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Income Smoothing

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Introduction

The income smoothing literature has been the centre of attention in the accounting world for the past few decades. When companies experience economic turbulence due to a poor performance year, they turn to the accounting management department to resolve the bottom line. A strategy that managers can approach is changing the true information content of the company. As a result this has led managers to resort to smoothing their income. Many questions have been raised whether or not it is common for companies to smooth their reported income, which many have argued whether if income smoothing is appropriate or ethical.

Income smoothing is defined as a technique to remove volatility in earnings by leveling off the peaks and …show more content…

The goal of smoothing confuses an operational goal of the firm with an accounting goal. If the results of operations are not, in fact, smooth, accounting should not make them appear as if they were.” (Hendriksen, E.S. 1964, p.274)

It was Myron Gordon’s articles that made a significant contribution to the income smoothing topic, in which he provided the rationale for early smoothing studies that launched the era of hypothesis testing in modern academic literature. Gordon wrote two articles in 1960 and 1964 but he was mostly renowned for his article in 1964. Gordon’s [1964] article was more dynamic and straightforward than his previous article as he provided a more ‘explicit’ treatment of the combination of his ideas based on income smoothing. Initially Gordon argues the proposal of income smoothing as a criterion for accounting choice by regulators. But the main significance in Gordon’s article was how income smoothing could impact on stockholder satisfaction. (Gordon, M.1964)

It is apparent that Hepworth’s [1953] and Gordon’s [1964] have made the most significant impact on income smoothing literature. During the last few decades there has been an influx of accounting researchers developing their theories. In addition accounting researchers have also empirically tested some of their theories and hypothesis that they have developed, which will be further discussed later.

Motivations for Income Smoothing

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