Income smoothing: An asymmetric information approach

This thesis adopts an informational perspective to explain why managers with private information engage in income smoothing and to provide new insights into income smoothing. In particular, this study extends the existing income smoothing literature by highlighting informational properties of income smoothing. Using comparative statics, this thesis also investigates the effect of a firm's underlying characteristics on the reporting strategy of the manager and develops testable implications of the model.A two-period agency model is developed in which initially, managerial ability is unknown to both shareholders and the manager but is known solely to the manager at the end of the first period. The implications of this model are manifold. First, in contrast to the traditional view, income smoothing serves a beneficial role by providing managers with a means to reveal their private information. Smoothed income has incremental information content over non-smoothed income given that smoothed income reveals the manager's private information about his ability (expected future cash flows). Income smoothing thus increases the informativeness of earnings; it represents an information transmission mechanism through which information about managerial ability (expected future cash flows) is channeled to the shareholders. Second, while all types of managers engage in income smoothing, the extent to which a manager smooths reported income varies, depending upon his expectation about a firm's future cash flows. This contrasts with the casual empiricism that only bad (low-quality) managers (firms) smooth their firm's income. The incentives for smoothing further depend upon the manager's ability, realized cash flows, the manager's attitude toward risk, intertemporal volatility of firm cash flows, and the risk attached to the firm's assets-in-place. Finally, a compensation contract based on accrual accounting Pareto-dominates a cash-basis contract. The contract based on the accrual accounting system provides for better risk sharing.U of I OnlyETDs are only available to UIUC Users without author permissio