scheiner [1981] To examine whether the
provision for loan losses
has been used to smooth
income in the banking
industry.
Operating income
before the loan loss
provision and income
taxes.
Loan loss provision. 107 banks.
1969-76.
Spearman Rank Correlation
Coefficient Test (association
between: the loan loss provision
and current operating income;
the loan loss provision and the
measures of business failure).
No evidence of IS.
87
Amihud, Kamin
and Ronen
[1983]
To test for the
differences between
owner-controlled and
manager-controlled firms
with respect to their risk.
Net operating income
per share.
Operating expenses per
share.
56 firms.
1957-71.
Method used in Kamin and
Ronen (1978). Detrend of time
series.
Manager-controlled firms
exercise IS to a greater extent
than owner-controlled firms.
Belkaoui and
Picur [1984]
To test the effects of the
dual economy on IS.
Operating income.
Ordinary income.
Operating expenses not
included in cost of sales.
Ordinary expenses.
Operating expenses plus
ordinary expenses.
Examination of 114
core companies and
57 periphery
companies.
Not mentioned.
Correlation coefficient between
the deviations of the smoothing
objects with the deviations of
the smoothing variables.
IS is stronger in the periphery
sector that in the core area.
Moses [1987] To test for associations
between smoothing and
variables commonly used
to proxy for particular
economic factors.
Earnings (unclear
which).
Discretionary accounting
changes (switch to Lifo,
change in pension method or
assumptions, depreciation,
tax credit, consolidation,
changes in amortization,
depreciation estimates,
changes in
expense/capitalization
policies).
212 change events.
1975-80.
T-tests and regression analysis. IS is associated with firm size,
bonus compensation plans, and
divergence from expected
earnings.
Ma [1988] To examine the income-
smoothing practice in the
US banking industry.
Operating income.
Income (unclear which).
Loan loss provision. 45 largest banks.
1980-84.
Equation showing the
relationship between operating
income, charge-off and loan-
loss provision.
Strong evidence of IS.
88
Brayshaw and
Eldin [1989]
To test the impact of
accounting for exchange
differences.
Ordinary income before
tax and extraordinary
items.
Net income.
Exchange differences. 40 UK companies.
1975-80.
Linear time trend expectancy
model.
Wilcoxon sign-test.
T-test.
Including exchange differences
in either of the two streams of
income (operating income
and/or net income) results in
greater variations therein.
Variations in operating profit
due to the inclusion of these
differences are more
significant that the variations
in net profit.
Craig and Walsh
[1989]
To discover whether the
accounts of a sample of
Australian listed
companies contain
evidence of IS.
Reported consolidated
net income after tax,
minority interests and
extraordinary items.
Artificial smoothing.
Extraordinary items
adjustments (timing, amount
and period of reporting).
Example: gain or loss on sale
of a non-current asset.
84 companies from
the Sydney Stock
Exchange.
1972-84.
Cox and Stuart test. Strong evidence that large
listed Australian companies are
engaged in profit smoothing.
Albrecht and
Richardson
[1990]
To determine the
importance of smoothing
in accounting practice.
To describe the type of
companies that smooth
income.
Operating income.
Income from
operations.
Income before
extraordinary items.
Net income.
No instrument. 128 core companies
and 128 periphery
companies.
1974-85.
Stepwise logit procedure in
order to fit a multivariate model
of smoothing behavior.
Eckel income variability
method.
IS exists and is fairly evenly
distributed in various sectors of
the economy (No difference
between core and periphery
sector firms).
89
Ashari, Koh, Tan
and Wong [1994]
To identify the factors
associated with the
incidence of IS.
Income from operations
Income before
extraordinary items.
Net income after tax.
No instrument. 153 companies listed
in the Singapore
stock exchange.
1980-90.
Four hypotheses relating IS to
size, profitability, industry and
nationality.
T-tests of differences, chi-
square tests of independence
and logit analyses
Use of an IS index (Eckel).
Total assets
Net income after tax to total
assets, industry sector and
nationality
IS is practiced and operational
income is the most common IS
objective.
Beattie et al.
[1994]
Study of classificatory
choices within an
explicit, incentives-based
approach.
Reported profit after
tax, but before
extraordinary items
Classification of items either
above the line (exceptional
items) or below the line
(extraordinary items).
228 UK companies.
1989-90 (one year).
Smoothing index based on
accounting risk, market risk,
agency costs, political costs,
ownership structure and
industry.
Multivariate regression.
Four variables are associated
with classificatory choices
consistent with smoothing
behavior: earnings variability
(+), managerial share options
(+), dividend cover (-) and
outside ownership
concentration (-).
Fern, Brown and
Dickey [1994]
To examine IS behavior
in the petroleum
industry. (Update of the
Ronen and Sadan [1981]
survey). To link
smoothing behavior to a
specified motivation (i.e.
avoidance of political
costs).
Ordinary income
(income before
extraordinary items).
No instruments specified. 26 oil refiners.
1971-89.
