Comparing The Informativeness of Two Income Smoothing PDF

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,/

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Comparing The Informativeness Of Two Income Smoothing
Measures

Faello, Joseph
Lakehead University

ABSTRACT

This study compares the informativeness of two income smoothing measures used extensively in
accounting research (i) Albrecht and Richardson (AR); and (ii) Tucker and Zarowin (TZ).
Researchers that have used either of these two income smoothing measures in their studies
include Bao and Bao (2004), Carlson and Bathala (1997), Grant et al. (2009), Sun (2009), and
Mascarenhas et al. (2010). Informativeness is defined as the association between earnings and
one period ahead operating cash flows. Researchers in prior studies define informativeness in a
similar manner (e.g., Kim and Kross 2005). Results indicate the TZ measure strengthens the
earnings association with one period ahead operating cash flows to a greater extent than the AR
measure, and thus, is more informative. Accounting researchers would find these results useful
because they can more effectively match the objectives of their income smoothing studies (i.e.,
either deceptive or informative income smoothing purpose)with the appropriate income
smoothing measure (i.e., either AR or TZ measure).

Keywords: Income smoothing, Informativeness, Earnings management, Quality of financial
reporting

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INTRODUCTION

Academics have studied income smoothing from both informative and deceptive perspectives.
On the informative side, firms managers smooth income to inform financial statement users
about the firms financial prospects. On the deceptive side, income smoothing is a form of
earnings management, utilized by managers to further their own interests at the shareholders
expense.

Firms income smoothing behavior cannot be observed directly, but must be implied by a
descriptor variable. Two descriptor variables used extensively in the literature are the Albrecht
and Richardson (1990) and Tucker and Zarowin (2006) income smoothing measures. The
Albrecht and Richardson (AR) approach uses the ratio of coefficients of variation between
changes in earnings and changes in sales respectively. If the ratio is less than one, then managers
are smoothing income because the variability of income is less than the variability of sales. Prior
studies that have used this approach include Albrecht and Richardson (1990), Bao and Bao
(2004), Carlson and Bathala (1997), Michelson et al. (1995 and 2000), and Faello (2012). The
Tucker and Zarowin (TZ) approach is an accrual-based measure and measures income smoothing
by the negative correlation of a firms change in discretionary accruals with its change in pre-
managed earnings. A greater degree of income smoothing is indicated by a more negative
correlation. Income smoothing studies utilizing the TZ approach include Tucker and Zarowin
(2006), Mascarenhas et al. (2010), Grant et al. (2009), Sun (2009) and Faello (2012).

Using data and results from Faello (2012), the purpose of this study is to compare the
informativeness of the two approaches and to determine which approach has a greater
association with the informative role of income smoothing in financial reporting. Accounting
academics would find this study beneficial because they can more effectively match the
objectives of their income smoothing studies (i.e., either informative or deceptive income
smoothing purpose) with the appropriate income smoothing measure (i.e., either AR or TZ
measure).

Defining the Income Smoothing Measures

Albrecht and Richardson (AR) Income Smoothing Measure

The AR method uses the relationship between earnings and sales revenue variability to develop
their income smoothing criterion (i.e., coefficient of variation ratio). Their income smoothing
criterion is calculated as follows:
(1.0)
Where: !I = one period change in income;

!S = one period change in sales;

CV = coefficient of variation

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CV = ______"Variance_______
Estimated Expected Value

If the ratio of coefficients of variation is less than one, then managers are considered income
smoothers because the variability of income is less than the variability of sales. This method
represents a dichotomous classification of firms into two categories that is, firms are classified
as either income smoothers or income non-smoothers.

