Effect of Accounting Discretion on Ability of Managers to Smooth Earnings

29 Pages Posted: 5 Nov 2005 Last revised: 11 Jun 2013

See all articles by Hwee Cheng Tan

Hwee Cheng Tan

University of New South Wales

Karim Jamal

University of Alberta - Department of Accounting, Operations & Information Systems

Multiple version iconThere are 2 versions of this paper

Date Written: October 26, 2005

Abstract

Managers use smooth earnings patterns to communicate their firm's superior earnings prospects to investors. These managers require a knowledge of future earnings (or foresight) in order to determine the level of smoothing in each financial period. However, with discretion in GAAP, low foresight managers can also smooth earnings. To prevent managers from misrepresenting their firm's prospects, regulators have advocated a reduction in accounting discretion. This paper reports an experiment that examines (1) whether managers are able to use operational variables to smooth earnings when accounting discretion is reduced, and (2) whether reducing accounting discretion creates less difficulty for high foresight managers to smooth earnings than for low foresight managers. The study shows that when accounting discretion is reduced, high foresight managers are more capable of smoothing earnings than low foresight managers. Reduced accounting discretion motivates high foresight managers to manage investments in order to reduce their firm's earnings variability. These results provide support for a policy of reducing accounting discretion in order to prevent misrepresentation by managers. However, a disadvantage of this policy is that high foresight managers who use smooth earnings to communicate with shareholders may resort to operational smoothing, which could be detrimental to a firm's long-term growth.

Keywords: Accounting discretion, managerial foresight, income smoothing, operating decisions, earnings management

JEL Classification: K20 M41, M43, M44, C92

Suggested Citation

Tan, Hwee Cheng and Jamal, Karim, Effect of Accounting Discretion on Ability of Managers to Smooth Earnings (October 26, 2005). Journal of Accounting and Public Policy, Vol. 25, No. 5, 2006; University of Alberta School of Business Research Paper No. 2013-689. Available at SSRN: https://ssrn.com/abstract=837204 or http://dx.doi.org/10.2139/ssrn.837204

Hwee Cheng Tan (Contact Author)

University of New South Wales ( email )

Kensington
High St
Sydney, NSW 2052
Australia

Karim Jamal

University of Alberta - Department of Accounting, Operations & Information Systems ( email )

Edmonton, Alberta T6G 2R6
Canada
780-492-5829 (Phone)
780-492-3325 (Fax)

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