A FRAMEWORK FOR THE CLASSIFICATION OF ACCOUNTS
MANIPULATIONS
Hervé Stolowy
Gaétan Breton
HEC School of Management (Groupe HEC)
Department of Accounting and Management
Control
1, rue de la Libération
78351 - Jouy en Josas Cedex
France
University du Québec à Montreal
Department of Accounting Sciences
P.O.B. 8888
Succursale Centre-Ville
Montréal (Québec)
H3C 3P8 - Canada
Tel: +331 39 67 94 42
Fax: +331 39 67 70 86
E-mail: stolowy@hec.fr
Tel: +1 514 987 3000 (4774)
Fax: +1 514 987 6629
E-mail: breton.gaetan@uqam.ca
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, we
might have forgotten some references. We make our apologies to the authors who have not been cited. We wish
to thank participants of the 2000 EAA Annual Meeting (Munich). Hervé Stolowy would like to acknowledge the
financial support of the Research Center of the HEC School of Management and thanks Etienne Lacam for his
research assistance.
Résumé/Abstract
Proposition d’un cadre conceptuel pour une
A Framework for the Classification of Accounts
classification des manipulations comptables
Manipulations
Les manipulations comptables ont fait l’objet de
Accounts manipulations have been a matter of
recherche, discussion et même controverse dans
research, discussion and, even, controversy in
plusieurs pays, comme les Etats-Unis, le Canada, le
several countries such as the United States, Canada,
Royaume Uni, l’Australie et la France. L’objectif de
the United Kingdom, Australia and France. The
ce cachier de recherche est de proposer un cadre
objective of this paper is to elaborate a general
conceptuel
des
framework for classifying accounts manipulations
manipulations comptables à travers une revue
through a thorough review of the literature. This
approfondie de la littérature. Ce cadre est fondé sur le
framework is based on the desire to influence the
désir d’influencer la perception par les marchés
market participants’ perception of the risk associated
financiers du risque associé à l’entreprise. Le risque
to the firm. The risk is materialized through the
se matérialise à deux niveaux : le bénéfice par action
earnings per share and the debt/equity ratio. The
et le ratio dettes/capitaux propres. La littérature sur ce
literature on this topic is already very rich, although
sujet est extrêmement riche. Cependant, plusieurs
we have identified series of areas in need for further
domaines mériteraient de faire l’objet de recherches
research.
permettant
la
classification
complémentaires.
MOTS CLÉS . – MANIPULATIONS COMPTABLES _
KEYWORDS . – ACCOUNTS MANIPULATIONS – EARNINGS
GESTION DU RÉSULTAT – LISSAGE DU RÉSULTAT –
MANAGEMENT – INCOME SMOOTHING – BIG BATH
NETTOYAGE DES COMPTES - COMPTABILITÉ CRÉATIVE
ACCOUNTING – CREATIVE ACCOUNTING
1
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”.
2
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.
3
Figure 1
A Framework for Classifying Accounts Manipulations
Accounts
manipulations
Modification of investors’
perception of the risk
Return:
Earnings per share (EPS)
Earnings management
(broad sense)
Main research
streams
Name of the
research
stream
Creative accounting
(window dressing)
Earnings
management
Income
smoothing
Big bath
accounting
Level of EPS
Variance of
EPS
Reduction of
current EPS
to increase
future EPS
Type ,of
research
Fair amount
of empirical
research
Fair
amount of
empirical
research
Representative
authors
Schipper
[1989]
Jones [1991]
DeAngelo et
al. [1994]
Copeland
[1968]
Imhoff
[1977, 1981]
Eckel [1981]
Ronen and
Sadan [1981]
Albrecht and
Richardson
[1990]
Main
objective
Structural risk:
Debt/equity ratio
Few real
empirical
research
Dye [1987]
Walsh et
al. [1991]
Pourciau
[1993]
Academic
perspective
Professional
perspective
EPS
Debt/equity
ratio
Few real
empirical
research
No empirical
research.
Professional
opinion
Tweedie and
Whittington
[1990]
Naser [1993]
Breton and
Taffler
[1995]
PierceBrown and
Steele [1999]
Griffiths
[1986, 1995]
Smith [1992]
Schilit
[1992]
Stolowy
[2000]
Transactions
Interpretations
4
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
5
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
6
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.
7
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 Average discretionary accruals: difference between total accruals and estimated
Sparks [1999]
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.
8
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).
9
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.
10
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
11
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 incomedecreasing 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
12
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
13
those of Jones [1991] and DeAngelo et al. [1994], to conduct on a longitudinal and crosssectional 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.
14
Table 2
Objectives of Earnings Management and their Contexts 1
Objectives
Contexts
Examples
Minimization of
Inquiries
or
Jones [1991]; Rayburn and Lenway [1992]: US International
political costs
surveillance
by
Trade Commission; Cahan [1992]: Anti-Trust Division of
regulatory bodies
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
Cahan, Chavis and Elemendorf [1997]; Labelle and Thibault
regulation
[1998]
Minimizing
income
tax
Warfield and Linsmeir [1992]; Boynton et al. [1992];
Guenther [1994]; Maydew [1997]
Negotiation:
labor
Liberty and Zimmerman [1986]
contract
Minimization of
IPO’s
Aharony et al. [1993]; Friedlan [1994]; Teoh et al. [1994];
the cost of capital
Cormier et Magnan [1995]; Magnan et Cormier [1997]
Renewal
of
debt
DeAngelo et al. [1994]; Sweeney [1994]; DeFond and
and
Jiambalvo [1994]
debt
McNichols and Wilson [1988]; Press and Weintrop [1990];
covenants
and
Healy and Palepu [1990]; Beneish and Press [1993]; Hall
restrictions
on
contracts
financial distress
Violation
of
[1994]
dividend payments
Maximization of
Maximizing
managers wealth
term
short
total
Healy [1985]; Holthausen et al. [1995]; Gaver et al. [1995];
Clinch and Margliolo [1993]
compensation
Changing of control
DeAngelo [1986]; Perry and Williams [1994]; DeAngelo
[1988]
Non
routine
changes
CEO
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.
15
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].
16
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.
17
Table 3
Earnings Management - Theoretical papers
Authors
Dye [1988]
Discussion
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
Ayres [1994]
Mozes [1997]
4.
Recognize the intergenerational problem for shareholders as for bondholders
5.
There must be a blocked communication condition
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
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
Case study about the decision of managing earnings taking into account the interest
[1999]
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.
18
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 France 2 . 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 this
paper: consumption smoothing and savings [Alessie and Lusardi, 1997], uses of formal savings and transfers for
income smoothing [Behrman et al. 1997].
19
•
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, JordanWagner 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.
20
Table 4
Principal Definitions of “Income Smoothing”
Copeland
101]
[1968,
p.
“Smoothing moderates year-to-year fluctuations in income by shifting earnings
from peak years to less successful periods”.
Beidleman [1973, p.
653]
“Smoothing of reported earnings may be defined as the intentional dampening of
fluctuations about some level of earnings that is currently considered to be normal
for a firm”.
Ronen and
[1975b, p. 62]
“By smoothing, we mean the dampening of the variations in income over time”.
Sadan
Barnea, Ronen and
Sadan [1976, p. 111]
“Deliberate dampening of fluctuations about some level of earnings which is
considered 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 smoothing
of income implies some deliberate effort to disclose the financial information in
such a way as to convey an artificially reduced variability of the income stream”.
Ronen and
[1981, p. 2]
“IS can be defined as a deliberate attempt by management to signal information to
financial users”.
Sadan
Koch [1981, p. 574]
“IS can be defined as a means used by management to diminish the variability of
stream of reported income numbers relative to some perceived target stream by
the 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 their
discretion over the choice among accounting alternatives within generally
accepted accounting principles so as to minimize fluctuations of earnings over
time 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 reported
earnings”.
Ma [1988, p. 487]
“Smoothing reported earnings may be defined as the intentional reduction of
earnings fluctuations with respect to some normal level”.
Ashari, Koh, Tan and
Wong [1994]
“Deliberate voluntary acts by management to reduce income variation by using
certain accounting devices”.
Beattie et al. [1994, p.
793]
“Smoothing can be viewed in terms of the reduction in earnings variability over a
number of periods, or, within a single period, as the movement towards an
expected level of reported earnings”.
Fern,
Brown
Dickey [1994]
and
“Attempts to reduce earnings variability, especially behavior designed to dampen
abnormal increases in reported earnings”.
Fudenberg and Tirole
[1995]
“IS is the process of manipulating the time profile of earnings or earnings reports
to make the reported income stream less variable, while not increasing reported
earnings 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
21
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]).
22
Figure 2
Different Types of Smooth Income Streams
Smooth Income Stream
Intentionally
Naturally Smooth
Being Smoothed
(“Natural Smoothing”)
by Management
(“Designed
Smoothing”)
Artificial Smoothing
Real Smoothing
(“Accounting Smoothing”)
(“Transactional or Economic
Smoothing”)
Accounting manipulations undertaken
Management actions undertaken to
The income generating
by management to smooth income.
control underlying economic events
process
[Eckel, 1981, p. 29].
[Eckel, 1981, p. 29].
produces
inherently
a
smooth
income stream [Eckel,
Accounting smoothing variety of
Actual selection of projects and
allocating over time the consequences
timing of operating decisions. Non-
of decisions already made and the
accounting smoothing of the firm’s
classification of these consequences
input and output series through the
within a period among different items
making and timing of operating
in
decisions [Kamin and Ronen, 1978,
the
financial
statements.
Accounting smoothing does not result
p. 144].
from changing the operating decisions
and their timing but affects income
Real
through
dimensions,
business decisions (selection of an
notably events’ recognition and the
advertising plan or of an R&D
allocation and/or classification of the
project) [Koch, 1981, p. 576].
accounting
variables
represented
by
effects of the recognized events
[Kamin and Ronen, 1978, p. 144].
The
management
can
smooth
earnings by altering the firm’s
Artificial variables represented by
production
accounting decisions (selection of a
decisions at year-end based on its
depreciation
the
knowledge of how the firm has
selection, of a method for the
performed up to that time in the year
investment tax credit) [Koch, 1981, p.
[Lambert, 1984, p. 606].
method
and
576].
23
and/or
investment
1981, p. 28].
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
24
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).