The AR method uses four measurements of income:
Operating income: sales minus cost of sales and operating expenses (excluding
depreciation and amortization);
Income from operations: operating income minus depreciation and amortization;
Income before extraordinary items; and
Net income.
In applying their methodology, AR decided that if the ratio is less than one for any one of the
four income measures, then the firm is considered an income smoother. AR (1990), Bao and
Bao (2004), Carlson and Bathala (1997), and Michelson et al. (1995 and 2000) apply the ratio in
this manner. However, degrees of income smoothing exist as some firms may smooth income to
a greater extent than other firms. Faello (2012) uses this income smoothing measure from the
perspective that income smoothing is a continuum; that is, degrees of income smoothing exist
and firms that score lower on the measure (i.e., lower variability) exhibit a higher degree of
income smoothing. By ranking firms along degrees of income smoothing for the four
measurements of income separately, additional information can be deduced about income
smoothing behavior (e.g., smoothing earnings before or after deducting depreciation and
amortization; before or after deducting an extraordinary loss). Rankings should not result in a
significant loss in explanatory power instead of using the raw statistics (Aczel 2002, p. 676).
This study follows the Faello (2012) approach in determining the AR income smoothing statistic.

The AR statistic accounts for accrual and cash-based transactions because it is an income-based
measure. That is, both accrual and cash-based transactions are included in ARs four income
measures (i.e., operating income; income from operations; income before extraordinary items;
and net income). Although accrual accounting is typically associated with income smoothing,
emerging evidence highlights the use of cash-based transactions to smooth income in a deceptive
manner. Murphy (2000) finds an association between accounting-based measures used in
performance contracts and income smoothing. Murphy (2000, p. 262) states:
Most studies of income smoothing in the accounting literature have
focused on discretionary accruals, reflecting accounting choices
managers can make to shift reported earnings from one period to
another. The implicit rationale for this approach is that managers
have more control over accounting phenomena than they have over
the timing of the organizations actual cash flows. Although
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resolving what may ultimately be an empirical issue is beyond the
scope of this paper, I conjecture that focusing on accruals while
ignoring direct manipulation of cash flows underestimates the
resourcefulness of clever managers.

Roychowdhury (2006) provides evidence of earnings management through manipulation of real
cash transactions. He finds firms use temporary price discounts to increase sales, overproduce to
reduce cost of sales, and reduce discretionary expenses to increase profit margins. Graham et al.
(2005) survey firms executives and find managers have multiple objectives and use accrual and
cash-based transactions for deceptive income smoothing purposes.

The case of Bristol-Myers Squibb Company (BMS) highlights the use of accruals and cash-based
transactions to manage and smooth earnings. From the first quarter of its fiscal year 2000 to the
fourth quarter of its fiscal year 2001 (U.S. SEC v. BMS 2004), the Securities and Exchange
Commissions (SEC) investigation found, The Controller told his assistant controllers that he
wanted no surprises, smooth earnings, and no unusual gains or losses that BMS would have to
explain to investors (U.S. SEC v. BMS 2004, para. 60). On the accrual-based side, BMS
created reserves on divestiture transactions to reduce the current periods earnings.
Subsequently, the reserves could be reversed if needed to increase the next accounting periods
operating income. On the cash-based side, BMS paid wholesalers cash incentives to take excess
inventory. The incentives paid were significant and cost BMS millions of dollars each quarter
(U.S. SEC v. BMS 2004, para. 32). Clearly, the use of cash-based transactions, the sole purpose
of which is to smooth income, cannot increase shareholders wealth. This type of expenditure is
unlike an investment in a factory that provides the firm with a stream of positive cash inflows
and positive net present value. Thus, the AR statistic with its ability to include cash-based
transactions in its measure possesses an additional feature to capture deceptive income
smoothing that is not present under the TZ approach.

The AR approach has been used extensively by researchers in support of informative (e.g.,
Michelson et al. 1995) and deceptive (e.g., Carlson and Bathala 1997) income smoothing.
Carlson and Bathala (1997) examine the effect of ownership differences on income smoothing.
They find lower proportions of inside ownership, higher proportions of institutional ownership,
higher proportion of debt financing, the existence of executive compensation plans tied to stock
performance, and wider dispersion of stock ownership, are all related to a higher probability of
income smoothing. The authors results support the deceptive role of income smoothing and
conclude: The findings presented in this paper imply that factors such as agency costs,
informational asymmetry, and incentive motives impact income smoothing behavior in firms
(Carlson and Bathala 1997, p. 194).

