A FRAMEWORK FOR THE CLASSIFICATION OF ACCOUNTS

MANIPULATIONS

Herv Stolowy

Gatan Breton

HEC School of Management (Groupe HEC)

Department of Accounting and Management
Control
1, rue de la Libration
78351 - Jouy en Josas Cedex
France

University du Qubec Montreal

Department of Accounting Sciences
P.O.B. 8888
Succursale Centre-Ville
Montral (Qubec)
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). Herv 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.

Rsum/Abstract

Proposition dun cadre conceptuel pour une

A Framework for the Classification of Accounts

classification des manipulations comptables

Manipulations

Les manipulations comptables ont fait lobjet de

Accounts manipulations have been a matter of

recherche, discussion et mme 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, lAustralie et la France. Lobjectif 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 travers une revue

through a thorough review of the literature. This

approfondie de la littrature. Ce cadre est fond sur le

framework is based on the desire to influence the

dsir dinfluencer la perception par les marchs

market participants perception of the risk associated

financiers du risque associ lentreprise. Le risque

to the firm. The risk is materialized through the

se matrialise deux niveaux : le bnfice par action

earnings per share and the debt/equity ratio. The

et le ratio dettes/capitaux propres. La littrature sur ce

literature on this topic is already very rich, although

sujet est extrmement riche. Cependant, plusieurs

we have identified series of areas in need for further

domaines mriteraient de faire lobjet de recherches

research.

permettant

la

classification

complmentaires.

MOTS CLS . MANIPULATIONS COMPTABLES _

KEYWORDS . ACCOUNTS MANIPULATIONS EARNINGS

GESTION DU RSULTAT LISSAGE DU RSULTAT

MANAGEMENT INCOME SMOOTHING BIG BATH

NETTOYAGE DES COMPTES - COMPTABILIT CRATIVE

ACCOUNTING CREATIVE ACCOUNTING

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 Levitts 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 firms 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.

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

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, managements 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 companys 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 firms 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

misleading or signaling accounts manipulations? And, in a managers 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.

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]

DeAngelos 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.

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
Healys 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).

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, Knivsfl and Sttem [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 Gagnons 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

IPOs

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 managements method of signaling its expectation of future results. As a
consequence, for this author, manipulated financial statements can measure firms
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 companys 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 models 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 Hepworths 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.

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 firms size.

Proposition 3: the achievement of the management goals stated in proposition 2 is

dependent in part on the satisfaction of stockholders with the firms 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 companys 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 firms

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 firms

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 managements 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 firms underlying cash flows are
also smoothed over the same period (i.e. the fluctuation in the firms 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 managements 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 stockholders 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 Copelands 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

Copelands 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 Archibalds 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

events

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 firms 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

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 managements 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 CPAs; 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 managements
decision-making process. Specifically, they address four methodological questions the
researcher has to cope with:

1. What is managements object of smoothing?

2. Through what dimension management is conducting smoothing?
3. What is managements 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 years 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.

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 years
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 firms 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 Snows 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 firms 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 firms 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 Tobins 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 firms 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 firms
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, executives 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 managers 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 firms 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
firms underlying economic earnings [see comments by Newman 1988].

The purpose of Suhs 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 agents
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

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 accountants 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; Agde, 1994], after having been
cleaned [Feitz, 1994a et b; Silbert, 1994; Polo, 1994]. They can be make up [Agde, 1994],
they may have their look improved [Loubire, 1992], or have a fiscal facelift [Agde, 1994].
Depreciation can be muscled and the provisions plumped [Agde, 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.

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

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74

Appendix 1
Empirical Studies of Earnings Management A Selected List

Authors

Motivations

Sample

Methodology

Results

Copeland and Wojdak

Accounting for merger to

Gagnons 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)

DeAngelos 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

DeAngelos 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 Healys 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

DeAngelos 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]

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.

stockholders 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.

years earnings. Descriptive

smoothes income when their

Investment credit.

statistics (ratios).

profitability is relatively low.

[1967]

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.

Managements 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.

years 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 auditors

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

years 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

years 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

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

executives 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