25
Table 5
The Smoothing Objects
Authors
Dopuch and Drake [1966]
Gordon, Horwitz and Meyers [1966]
Archibald [1967]
Gagnon [1967]
Copeland [1968]
Cushing [1969]
White [1970, 1972]
Dascher and Malcolm [1970]
Barefield and Comiskey [1972]
Beidleman [1973, 1975]
Ronen et Sadan [1975a, 1975b]
Barnea, Ronen and Sadan [1976, 1977]
Kamin and Ronen [1978]
Givoly and Ronen [1981]
Imhoff [1981]
Koch [1981]
Amihud, Kamin and Ronen [1983]
Belkaoui and Picur [1984]
Moses [1987]
Brayshaw and Eldin [1989]
Craig and Walsh [1989]
Albrecht and Richardson [1990]
Ashari, Koh, Tan and Wong [1994]
Beattie et al. [1994]
Fern, Brown and Dickey [1994]
Sheikholeslami [1994]
Michelson, Jordan-Wagner and Wooton [1995]
Bhat [1996]
Saudagaran and Sepe [1996]
Breton and Chenail [1997]
Godfrey and Jones [1999]
Objects of smoothing
Net income
Earnings per share
Rate of return on stockholder’s equity
Net income
Earnings (less preferred dividends)
Net income
Earnings per share (unclear which type))
Earnings per share (unclear which type)
Income (not clear which one)
Before tax earnings (unclear which one)
Earnings (unclear which one)
Ordinary income per share before extraordinary items
Extraordinary income per share
Ordinary income (before extraordinary items) per share
Operating income per share (before period charges and extraordinary
items)
Operating income
Ordinary income
Earnings per share (before extraordinary items), adjusted for stock splits
and dividends.
Fully diluted Earnings per share
Net income
Net income before extraordinary items
Operating income
Gross margin
Earnings per share
Net operating income per share
Operating income
Ordinary income
Earnings (unclear which)
Ordinary income before tax and extraordinary items
Net income
Reported consolidated net income after tax, minority interests and
extraordinary items.
Operating income
Income from operations
Income before extraordinary items
Net income
Income from operations
Income before extraordinary items
Net income after tax
Reported profit after tax, but before extraordinary items
Ordinary income (income before extraordinary items).
Pre-tax income
Net income
Operating income
Operating income after depreciation
Pre-tax income
Income before extraordinary items
Net income
Earnings after taxes and before extraordinary items
Earnings (unclear which)
Net income
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
26
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].
27
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 longterm 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 longrun earnings (growth) objective.
2.
Once used, it should not commit the firm to any particular future action.
28
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.
29
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.
30
Figure 3
The Three Smoothing Dimensions
Smoothing
Management can schedule transactions so that their
through an
effects on reported income tend to dampen its
event’s
variations over time. For example, the delivery of
occurrence
goods can be included in, or excluded from, a
and/or
specific accounting period.
recognition
Inter-temporal
Given that an event has occurred and has been
Smoothing
recognized in the firm’s accounting, management still
through
has partial discretion to determine the number of
allocation
future periods affected and the impact on each period
over time
through depreciation or amortization, for instance.
Dimensions
of smoothing
Depending on the classification of income statement
items, management can reduce the variance of
income figures other than net income. Classificatory
Classificatory
Smoothing
smoothing is effective only when the objects of
through
smoothing are income figures other than net income.
classification
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
31
[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
32
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 firstdifference 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.
33
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
Archibald [1967], Copeland [1968],
Copeland and Licastro [1968], White
[1970]
Methodology used or described
Normal or target earnings equal the preceding year’s
earnings.
Gordon, Horwitz and Meyers [1966]
•
•
•
Exponential weighting of prior year normal earnings and
current year actual earnings to calculate current year
normal earnings
Adjusts “normal” earnings using an exponentially
weighted one-year growth rate and compares it with
actual earnings per share to determine the direction of
deviations from normality
Two-period exponentially smoothed rate of return on
book value per share. This is then multiplied by actual
book 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 and
Richardson [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
34
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.
35
Table 7
Examples of Motivations for Smoothing
Authors
Hepworth [1953]
Motivations
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],
-
To reduce the uncertainty resulting from the fluctuations of income numbers in general and
Lev and Kunitzky
-
To reduce systematic risk in particular by reducing the co-variance of the firm’s returns with
[1974]
Barnea et al. [1976]
the market returns.
Management may attempt to smooth income number to convey their expectations of future cash
flows
Ronen, Sadan and
Smoothing could be aimed at
Snow [1977]
-
external users of financial statements, such as investors and creditors, and
-
management itself.
-
Management compensation schemes are normally linked to firm performance represented by
Brawshaw and Eldin
[1989]
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
-
To affect a firm’s stock prices and risk
Dickey [1994]
-
To manipulate management compensation
-
To escape restrictive debt covenant
-
To avoid political costs.
Fudenberg and Tirole
The paper builds a theory of IS based on the managers’ concern about keeping their position or
[1995]
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.
36
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.
37
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
38
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 tradeoff 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 stockholdermanager 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.
39
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
40
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).
41
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,
42
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.
43
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.
44
British people like Griffiths [1986, 1995 5 ], 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]
45
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 windowdressing. 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
46
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
47
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
48
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].
49
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].
50
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?
51
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.
52
REFERENCES
Agède, P. 1994. Habiller ses comptes (To dress its accounts). L'Entreprise 106 (July-August):
82-85.
Aharony, J., C.J. Lin and M.P. Loeb. 1993. Initial public offerings, accounting choices and
earnings management. Contemporary Accounting Research 10(1): 61-81.
Ahmed, A.S., C. Takeda and S. Thomas. 1999. Bank loan loss provisions: A reexamination of
capital management, earnings management and signaling effects. Journal of Accounting and
Economics 28(1) (November): 1-25.
Albrecht, W.D., and F.M. Richardson. 1990. Income smoothing by economy sector. Journal
of Business Finance & Accounting 17(5) (Winter): 713-730.
Alessie, R. and A. Lusardi. 1997. Saving and income smoothing: Evidence from panel data.
European Economic Review 41(7) (July): 1251-1279.
Amihud, Y., J.Y. Kamin and J. Ronen. 1983. ‘Managerialism’, ‘ownerism’ and risk. Journal
of Banking & Finance 7(2) (June): 189-196.
Anderson, J.C. and J.G. Louderback III. 1975. Income manipulation and purchase-pooling:
Some additional results. Journal of Accounting Research (Autumn): 338-343.
Archibald, T.R. 1967. The return to straight-line depreciation: An analysis of a change in
accounting method. Journal of Accounting Research, Empirical Research in Accounting,
Selected Studies 5 (Supplement): 164-180.
Ashari, N., H.C. Koh, S.L. Tan and W.H. Wong. 1994. Factors affecting income smoothing
among listed companies in Singapore. Accounting and Business Research 24(96): 291-301.
Audas, J. 1993. Le window-dressing ou l'habillage des bilans (Window dressing or how to
dress balance sheets). Option Finance 242 (January 18): 29.
53
Averitt, R.T. 1968. The dual economy: the dynamics of American industry structure. W.W.
Norton & Company, Inc.
Ayres, F.L. 1994. Perceptions of earnings quality: What managers need to know.
Management Accounting 75(9): 27-29.
Ball R. 1972. Changes in accounting techniques and stock prices. Journal of Accounting
Research 10 (supplement): 1-41.
Ball, R. and R. Watts. 1972. Some time series properties of accounting income. Journal of
Finance (June): 663-682.
Barefield, R.M. and E.E. Comiskey. 1972. The smoothing hypothesis: An alternative test. The
Accounting Review (April): 291-298.
Barnea, A., J. Ronen and S. Sadan. 1975. The implementation of accounting objectives: An
application to extraordinary items. The Accounting Review (January): 58-68.
Barnea, A., J. Ronen and S. Sadan. 1976. Classificatory smoothing of income with
extraordinary items. The Accounting Review (January): 110-122.
Barnea, A., J. Ronen and S. Sadan. 1977. Classificatory smoothing of income with
extraordinary items: A reply. The Accounting Review 52(2) (April): 525-526.
Bartov, E. 1993. The timing of asset sales and earnings manipulation. The Accounting Review
68: 840-855.
Beattie, V., S. Brown, D. Ewers, B. John, S. Manson, D. Thomas and M. Turner. 1994.
Extraordinary items and income smoothing: A positive accounting approach. Journal of
Business Finance and Accounting 21(6) (September): 791-811.
Beaver, W.H. and R.E. Dukes. 1973. Delta depreciation methods: Some empirical results. The
Accounting Review (July): 549-559.
54
Becker, C.L., M.L. DeFond, J. Jiambalvo and K.R. Subramanyam. 1998. The effect of audit
quality on earnings management. Contemporary Accounting Research 15(1) (Spring):1-24.
Beidleman, C.R. 1973. Income smoothing: The role of management. The Accounting Review
48(4) (October): 653-667.
Beidleman, C.R. 1975. Income smoothing: The role of management: A reply. The Accounting
Review (January): 122-126.
Behrman, J.R., A. Foster and M.R. Rosenzweig. 1997. Dynamic savings decisions in
agricultural environments with incomplete markets. Journal of Business & Economic
Statistics 15(2) (April): 282-292.
Belkaoui, A. 1983. Accrual accounting and cash accounting: Relative merits of derived
accounting indicator numbers. Journal of Business Finance & Accounting 10(2) (Summer):
299-312.
Belkaoui, A. 1989. The Coming Crisis in Accounting. Quorum Books, New-York.
Belkaoui, A. and R.D. Picur. 1984. The smoothing of income numbers: Some empirical
evidence on systematic differences between core and periphery industrial sectors. Journal of
Business Finance and Accounting 11(4) (Winter): 527-545.
Beneish, M.D. 1997. Detecting GAAP violation: Implications for assessing earnings
management among firms with extreme financial performance. Journal of Accounting and
Public Policy 16(3): 271-309.
Beneish, M.D. 1999a. Incentives and penalties related to earnings overstatements that violate
GAAP. The Accounting Review 74(4): 425-458.
Beneish, M.D. 1999b. The detection of earnings manipulation. Financial Analysts Journal
(September/October): 24-36.
Beneish, M.D. 1999c. A note on Wiedman Instructional case: Detecting earnings
manipulation. Issues in Accounting Education 14(2) (May): 369-370.
55
Beneish, M.D. and E.G. Press. 1993. Cost of technical violation of accounting-based debt
covenants. The Accounting Review 68(2): 233-257.