Bao and Bao (2004) examine the effect of income smoothing and earnings quality on value
relevance. Value relevance in accounting research is represented by the association of an
accounting amount (e.g. earnings) with equity market values (Barth et al. 2001a). The greater
the degree of association, then the more value relevant the accounting amount is. The authors
categorize firms along earnings quality (using Sloan [1996]) and income smoothing (using the
AR approach) lines, resulting in the following categories: quality earnings smoothers, quality
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earnings non-smoothers, non-quality earnings smoothers, and non-quality earnings non-
smoothers. When controlling for earnings quality, Bao and Bao find quality earnings income
smoothers have a significantly higher price-earnings multiple than non-quality non-smoothers.
Thus, income smoothing provides additional information for higher earnings quality firms by
strengthening the price-earnings ratio.

Michelson et al. (1995) examine the relationship between income smoothing and stock returns.
They use the AR approach to identify income smoothing firms and examine the differences
between income smoothing and non-income smoothing firms mean stock returns, beta, and
market value of equity. The authors find income smoothing firms have lower annualized stock
returns, lower betas, and higher market values of equity. The combination of lower betas (risk)
and lower returns is appropriate in the context of market efficiency and supports the informative
role of income smoothing.

Michelson et al. (2000) test the firms in the S & P 500 for the association between cumulative
average abnormal returns and degrees of income smoothing using the AR income smoothing
approach. The authors find income smoothers have higher cumulative average abnormal returns
than non-smoothers. Also, firms in the transportation, communications, and mining segments
smooth income to a greater degree than firms in other industry segments.

Tucker and Zarowin (TZ) Income Smoothing Measure

The TZ method measures income smoothing by the negative correlation of a companys change
in discretionary accruals with its change in pre-managed earnings. A greater degree of income
smoothing is indicated by a more negative correlation. The authors assume that there is an
underlying pre-managed income series and that managers use discretionary accruals to make the
reported series smooth (Tucker and Zarowin 2006, p. 254). Discretionary accruals are
measured by a modified cross-sectional version of the Jones Model which is used by TZ to
estimate discretionary accruals as follows:

Accruals
t
= a(1 / Assets
t-1
) + b #Sales
t
+ cPPE
t
+ d ROA
t
+ $
t
(2.0)
Where:
Accruals
t
= total accruals in year t; that is, net income minus cash flows from operations
scaled by total assets at (t 1);
#Sales
t
= sales in year t minus sales in year (t 1) scaled by total assets
at (t 1);
PPE
t
= gross property, plant and equipment in year t scaled by total assets at (t 1);
Assets
t-1
= total assets at (t 1); and
ROA
t
= return on assets in year t (net income
t
/ total assets
t-1
).

The non-discretionary accruals are the fitted values generated from regression equation (2.0).
The discretionary accruals are the deviations between actual accruals and non-discretionary
accruals. Pre-managed earnings are determined by subtracting discretionary accruals from net
income. TZ use five observations (i.e., including the current years observation) to construct the
income smoothing measure.
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TZ use a fractional ranking of firms each year within its industry (Tucker and Zarowin 2006, p.
255). A more negative correlation between a companys change in discretionary accruals and its
change in pre-managed earnings implies a higher degree of income smoothing (Tucker and
Zarowin 2006, p. 255). TZ use four regression models to relate earnings, income smoothing, and
stock returns. These models are additive in nature, beginning with regressing stock returns on
the difference between annual realized and expected earnings and the change in expected
earnings (Collins et al. 1994) and then, extend the model by adding income smoothing as a
standalone variable and as an interaction variable with past, current, and future earnings and
future returns. TZs purpose of developing the regression models in this manner is to illustrate
the added information content of income smoothing. First, the standalone coefficients for
current and future earnings in the initial model are positive and significant indicating earnings
information gets impounded in stock returns (Tucker and Zarowin 2006, p. 259). Second, the
authors find the coefficient for the interaction variable between income smoothing and current
earnings significant meaning income smoothing strengthens earnings persistence (Tucker and
Zarowin 2006, p. 259). Next, the coefficients for the interaction variables between income
smoothing and prior earnings, income smoothing and current earnings, and income smoothing
and future earnings are significant, but the coefficient for future earnings by itself is no longer
significant. These results indicate stock returns impound future earnings information only when
income smoothing is present. Taken together, TZ provide evidence of strong support for the
informative role of income smoothing in financial reporting.

