Accounting Research Center, Booth School of Business, University of Chicago

Discussion of An Explanation for Accounting Income Smoothing

Author(s): Paul Newman
Source: Journal of Accounting Research, Vol. 26, Studies on Management's Ability and
Incentives to Affect the Timing and Magnitude of Accounting Accruals (1988), pp. 140-143
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
Stable URL: http://www.jstor.org/stable/2491185
Accessed: 02-01-2016 19:18 UTC

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://www.jstor.org/page/
info/about/policies/terms.jsp

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content
in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship.
For more information about JSTOR, please contact support@jstor.org.

Accounting Research Center, Booth School of Business, University of Chicago and Wiley are collaborating with
JSTOR to digitize, preserve and extend access to Journal of Accounting Research.

http://www.jstor.org

This content downloaded from 131.172.36.29 on Sat, 02 Jan 2016 19:18:05 UTC
All use subject to JSTOR Terms and Conditions
Journal of Accounting Research
Vol. 26 Supplement 1988
Printed in U.S.A.

Discussion of
An Explanation for Accounting Income Smoothing

PAUL NEWMAN*

The conference discussion of "An Explanation for Accounting Income

Smoothing" focused on three topics: (1) the assumed setting, (2) robust-
ness of the conclusions, and (3) empirical implications of the model.

The Setting
Trueman and Titman (henceforth TT) consider a setting in which
there are four types of firms: smoothing low-variance (type sa), non-
smoothing low-variance (na), smoothing high-variance (sb), and
nonsmoothing high-variance (nb). Reported income for two "subperiods"
is observed by prospective debt holders prior to contracting with firms.
Firms are unable to signal their types credibly. Because of bankruptcy
risk, debt holders require a lower rate of return for a low-variance firm
than for a high-variance firm, providing each firm with an incentive to
maximize the creditors' posterior beliefs that the firm is a low-variance
type (type a). By smoothing income, types sa and sb shift the beliefs of
creditors toward type a.
Given that all firms in the model have the same kind of incentive to
smooth income, one question raised by conference participants related
to the underlying determinants of firms' differential abilities to smooth
and why those determinants could not be observed. If debt holders can
sort between smoothing and nonsmoothing types perfectly on observa-
bles, the incentive to smooth is eliminated. Presumably the ability to
smooth is a function of firm-specific characteristics, including accounting
choices (e.g., the choice of LIFO versus FIFO), many of which are
observable.

* University of Texas at Austin.

140
Copyright ?, Institute of Professional Accounting 1989

This content downloaded from 131.172.36.29 on Sat, 02 Jan 2016 19:18:05 UTC
All use subject to JSTOR Terms and Conditions
 EXPLANATION FOR INCOME SMOOTHING 141

Expanding on the assumptions of the model, conference participants

noted that, if debt holders cannot observe all characteristics costlessly,
nonsmoothing firms have an incentive to disclose their nonsmoothing
type. In particular, nonsmoothing firms can commit to specific account-
ing procedures that signal that smoothing is not available. Such disclo-
sures could be provided credibility by employing independent auditors to
attest to the disclosures. Nonsmoothing firms could thus avoid the
penalty imposed on them by smoothing firms. No such disclosures are
allowed in the TT model.
Participants were also concerned with analyzing a phenomenon-
income smoothing-using a model in which no demand for the phenom-
enon arises endogenously. In particular, the model provides no rationale
for the existence of claim holders, such as debt holders, who are concerned
with the volatility of firms' income streams. As concern with volatility
diminishes, the demand for smoothing correspondingly declines. Partic-
ipants suggested various alternative contractual arrangements, such as
long-term debt, that might mitigate the demand for income smoothing
or eliminate it entirely if smoothing is costly. Such long-term contracts
are precluded in the TT model.
Concern was expressed regarding the limited role of firm managers,
whose only task is accounting income smoothing. In such an environ-
ment, one might expect institutional intermediaries to arise, effectively
replacing managers by specifying accounting methods before the first
period begins and monitoring their application thereafter. By contracting
with such intermediaries, shareholders in nonsmoothing firms could
avoid the harmful effects of smoothing behavior by smoothing firms.
These richer contractual alternatives are not considered by TT, although
there are no endogenous reasons for excluding them.
Robustness
Conference participants raised several issues regarding the robustness
of the TT model's conclusions, that is, how rather minor alterations in
the assumptions would change the conclusions. For example, in the
model, the amount the smoothing firms can transfer from one subperiod
to another is a fixed proportion of the first-subperiod income's deviation
from the mean (see TT, equation (2)). In practice, of course, the amount
transferred is discretionary. To see the implications of discretionary
smoothing amounts, suppose smoothing firms can select any first-sub-
period income amount to report. Because smoothing is desirable and is
enhanced as xis approaches Ai (see TT, proposition 5), discretionary
smoothing suggests that firms will report first-subperiod income very
near A. Of course, it will take few periods for debt holders to sort firm
types given such behavior, thereafter eliminating the desirability of
smoothing. In such a setting, the optimal strategy for smoothing firms
may involve randomization over amounts smoothed to avoid rapid detec-
tion as a smoother.