Bertolus, J.-J. 1988. L’art de truquer un bilan (The art of cooking the books). Science & vie
économie 40 (June): 17-23.
Bhat, V.N. 1996. Banks and income smoothing: An empirical analysis. Applied Financial
Economics 6: 505-510.
Bitner, L.N. and R.C. Dolan. 1996. Assessing the relationship between income smoothing and
the value of the firm. Quarterly Journal of Business and Economics 35(1) (Winter): 16-35.
Black, E.L., K.F. Sellers and T.S. Manly. 1998. Earnings management using asset sales: An
international study of countries allowing noncurrent asset revaluation. Journal of Business
Finance & Accounting 25(9) & (10) (November/December): 1287-1317.
Blake J. et Amat O. 1996. Creative accounting is not just an English disease. Management
Accounting (October): 54.
Booth, G.G., J.P. Kallunki and T. Martikainen. 1996. Post-announcement drift and income
smoothing: Finnish evidence. Journal of Business Finance & Accounting 23(8) (October):
1197-1211.
Boynton, C., P. Dobbins and G. Plesko. 1992. Earnings management and the corporate
alternative minimum tax. Journal of Accounting Research 30: 131-160.
Brayshaw, R.E. and A.E.K. Eldin. 1989. The smoothing hypothesis and the role of exchange
differences. Journal of Business Finance and Accounting 16(5) (Winter): 621-633.
Bremser, W.G. 1975. The earning characteristics of firms reporting discretionary accounting
changes. The Accounting Review (July): 563-573.
Breton G. and R.J. Taffler. 1995. Creative Accounting and Investment Analyst Response.
Accounting and Business Research 25(98): 81-92.
56
Breton, G. and J.-P. Chenail. 1997. Une étude empirique du lissage des bénéfices dans les
entreprises canadiennes (An empirical investigation of income smoothing by Canadian
companies). Comptabilité – Contrôle – Audit 3(1) (March): 53-67.
Briloff, A. 1976. More Debits than Credits. Harper and Row Publishers, New-York.
Brown, P.R. 1999. Earnings management: A subtle (and troublesome) twist to earnings
quality. Journal of Financial Statement Analysis 4(2) (Winter): 61-63.
Buckmaster, D. 1992. Income smoothing in accounting and business literature prior to 1954.
The Accounting Historians Journal 19(2) (December): 147-173.
Buckmaster, D. 1997. Antecedents of modern earnings management research: Income
smoothing in literature, 1954-1965. The Accounting Historians Journal 24(1) (June): 75-91.
Burgstahler, D. and I. Dichev. 1997. Earnings management to avoid earnings decreases and
losses. Journal of Accounting and Economics 24: 99-126.
Cahan, S.F. 1992. The effect of antitrust investigations on discretionary accruals: a refined
test of the political-cost hypothesis. The Accounting Review 67(1): 77-96.
Cahan, S.F., B.M. Chavis and R.G. Elemendorf. 1997. Earnings management of chemical
firms in response to political costs from environmental legislation. Journal of Accounting,
Auditing and Finance 12(1) (Winter): 37-65.
Carlson, S.J. and C.T. Bathala. 1997. Ownership differences and firms’ income smoothing
behavior. Journal of Business Finance & Accounting 24(2) (March): 179-196.
Cassidy J., Randall J. et Hamilton K. 1992. Revealed: how top firms massage their profits.
Sunday Times (August 16).
Chalayer. 1994. Identification et motivations des pratiques de lissage des résultats
comptables des entreprises françaises cotées en Bourse (Identification and motivations of
57
income smoothing behavior by French listed companies). Ph.D. Dissertation, University of
Saint-Etienne.
Chalayer, S. 1995. Le lissage des résultats. Elements explicatifs avancés dans la littérature
(Income smoothing. Explanatory elements in the accounting literature). ComptabilitéContrôle – Audit 2(1): 89-104.
Chambers, R.J. 1973. Securities and obscurities: A case for reform of the law of company
accounts. Gower, Australia.
Chaney, P.K. and C.M. Lewis. 1995. Earnings management and firm valuation under
asymmetric information. Journal of Corporate Finance 1: 319-345.
Christensen, T.E., R.E. Hoyt and J.S. Paterson. 1999. Ex ante incentives for earnings
management and the informativeness of earnings. Journal of Business Finance & Accounting
26(7) & (8) (September-October): 807-832
Clinch, G. and J. Margliolo. 1993. CEO compensation and components of earnings in bank
holding companies. Journal of Accounting and Economics 16: 241-272.
Cogger, K.O. 1981. A time-series analytic approach to aggregation issues in accounting data.
Journal of Accounting Research 19(2): 285.
Cohen, J.R., L.W. Pant and D.J. Sharp. 2000. Project earnings manipulation: An ethics case
based on agency theory. Issues in Accounting Education 15(1) (Frebruary): 89-104.
Copeland, R.M. 1968 Income smoothing. Journal of Accounting Research, Empirical
Research in Accounting, Selected Studies 6 (Supplement): 101-116.
Copeland, R.M. and R.D. Licastro. 1968. A note on income smoothing. The Accounting
Review 43 (July): 540-545.
Copeland, R.M. and M.L. Moore. 1972. The financial bath: Is it common ? MSU Business
Topics 63-69.
58
Copeland, R.M. and J.F. Wojdak. 1969. Income manipulation and the purchase-pooling
choice. Journal of Accounting Research (Autumn): 188-195.
Cormier, D. and M. Magnan. 1995. La gestion stratégique des résultats: le cas des firmes
publiant des prévisions lors d’un premier appel public à l’épargne (Earnings management: the
case of companies publishing forecasts at the time of a first IPO). Comptabilité- ContrôleAudit 1(1): 45-61.
Cormier, D., M. Magnan and B. Morard. 1998. La gestion stratégique des résultats: le modèle
anglo-saxon convient-il au contexte suisse ? (Earnings management: is the Anglo-Saxon
model relevant to the Swiss context?). Comptabilité – Contrôle – Audit 4(1) (March): 25-48.
Craig, R. and P. Walsh. 1989. Adjustments for ‘extraordinary items’ in smoothing reported
profit of listed Australian companies: Some empirical evidence. Journal of Business Finance
and Accounting 16(2) (Spring): 229-245.
Cummings, J.P. 1967. Discussion of The return to straight-line depreciation: An analysis of a
change in accounting method. Journal of Accounting Research, Empirical Research in
Accounting, Selected Studies 5(Supplement): 181-183.
Cushing, B.E. 1969. An empirical study of changes in accounting policy. Journal of
Accounting Research (Autumn): 196-203.
Dascher, P.E. and R.E. Malcolm. 1970. A note on income smoothing in the chemical industry.
Journal of Accounting Research (Autumn): 253-259.
Datar, S.M., G.A. Feltham and J.S. Hughes. 1991. The role of audits and audit quality in
valuing new issues. Journal of Accounting and Economics 14: 3-49.
Davidson, S.D., C. Stickney and R. Weil. 1987. Accounting: The language of business. 7th
edition, Thomas Forton and Daughter.
DeAngelo, H., L. De Angelo and J. Skinner. 1994. Accounting choice in troubled companies.
Journal of Accounting and Economics 17: 113-143.
59
DeAngelo, L. 1986. Accounting numbers as market valuation substitutes: A study of
management buyouts of public stockholders. The Accounting Review 61: 400-420.
DeAngelo, L.E. 1988. Managerial competition, information costs and corporate governance:
The use of accounting performances measures in proxy contests. Journal of Accounting and
Economics 9(1): 3-36.
Dechow, P.M. and R.G. Sloan. 1991. Executive incentives and the horizon problem: an
empirical investigation. Journal of Accounting and Economics 14: 51-89.
Dechow, P., R. Sloan and A. Sweeney. 1995. Detecting earnings management. The
Accounting Review 70(2): 193-225.
DeFond, M.L. and J. Jiambalvo. 1994. Debt covenant violations and manipulation of accruals.
Journal of Accounting and Economics 17: 145-176.
Degeorge, F., J. Patel and R. Zeckhauser. 1999. Earnings management to exceed thresholds.
Journal of Business 72(1): 1-32.
Dempsey, S.J., H.G. Hunt III and N. Schroder. 1993. Earnings management and corporate
ownership structure: An examination of extraordinary item reporting. Journal of Business
Finance & Accounting 20(4): 479-500.
Demski, J.S. 1998. Performance measure manipulation. Contemporary Accounting Research
15(3) (Fall): 261-285.
DePree, C.M. and C.T. Grant. 1999. Earnings management and ethical decision making:
Choices in accounting for security investments. Issues in Accounting Education 14(4): 613640.
Dopuch, N. and D.F. Drake. 1966. The effect of alternative accounting rules for nonsubsidiary
investments. Journal of Accounting Research, Empirical Research in Accounting, Selected
Studies 4 (Supplement): 192-219.
60
Dopuch, N. and R. Watts. 1972. Using time-series models to assess the significance of
accounting changes. Journal of Accounting Research (Spring): 180-194.
Dye, R.A. 1988. Earnings management in an overlapping generations model. Journal of
Accounting Research 26(2) (Autumn): 195-235.
Eckel, N. 1981. The income smoothing hypothesis revisited. Abacus 17(1): 28-40.
Eilifsen, A., K.H. Knivsflå and F. Sættem. 1999. Earnings manipulation: cost of capital versus
tax. European Accounting Review 8(3): 481-491.
Erickson, M. and S. Wang. 1999. Earnings management by acquiring firms in stock for stock
mergers. Journal of Accounting and Economics 27: 149-176.
Feitz, A. 1994a. Comment les banques nettoient leur bilan (How banks clean their balance
sheet). Option Finance 310 (June 6): 14-18.
Feitz, A. 1994b. La BIMP innove pour nettoyer son bilan (BIMP innovates to clean its
balance sheet). Option Finance 30 (May 30): 49-21.
Fern, R.H., B. Brown and S.W. Dickey. 1994. An empirical test of politically-motivated
income smoothing in the oil refining industry. Journal of Applied Business Research 10(1)
(Winter): 92.
Francis, J.R., E.L. Maydew and H.C. Sparks. 1999. The role of Big 6 auditors in the credible
reporting of accruals. Auditing: A Journal of Practice and Theory 18(2) (Fall): 17-34.
Friedlan, J.M. 1994. Accounting choices of issuers of initial public offerings. Contemporary
Accounting Research 11(1): 1-31.
