A new measure of managers' intentional income smoothing

The purpose of our study is to further understand managerial incentives that affect the volatility of reported fiscal-year earnings. We do this by examining income smoothing based on pseudo fiscal years. For each firm, we create pseudo-year earnings using four consecutive quarters other than the reported fiscal year. We then compare earnings volatility of pseudo years to the earnings volatility of the firm's own reported fiscal year. To the extent managers use accruals to reduce annual earnings volatility, we expect the volatility of reported fiscal-year earnings to decrease relative to the volatility of pseudo-year earnings. We find that this measure of income smoothing behaves as expected in a variety of cross-sectional tests. Moreover, we find that cash flow and accrual patterns for firms with high values of our smoothing measure are more consistent with intentional income smoothing than with the integral approach to accounting. Our evidence is consistent with income smoothing being primarily driven by accruals rather than cash flows. Overall, we contribute to the literature exploring alternative explanations for the differential volatility of fiscal-year and fourth-quarter earnings