Income smoothing has existed for decades, and there are generally two schools of thought as to what motivates managers to smooth. First, smoothing presents an arguably efficient vehicle for managers to reveal private information. Second, smoothing represents "garbling"; that is, smoothing is an exercise undertaken by managers in an attempt to fool analysts and others and to enhance managerial compensation.
The first school of thought is reflected in the works of Ronen and Sadan (1981), Demski (1998), Sankar and Subramanyam (2001), Srinidhi, Ronen and Maindiratt (2001), Kirschenheiter and Melumad (2002), and Goel (2003), among others. For example, Ronen and Sadan (1981) employ a signaling model and contend that only firms with good prospects elect to smooth. Essentially, the first school holds that income smoothing may aid in the revelation of private information in much the same way that dividend smoothing can occasion information revelation (cf.Miller and Rock (1985)).
The second school of thought is reflected in the works of Beidleman (1973), Lambert (1984), Healy (1985), Fudenberg and Tirole (1995), Arya, Glover and Sunders (1998), and Demski and Frimor (1999), among others. In addition, garbling has been evidenced by some recent and high profile cases of smoothing abuse. For example, the Federal Home Loan Mortgage Corporation ("Freddie Mac" or "Steady Freddie") was found by the government to have illicitly altered the volatility mark on its put swaptions in order to achieve a smoother earnings growth profile. Top managers either quit or were fired after the discovery of the abuse.
The Federal National Mortgage Association ("Fannie Mae") also engaged in accounting abuses to smooth earnings and increase managerial compensation. This firm, which finances approximately twenty percent of all home loans in the U.S., had to recently restate its 2001-2004 earnings (lowering them by approximately $6.3 billion) as well as pay a record $400 million civil fine to the Office of Federal Housing Enterprise Oversight and the SEC.