Sun (2011) examines whether income smoothing improves earnings informativeness to a greater
extent for firms with high analyst coverage versus firms with low analyst coverage. The author
adopts TZs income smoothing and modeling methodologies (Tucker and Zarowin 2006). First,
stock returns are regressed on prior, current, and future earnings. Next, income smoothing is
added as a standalone and interaction variables. Then, an analyst coverage variable is included
in the model (i.e., standalone and interaction formats) along with various control variables (Sun
2011, p. 340, model 4). Sun finds the interaction variable of future earnings, income smoothing,
and analyst coverage significant. Thus, the author concludes income smoothing improves
earnings informativeness to a greater extent for firms with higher analyst coverage.

Mascarenhas et al. (2010) examine whether audit specialists restrict the discretionary accruals of
their clients to a greater extent than non-specialist auditors. Discretionary accruals can be
informative or deceptive and the authors hypothesize that audit industry specialists can reduce
opportunistic behavior and make earnings more informative. The authors use the TZ approach to
identify income smoothing firms and TZs regression modeling to test informativeness (Tucker
and Zarowin 2006). The authors replicate TZs results; that is, income smoothing is informative
as the two-way earnings-income smoothing variables are significant in the regression model.
However, when the standalone audit industry specialist variable is added to the model, the three-
way interaction term of audit industry specialist-income smoothing-earnings is not significant.
The authors conclude clients discretionary accruals of audit industry specialists are not more
highly related to stock returns and thus, are not more informative than clients discretionary
accruals of non-specialist auditors.

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Grant et al. (2009) use the TZ approach in determining income smoothing firms to examine the
relation between chief executive officers (CEOs) risk-taking incentives and income smoothing.
The authors consider risk-taking incentives as an endogenous variable in explaining its relation
with income smoothing. Consequently, risk-taking incentives is a dependent variable in a
regression model whose predicted values are then used as an independent variable in an income
smoothing model. Results show higher risk-taking incentives is significant and positive in the
income smoothing model. The authors conclude income smoothing is used by CEOs to reduce
the appearance of firms risk.

Faello (2012) examines the link between income smoothing and corporate governance using the
AR and TZ approaches. His results indicate a weak link between a higher degree of income
smoothing and strong corporate governance measures, but only under the TZ approach. No
significant results were found under the AR measure.

Once the income smoothing measures are calculated for each firm under the AR and TZ
methods, then the firms ranking determines its degree of smoothing under the respective income
smoothing method. Ranking firms by income smoothing measures, results in five income
smoothing rankings:

Firms rankings under the AR approach using operating income: sales minus cost of
sales and operating expenses (excluding depreciation and amortization) as the
measure of income;
Firms rankings under the AR approach using income from operations: operating
income minus depreciation and amortization as the measure of income;
Firms rankings under the AR approach using income before extraordinary items as
the measure of income;
Firms rankings under the AR approach using net income as the measure of income;
and
Firms rankings under the TZ approach.

In summary, the TZ and AR income smoothing measures have been used in prior research to
examine firms income smoothing behavior. Ranking firms for degrees of income smoothing
and then determining the informativeness of the measures will provide researchers with useful
insights in developing their income smoothing studies.

Hypotheses Development

Comparing the informativeness of the TZ and AR income smoothing rankings requires a four-
step process:
1. Define informativeness;
2. Determine the informativeness of the TZ and AR measures;
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3. Compare the informativeness of the two measures; and
4. Conclude which measure is the most informative.