Fudenberg, D. and J. Tirole. 1995. A theory of income and dividend smoothing based on
incumbency rents. Journal of Political Economy 103(1): 75-93.
Gagnon, J.M. 1967. Purchase versus pooling of interests: The search for a predictor. Journal
of Accounting Research, Empirical Research in Accounting, Selected Studies 5 (Supplement):
187-204.
61
Gaver, J., K.M. Gaver and J.R. Austin. 1995. Additional evidence on bonus plans and income
management. Journal of Accounting & Economics 19(1) (February): 3-28.
Genay, H. 1998. Assessing the condition of Japanese banks: How informative are accounting
earnings? Economic Perspectives 22(4): 12-34.
Gibbins, M. 1977. Classificatory smoothing of income with extraordinary items: research
implications. The Accounting Review 52(2) (April): 516-524.
Givoly, D. and J. Ronen. 1981. ‘Smoothing’ manifestations in fourth quarter results of
operations: Some empirical evidence. Abacus 17(2): 174-193.
Godfrey, J.M. and K.L. Jones. 1999. Political cost influences on income smoothing via
extraordinary item classification. Accounting and Finance 39(3) (November): 229-254.
Gonedes, N.J. 1972. Income-smoothing behavior under selected stochastic processes. The
Journal of Business 45(4): 571-584.
Gordon, M.J. 1964. Postulates, principles and research in accounting. The Accounting Review
39 (April): 251-263.
Gordon, M.J., B.N. Horwitz and P.T. Meyers. 1966. Accounting measurements and normal
growth of the firm. in Jaedicke, Ijiri and Nielson (eds), Research in Accounting Measurement
(American Accounting Association): 221-231.
Gordon, M.J. 1966. Discussion of The effect of alternative accounting rules for nonsubsidiary
investments. Journal of Accounting Research, Empirical Research in Accounting, Selected
Studies 4 (Supplement): 220-223.
Gounin, I. 1991. L'art de présenter un bilan (The art of presenting a balance sheet). La
Tribune March 28: 11.
Grace, E. 1990. Property-liability insurer reserve errors: A theoretical and empirical analysis.
Journal of Risk and Insurance 57(1) (March): 28-46.
62
Greenwalt, M.B. and J.F. Sinkey. 1988. Bank loan-loss provisions and income smoothing
hypothesis: an empirical analysis, 1976-84. Journal of Financial Services Research 1: 301318.
Griffiths, I. 1986. Creative Accounting. Irwin Paperback, London.
Griffiths, I. 1995. New Creative Accounting. Macmillan.
Guenther, D.A. 1994. Earnings management in response to corporate tax rate changes. The
Accounting Review 69(1): 230-243.
Guidry, F., A. Leone and S. Rock. 1999. Earnings-based bonus plans and earnings
management by business-unit managers. Journal of Accounting and Economics 26(1-3)
(January): 113-142.
Hall. S.C. 1994. Dividend Restriction and Accounting Choices. Journal of Accounting,
Auditing and Finance 9(3): 447-463.
Hall, S.C. and W.W. Stammerjohan. 1997. Damage awards and earnings management in the
oil industry. The Accounting Review 72(1): 47-65.
Han, J.C.Y. and S-W. Wang. 1998. Political costs and earnings management of oil companies
during the 1990 Persian Gulf Crisis. The Accounting Review 73(1): 103-117.
Hand, J. 1989. Did firms undertake debt-equity swaps for an accounting paper profit or true
financial gain? The Accounting Review 64: 587-623.
Hasan, I. and W.C. Hunter. 1994. The income smoothing hypothesis: an analysis of the thrift
industry. Federal Reserve Bank of Atlanta Working Paper 94-3.
Healy, P.M. 1985. The effect of bonus schemes on accounting decisions. Journal of
Accounting and economics 7: 85-107.
63
Healy, P.M. and K.G. Palepu. 1990. Effectiveness of accounting-based dividend covenants.
Journal of Accounting and Economics 12(1-3): 97-123.
Healy, P.M. 1999. Discussion of Earnings-based bonus plans and earnings management by
business-unit managers. Journal of Accounting and Economics 26(1-3) (January): 143-147.
Healy, P.M. and J.M. Wahlen. 1999. A review of the earnings management literature and its
implications for standard setting. Accounting Horizons 13(4) (December): 365-363.
Hellman, N. 1999. Earnings manipulation: cost of capital versus tax. A commentary.
European Accounting Review 8(3): 493-497.
Hepworth, S.R. 1953. Periodic income smoothing. The Accounting Review 28(1) (January):
32-39.
Holthausen, R.W., D.F. Larcker, and R.G. Sloan. 1995. Annual bonus schemes and the
manipulation of earnings. Journal of Accounting and Economics 19: 29-74.
Horwitz, B. 1977. Comment on income smoothing: a review by J. Ronen, S. Sadan and C.
Snow. Accounting Journal (Spring): 27-29.
Hunt, A., S.E. Moyer and T. Shevlin. 1995. Earnings smoothing and equity value. Working
paper, University of Washington, Seattle, WA.
Imhoff, E.A. 1975. Income smoothing: The role of management: A comment. The Accounting
Review (January): 118-121.
Imhoff, E.A. 1977. Income smoothing – A case for doubt. Accounting Journal (Spring): 85100.
Imhoff, E.A. 1981. Income smoothing: an analysis of critical issues. Quarterly Review of
Economics and Business 21(3) (Autumn): 23-42.
Jameson, M. 1988. A practical Guide to Creative Accounting. Kogan Page, London.
64
Jeter, D.C. and L. Shivakumar. 1999. Cross-sectional estimation of abnormal accruals using
quarterly and annual data: effectiveness in detecting event-specific earnings management.
Accounting and Business Research 29(4): 299-319.
Jones, J. 1991. Earnings management during import relief investigations. Journal of
Accounting Research 29(2): 193-228.
Kallunki, J.P. and T. Martikainen. 1999. Do firms use industry-wide targets when managing
earnings? Finnish evidence. International Journal of Accounting 34(2): 249-259.
Kamin, J.Y. and J. Ronen. 1978. The smoothing of income numbers: Some empirical
evidence on systematic differences among management-controlled and owner-controlled
firms. Accounting, Organization and Society 3(2): 141-157.
Kaplan, R.S. 1985. Comments on Paul Healy Evidence on the effect of bonus schemes on
accounting procedure and accrual decisions. Journal of Accounting and Economics 7: 109113.
Kasanen, E., J. Kinnunen and J. Niskanen. 1996. Dividend-based earnings management:
Empirical evidence from Finland. Journal of Accounting and Economics 22(1-3): 283-312.
Kasznik, R. 1999. On the association between voluntary disclosure and earnings management.
Journal of Accounting Research 37(1): 57-81.
Kennelly, J.W., E.H. Jennings and D. DeJong. 1971. On the effectiveness of income
smoothing. The University of Iowa Bureau of Business and Economics Research Working
Paper (August): 71-19.
Kellog, I. and L.B. Kellog. 1991. Fraud, window dressing and negligence in financial
statements. McGraw Hill, Colorado Springs.
Key, K.G. 1997. Political cost incentives for earnings management in the cable television
industry. Journal of Accounting and Economics 23(3) (November): 309-337.
65
Kinnunen, J., E. Kasanen and J. Niskanen. 1995. Earnings management and the economy
sector hypothesis: empirical evidence on a converse relationship in the Finnish case. Journal
of Business Finance & Accounting 22(4): 497-520.
Kirchheimer, H.W. 1968. Discussion of income smoothing. Journal of Accounting Research,
Empirical Research in Accounting, Selected Studies 6 (Supplement): 117-119.
Koch, B.S. 1981. Income smoothing: An experiment. The Accounting Review 56(3) (July):
574-586.
Labelle, R. and M. Thibault. 1998. Gestion du bénéfice à la suite d’une crise
environnementale : un test de l’hypothèse des coûts politiques (Earnings management in
response to environmental crises: a test of the political cost hypothesis). Comptabilité –
Contrôle – Audit 4(1) (March): 25-48.
Lambert, R.A. 1984. Income smoothing as rational equilibrium behavior. The Accounting
Review 59(4) (October): 604-618.
Lamont, O. 1998. Earnings and expected returns. The Journal of Finance LIII(5): 1563-1587.
Larner, R.J. 1971. Management control and the large corporation. New-York, Dinellen.
Ledouble, D. 1993. La créativité en comptabilité (Creativity in financial accounting). Semaine
juridique (J.C.P. - E) February 25: 224.
Lev, B. and S. Kunitzky. 1974. On the association between smoothing measures and the risk
of common stock. The Accounting Review 49(2) (April): 259-270.
Liberty, S. and J. Zimmerman. 1986. Labor union, contract negotiation and accounting
choices. The Accounting Review 61(4): 692-712.
Lim, S. and Z. Matolscy. 1999. Earnings management of firms subjected to product price
controls. Accounting and Finance 39: 131-150.
66
Lignon, M. 1989. L'art de calculer ses bénéfices (The art of computing its profits).
L’Entreprise 50 (November): 17-18, 20.
Loomis, C.J. 1999. Lies, damned lies, and managed earnings. Fortune 140(3) (Aug. 2): 74-92.
Lorek, K.S., R. Kee and W.H. Vass. 1981. Time-series properties of annual earnings data:
The state of the art. Quarterly Review of Economics and Finance 21(1) (Spring): 97-113.
Loubière, P. 1992. Pour embellir ses comptes, Thomson cède ses brevets (To improve the
look of its accounts, Thomson sells its patents). Libération (May 5).
Ma, C.K. 1988. Loan loss reserves and income smoothing: The experience in the US banking
industry. Journal of Business Finance and Accounting 15(4) (Winter): 487-497.
Magnan, M. and D. Cormier. 1997. The impact of foreward-looking financial data in IPOs on
the quality of financial reporting. Journal of financial statement analysis 3(2): 6-17.
Magnan, M., C. Nadeau and D. Cormier. 1999. Earnings management during antidumping
investigations: Analysis and implications. Canadian Journal of Administrative Sciences 16(2)
(June): 149-162.
Makar, S.D. and A. Pervaiz. 1998. Earnings management and antitrust investigations:
Political cost over business cycles. Journal of Business Finance and Accounting 25(5/6)
(June/July): 701-720.
Mathews, M.R. and M.H.B. Perera. 1996. Accounting Theory and Development. Nelson ITPC, Melbourne, 402 pages.
