Effect of accounting discretion on ability of managers to smooth earnings

Managers use smooth earnings patterns to communicate their firm’s superior earnings prospects to investors. These managers require a knowledge of future earnings (or foresight) in order to determine the level of smoothing in each financial period. However, with discretion in GAAP, low foresight managers can also smooth earnings. To prevent managers from misrepresenting their firm’s prospects, regulators have advocated a reduction in accounting discretion. This paper reports an experiment that examines (1) whether managers are able to use operational variables to smooth earnings when accounting discretion is reduced and (2) whether reducing accounting discretion creates less difficulty for high foresight managers to smooth earnings than for low foresight managers.The study shows that when accounting discretion is reduced, high foresight managers are more capable of smoothing earnings than low foresight managers. Reduced accounting discretion motivates high foresight managers to manage investments in order to reduce their firm’s earnings variability. These results provide support for a policy of reducing accounting discretion in order to prevent misrepresentation by managers. However, a disadvantage of this policy is that high foresight managers who use smooth earnings to communicate with shareholders may resort to operational smoothing, which could be detrimental to a firm’s long-term growth.