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

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  • Srinidhi, Bin
  • Ronen, Joshua
  • Maindiratta, Ajay

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. We argue that other market imperfections could also cause income smoothing if the manager is privately better informed about future prospects. As such, this paper supports the view that income smoothing is not always opportunistic but can be induced by the owner to satisfy his need to be informed about the future performance of the firm. Copyright 2001 by Kluwer Academic Publishers

Suggested Citation

  • Srinidhi, Bin & Ronen, Joshua & Maindiratta, Ajay, 2001. "Market Imperfections as the Cause of Accounting Income Smoothing--The Case of Differential Capital Access," Review of Quantitative Finance and Accounting, Springer, vol. 17(3), pages 283-300, November.
    • Handle: RePEc:kap:rqfnac:v:17:y:2001:i:3:p:283-300
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    Cited by:

    1. Takashi Obinata & Kazuyuki Suda, 2006. "Value Relevance of the Multi-step Income Statement in Japan," CARF F-Series CARF-F-061, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
    2. Abdullah Mamun & Md Didarul Alam & George Tannous, 2019. "Did the regulatory changes of 1999 and 2001 affect income smoothing behavior of US banks?," Review of Quantitative Finance and Accounting, Springer, vol. 52(4), pages 1011-1041, May.
    3. Takashi Obinata & Kazuyuki Suda, 2006. "Value Relevance of the Multi-step Income Statement in Japan," CIRJE F-Series CIRJE-F-403, CIRJE, Faculty of Economics, University of Tokyo.
    4. Ahmad N. Obaidat, 2017. "Income Smoothing Behavior at the Times of Political Crises," International Journal of Academic Research in Accounting, Finance and Management Sciences, Human Resource Management Academic Research Society, International Journal of Academic Research in Accounting, Finance and Management Sciences, vol. 7(2), pages 1-13, April.
    5. Christian Gaber, 2005. "Bewertung von Fertigerzeugnissen zu Volloder Teilkosten? Ansatz von Forderungen zum Nennwert oder Barwert?," Schmalenbach Journal of Business Research, Springer, vol. 57(4), pages 325-352, June.

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