Accounting Income Smoothing, Hedging and Corporate Governance

Article excerpt

Introduction

Firms are engaged, since a long time, in accounting manipulation that literature has described in several ways: earnings management, income smoothing, big bath accounting, window dressing and creative accounting (Breton and Stolowy, 2004). Recently, earnings management practices are no longer motivated by a negative or a decreased earnings, but they aims to meet forecasted earnings (Chen et al. 2010). Since, the forecasts on earnings are generally based on the previous firm income, earnings management practices lead to income smoothing. The majority of studies were mainly interested to income smoothing motivations (Chalayer, 1995), its dimensions (Imhoff, 1977) and objects (Kamin and Ronen, 1978). Those studies considered the accounting techniques as being the first income smoothing instrument despite the existence of others. In fact, hedging by derivatives is a real income smoothing instrument (Barton, 2001). It reduces the volatility of cash flow by transferring risk to another participant in the financial market.

Studies that have examined the nature of interaction between accounting income smoothing (AIS) and hedging by derivatives (HD) are few and provide different results. For example, Barton (2001) show that derivatives and accounting manipulations are used as substitutable instruments to manage earnings volatility. Managers can use derivatives to reduce volatility in cash flow due to change of interest rates, exchange rate and commodity prices as they can manage company accounts to reduce earnings volatility. Unlike Barton (2001), Pincus and Rajgopal (2002) find evidence of a partial substitution relationship where derivatives use is associated with earnings management, but find no evidence that earnings management similarly influences the use of derivatives.

Ben rejeb attia (2011) argues that the interaction between AIS and HD reduces the information content of earnings and that the real motivation of using derivatives is to hide opportunistic accounting manipulations. Besides, Huang et al (2009) argue that managers use derivatives when they are intended smoothing income for long-term interests of investors and they use accounting manipulations when they prefer their own opportunistic interests. Those results implied that AIS and HD are not perfect substitutes and their relationship depends on agency relationships and corporate governance mechanisms. Moreover, Ewert and Wagenhofer (2005) assume that real income smoothing increases when the accounting standards make accruals management more difficult. In fact, hedging decisions are controlled by management while accounting choices are controlled by the auditors. Similarly, Trueman and Titman (1988) argue that AIS depends on the nature of firm operations and on its flexibility to transfer certain amounts from one period to another. This flexibility may be highly dependent to information asymmetry and, thus, to corporate governance mechanisms. In fact, earnings management could be considered as an agency cost that is caused by the informational asymmetry between the firm's insiders and its financial suppliers (Rodriguez-Perez and Hemmen, 2010).

This research complements Ben rejeb attia (2011) by focusing on the nature of the interaction between AIS and the HD and the effect of corporate governance quality on that interaction. This study aims to address the following questions: what type of interaction is there between AIS and HD? Is it a substitutable or complementary relationship? Does the corporate governance quality have an effect on this interaction?

The interest of this study is to better understand the income smoothing process and to consider the benefits and costs of using each income smoothing method. This can help companies to determine an optimal strategy of smoothing. In addition, the study of the interaction between income smoothing instruments is informative to regulators and accounting standards that control the accounting methods and restrict earnings management practices. …