Income-Smoothing Behavior Under Selected Stochastic Processes

This paper attempts to provide a framework for clarifying and testing a version of the income-smoothing hypothesis. This hypothesis has been variously expressed in terms of income levels, rates of change in income, and rates of return, inter alia. In general, each version of the hypothesis is concerned with the extent to which managers may attempt to affect the volatility of a series of reported accounting numbers (or, in the case of rates of return, a series of relationships among accounting numbers) via selections and applications of accounting procedures. The alleged moti- vation for this behavior is a desire to reduce the extent to which bad times and-at the other extreme- good times are revealed by re- ported accounting numbers. It is suggested by some that a smoothed series of accounting numbers, particularly income numbers, will enhance the value of a firm. A typical statement of this argument was provided by Hepworth: Certainly the owners and creditors of an enterprise will feel more confident toward a corporate management which is able to report stable earnings than if considerable fluctuation of reported earnings exists

Evidence on the Tax Effects of Inflation Under Historical Cost Accounting Methods

It is often argued that the failure to use indexation (i.e., the use of historical cost accounting methods) implies that real income tax rates will vary directly with rates of inflation. This substantive effect of mere bookkeeping methods is often predicted even though it is recognized to have some adverse implications. This is the tax effects of inflation hypothesis. The major objective of this paper is to examine the descriptive adequacy of this hypothesis using a variety of macro- economic data for the years 1929-74. My empirical results appear to be substantially inconsistent with the tax- effects hypothesis