Maydew, E.L. 1997. Tax-induced earnings management by firms with net operating losses.
Journal of Accounting Research 35(1) (Spring): 83-96.
McNichols, M. and G.P. Wilson. 1988. Evidence of earnings management from the provision
for bad debts. Journal of Accounting Research 26(Supplement): 1-31.
67
Merchant, K. 1987. Fraudulent and Questionable Financial Reporting: A corporate
Perspective. Financial Executive Research Foundation, New-York.
Merchant, K. and J. Rockness. 1994. The ethics of managing earnings: An empirical
investigation. Journal of Accounting and Public Policy 13:79-94.
Michelson, S.E., J. Jordan-Wagner and C.W. Wootton. 1995. A market based analysis of
income smoothing. Journal of Business Finance & Accounting 22(8) (December): 1179-1193.
Monsen, R.J., J.S. Chiu and D.E. Cooley. 1968. The effects of separation of ownership and
control on the performance of the large firm. Quarterly Journal of Economics 82 (August):
435-451.
Moore, M.L. 1973. Management changes and discretionary accounting decisions. Journal of
Accounting Research (Spring): 100-107.
Moses, O.D. 1987. Income smoothing and incentives: Empirical tests using accounting
changes. The Accounting Review 62(2) (April): 358-377.
Mozes, H.A. 1997. The implications of a LIFO liquidation for future gross margins. Journal
of Financial Statement Analysis 2(4) (Summer): 39-51.
Murphy, K. and J. Zimmerman. 1993. Financial performance surrounding CEO turnover.
Journal of Accounting and Economics 16: 273-316.
Naser, K.H.M. 1993. Creative Financial Accounting. Prentice Hall, Hemel Hempstead.
Navissi, F. 1999. Earnings management under price regulation. Contemporary Accounting
Research 16(2) (Summer): 281-304.
Neill, J.D., S.G. Pourciau and T.F. Schaefer. 1995. Accounting method choice and IPO
valuation. Accounting Horizons 9(3): 68-80.
Newman, P. 1988. Discussion of An explanation for accounting income smoothing. Journal
of Accounting Research 26 (Supplement): 140-143.
68
Parker, R.H. and C.W. Nobes. 1991. ‘True and fair’: UK auditors’ view. Accounting and
Business Research 21(84): 349-361.
Pasqualini, F. and R. Castel. 1993. Le dixième anniversaire de la loi comptable. - 6. la loi
comptable, l'image fidèle et la créativité déviante (The tenth anniversary of Accounting law –
6. Acounting law, true and fair view and deviating accounting). Revue de Droit Comptable
93-1(March): 13-18.
Paterson R. 1995. New Creative Accounting – Book Review. Accountancy (November): 88.
Peasnell, K.V. 1998. Discussion of Earnings management using asset sales: An international
study of countries allowing noncurrent asset revaluation. Journal of Business Finance &
Accounting 25(9) & (10) (November/December): 1319-1324.
Perry, S.E. and T.H. Williams. 1994. Earnings management preceding management buyout
offers. Journal of Accounting and Economics 18(2): 157-180.
Peter W. 1994. Creative Accounting: The effectiveness of financial reporting in the UK – A
book review. Accountancy (July): 78.
Pierce-Brown, R. and T. Steele. 1999. The economics of Accounting for Growth. Accounting
and Business Research 29(2) (Spring): 157-173.
Pijper T. 1994. Creative Accounting: The Effectiveness of Financial Reporting in the UK.
Macmillan.
Polo, J.-F. 1994. Elf toilette ses comptes avant la privatisation (Elf cleans its accounts before
privatization). Les Échos (January 19): 1, 11.
Pourciau, S. 1993. Earnings management and nonroutine executive changes. Journal of
Accounting and Economics 16: 317-336.
Pourquery, D. 1991. Les provisions ou l'art de mettre de l'argent de côté (The provisions or
the art to save money). Science & vie économie 73 (June): 72-75.
69
Press, E.G. and J.B. Weintrop. 1990. Accounting based constraints in public and private debt
agreements: Their association with leverage and impact on accounting choice. Journal of
Accounting and Economics 12(1): 65-95.
Rayburn, J. and S. Lenway. 1992. An investigation of the behavior of accruals in the
semiconductor industry. Contemporary Accounting Research 9(3): 237-251.
Rennie, P. 1985. The Corporate AIDS – Funny financing and creative accounting. Rydges
LVIII(11) (November): 18-20.
Revsine, L. 1991. The selective financial misrepresentation hypothesis. Accounting Horizons
(December): 16-27.
Robb, S.W.G. 1998. The effect of analysts’ forecasts on earnings management in financial
institutions. Journal of Financial Research 21(3) (Fall): 315-331.
Ronen, J. and S. Sadan. 1975a. Classificatory smoothing: Alternative income models. Journal
of Accounting Research (Spring): 133-149.
Ronen, J. and S. Sadan. 1975b. Do corporations use their discretion in classifying accounting
items to smooth reported income? Financial Analysts Journal 31(5) (September-October): 6268.
Ronen, J. and S. Sadan. 1976. Ups and downs of income numbers: Inter-temporal smoothing.
Proceedings on Topical Research in Accounting: 285-316.
Ronen, J. and S. Sadan. 1980. Accounting classification as a tool for income prediction.
Journal of Accounting, Auditing & Finance Summer: 339-353.
Ronen, J. and S. Sadan. 1981. Smoothing income numbers, Objectives, Means, and
Implications. Reading, MA, Addison Wesley.
Ronen, J., S. Sadan and C. Snow. 1977. Income smoothing: A review. Accounting Journal
(Spring): 11-26.
70
Rutherford, B.A. 1985. The true and fair view doctrine: A search for explication. Journal of
Business Finance & Accounting 12(4): 483-494.
Sapienza, S.R. 1967. Discussion of Purchase versus pooling of interests: The search for a
predictor. Journal of Accounting Research, Empirical Research in Accounting, Selected
Studies 5 (Supplement): 205-209.
Saudagaran, S.M. and J.F. Sepe. 1996. Replication of Moses’ income smoothing tests with
Canadian and UK data: A note. Journal of Business Finance & Accounting 23(8) (October)
1219-1222.
Savoie, L.M. 1966. Discussion of The effect of alternative accounting rules for nonsubsidiary
investments. Journal of Accounting Research, Empirical Research in Accounting, Selected
Studies 4 (Supplement): 224-227.
Scheiner, J.H. 1981. Income smoothing: An analysis in the banking industry. Journal of Bank
Research 12(2) (Summer): 119-123.
Schiff, M. 1968. Discussion of income smoothing. Journal of Accounting Research,
Empirical Research in Accounting, Selected Studies 6 (Supplement): 120-121.
Schilit, H.M. 1993. Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud
in Financial Reports. McGraw Hill, New-York.
Schipper, K. 1989. Commentary on earnings management. Accounting Horizons 3(4): 91-102.
Scholes, M.S., G.P. Wilson and M.A. Wolfson. 1992. Firms responses to anticipated
reductions in tax rates: The tax reform act of 1986. Journal of Accounting Research
(Supplement): 161-185.
Scott, W.R. 1997. Financial Accounting Theory. Prentice Hall, Scarborough.
Shah, A.K. 1996. Creative compliance in financial reporting. Accounting Organizations and
Society 21(1): 23-39.
71
Shank, J.K. and M.A. Burnell. 1974. Smooth your earnings growth rate. Harvard Business
Review (January-February): 136.
Sheikholeslami, M. 1994. The impact of foreign stock exchange listing on income smoothing:
Evidence from Japanese firms. International Journal of Management 11(2) (June): 737-742.
Silbert, N. 1994. Club Méditerranée - le nettoyage des comptes (Club Méditerranée – the
cleaning of accounts). La Vie Française (February 1-7): 12.
Simpson, R.H. 1969. An empirical study of possible income manipulation. The Accounting
Review (October): 806-817.
Smith, E.D. 1976. Effects of separation of ownership from control on accounting policy
decisions. The Accounting Review 51 (October): 707-723.
Smith, T. 1992. Accounting for growth - Stripping the camouflage from company accounts.
Century Business, London, 2nd edition 1996.
Sprouse, R.T. 1967. Discussion of The return to straight-line depreciation: An analysis of a
change in accounting method. Journal of Accounting Research, Empirical Research in
Accounting, Selected Studies 5(Supplement): 184-186.
Stolowy, H. 2000. Comptabilité créative (creative accounting). Encyclopédie de Comptabilité,
Contrôle de Gestion et Audit (ed. Bernard Colasse). Economica: 157-178.
Subramanyam, K.R. 1996. The pricing of discretionary accruals. Journal of Accounting &
Economics 22(1-3) (August-December): 249-281.
Suh, Y.S. 1990. Communication and income smoothing through accounting method choice.
Management Science 36(6) (June): 704-723.
Sweeney, A.P. 1994. Debt covenant violations and managers’ accounting response. Journal of
Accounting and Economics 17: 281-308.
72
Swinson C. 1992. Accounting for growth: no accounting for the fuss. Accountancy (October):
89.
Teoh, S.H., I. Welch and T.J. Wong. 1998. Earnings management and the long run market
performance of initial public offerings. The Journal of Finance LIII(6): 1935-1974.
Titman, S. and B. Trueman. 1986. Information quality and the valuation of new issues.
Journal of Accounting and Economics 8: 159-172.
Trueman, B. and S. Titman. 1988. An explanation for accounting income smoothing. Journal
of Accounting Research 26 (Supplément): 127-139.
Turner, L.E. and J.H. Godwin. 1999. Auditing, earnings management, and international
accounting – Issues at the Securities and Exchange Commission. Accounting Horizons 13(3)
(September) 281-287.
Tweedie, D. and G. Whittington. 1990. Financial reporting: current problems and their
implications for systematic reform. Accounting and Business Research: 87-102.
Visvanathan, G. 1998. Deferred tax valuation allowances and earnings management. Journal
of Financial Statement Analysis 3(4) (Summer): 6-15.
Walsh, P., R. Craig and F. Clarke. 1991. ‘Big bath accounting’ using extraordinary items
adjustments: Australian empirical evidence. Journal of Business Finance & Accounting 18(2):
173-189.
Wang, Z. and T.H. Williams. 1994. Accounting income smoothing and stockholder wealth.
Journal of Applied Business Research 10(3) (Summer): 96-110.
