Review of Quantitative Finance and Accounting

, Volume 17, Issue 3, pp 283–300

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

  • Bin Srinidhi
  • Joshua Ronen
  • Ajay Maindiratta
Article

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.

income smoothing earnings management efficient contract market imperfections 

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Copyright information

© Kluwer Academic Publishers 2001

Authors and Affiliations

  • Bin Srinidhi
    • 1
    • 2
  • Joshua Ronen
    • 3
  • Ajay Maindiratta
    • 3
  1. 1.City University of Hong KongHongkong
  2. 2.Rutgers UniversityUSA
  3. 3.New York UniversityUSA

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