An Explanation for Accounting Income Smoothing

Abstract

It is widely believed that corporate managers often engage in income smoothing, taking actions to dampen fluctuations in their firms' publicly reported net income. One reason given for this is that managers think that investors pay more for a firm with a smoother income stream. (See Ronen and Sadan [1981].) While there have been many empirical studies attempting to document whether or not income smoothing actually occurs, there has been little exploration of why a manager might rationally want to smooth his firm's income. Explaining why smoothing might be observed, and how it can result in an increased stock price, is the focus of this paper. In two recent studies, Lambert [1984] and Dye [1988] demonstrate, in agency settings, that a risk-averse manager who is precluded from borrowing and lending in the capital markets has an incentive to smooth his firm's reported income. In this paper, in contrast, it is shown that within a market setting an incentive exists for a manager to smooth income that is independent of either risk aversion or restricted access to capital markets. The market setting is also useful in that it allows for the analysis of the effect of income smoothing on stock prices. It is shown here that if a manager can choose which of two periods to recognize certain income, he may prefer the choice that is expected to