Income Smoothing: The Role of Management.

Abstract The article discusses the role of the firm's management in the smoothing of reported earnings based on sound accounting and management principles. The case for smoothing reported earnings rests primarily with those for whom accounting earnings are calculated and reported. From the standpoint of an investor, the relevant cash flows are dividends and capital gains. The defense for smoothing reported income that arises from external uses is rooted in the theory of capital asset values. Effective smoothing requires specification of the magnitude of the desired adjustment with some precision and knowledge of techniques used to accomplish the desired adjustment. The test results strongly suggest that firms employ certain devices over which they have discretion to normalize reported earnings. The evidence cannot prove that intentional or premeditated smoothing took place, but the results suggest that firms employ certain devices to counter short run movements in earnings that deviate from their time trend. A tendency to normalize reported data also supports the oft-used argument that past observations are desirable ingredients in the formulation of a firm's budgets and forecasts.