Académique Documents
Professionnel Documents
Culture Documents
1, 1981
NORM ECKEL
1. INTRODUCTION
The purpose of this paper is to review earlier studies of income smoothing, and to offer
an alternative conceptual framework for detecting or identifying income smoothing
behaviour of firms. There has been a number of studies conducted in the area; however,
the conceptual framework for most of these studies tended to be similar with
differences limited to the sample of firms, the expectancy model ussd, the time-frame
studied, or the soothing objects and smoothing variables considered. The present study
proposes a conceptually different manner of viewing income smoothing behaviour.
The supposition that firm may intentionally smooth income was fist suggested by
Hepworth [1953] and further elaborated upon by Gordon [1966]. The latter constructed
a framework from which one could logically deduce the impetus for the act of income
smoothing. There followed a number of empirical studies (Copeland and Licastro
[1968], Copeland and Wojdak [19691, Cushing [1969], Simpson [1969], White [1970],
Ronen and Sadan [1975], Barnea, Ronen and Sadan [1976]) all aimed at ascertaining
whether or not firms intentionally smooth reported income.* The general findings of
these and other such studies, suggest that fkms do behave as if they are smoothing
income, although there was not complete unanimity.
The conceptual framework employed by most researchers was similar to that proposed by Gordon ([1966],
p. 223). Hereafter it will be termed the Gordon methodology.
See Ronen, Sadan and Snow [1977] for an excellent review of the income smoothing literature.
NORMECKELis an Assistant Professor of Accounting and MIS,Bowling Green State University, Ohio.
28
Smooth Income
1,
Intentionally Being
Smoothed by Management
Smoothing
naturally smooth. But both real and artificial smoothing are the result of actions taken by
management.
Real smoothing represents management actions undertaken to control underlying
economic events. Horwitz ([1977], p. 27) asserts that real smoothing affects cash flows
whereas artificial smoothing does not. Dascher and Malcolm ([1970], pp. 253-4) indicate
that real smoothing represents actual transactions undertaken or not undertaken on the
basis of its smoothing effect on income. For example, a lirm might select capital projects
on the basis of the co-variance of their expected income series. This represents the
control of actual economic events that directly affect future income, and is thus termed
real smoothing.
Artificial smoothing represents accounting manipulationsundertaken by management
to smooth income. These manipulationsdo not represent underlying economic events or
affect cash flows, but shift costs and/or revenues from one period to another. For
example, a firm could increase or decrease reported income simply by changing its
actuarial assumptions concerning pension costs.)
3. PREVIOUS IDENTIFICATION OF INCOME SMOOTHING BEHAVIOUR:
THE GORDON METHODOLOGY
Copeland ([1968], p. 105) suggests three general methods for identifying income
smoothing behaviour: (1) directly ascertain from management by interview,
questionnaire,or observation; (2) contact second parties such as CPAs; or (3) examine
For other examples of artificial smoothing and its accounting manipulations, see Ronen ef a/. ([1977],
pp. 17-19).
29
ABACUS
ex post data. By far the great majority of researchers selected the last method. In fact, I
know of no such studies that utilized the other methods.
Generally speaking, those researchers examining expost data have assumed the same
conceptual framework; that is, 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.
The problems inherent in the use of the above conceptual framework are now
examined. Firstly, these examinations require the specification of an expectancy model
for normalized income which is indeed a difficult task. If the expectancy model does not
adequately describe the process generating the income time series, the inferences made
concerning the inclusion of a specific smoothing variable could be a function of random
error. Some researchers used what is generally termed the naive prediction model (El =
El-,), in which the preceding periods income becomes the predicted income for the next
period. Other researchers used a linear time trend model, exponential smoothing model,
Box-Jenkins Model or some other method of generating a normalized ir~corne.~
One
common element of these expectation models is that in all of them, El (earnings at time
t) is a function of time, a constant growth rate, or pre-specified parameters (exponentialsmoothing, Box-Jenkins, etc). Imhoff [1977] was the fmt to suggest that normalized
earnings could be a function of an independent variable rather than the above. The
independent variable selected by Imhoff was sales, with the implicit assumption that
sales revenues are not subject to smoothing, or are subject only to a minimal e ~ t e n t . ~
Secondly,and more importantly, the examination of one smoothing variable at a time
on the normalized income stream could produce biased results. The smoothing effect of
one potential smoothing variable on the normalized income stream could possibly be
mitigated by the aggregate effect of several potential smoothing variables on the
normalized income stream. In other words, it may be possible that managements
selection of some variables tends to smooth income, whereas their selection of other
variables tends to work in the opposite direction, thereby affording no conclusive
evidence for the income smoothing hypothesis.
