Market Imperfections as the Cause of Accounting Income Smoothing—The Case of Differential Capital Access

Market Imperfections as the Cause of Accounting Income Smoothing—The Case of Differential... We show income smoothing results as a rational equilibrium behavior in a setting where the manager has superior foresight about the firm's prospects but faces inferior capital access relative to the owner. Under a legal structure that makes forecast-based compensation impractical and an accounting framework that requires reported income to be consistent, unbiased and cash-flow convergent, we show that the manager reports a composite of the underlying income and his foresight information. Moreover, the reported income will exhibit a lower inter-temporal variance than the underlying income. The extent of smoothing is shown to increase with the accuracy of foresight information. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Market Imperfections as the Cause of Accounting Income Smoothing—The Case of Differential Capital Access

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Publisher
Kluwer Academic Publishers
Copyright
Copyright © 2001 by Kluwer Academic Publishers
Subject
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1023/A:1012244710378
Publisher site
See Article on Publisher Site

Abstract

We show income smoothing results as a rational equilibrium behavior in a setting where the manager has superior foresight about the firm's prospects but faces inferior capital access relative to the owner. Under a legal structure that makes forecast-based compensation impractical and an accounting framework that requires reported income to be consistent, unbiased and cash-flow convergent, we show that the manager reports a composite of the underlying income and his foresight information. Moreover, the reported income will exhibit a lower inter-temporal variance than the underlying income. The extent of smoothing is shown to increase with the accuracy of foresight information.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Oct 3, 2004

References

  • Performance Measure Manipulation
    Demski, J. S.

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