The Smoothing of Reported Corporate Earnings Through Target Setting: Acceptable Practice or Shareholder Deception

Abstract

The setting of earnings targets is frequently used by corporate managers to reduce the volatility of reported earnings over successive periods. The practice exemplifies the more informal or ad hoc category of income smoothing approaches. This paper investigates the volatility reduction potential of target setting relative to the underlying (but unobservable) income stream. The analysis uses a simulation approach based on a statistical model of accounting measurement that treats periodic earnings reports as successive samples drawn from the underlying earnings generation process. The results indicate substantial reductions in earnings volatility that are remarkably resilient to inaccuracies in targets and increase over reporting periods. But accumulating errors due to misalignment between targets and the firm’s expected sustainable earnings capacity may produce explosive volatility when finally reported - to the detriment of shareholders and other long term stakeholders relying on corporate reports.