The Use of Accruals in Earnings Management: A Permanent Earnings Hypothesis

Abstract

We suggest and present evidence that managers use discretionary accruals to smooth income around the managers' assessment of the firms' permanent earnings. We suggest that income smoothing is a long-term strategy which accomplishes multiple purposes. We form predictions regarding the direction of discretionary accruals in a given year by comparing income before discretionary accruals to the previous year's reported earnings. We further hypothesize and present evidence that earnings response coefficients which measure the extent to which reported earnings reflect the information used by the market in forming prices are higher for firms that engage consistently in income smoothing.

JEL Classification: M40