Is reporting company earnings so as to smooth them out over time really a blameworthy practice?

Corporate executives apparently don’t think so, as a large survey of them a few years back found an overwhelming preference for smoothing, for a variety of seemingly good reasons. Yet most other observers consider the practice to be deceptive.

However, a new study finds that to a large extent, the answer actually depends on the relative volume of stock and stock options held by the CEO.

Prior research has offered two competing explanations for corporate income smoothing, notes the study, “Managerial Equity Holdings and Income-Smoothing Behavior,” published in the spring issue of the American Accounting Association’s Journal of Management Accounting Research.

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One is that managers use it to dampen the volatility of stock performance caused by their own opportunistic, risk-taking behavior.

The other, less nefarious explanation: a desire to help investors better predict future performance by reducing reported earnings volatility caused by transitory items.

The research found that granting stock to a CFO supports the second motivation, while option grants support the first.

Stock grants, the professors write, align managers’ actions with shareholders’ interests by linking their respective wealth. The relationship between past income smoothing and investors’ ability to predict future earnings increases with greater CEO stock holdings, they found.

In contrast, option grants “offer a convex payoff structure where the value of the option to a manager relates positively to the volatility of the [stock price]. Managers, therefore, benefit proportionately more from engaging in risky actions,” says the paper, by Sydney Qing Shu of San Diego State University and Wayne B. Thomas of the University of Oklahoma.

Consistent with managers attempting to hide the excessive risk-taking activities that can lead to high volatility, the professors found, the relationship between income smoothing and future earnings predictability decreases with greater option holdings.

What motivates the desire for earnings to appear smooth rather than volatile? Advantages of a smooth earnings stream cited by executives in prior research include lower costs of equity, higher credit rating, greater assurance among customers and suppliers regarding terms of trade, and anticipation of higher growth prospects among investors.

However, the study results seem likely to add to the concern raised by prior research that option-based compensation induces managerial behavior that’s detrimental to shareholders. Indeed, in recent years the typical executive compensation mix has trended toward more restricted stock and fewer stock options.

The study, which analyzed 17 years’ worth of information on about 1,700 companies drawn from corporate finance and executive compensation databases, measured income smoothing by changes in companies’ net income compared with changes in discretionary accruals.

Discretionary accruals are non-cash accounting items that typically involve some element of uncertainty — for example, future receipts from receivables or estimates of inventory valuations — and thereby lend themselves to manipulation.

The professors found that for the sample as a whole, a pattern of income smoothing in the five years prior to a given year increased the predictability of earnings in the three years subsequent to that focal year.

But when taking into account CEO compensation in focal years, pay packages leaning toward stock grants and those leaning toward option grants yielded opposite results.

Stock holdings move managers to “use discretionary accruals to dampen the fluctuations in reported earnings caused by transitory items to better reveal to investors the firm’s [expected future] performance,” the authors write.

In contrast, as options increase managers use discretionary accruals to mask the volatility of risky operations, the paper says.

Furthermore, that effect increases where CEOs also serve as board chair, where they are relatively new to the job and under pressure to prove themselves, or when their options are out of the money (i.e., they would vest for less than the current price of company shares).

According to Shu, the study results may be of value to investors unsure of what to make of a company’s pattern of smoothly rising earnings over the years. “Check the CEO’s relative holdings of options and stock,” she advises investors. “If the options dominate, proceed with caution.”

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