Finally, some studies examined the effect of a potential smoothing variable on the
normalized income of one period only. Clearly, as indicated by Copeland ([1968],
p. 107) and Imhoff ([1977], p. 86), any inferences concerning income smoothing
behaviour made from a cross-sectional (one-period) study are tenuous at best. To be
sure, when making inferences concerning income smoothing behaviour, one is implicitly
alluding to a pattern of behaviour over time, not just in a single period. Therefore,
empirical tests of income smoothing behaviour should be conducted on time series data.
30
inconclusive results because of the inclusion of natural smoothers in their samples led
him to construct an alternative methodology for the identification of income smoothers.
Imhoff first regressed income and sales on time: Income = a + p (time) and Sales =
a + p (time). He then defined variability as the size of R2 for each regression. For
example, if the R2 of sales as a function of time is greater than the R2 of income as a
function of time (R2(s= f (t) ) ) > (R2(I= f (t) ) ), then the sales time series is defined
as less variable than the income time series. Additionally, Imhoff regressed income on
sales (I = f ( s )) to determine the extent to which income is related to sales.
To determine whether or not a specific firm was exhibiting smoothing behaviour,
Imhoff (p. 92) applied the following criteria:
(i) . . . we define smoothing to be a smooth income stream and a weak association
between sales and income, or
(ii) a smooth income stream and a variable sales stream.
He concludes from the data analyzed that there was not a single case of obvious
smoothing. As before, with the discussion of the Gordon, the difficulties associated with
the conceptual framework will be examined.
The first difficulty that one would encounter when attempting to use the Imhoff
methodology would be to establish how smooth is a smooth income stream, how weak is
a weak association between sales and income, and how variable is a variable sales
stream. In other words, Imhoff did not state the cutoff points of his criteria; the present
study attempts to remedy this deficiency.
A second difficulty of the Imhoff methodology is his reliance on the R2sof regressions
011 time as the measure of variability. For example, consider the following information:6
dollar($)
--
0
time (t)
Imhoff would conclude from the above information that the firm is a non-smoother
because the variability of income is greater than the variability of sales, and the
relationship between income and sales is small (per his definition that the larger the R2
the lower the variability). Let us examine a perhaps more realistic example of the same
difficulty:
Although the reduction of income variability at the expense of displaying slower growth is somewhat
unrealistic, it is nevertheless possible.
31
ABACUS
dollar ($)
(ii)
>
time (1)
In this example, Imhoff would conclude that the firm is a smoother because the income
stream is less variable than the sales stream (per his notion of variability). Alternative
notions of variability could lead to opposite conclusions for both of these examples.
5. PROPOSED CONCEPTUAL FRAMEWORK
to smooth the reported income timeseries and thus distort the representation of
economic reality. Moreover, the proposed conceptual framework of this paper is used to
identify only successful income smoothing behaviour. As with the Gordon and Imhoff
methodologies, the model utilized in this study cannot identify unsuccessful attempts by
managers to smooth artifically the reported income time-series.
It appears to me that a major problem with Imhoffs conceptual structure is that he
assumed that all three types of income smoothness (naturally smooth, real smoothed,
artificiallysmoothed) must be mutually exclusive. The present study explicitly assumes
them not to be mutually exclusive. Imhoff (p. 87) states that a firm with an extremely
high degree of income variability might be classified as an income smoother.Of course,
Imhoff considers this to be incorrect. However, this researcher considers that to be
possible. For example, a company that is in the electric utility industry (naturally
smooth) that does not practice either real or artificial smoothing may nevertheless have
an income stream that is less variable than a company in the automobile industry that
does practice artificial smoothing.