This content downloaded from 131.172.36.29 on Sat, 02 Jan 2016 19:18:05 UTC
All use subject to JSTOR Terms and Conditions
142 MANAGEMENT S ABILITY TO AFFECT ACCRUALS: 1988

Concern was expressed over whether the single-period results would

generalize to a multiperiod setting. In particular, observed income in
each subperiod is drawn from a distinct distribution for each type. For
example, in subperiod one, the observed income of type na is normally
distributed with mean Azand variance -a2, whereas the observed income
of type sa is normally distributed with mean A and variance (1 _g)2-6a 2.
Given the observed subperiod-one income, the distribution of subperiod-
two income for smoothers undergoes a mean shift [E(x2s I xls) = (1 -g)u
+ gxj. As debt holders observe many realizations of income for the two
subperiods, discrimination among types improves. When the debt holders
have "sufficiently" identified types, costly smoothing will cease. In the
absence of structural changes in the income-generating processes, virtual
identification of types and no smoothing becomes the absorbing state-
it never becomes optimal to smooth in subsequent periods. Thus, in the
long run, no smoothing will occur if smoothing is costly. The time to
reach the no-smoothing absorbing state will depend on the feasible
amount of smoothing, the variances of type a and type b firms, and the
cost of smoothing.
A multiperiod model creates additional problems if debt is issued at
the end of each period. In the second period, the existence of debt holders
already in place creates an incentive for managers to take variance-
increasing actions. Such actions will transfer wealth from existing debt
holders to shareholders. The effects of incentives to smooth created by
existing debt holders versus prospective debt holders are countervailing.
One conference participant noted that the assumed income-generating
process was critical to the results. If the process is mean-reverting (as
assumed by TT), smoothing reduces variability on average and is desir-
able from the firm's perspective. On the other hand, if the process is a
random walk, smoothing increases the variability of the observations and
is undesirable given the assumptions of the paper. Of course, determining
the nature of the underlying process that generates income is difficult if
some observations are smoothed while others are not.

EmpiricalIssues
Conference participants questioned whether there were any empirically
testable implications of the model. TT suggest several. For example, TT
state: "Given differential costs and benefits to smoothing, predictions
are made as to the types of firms that are more likely to smooth income.
These predictions can potentially be empirically tested." The problem
with such claimed implications is that researchers are no more able to
distinguish smoothing firms than are debt holders. That is, smoothing is
inherently unobservable if it exists, and no tests of the effects of firm
characteristics on smoothing behavior, such as those suggested by prop-
ositions 4 and 5, are possible. If smoothing is observable, this model
predicts that no smoothing occurs. Thus, no direct empirical tests are

This content downloaded from 131.172.36.29 on Sat, 02 Jan 2016 19:18:05 UTC
All use subject to JSTOR Terms and Conditions
 EXPLANATION FOR INCOME SMOOTHING 143
possible using reported income observations and the framework of this
model.
On the other hand, it should be possible to test the model through
controlled laboratory experiments in which the underlying income-gen-
erating process and firm types are known to the experimenter but not to
the subjects, and parameters of the model are manipulated.

Summary
As the above remarks indicate, conference participants were concerned
with the exogenous and ad hoc nature of restrictions placed on the
strategies of the managers, shareholders, and debt holders. Enriching the
strategy space, by including alternatives such as precommitment, long-
term arrangements, contractually determined accounting methods, and
auditing, appears to mitigate or eliminate the demand for smoothing.
Allowing the manager the flexibility to select the amount of reported
income creates a problem in determining equilibrium strategies. Trueman
and Titman have provided a rather delicate explanation for accounting
income smoothing.

This content downloaded from 131.172.36.29 on Sat, 02 Jan 2016 19:18:05 UTC
All use subject to JSTOR Terms and Conditions