Warfield T. and T.J. Linsmeir. 1992. Tax planning, earnings management, and the differential
information content of bank earnings components. The Accounting Review 67(3): 546-562.
Watts, R.L. and J. Zimmerman. 1978. Towards a positive theory of the determination of
accounting standards. The Accounting Review 56 (January): 112-134.
73
Watts, R.L., and J.L. Zimmerman. 1986. Positive Accounting Theory. Prentice-Hall,
Englewood cliffs.
Westmore, J.L. and J.R. Brick. 1994. Loan loss provisions of commercial banks and adequate
disclosure: a note. Journal of Economics and Business 46: 299-305.
Wiedman, C.I. 1999. Instructional case: Detecting earnings manipulation. Issues in
Accounting Education 14(1) (February): 145-176.
White, G.E. 1970. Discretionary accounting decisions and income normalization. Journal of
Accounting Research (Autumn): 260-273.
White, G.E. 1972. Effects of discretionary accounting policy on variable and declining
performance trends. Journal of Accounting Research (Autumn): 351-358.
Wu, Y.W. 1997. Management buyouts and earnings management. Journal of Accounting,
Auditing and Finance 12(4) (Fall): 373-389.
Wyatt, A.R. 1967. Discussion of Purchase versus pooling of interests: The search for a
predictor. Journal of Accounting Research, Empirical Research in Accounting, Selected
Studies 5 (Supplement): 210-212.
Young, S. 1999. Systematic measurement error in the estimation of discretionary accruals: An
evaluation of alternative modelling procedures. Journal of Business Finance & Accounting
26(7) & (8) (September-October): 833-862.
Zmijewski, M.E. and R.L. Hagerman. 1981. An income strategy approach to the positive
theory of accounting standard setting/choice. Journal of Accounting and Economics. 3
(August): 129-149.
74
Appendix 1
Empirical Studies of Earnings Management – A Selected List
Authors
Motivations
Sample
Methodology
Results
Copeland and Wojdak
Accounting for merger to
Gagnon’s 55-58 data, plus 118
Changes in accounting
Strong support for the hypothesis of
[1969]
maximize future income
recent NYSE mergers
treatments
income maximization through a massive
use of the pooling method
Anderson and Louderback III Purchase-pooling decision
114 mergers of the NYSE (pre- Test for significnce of the difference No significant decline of the maximazing
[1975]
Opinion 16 period) and 64 mergers between proportions: Z statistic.
(post-opinion
period):
behavior after APB 16.
1967-70.
1970-74
Bremser [1975]
Healy [1985]
Use of accounting changes for
80 firms with changes compared
Comparison of both groups on
Changing firms have a poorer pattern of
EM
to 80 without
EPS and ROI
profit
Effects of bonus plans on
Population = 250 largest US
Non discretionary accruals = a
If the profit is too low, managers will take
accounting choices
firms from Fortune
mean value over a period
a bath otherwise they will pick income -
Sample = 94 firms for 239 firm-
increasing or decreasing procedures
years
DeAngelo [1986]
Proxy contest and
64 NYSE and American SE
Discretionary accruals = total
The empirical evidence does not support
management buyout
proposing a management buyout
accruals
the hypotheses
(73-82)
McNichols and Wilson
Decrease the variance of
138 firms from the printing and
Test of the change on bad
Results are consistent with the income
[1988]
earnings
publishing industry giving a
discretionary bad debt
decreasing hypothesis although not with
When the profit is too low,
total of 2038 firm-years
provision, the discretionary
the smoothing hypothesis
managers will choose to take a
portion being estimated with 4
bath
benchmarks
75
Dechow and Sloan [1991]
Jones [1991]
CEO situation and R&D
Compustat firms in specific SIC
Non discretionary accruals =
Positive evidence of income -increasing
expenditure
codes - 405 firms
the mean of the industry sector
accounting choices by CEO
EM during an inquiry of the
23 firms in 5 industrial sectors
Non discretionary accruals are
Managers make income-decreasing
International Trade
established by providing for
accounting choices during investigations
Commission
the normal growth of the firm
(revenues and assets) by
normalizing with total assets
at the beginning
Aharony, Lin and Loeb
EM in an IPO context
229 industrial firms (1985-87)
DeAngelo’s model; total
No evidence of manipulation through the
on a population of 1162 US
accruals standardized by
accruals
firms
average total assets
EM from specific items
653 firm-year observations from
Through a regression, the
Highly geared and low income firms have
manipulation: income
Compustat, classified by
income from asset sales is
significantly higher revenues from asset
recognition from disposals
industrial sector
explained by the variation of
sales
[1993]
Bartov [1993]
earnings per share and the
book value of the debt/equity
ratio
Dempsey, Hunt and
Effect of ownership structure
Compustat firms with at least
3 groups: 1 - owner managed,
When management and ownership are
Schroeder [1993]
on EM
one extraordinary item between
2 - externally controlled, 3 -
separated, high level of EM through
1960 and 1966. Total 248 firms
management controlled.
extraordinary items
Classification into
extraordinary items and
ownership structure
Pourciau [1993]
The effect of nonroutine top
73 firms from Disclosure having
Examination of unexpected
As expected new CEO decrease income in
executive changes on
experience a nonroutine CEO
earnings, accruals and cash
their first year (big bath), unexpectedly
accounting choices
change
flows and special items
leaving CEO do the same in their last year
76
DeAngelo, DeAngelo and
Potential problems to comply
76 firms from the NYSE with
Looked for a movement in the
No real significant income increasing
Skinner [1994]
with debt covenant dealt
three years of losses within
accruals around the dividend
procedures
through dividend cuts
1980-85
reduction date
Accruals = net income - cash
flows
DeFond and Jiambalvo
Possibility of a default of the
94 firms from the NAARS
2 measures: total accruals and
EM occurs the year before the default
[1994]
debt covenant
database disclosing a violation
working capital accruals
becomes publicly known
277 IPO firms from 1981 to
DeAngelo’s model modified
Income increasing procedures just before
1984
through standardizing by sales
the IPO
Debt covenants default
130 firms first time violators
Direct test of the use of certain
Significant manipulations when in danger
possibilities
(1980-89) with data on
accounting methods, e.g.
of defaulting
Compustat
LIFO vs FIFO
between 1985 and 1988
Friedlan [1994]
Sweeney [1994]
EM in a IPO context
Dechow, Sloan and
To test the validity of
4 samples: 2 randoms of 1000
Models tested: Jones original,
Jones modified is the best model although
Sweeney [1995]
available models in detecting
each, 1 from firms having
Jones modified, Healy,
none is really complete
EM
extreme performances, and 1 of
DeAngelo and the industry
36 firms prosecuted by the SEC
model
Gaver, Gaver and Austin
Effects of bonus plans on
102 firms, between 1980 and
Replication of Healy’s study
No big bath. They increase the profit
[1995]
accounting choices
1990
using Jones’ model
when too low and decrease it when too
high
Holthausen, Larcker and
Effects of bonus plans on
Sloan [1995]
accounting choices
Kinnunen, Kasanen and
EM and economy sectors
Niskanen [1995]
Income-reducing procedures at the top
37 listed firms, 17 core and 20
Total EM = profit from IASC
Opportunity for and use of EM is greater
peripheric
standards less profit presented
in the core sector, and the sector is
in Finnish standards
making a difference
77
Neil, Pourciau et Schaefer
EM in an IPO context
[1995]
Population = 2609 IPOs (1975-
Classification of accounting
Relationship between the size of the
84). Sample = 505 following
methods: depreciation and
proceeds and the liberality of accounting
data availability
stock valuation, as
policies
conservative or liberal
Beneish [1997]
Firms experiencing extreme
Experimental: 64 firms charged
The Jones model for selecting
The model can detect the possibility of
financial performance.
by the SEC
the aggressive accruers
opportunistic reporting among firms with
Distinguish GAAP violaters
Control group: firms with high
(control)
large accruals
from simply aggressive
accruals - 2118 firms
A regression to explain the
Recommendations to improve Jones
differences between violators
model
accruers
and non violators through a set
of variables
Burgstahler and Dichev
EM around profit = 0 or a
64466 observation-years (1977-
Gaps in the density of the
Strong evidence of EM when earnings
[1997]
negative value
94)
distribution of earnings
decrease or are negative
Black, Sellers and Manly
EM through asset disposals
From data available in Global
Comparison of the
Testing for asset revaluation
[1998]; Peasnell [1998]
and accounting regulation in
Vantage. 750 firms from
characteristics of the revaluers
No evidence of EM in Australia and New-
an international context
Australia, New-Zealand and
and non revaluers
Zealand but strong one in the UK
UK, for a total of 1199 firmyears
Cormier, Magnan and
Firms in financial distress and
60 Swiss firms on 5 years on the
Explain the level of total
Principles of the agency theory (or
Morard [1998]
takeover attempts
total of 172 listed Swiss firms
accruals by a list of variables
positive accounting theory) are applicable
like the Beta, the cash flow,
in Switzerland as well as in anglo-saxon
structure of ownership, etc.
countries
Han and Wang [1998]
EM to decrease political
76 firms in predetermined Sic
DeAngelo’s model adjusted
Evidence that oil companies used income
visibility
codes
by total assets
decreasing procedures during the Gulf
war
78
Labelle and Thibault [1998]
Environmental crises
Sample of 10 firms having
Jones model modified,
No evidence of earnings management
known an environmental crisis
adjusted for the differences in
following an environmental crisis
reported on the front page of the
cash flows
New-York Times
Teoh, Welsh and Wong
IPOs, increased asymmetry of
[1998]
information
1649 IPO firms (1980-92)
Four types of accruals
Positive evidence of earnings
discretionary and non, short
management immediately after the issuing
term and long term
Beneish [1999a]
Consequences of earnings
Same sample than in 1997
Managers are more likely to sell their
overstatement
holdings and exercise stock appreciation
rights in the period when earnings are
overstated than are managers in control
firms
Beneish [1999b]
Detection of earnings
74 companies and all Compustat
manipulation
companies matched by two-digit
8 variables.
Identification of half of the companies
involved in earnings manipulation
SIC numbers. Data available for
1982-92 period.