Therefore, it is not the degree of variability in the income time series (in any absolute
sense) that the income smoothing hypothesis is addressing, but rather whether or not
the reported income variability is a function of any overt actions undertaken on the part
of management to explicitly reduce the variability of reported income and distort the
representation of the economic reality of the firm.
First, some premises should be stated:
1. Income is a linear function of sales: Income = Sales - Variable Costs - Fixed
costs.
2. The ratio of variable costs in dollars to sales in dollars remains constant over time.
3. Fixed costs may remain constant or increase from period to period, but may not be
reduced.
4. Gross sales can only be intentionally smoothed by real smoothing; that is, gross
sales cannot be artificially smoothed.
The four research premises represent my a priori assumptions, and as such remain
open to empirical validation. The premises are general in nature and are assumed to be
reasonable representations of real world phenomena. It is not known how large
deviations from the premises would need to be before the veracity of the research results
could be questioned.
Given premises 1 to 4, the following conclusions may be stated:
If
I = s - c,s- c,
and
C2>0
and
and
c2,1+1
3 c2,
and
Cl.t+l= C1,t = c,
CVAS1.c v ~ ?
then
0 < C,
<1
ABACUS
where:
= income in
dollars;*
= sales revenues in
c
2
= fixed costs;
c,
CV,,
= the
dollars;
and
CV,,
Given the previous analyses, one part of the testing procedure is to determine whether
the specified variability measure of sales is greater than the same variability measure of
income. If not, it would appear at first glance that the firm is artificially smoothing. In
addition to the first test, it was considered necessary to add an 'industry filter'. For
example, what if there were the unlikely situation that most of the firms in a particular
industry had income time series that were less variable than their sales time series? It
would indicate an unusual process underlying the relationship between sales and
income, which would negate the assertion of premises 1 to 4.9 Therefore, dual tests were
used.
Tests for Artijcial Smoothing
(ii)
d, = ICVAIit CV,?
To illustrate this procedure, a hypothetical example should prove beneficial. Assume that
industry A consists of four different firms identified as numbers 1, 2, 3 and 4.
Furthermore, assume the following:
Firm 1:
Firm2:
Firm3:
Firm4:
CV,,
CV,,
CV,,
CV,,
=
=
=
=
2.024,
4.876,
5.775,
5.367,
CV,,
CV,,
CV,,
CV,,
=
=
=
=
6.322
2.667
2.389
2.228
If income is a linear function of sales (as postulated), it must be assumed that [income (I) = reported
income] in the absence of income smoothing behaviour.
The empirical evidence of this paper wherein all but two of the fums' CV,, > CV,, suggests that the
research premises may be well specified.
34
The first part of the dual testing procedure indicates that the CVAS> CV,, for any
firm to be identified as an income smoother. Therefore, only firm 1 appears to be a likely
candidate. The second part of the dual testing procedure then is to determine whether or
Given the
not firm 1s ICV,, + CV,, 1 is significantly less than the industry average.]@
above data, the mean ICV,, + CVASI for the industry is 1.74 and the standard deviation
of the ratios is .99; therefore, firm 1 would be identified as an income smoothing firm.
6 . THE EMPIRICAL STUDY
Given the purpose of the present research to offer an alternative conceptual framework
and an alternative schema with which to identify income smoothers, it was deemed
appropriate to test both the Gordon and the Imhoff methodologies with that of this
study.
A study by Barnea et al. [1976] was selected as the base study with which to
undertake this comparative analysis. Barnea et al. used the Gordon methodology on a
sample of 62 firms over the years 1951-1970 to examine whether these firms artificially
smoothed reported operating income by discretionary manipulation of extraordinary
items. The present empirical examination will use the income smoothing tests of Imhoff,
and the conceptual framework proposed here on the same sample of 62 firms and same
twenty year time frame as the Barnea et al. study. The results of these three tests of
income smoothing behaviour will be evaluated relative to each other.
Results and Conclusions
Table 1 presents a summary of the analyses for the sixty-two companies that comprised
the sample.
As previously discussed, Imhoff did not fully describe his methods of identifying
income smoothing behaviour; therefore, I can only deduce that identification. The
asterisks in Table 1 depict those firms that had a smoother income time series than sales
time series. Therefore, using Imhoffs definition, only eight firms or 13 per cent of the
sample firms exhibited income smoothing behaviour.