First, informativeness is defined as the association between earnings and one period ahead cash
flows from operations. Greater positive association between the two indicates a higher degree of
informativeness. Prior researchers have defined in a similar manner the information content of
earnings (including its components such as accruals) to predict cash flows (e.g., Barth et al.
2001b; Dechow and Dichev 2002; Kim and Kross 2005). Second, the informativeness of each
measure is determined by the additional explanatory power that the particular measure (either TZ
or AR) gives to earnings in explaining the operating cash flows. Third, the informativeness
comparison involves determining the difference in explanatory power (i.e., adjusted R
2
) under
the two income smoothing approaches and finally, drawing a conclusion from the results.
The TZ approach is accrual-based and does not include the effect of cash-based transactions.
Under the AR approach, deceptive cash-based transactions used to smooth earnings are
embedded in the measure and are predicted to reduce informativeness. In effect, these cash-
based transactions mask the AR measures degree of informativeness. Thus, the TZ income
smoothing ranking is expected to capture a stronger relationship between current earnings and
one period ahead operating cash flows than the AR income smoothing ranking. This studys
hypothesis is stated as follows:

H1: The TZ income smoothing rankings capture a stronger relationship between firms
current earnings and one period ahead operating cash flows than the AR income
smoothing rankings.

If the results support the hypothesis, then this study would provide academics with greater
insights in designing their research and it would make a valuable contribution to the income
smoothing literature stream.

Research Methodology

The methodology used to test H1 is similar to that of TZ (Tucker and Zarowin, 2006). First, one
period ahead cash flows are regressed on earnings and control variables. Next, the income
smoothing rankings (i.e., TZ or AR) are included as independent variables. In this manner, the
additional explanatory power of income smoothing can be determined by examining the
significance of the coefficients for the income smoothing variables and comparing the adjusted
R
2
for the regression models. Comparing adjusted R
2
between models is justified when the
dependent variable and sample size are the same across all models (Gujarati 2003, p. 219).
There should not be a significant loss in explanatory power by using ranks instead of the raw
statistic (Aczel 2002, p. 676).
The process of adding each income smoothing variable to the research models as a standalone
variable and as an interactive variable with earnings, will lead to insights as to whether or not
income smoothing enhances the informativeness of earnings vis--vis cash flows. If income
smoothing enhances informativeness, then the coefficients for the income smoothing variables
should be positive and significant. The models for determining the informativeness of the TZ
and AR measures are stated as follows:
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CF
it
= % + &
1
EARN
i,t-1
+

' (&
j
CONTROLVAR
ji,t-1
) + (
it
(3.0)

CF
it
= % + &
1
EARN
i,t-1
+ &
2
TZRank
i,t-1
+ &
3
(EARN
i,t-1
*

TZRank
i,t-1
) +

' (&
j
CONTROLVAR
ji,t-1
) + (
it
(3.1)

CF
it
= % + &
1
EARN
i,t-1
+ &
2
ARRank
mi,t-1
+ &
3
(EARN
i,t-1
*
ARRank
mi,t-1
) +

' (&
j
CONTROLVAR
ji,t-1
) + (
mit
(3.2)

Where:
CF
it
= the dependent variable representing the firms next period cash flows from
operations;
TZRank
i,t-1
= firm is ranking as an income smoother under the Tucker-Zarowin
approach with a ranking of 1 indicating the highest degree of income
smoothing and n indicating the lowest degree of income smoothing in year
t-1 (1997 to 2000);
ARRank
mi,t-1
= the dependent variable, is firm is ranking as an income smoother under
the m
th
version of the Albrecht-Richardson approach with a ranking of 1
indicating the highest degree of income smoothing and n indicating the
lowest degree of income smoothing in year t-1 (1997 to 2000);
m = 1 to 4, each representing a different version of income under the
Albrecht)Richardson approach: (1) Operating income, (2) Income from
operations, (3) Income from extraordinary items, and (4) Net income;
EARN
i,t-1
= the firms earnings at t -1;
CONTROLVAR
i,t-1
= explanatory variables representing control variables (described below);