Methodology of Ronen and
Sadan [1981].
Evidence of a political
motivation to practice IS is
reported. No evidence of
significant classificatory IS but
evidence of significant inter-
temporal IS.
90
Sheikholeslami
[1994]
To study the hypothesis
that IS practices are
altered when firms list
their stocks on foreign
stock exchanges.
Operating income.
Pre-tax income.
Net income.
No instrument. 24 firms listed
abroad. Firms non
listed abroad.
1982-87.
Methodology of Imhoff [1977]
and Eckel [1981].
No significant difference
between the two samples.
Wang and
Williams [1994]
To examine the
relationship between
accounting IS and
stockholder wealth.
No object. No instrument. 456 companies.
1977-86.
Regression of unexpected
income on cumulative abnormal
returns.
The market response to
earnings for firms with a
smooth income series is four
times as large as that for other
firms.
Michelson,
Jordan-Wagner
and Wooton
[1995]
To test for an association
between IS and
performance in the
marketplace.
The paper examines:
The tendency of major
corporations to become
income smothers
The difference in the
mean returns on the
common stock of
smoothing and non
smoothing companies
The relationship between
perceived market risk
and IS.
Operating income after
depreciation.
Pretax income.
Income before
extraordinary items.
Net income.
No instrument (variation in
sales).
358 firms.
1980-91.
Coefficient of variation method
[Eckel, 1981].
Find that firms that smooth
income have a significantly
lower mean annualized return
than firms that do not smooth
income. Smoothing firms have
lower betas and higher market
value of equity.
91
Bhat [1996] Examination of the IS
hypothesis for large
banks.
Earnings after taxes and
before extraordinary
items.
Loan-loss provisions. 148 banks.
1981-91.
Regression of logarithms of
earnings after taxes and loan-
loss provisions against the year
and computation of R2 for each
bank.
Banks with a close relationship
between their earnings before
loan-loss provisions and after
taxes and loan-loss provisions
tend to have smooth earnings.
Small banks with high risk and
poor financial condition are
likely to smooth their earnings.
Saudagaran and
Sepe [1996]
To replicate Moses’
[1987] investigation.
Earnings (unclear
which).
Discretionary accounting
changes.
58 UK companies
and 20 Canadian
companies.
1983-86.
T-tests and regression analysis. Results different from those of
Moses. Lack of association
between the smoothing
variable and firm size.
Breton and
Chenail [1997]
To test the presence of IS
by Canadian companies.
Net income. No instrument. 402 Canadian
companies.
1987-91.
Imhoff [1977] and Eckel [1981]
model.
The results support the
hypothesis that IS is widely
practiced.
Results for certain industrial
sectors show a greater
propensity for smoothing.
The results do not support the
Belkaoui-Picur hypothesis of
differences in corporate
behavior between core and
peripheral activity sectors.
92
Carlson and
Bathala [1997]
To examine the
association between
differences in ownership
structure and IS
behavior. Several factors
are identified: manager
versus owner control,
debt financing,
institutional ownership,
dispersion of stock
ownership, profitability
and firm size
No object No instrument 265 firms.
1982-88
Albrecht and Richardson [1990]
methodology. Logistic
regression model
Dimensions reflecting
ownership differences,
executive’s incentive structure
and firm profitability are
important in explaining IS
smoothing
Godfrey and
Jones [1999]
IS in companies subject
to labor-related political
costs
Net operating profit Extraordinary items
(recurring gains and losses)
1,568 Australian
firms listed between
1985 and 1993
Least squares regression
analysis
Evidence of IS associated with
the degree of management
ownership
93
Appendix 3
Examples of Smoothing Variables
Gains andlosses on
sale ofsecurities
Dividendsof non-
subsidiaryinvestments
Invest-ment tax
credit
Changefrom
acceleratedto straight-
linedepreciation
Purchase-poolingdecision
Changesin accoun-
tingpolicies
Unusualgainsand
losses
Investmentin common
stocks
Losscarry-
forwardtax
benefit
Discre-tionaryaccoun-
tingdecisions
Pen-sioncosts
Extra-ordinary
items(classi-ficatoryor inter-temporal
R&Dcosts
Ope-rating or
ordi-nary
expen-ses
Loan-loss
provi-sion
Exchangedifferences
Dopuch & Drake [1966] x xGordon et al. [1966] xArchibald [1967] x xGagnon [1967] xCopeland [1968] xCopeland & Licastro[1968]
x
Cushing [1969] xWhite [1970, 1972] xDascher & Malcolm[1970]
x x x x
Beidleman [1973] x xBarnea et al. [1976] xKamin & Ronen [1978] xEckel [1981] x xAmihud et al. [1983] xBelkaoui & Picur [1984] xMoses [1987] xMa [1988] xBrayshaw & Eldin[1989]
x
Craig & Walsh [1989] xBeattie et al. [1994] xBhat [1996] xSaudagaran & Sepe[1996]
x
Godfrey & Jones [1999] x