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The Time Series Behavior of Earnings

209 citations0/0 files storedJournal of Accounting Research

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Auditing, Earnings Management, Governance Financial Markets and Investment Strategies Accounting Theory and Financial Reporting

Abstract

The time series behavior of earnings is an important area for empirical research because of its implications for related research in several areas of and finance. Although many other examples could be provided, three accounting issues immediately come to mind: (1) income smoothing, (2) the relative forecast ability of alternative income measurements, and (3) interim reporting. The hypothesis that management uses discretionary practices to smooth income was first posited by Gordon [21] and later tested by Gordon, Horwitz, and Meyers [22] and by Copeland [14] among others. As stated by Gordon, smoothing involves minimizing the deviations of reported income from some standard, where the standard is defined in terms of normal income. Normal income has never been precisely defined at the conceptual level, but in many cases it appears to have been used in the sense of the expected value of the process at a given point in time. A variety of models could be used, and in fact have been used, to assess the normal or expected value of income for a given period. Each model makes specific assumptions about the process generating income numbers. Any inferences drawn from empirical evidence regarding the existence of income smoothing (or the lack of it) are dependent upon the validity of the assumptions made about the underlying earnings process. Moreover, as shown later in the paper, for certain processes attempts to smooth income can have exactly the opposite effect. Yet the models used in the smoothing literature represent only a narrow range of the possible alternatives, little justification (either a priori or empirical) has been offered in their behalf, nor has there been any direct, rigorous investigation of the underlying nature of the earnings process itself.

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References

1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1968FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY 1965The Behavior of Stock-Market Prices 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1968An Empirical Evaluation of Accounting Income Numbers 1966Financial Ratios As Predictors of Failure 1963A Simplified Model for Portfolio Analysis 1959Theory of Value

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