Degeorge, Patel and
Manage investors impression
Zeckhauser [1999]
Quarterly data on 5387 firms
Analysts’ expectations = a
Firms are using EM to avoid reporting
from 1974 to 1996
mean of forecasts. They study
earnings below some threshold identified
the distribution of changes in
empirically in the study
EPS and earnings forecasts to
identify discontinuities
Erickson and Wang [1999]
Increasing stock value prior to
55 firms from 24 industries
a stock for stock merger
Total accruals = net income
Income increasing procedures are found
less operating cash flows.
just before the merger
Jones model to determine
discretionary accruals
79
Jeter and Shevakumar
Improve the methodology to
1000 firms-periods in each cash
Modified Jones model to take
The Jones model is not well specified for
[1999]
detect event-specific EM
flow quartile
into account the level of cash
extreme cash flow
flow
Kasznik [1999]
Managers will try to present
499 management earnings
Jones model as modified by
Found evidence of EM to align the
earnings in the neighborhood
forecasts from Lexis news
Dechow, Sloan and Sweeney
presented and the forecasted earnings
EM facing price control in
3 groups: 1. 32 investigated, 2.
Jones model
Evidence of EM for the category 1 in year
Australia
34 subject to be inquired, 3- not
of analysts forecasts
Lim and Matolcsy [1999]
0
subject to be inquired
Magnan, Nadeau and
EM by firms participating as
17 Canadian firms (1976-92
Model relating accruals to
Evidence of reduction of earnings to
Cormier [1999]
plaintiffs in antidumping
period)
return, cash flow, PPE, control
obtain favorable rulings from the tribunal
investigations
Navissi [1999]
EM under price regulation
and tribunal
62 firms from New Zealand (2
Dechow, Sloan and Sweeney
samples). One control sample.
model adjusted for the impact
Evidence of EM
of general price inflation
Young [1999]
To test the robustness of 5 models
to measurement error
158 firms distributed over3 years
80
Mode tested: Healy, DeAngelo,
modified DeAngelo, Jones,
modified Jones
Jones and modified Jones are the best models
Appendix 2
Studies of Income Smoothing (IS) – A Selected List7
Authors
Purpose of the paper
Dopuch and
To investigate the effects
Drake [1966],
Object of smoothing
Net income.
Variable (instrument) of
Sample
Methodology – Expectancy
smoothing
Period of analysis
model
Results - comments
Gains and losses on sale of
12 firms.
Time series regression
No evidence of smoothing with
of alternative accounting
securities.
1955-64.
techniques on net income.
gain or loss of securities.
Gordon [1966],
rules for valuing non
Dividends of non-subsidiary
No expectancy model specified.
Some evidence with dividend
Savoie [1966]
subsidiary investments.
investments.
Gordon, Horwitz
To test the hypothesis
Earnings per share.
21 firms in the
Exponential weighting of prior
and Meyers
that firms attempt to
Rate of return on
chemical industry.
years normal earnings and
[1966]
smooth income.
stockholder’s equity.
1962-63.
current year actual earnings.
income.
Investment tax credit.
Income (unclear which).
Inconclusive results.
Exponentially weighted oneyear growth rate.
Two-period exponentially
smoothed rate of return.
Archibald
To discover how and
[1967], Sprouse
[1967],
Cummings
Net income.
Change from accelerated
53 firms.
Target earnings are the
Mitigated results. A high
why an accounting
depreciation to straight-line
1962-64.
reproduction of the preceding
proportion of companies
change is made.
depreciation.
year’s earnings. Descriptive
smoothes income when their
Investment credit.
statistics (ratios).
profitability is relatively low.
[1967]
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 in
chronological order. For each study, the references following the first one, when mentioned, is related to comments or discussions.
81
Gagnon [1967],
To find out whether there
Earnings (less preferred
Sapienza [1967],
is any empirical basis for
dividends).
Wyatt [1967]
assuming that managers
Purchase-pooling decision.
500 mergers from the Discriminant function.
Management’s choice is more
NYSE.
consistent with income
1955-58.
maximization than with
seek to smooth reported
income normalization.
income.
Copeland [1968],
To specify some
Schiff [1968],
Net income.
Dividend income received
19 companies from
Target earnings were the
Defines what a good
attributes of accounting
from unconsolidated
the NYSE.
reproduction of the preceding
smoothing device must
Kirchheimer
variables which have a
subsidiaries reported by
From 4 to 20 years.
year’s earnings.
possess.
[1968]
capacity for smoothing.
parent at cost.
Increasing the number of
To evaluate earlier
Other smoothing variables
variables and the length of the
investigations in terms of
(extraordinary charges or
time series reduces the error
criteria so developed.
credits, write-offs of fixed
involved in classifying firms as
To report on empirical
assets or intangibles,
smoothers or non-smoothers.
investigations of three
cessation or unusual changes
hypotheses which have
in pension charges, changes
implications for further
in accounting methods or
research on income
procedures, fluctuations in
smoothing.
contingency or selfinsurance reserves, changes
in deferred charge or credit
accounts…).
Copeland and
Study of accounting for
Licastro [1968]
Net income.
Dividend income.
20 companies from
Year-to-year changes.
unconsolidated
the NYSE.
Chi-square statistics.
subsidiaries reported by
Periods from 5 to 12
the parent at cost.
years (1954-65).
82
No evidence of IS.
Cushing [1969]
To study the effects of
Earnings per share
Reported changes in
249 cases of changes. A $0.01 increase in earnings per
Evidence that management
changes in accounting
(unclear what type of
accounting policies
1955-66.
share over the preceding year; a
chooses the periods in which to
policy on the reporting
EPS).
(consistency qualifications
distributed lag model.
implement a change so as to
earnings with emphasis
variables in the auditor’s
Weighted straight-line
report favorable effects on
on the IS effects of such
report).
projection based on the five
current earnings per share.
changes.
White [1970]
previous years.
Study of discretionary
Earnings per share
Discretionary accounting
42 firms (chemical
Target earnings were the
Evidence that companies faced
accounting decisions.
(unclear which type).
decisions.
industry) and 54
reproduction of the preceding
with highly variable
firms (building
year’s earnings.
performance pattern and
materials industry).
declining earnings smooth
1957-66.
income.
However, those faced with
variability in positive earnings
do not smooth income.
Dascher and
Examine companies in
Income (not clear
Pension costs.
52 firms.
Time series regression
Malcolm [1970]
the chemical and
which).
Dividend from
1955-66 and 1961-
techniques on net income.
chemical preparations
unconsolidated subsidiaries
industries.
reported by the parent at
Results considered being
consistent with the smoothing
x
66.
Exponential of the form y = ab .
assumption.
30 firms. 10 (cost
Linear relationship between
Modest support for the
basis); 14 (equity); 6
earnings and time. Parametric
hypothesis that firms select
method of accounting for
(both methods).
two factor analysis of variance
that method which produces
unconsolidated
1959-68.
design with repeated measures
smoother earnings.
cost.
Extraordinary charges and
credits.
R&D costs.
Barefield and
Differential impact of the
Before tax earnings
Comiskey [1972]
cost versus the equity
(unclear which).
Cost or equity method.
subsidiaries.
on one factor.
83
White [1972]
Study of discretionary
Earnings per share
Discretionary accounting
42 chemical
Target earnings were the
Mixed results with companies
accounting decisions
(unclear which type).
decisions.
companies, 39 retail
reproduction of the preceding
faced with highly variable
(other companies than in
companies and 41
year’s earnings.
performance pattern and
the previous study).
electrical and
declining earnings smooth
electronics
income.
companies.
1957-66 or 1959-68.
Beidleman
The paper addresses 3
Earnings (unclear
Pension and retirement
43 firms.
Linear time trend.
Many firms employ certain
[1973, 1975],
questions:
which).
expense.
1951-70.
Semi logarithmic time trend.
devices to normalize reported
Imhoff [1975]
Is it desirable for
Incentive compensation.
Correlation of residuals from
earnings.
management to have
R&D expense.
time-series regressions of
Evidence of smoothing with
smooth earnings?
Remitted earnings from
reported income with similarly
the instruments: pension costs,
If desirable, can
unconsolidated subsidiaries.
derived residuals of variables
incentive compensation, R&D
management create the
Sales and advertising
which have smoothing
and sales and advertising
appearance of smooth
expense.
potential.
expense.
earnings?
Plan retirements.
If desirable and possible,
do firms succeed in their
attempt to normalize
reported income?
Lev and
To suggest that firms
260 firms.
Mean-standard deviation
Reveal a significant
Kunitzky [1974]
actively engage in the
No object.
No instrument.
1949-68 (15 years of
portfolio model.
association between the extent
smoothing of various
continuous annual
Overall risk and systematic risk.
of smoothness of sales, capital
input and output series,
data).
expenditures, dividends, and
such as sales and capital
earnings series and the risk of
expenditure, in order to
common stock.
decrease environmental
uncertainty.
84
Ronen et Sadan
To report the results of a
Ordinary income per
Extraordinary items
62 firms.
Correlation coefficient between
Strong support of the
[1975a, 1975b]
test for classificatory
share before
(classificatory smoothing).
1951-70.
the ordinary income series and
smoothing hypothesis.
smoothing with
extraordinary items.
the extraordinary income (or
extraordinary items.
Extraordinary income
expense) series.
To present evidence that
per share.
First differences income market
firms make use of
index.
whatever discretion they
Submartingale.
have to “smooth”
income.
Firms from four
industries: paper,
chemicals, rubber and
airlines.
Barnea, Ronen
Tests of whether
Ordinary income
Classification of non
62 firms from 4
Regression of the extraordinary
Strong support for the
and Sadan [1976,
extraordinary revenues
(before extraordinary
recurring items as either
industries: paper,
items deviations on the
hypothesis that management
1977]
and expenses are used to
items) per share.
ordinary or extraordinary.
chemicals, rubber
smoothed variables deviations.
behave as if they smoothed
smooth ordinary or
Operating income
and airlines.
Linear time trend. Industry
income before extraordinary
operating income over
(before period charges
1951-70
leader trend.
items through the accounting
time.
and extraordinary items)
manipulation of extraordinary
per share.
items
Imhoff [1977]
To question the
94 industrial firms.
Suggested that IS can be studied
definition of what
No object.
No instrument.
1962-72 (or 1961-
by comparing the variance of
constitutes IS and to
71).
sales to the variance of income.
suggest an alternative
Regressions for the net income
definition.
and sales time –series as well as
Empirical study on the
the association between net
possible existence of
income and sales.
smoothing.
85
No evidence of IS.
Kamin and
Factors associated with
Operating income.
Discretionary items:
310 U.S. industrial
Time trend.
Compared to owner-controlled
Ronen [1978]
IS. Examined the effects
Ordinary income.