The control variables are as follows:
SIZE = firms total assets to control for the effect of firm size;
GROWTH = market-to-book ratio as measured by the market value divided by the
book value of equity;
LEVERAGE = debt to assets ratio;
SEGNUM = number of operating segments reported by the firm; and
INDUSTRY = indicator variables, numbered one through eight representing the two-
digit Standard Industrial Classification (SIC) code for industry types and
change in classification over the study period. The numbering is as
follows: (1) Division A: agriculture, forestry, and fishing; (2) Division B:
mining; (3) Division C: construction; (4) Division D: manufacturing; (5)
Division E: transportation, communications, electric, gas, and sanitary
services; (6) Division F: wholesale trade; (7) Division G: retail trade; and
(8) change in SIC code classification over the study period; and
(
it
, (
mit
= error term.

Bao and Bao (2004) include control variables for SIZE and LEVERAGE in their study. Tucker
and Zarowin (2006) control for SIZE and GROWTH. SEGNUM proxies for the role of the
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firms organizational structure in influencing income smoothing behavior. Lee et al. (2007) find
highly intrarelated divisions are associated with earnings management. SEGNUM is expected to
be negatively associated with the dependent variable. For INDUSTRY, there are eight
categories as described on the Occupational Safety & Health Administration website of the
Department of Labor (OSHA, 2011). Model specification requires (m 1) dummy variables for
m categories (Gujarati 2003, p. 302). Thus, the first seven dummy variables denote the different
industry categories and the eighth category denotes whether or not a firm changed categories
over the study period. No prediction is given for INDUSTRY because Albrecht and Richardson
(1990) did not find particular industries or sectors of the economy statistically significant with
income smoothing behavior. Michelson et al. (2000) find firms in the Mining and Transportation
and Communications segments possess a higher likelihood of being classified as an income
smoother rather than a non-smoother.

Both the TZ and AR income smoothing measures have been used in prior research to highlight
the informative aspects of income smoothing (e.g., Tucker and Zarowin 2006; Bao and Bao
2004). However, the TZ measure is expected to have a greater association with informativeness
because it does not include deceptive cash-based transactions in its measure. In assessing
whether the link between earnings and cash flows is strengthened with the two income
smoothing measures present, any increase in adjusted R
2
from the TZ or AR models provides the
necessary evidence of additional explanatory power. Comparing adjusted R
2
between models is
justified when the models have the same dependent variable and sample size (Gujarati 2003, p.
219). The TZ and AR regression models are represented by equations 3.1 and 3.2. Including
both measures in equation 3.0 results in equation 3.3 below and provides the basis for testing H1:
CF
it
= % + &
1
EARN
i,t-1
+ &
2
TZRank
i,t-1
+ &
3
(EARN
i,t-1
* TZRank
i,t-1
)
+

&
4
ARRank
mi,t-1

+ &
5
(EARN
i,t-1
* ARRank
mi,t-1
)

+

' (&
j
CONTROLVAR
ji,t-1
) + (
mit
(3.3)
Where:
CF
it
= the dependent variable representing the firms next period cash flows
from operations;
TZRank
i,t-1
= firm is ranking as an income smoother under the Tucker-Zarowin
approach with a ranking of 1 indicating the highest degree of income
smoothing and n indicating the lowest degree of income smoothing in year
t-1 (1997 to 2000);
ARRank
mi,t-1
= the dependent variable, is firm is ranking as an income smoother under
the m
th
version of the Albrecht-Richardson approach with a ranking of 1
indicating the highest degree of income smoothing and n indicating the
lowest degree of income smoothing in year t-1 (1997 to 2000);
m = 4, representing the net income version of income under the Albrecht-
Richardson approach;
CONTROLVAR
i,t-1
= explanatory variables representing control variables (described above);
and
(
mit
= error term.

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Overall, this study will provide researchers with unique insights in developing their own income
smoothing studies.

