Competition level, product type and differential income smoothing among manufacturing firms

This study investigates managers\u27 differential income smoothing behavior among manufacturing companies because of job security concerns. The previous literature finds that managers engage in income smoothing because of job security concerns. However, the previous literature does not address the relationship between the level of job security concerns and the extent of income smoothing behavior. This study is the first attempt to address this issue. Given the constraints of generally accepted accounting principles (GAAP), how and why managers exercise accounting discretion are important questions since the answers to these questions help shed light on the interpretation of accounting numbers and whether current GAAP is effective in ensuring that companies provide information useful to present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash flows. This study contributes to the understanding of how and why managers exercise accounting discretion through investigating a special case of earnings management where managers engage in income smoothing because of job security concerns. This study confirms the theoretical predictions of Fudenberg and Tirole (1995) and the findings in DeFond and Park (1997) that managers use discretionary accruals to smooth income because of job security concerns. Income smoothing is expected to occur when firms\u27 pre-managed earnings are above (below) the industry median and future earnings are below (above) the industry median. More importantly, this study finds that managers in more competitive industries and durable goods industries engage more in income smoothing because of job security concerns. Alternative measures of competition level and product type are significantly positively (negatively) related to discretionary accruals when firms\u27 current pre-managed earnings are above (below) the industry median and future earnings are below (above) the industry median. That is, firms in more competitive industries and durable goods industries save more for (borrow more from) the future when firms\u27 current pre-managed earnings are above (below) the industry median and future earnings are below (above) the industry median to alleviate job security concerns. The empirical findings in this study have implications for accounting standard setting since smoothing reduces the information content of earnings announcements; managers prefer accounting methods that provide latitude in income determination rather than methods that tightly specify financial statement numbers under given conditions. The market reaction to earnings announcement is expected to differ systematically across firms based on the market\u27s perception of the likelihood that income is being smoothed differently in different industries. The empirical findings in this study also have implications for interpreting financial information. Since income smoothing varies with the level of competition and product type, and firms in more competitive industries and durable goods industries smooth earnings to a larger extent, earnings reported from different industries should be viewed differently. That is, although earnings reflect a bottom-line firm performance, the meaning and content of this bottom-line performance varies among different industries. Competition level and product type influence earnings quality. Earnings from more competitive industries and durable goods industries can be considered of lower quality (more divergence from true earnings) since they are smoothed to a larger extent