A New Measure of Managers' Intentional Income Smoothing

• In Event: Earnings Management - II

Abstract

We provide a new measure of income smoothing using each firm as its own control. For each firm, we create pseudo-fiscal-year earnings using four consecutive quarters other than the reported fiscal year. We then compare earnings volatility of pseudo fiscal years to the earnings volatility of the reported fiscal year. To the extent managers use accruals to reduce annual earnings volatility, we expect the volatility of reported fiscal year earnings to be less than the volatility of pseudo-year earnings. We first document that, on average, earnings volatility is greater for reported fiscal years, and this greater volatility is attributable to accruals (not cash flows). However, for 47.6% of our sample, fiscal year earnings have lower volatility, consistent with income smoothing for some firms. Next, we validate our measure of income smoothing by showing that it behaves as expected in a variety of cross-sectional tests. Finally, we compare our measure of income smoothing to two commonly used measures in the literature and find that inferences across these measures are not the same in our cross-sectional tests.

Authors

• Dirk E Black, Dartmouth College

• Spencer Ryan Pierce, Florida State University

• Wayne B. Thomas, University of Oklahoma