A Note on Income Smoothing.

Abstract In 1964 Myron Gordon hypothesized that business managers can be expected to select those measurement and reporting rules which smooth periodic net income. Normal income and smoothed earnings were defined with considerable rigor. The smoothing hypothesis was tested by considering whether an accounting measurement rule was selected which tended to: adjust the firm's percentage change in earnings per share to the average percentage change in the industry or smooth the firm's earnings per share toward a normal value or smooth the firm's rate of return on common stockholders' equity. The dividend-income basis is particularly open to manipulation. Parent company management may wait until the very end of an accounting period, approximate the size of the parent's earnings, and then arrange to have the subsidiary declare or pass dividends in such magnitudes as to move reported net income in some sired direction. Management's ability to manipulate reported parent profits in this situation is eliminated under two alternative accounting methods for recording subsidiary operations. These methods are consolidated reporting and unconsolidated reporting under the equity method.