RIS ID
12570
Abstract
The financial demise of several high-profile firms in the UK, US and Australia started with the fairly innocuous practice of smoothing reported earnings and profits to fulfill projected earnings targets. The practice is a widely accepted form of corporate earnings management. Corporate financial performance targets for the next period are pre-set and then the actual earnings stream, if significantly different from the target, is manipulated through accrual accounting choice flexibility to conform to the pre-set earnings target. This study examines whether this form of earnings management does actually reduce the volatility of reported income streams over varying time horizons. Previous work has established that the systematic time-averaging of costs and revenues across periods can effectively smooth unadjusted incomes. Indeed, the practice is a required element of accrual accounting. But the potential for significant earnings stream smoothing through more opportunistic methods such as periodic target setting has not been investigated. Our approach uses an interesting alternative view of accounting numbers that treats each period's reported earnings as sample measurement drawn from the underlying, continuous flow of the firm's activities rather than as a direct measurement of economic earnings for that period. This statistical estimation perspective of accounting measurement treats each period's earnings measurement as a sample estimate of the firm's longer run earning potential. The approach now views earnings volatility as a potential measure of the estimation efficiency of reported earnings. Less volatility means greater estimation efficiency. Our results show that reductions in earnings volatility achieved through adjusting the underlying earnings figures to match target figures before reporting may be more apparent than real. The practice often merely shifts accumulating earnings volatilities into later periods. When finally reported, these accumulated adjustments between actual and target earnings can create explosive volatility. Thus, self-interest motivated managers may q.chieve 'apparent' short-term earnings smoothing that deceive shareholders and those interested in the longer term implications of periodic financial reports.
Publication Details
McCrae, M. & Hillier, J. (2005). The smoothing of reported corporate earnings streams through target setting: do managers mislead stakeholders?. Seventeenth Asian-Pacific Conference on International Accounting Issues Program & Proceedings CD-ROM: Victoria University of Wellington & California State University.