The methodology proposed in this paper resulted in the identiation of only two firms
or approximately 3 per cent of the sample firms that appeared as ifthey were smoothing
their income during the twenty year period. These two firms, numbers 31 and 34, were
both in the chemical industry. Both firms had (1) CV,, > CV,,, and (2) the
(CV,, + CVASI for each firm was more than one standard deviation smaller than the
industry average, the two elements necessary to identify the firms as income smoothers.
Moreover, it is noteworthy that both of the firms were also identified as income
smoothers by the Imhoff methodology. The Barnea et al. study (from which the sample
firms were taken) indicated that between 50-94 per cent of the companies were
exhibiting income smoothing behaviour, with the percentages varying as a function of
the measurement of income.
I@
Although t:ie measure (using one standard deviation less than the industry average) was ad hoc in nature,
it nonetheless appeared to me to be reasonable, given the purpose of the industry filter.
35
ABACUS
TABLE1
SUMMARY TABLE OF STATISTICAL ANALYSIS
Company
R:S=f(t)
Rz:I=f(t)
.869
,979
.845
,944
,979
,913
,970
.978
,889
,931
.988
,936
,945
,943
,956
.893
,808
,883
.893
,808
,740
,929
.924
,035
,861
,791
,950
,778
.667
,496
,935
.971
,917
.746
,970
,964
.917
,980
,899
,795
,846
.864
,841
,967
,869
,849
,926
.783
.890
,898
,863
,967
,891
,490
.238
,556
,710
,420
,479
,658
.765
.720
,947
,801
,359
,908
,641
,171
,878
,622
,800
,402
,177
,602
,733
.852
,164
,044
,863
,734
,915
.476
,342
,081
,962
,739
-.053
,747
.512
,823
,870
,515
,027
,145
,307
.757
--.030
,969
,366
,732
,546
.061
SO5
.553
,396
,684
,559
,339
R:I=f(s)
CVAS
A,
.709
.973
2.107
1.036
,804
1.287
,914
1.016
1.003
1.140
,830
,937
1.712
1.529
,874
,979
2.497
2.281
45.902
1.428
1.757
.725
1.249
9.508
1.369
1.237
1.054
1.483
3.662
3.324
.709
,882
1.759
12.314
1.422
,855
1.377
1.173
.866
1.238
1.013
.944
3.660
3.505
6.482
5.305
3.088
7.554
4.545
4.924
2.024
3.293
3.087
1.067
9.216
14.874
3.190
4.800
9.193
- 12.177
-350.227
1.618
3.306
4.909
6.133
11.965
2.804
4.078
1.924
-10.438
23.791
6.785
,690
9.163
18.050
5.931
2.727
3.969
3.440
9.794
-8.714
-4.74
21.120
2.579
-170.95
,726
41.354
2.699
5.926
63.238
6.137
7.706
-92.962
15.003
-7.159
17.610
IcvAI+cvASl
~
1
2
3
4
5
6
7
8
9 *
10
11
12
13
14
C
C
C
C
C
C
C
I5
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
P
P
P
P
P
P
P
P
P
P
P
c
c
c
C
* C
* C
C
C
C
C
C
t* C
C
t*
c
c
c
C
c
C
A
A
A
A
A
* A
A
A
A
A
A
A
A
R
R
R
.I34
,593
,902
,517
.395
,693
,768
.700
,893
,849
,429
,989
,645
,213
.886
.674
,929
,540
.ox
,615
,913
.838
,069
,728
,945
,726
,914
.013
.659
,767
,993
,755
-.OW
.832
,566
,800
,808
,374
-.015
.062
,215
.878
-.058
,979
,676
.872
,579
-.022
,490
,611
,210
,671
,530
,246
36
1.075
,514
2.231
2.014
.879
1.737
.905
,862
1.131
1.332
1.151
2.635
5.163
3.602
3.076
5.120
3.841
5.869
4.973
4.846
2.018
2.888
3.720
1.139
5.383
9.728
3.650
4.900
3.681
5.338
7.629
1.133
1.882
6.772
4.910
1.258
2.048
3.297
1.825
7.038
6.497
2.041
,974
10.389
10.261
.482
1.918
4.642
2.498
8.349
10.06
3.829
20.849
2.732
159.025
1.412
18.536
1.340
6.741
6.781
8.940
92.194
11.263
6.22
6.683
TABLE1 -continued
SUMMARY TABLE OF STATISTICAL ANALYSIS
ampany
55
56
57
58
59
60
61
62
* R
R
R
* R
R
Nores:
R
R
R2:S=f(t)
R:I=f(t)
R2:I=f(s)
CVAS
CV,,
.747
.852
,874
,866
,630
.876
,928
.850
.835
,793
,630
,863
1.582
1.374
1.902
1.252
8.356
1.464
,720
14.460
4.480
4.792
-8.259
2.209
22.561
32.064
I .952
-46.585
- ,000
,887
,190
,640
,850
.099
-.051
.953
,400
,620
,914
.27Q
lCVAl+CVA,
2.832
3.487
4.343
1.765
2.700
2 1.902
2.71 1
3.22
ABACUS
reduce the variability of their income time series below the variability of their sales time
series. For the income smoothing hypothesis this may indicate that the jury is still out.