Operating expenses (not
firms.
Market trend.
companies, manager-controlled
of the separation of
included in the cost of sales). 1957-71.
ones tend to smooth income.
ownership and control on
Ordinary expenses including
Barrier entry have an effect on
IS under the hypothesis
non-manufacturing
IS.
that management-
depreciation and fixed
controlled firms are more
charges.
likely to be engaged in
smoothing as a
manifestation of
managerial discretion
and budgetary slack.
Eckel [1981]
To offer an alternative
Net income.
conceptual framework
(Artificial smoothing).
No instrument.
for identifying IS
62 industrial
To compare the variability of
Finds only two firms that
companies.
sales and the variability of
appeared as if they smoothed
1951-70.
income.
income.
50 companies and 42
Submartingale.
The manifestations of end-of-
Polynomial regression.
year actions by managers are
behavior.
Givoly and
To test the hypothesis
Earnings per share
Sales (real smoothing).
Ronen [1981]
that the observed first
(before extraordinary
companies.
three quarters’ results
items), adjusted for
1947-72.
trigger actions by
stock splits and
attempt on their part to alter
management during the
dividends.
fourth quarter reported.
consistent with the possible
fourth quarter that appear
as smoothing behavior.
Scheiner [1981]
To examine whether the
Operating income
Loan loss provision.
provision for loan losses
before the loan loss
has been used to smooth
provision and income
between: the loan loss provision
income in the banking
taxes.
and current operating income;
industry.
107 banks.
Spearman Rank Correlation
1969-76.
Coefficient Test (association
the loan loss provision and the
measures of business failure).
86
No evidence of IS.
Amihud, Kamin
To test for the
Net operating income
Operating expenses per
56 firms.
Method used in Kamin and
Manager-controlled firms
and Ronen
differences between
per share.
share.
1957-71.
Ronen (1978). Detrend of time
exercise IS to a greater extent
[1983]
owner-controlled and
series.
than owner-controlled firms.
manager-controlled firms
with respect to their risk.
Belkaoui and
To test the effects of the
Operating income.
Operating expenses not
Examination of 114
Correlation coefficient between
IS is stronger in the periphery
Picur [1984]
dual economy on IS.
Ordinary income.
included in cost of sales.
core companies and
the deviations of the smoothing
sector that in the core area.
Ordinary expenses.
57 periphery
objects with the deviations of
Operating expenses plus
companies.
the smoothing variables.
ordinary expenses.
Not mentioned.
Moses [1987]
To test for associations
Earnings (unclear
Discretionary accounting
212 change events.
between smoothing and
which).
changes (switch to Lifo,
1975-80.
T-tests and regression analysis.
IS is associated with firm size,
bonus compensation plans, and
variables commonly used
change in pension method or
divergence from expected
to proxy for particular
assumptions, depreciation,
earnings.
economic factors.
tax credit, consolidation,
changes in amortization,
depreciation estimates,
changes in
expense/capitalization
policies).
Ma [1988]
To examine the income-
Operating income.
smoothing practice in the
Income (unclear which).
Loan loss provision.
US banking industry.
45 largest banks.
Equation showing the
1980-84.
relationship between operating
income, charge-off and loanloss provision.
87
Strong evidence of IS.
Brayshaw and
To test the impact of
Ordinary income before
Eldin [1989]
accounting for exchange
tax and extraordinary
differences.
Exchange differences.
40 UK companies.
Linear time trend expectancy
Including exchange differences
1975-80.
model.
in either of the two streams of
items.
Wilcoxon sign-test.
income (operating income
Net income.
T-test.
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
To discover whether the
Reported consolidated
Extraordinary items
84 companies from
[1989]
accounts of a sample of
net income after tax,
adjustments (timing, amount
the Sydney Stock
Cox and Stuart test.
Strong evidence that large
listed Australian companies are
Australian listed
minority interests and
and period of reporting).
Exchange.
engaged in profit smoothing.
companies contain
extraordinary items.
Example: gain or loss on sale 1972-84.
evidence of IS.
Artificial smoothing.
of a non-current asset.
Albrecht and
To determine the
Operating income.
No instrument.
Richardson
importance of smoothing
[1990]
128 core companies
Stepwise logit procedure in
IS exists and is fairly evenly
Income from
and 128 periphery
order to fit a multivariate model
distributed in various sectors of
in accounting practice.
operations.
companies.
of smoothing behavior.
the economy (No difference
To describe the type of
Income before
1974-85.
Eckel income variability
between core and periphery
companies that smooth
extraordinary items.
method.
sector firms).
income.
Net income.
88
Ashari, Koh, Tan
To identify the factors
Income from operations
153 companies listed
Four hypotheses relating IS to
IS is practiced and operational
and Wong [1994]
associated with the
Income before
No instrument.
in the Singapore
size, profitability, industry and
income is the most common IS
incidence of IS.
extraordinary items.
stock exchange.
nationality.
objective.
Net income after tax.
1980-90.
T-tests of differences, chisquare 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
Beattie et al.
Study of classificatory
Reported profit after
Classification of items either
228 UK companies.
Smoothing index based on
Four variables are associated
[1994]
choices within an
tax, but before
above the line (exceptional
1989-90 (one year).
accounting risk, market risk,
with classificatory choices
explicit, incentives-based
extraordinary items
items) or below the line
agency costs, political costs,
consistent with smoothing
(extraordinary items).
ownership structure and
behavior: earnings variability
industry.
(+), managerial share options
Multivariate regression.
(+), dividend cover (-) and
approach.
outside ownership
concentration (-).
Fern, Brown and
To examine IS behavior
Ordinary income
Dickey [1994]
in the petroleum
(income before
industry. (Update of the
extraordinary items).
No instruments specified.
26 oil refiners.
Methodology of Ronen and
Evidence of a political
1971-89.
Sadan [1981].
motivation to practice IS is
reported. No evidence of
Ronen and Sadan [1981]
significant classificatory IS but
survey). To link
evidence of significant inter-
smoothing behavior to a
temporal IS.
specified motivation (i.e.
avoidance of political
costs).
89
Sheikholeslami
To study the hypothesis
Operating income.
24 firms listed
Methodology of Imhoff [1977]
No significant difference
[1994]
that IS practices are
Pre-tax income.
No instrument.
abroad. Firms non
and Eckel [1981].
between the two samples.
altered when firms list
Net income.
listed abroad.
456 companies.
Regression of unexpected
The market response to
1977-86.
income on cumulative abnormal
earnings for firms with a
returns.
smooth income series is four
their stocks on foreign
1982-87.
stock exchanges.
Wang and
To examine the
Williams [1994]
relationship between
No object.
No instrument.
accounting IS and
stockholder wealth.
times as large as that for other
firms.
Michelson,
To test for an association
Operating income after
No instrument (variation in
358 firms.
Coefficient of variation method
Find that firms that smooth
Jordan-Wagner
between IS and
depreciation.
sales).
1980-91.
[Eckel, 1981].
income have a significantly
and Wooton
performance in the
Pretax income.
lower mean annualized return
[1995]
marketplace.
Income before
than firms that do not smooth
The paper examines:
extraordinary items.
income. Smoothing firms have
The tendency of major
Net income.
lower betas and higher market
corporations to become
value of equity.
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.
90
Bhat [1996]
Examination of the IS
Earnings after taxes and
hypothesis for large
before extraordinary
banks.
items.
Loan-loss provisions.
148 banks.
Regression of logarithms of
Banks with a close relationship
1981-91.
earnings after taxes and loan-
between their earnings before
loss provisions against the year
loan-loss provisions and after
2
and computation of R for each
taxes and loan-loss provisions
bank.
tend to have smooth earnings.
Small banks with high risk and
poor financial condition are
likely to smooth their earnings.
Saudagaran and
To replicate Moses’
Earnings (unclear
Discretionary accounting
58 UK companies
Sepe [1996]
[1987] investigation.
which).
changes.
and 20 Canadian
Moses. Lack of association
companies.
between the smoothing
1983-86.
variable and firm size.
Breton and
To test the presence of IS
Chenail [1997]
by Canadian companies.
Net income.
No instrument.
T-tests and regression analysis.
Results different from those of
402 Canadian
Imhoff [1977] and Eckel [1981]
The results support the
companies.
model.
hypothesis that IS is widely
1987-91.
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.
91
Carlson and
To examine the
Bathala [1997]
association between
No object
No instrument
265 firms.
Albrecht and Richardson [1990]
Dimensions reflecting
1982-88
methodology. Logistic
ownership differences,
regression model
executive’s incentive structure
differences in ownership
structure and IS
and firm profitability are
behavior. Several factors
important in explaining IS
are identified: manager
smoothing
versus owner control,
debt financing,
institutional ownership,
dispersion of stock
ownership, profitability
and firm size
Godfrey and
IS in companies subject
Jones [1999]
to labor-related political
Net operating profit
Extraordinary items
1,568 Australian
Least squares regression
Evidence of IS associated with
(recurring gains and losses)
firms listed between
analysis
the degree of management
costs
1985 and 1993
92
ownership
Appendix 3
Examples of Smoothing Variables
Gains and Dividends InvestChange
Purchase- Changes Unusual Investment
Loss
Discre- Pen- Extra- R&D Opelosses on
of nonment tax
from
pooling in accoun- gains in common carrytionary sion ordinary costs rating or
sale of
subsidiary
credit accelerated decision
ting
and
stocks
forward accoun- costs items
ordisecurities investments
to straightpolicies
losses
tax
ting
(classinary
line
benefit decisions
ficatory
expendepreciation
or interses
temporal
Dopuch & Drake [1966]
x
x
Gordon et al. [1966]
x
Archibald [1967]
x
x
Gagnon [1967]
x
Copeland [1968]
x
Copeland & Licastro
x
[1968]
Cushing [1969]
x
White [1970, 1972]
x
Dascher & Malcolm
x
x
x
x
[1970]
Beidleman [1973]
x
x
Barnea et al. [1976]
x
Kamin & Ronen [1978]
x
Eckel [1981]
x
x
Amihud et al. [1983]
x
Belkaoui & Picur [1984]
x
Moses [1987]
x
Ma [1988]
Brayshaw & Eldin
[1989]
Craig & Walsh [1989]
x
Beattie et al. [1994]
x
Bhat [1996]
Saudagaran & Sepe
x
[1996]
Godfrey & Jones [1999]
x
93
Loanloss
provision
Exchange
differences
x
x
x