APPENDIX A
ARTIFICIAL SMOOTHING BEHAVIOUR
The following objectives represent the rationale for using the coefficient of variation of the chunge in income
and sales as opposed to the ordinary coefficient of variation.
1. If income is a linear function of sales, then the variability measure of sales should equal the variability
measure of income.
2. Companies in the same industry experiencing the same macro-economic affects should have variability
measures that are equal.
3. Number 2 should be true regardless of the absolute sales dollar size, or the form of the linear relationship.
For Example:
Linear Relationship: I
S - .7S - 70
Firm 1
Sales
200
240
204
183.60
238.68
286.42
TI = 255.42
a,, = 31.52
CVs, =
.I65
Macro-economic
effect
+20%
-15%
-10%
+30%
+20%
Firm 2
Sales
400
480
408
367.20
471.36
572.83
F2 = 450.89
uS2= 74.63
CV,=
.I65
Firm 1
Income
-10
2
-8.80
-14.92
1.60
15.93
I , = 2.365
uIt = 11.19
cvI 1
-4.73
Firm 2
Income
50
74
52.40
40.16
73.21
101.85
= 65.27
u ,=
~ 22.39
CV,,=
,343
AFirm I
A Firm 2
AFirm 1
AFirm 2
Income
Sales
Sales
Income
+24
+40
+I2
+80
-21.60
- 10.80
-72
-36
-12.24
-6.12
-40.8
-20.4
+33.05
+16.52
+110.16
+55.08
+28.64
+14.33
+95.47
+47.74
AT, = 17.28
=
5.19
A& = 10.37
=
34.57
uA12= 25.33
ITAI,= 12.67
uAS,= 42.22 uAS, = 84.45
2.44
CVAS, = 2.44 CVAS, =
2.44 CVAI, = 2.44 C V A I , =
Aq
Linear Relationship: I
A6
S - .2S - 150
Firm 1
Sales
200
240
204
183.6
238.6
286.42
= 225.42
US, = 31.32
CVs, =
.I65
A Firm 1
Sales
A Firm 1
Income
42
13.20
-3.12
40.88
79.14
+40
-36
-20.4
+55.08
47.74
+32
-28.8
-16.32
30.35
29.85
.98
As; = 17.28
UAS, = 42.22
CVASl= 2.44
Firm I
Income
10
7=
uI,
CV, =
1
38
+44.00
+38.26
Aq
13.83
aAI,
33.78
CV,,, = 2.44
=
=
By using CVAX =
Ax
APPENDIX B
Define:
(b)
- 1,;
DC2.t = c2,1+1
-c2,,;
- c,,,
If
(1) 1, = s, - C,,?,
where:
0) c,,t+I2 CZ,, O
(ii) Cl,,+l = C,,, = C, with0 < C, < 1
(iii) C,,,
=a
+ kS,+ e, with
Case I:
(2) C,,,
=a
=0
+ kS,;i.e., e, ~0
since 1-C,-k
:.
>0
CVAS= cv,,
Case 11:
39
ABACUS
since 1-C,-k
:.
>0
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40