Data and Empirical Results

Firms financial data come from Compustats annual combined industrial data bases for the
period 1992 to 2001. Although the study covers the 1998 to 2001 period, financial data has to be
extracted from 1992 to 2001 because the income smoothing measures require five years of data
to construct the test statistics. Financial institutions (SIC codes 6000 to 6999) are excluded from
the analysis because of their unique accounting. Another restriction on the sample relates to
firms financial year-ends. Prior studies show firms manage earnings during the last fiscal
quarter (Oyer 1998). Including firms in the sample with a break in the continuity of fiscal
quarters because of a merger or acquisition would bias the sample. Thus, these firms are
excluded from the study.

The final sample size is 125 firms (n = 125). An alphabetical list of sample firms is presented in
Appendix A, Table A.1. Industry representation of these firms is presented in Table 1 and
follows the classification system of the Standard Industrial Classification (SIC) code (OSHA,
April 24, 2011). The sample consists predominantly of manufacturing firms (64% of total
sample, see Table 1) and is similar to that of prior studies (e.g., Michelson et al. 2000). The
samples descriptive statistics are presented in Table 2. Over the period 1997 to 2001, firms
average earnings increased over the first four years (i.e., 1997 to 2000) and then declined in
2001. These results reflect the business activities of the general economy as a recession
commenced and ended during the first and fourth quarters of 2001 respectively (National Bureau
of Economic Research, 2008). From an accounting perspective, these conditions present
opportunities for firms to manage earnings by income smoothing. During a period of earnings
growth (i.e., 1997 to 2000 period), firms have an incentive to smooth earnings downward. Kieso
et al. (2008, p. 128) explain the incentive using W.R. Grace Company as an example:
Managing earnings up or down adversely affects the quality of
earnings. For example, W.R. Grace managed earnings down by
taking excess cookie jar reserves in good earnings years. During
the early 1990s, Grace was growing fast, with profits increasing 30
percent annually. Analysts targets had Grace growing 24 percent
each year. Worried about meeting these growth expectations,
Grace began stashing away excess profits in an all-purpose reserve
(a cookie jar). In 1995, when profits fell below expectations,
Grace wanted to reduce this reserve and so increase income. The
SEC objected, noting this violated generally accepted accounting
principles.

Thus, the descriptive statistics provide evidence that the conditions exist for firms to smooth
income in an informative or deceptive manner. From an informative point of view, firms attempt
to align earnings with one period ahead operating cash flows. From a deceptive point of view,
firms manage earnings to achieve earnings targets.
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Table 1 Industry Representation

SIC Code

Description
No. of Firms /
%

00 to 09 Division A: Agriculture, Forestry and Fishing 1 / 1%

10 to 14 Division B: Mining 5 / 4%

15 to 17 Division C: Construction 1 / 1%

20 to 39 Division D: Manufacturing 80 / 64%

40 to 49 Division E: Transportation, Communications,
Electric, Gas and Sanitary Services

6 / 5%

50 to 51 Division F: Wholesale Trade 9 / 7%

52 to 59 Division G: Retail Trade 5 / 4%

70 to 99 Divisions I and J: Services and Public Administration 18 / 14%
125/ 100%

Reproduced from: Faello, J., Is Strong Corporate Governance Associated With Informative
Income Smoothing? ProQuest LLC., 2012, Table 4.1 Panel A, p. 57.

Table 2 Descriptive Statistics (n = 125)

Mean (in millions) 1997 1998 1999 2000 2001

Assets 7,018.66 7,933.94 9,976.57 11,577.30 11,697.83

Sales 4,792.40 4,895.92 5,558.92 6,226.60 6,097.11

Operating cash flows 579.67 628.92 772.79 844.11 959.19

Income before
extraordinary items

282.27

317.79

366.27

402.15

335.24

Net income 280.61 313.46 377.81 399.21 333.41

Income Smoothing? ProQuest LLC., 2012, Table 4.2, p. 59
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Tucker and Zarowin (TZ) Income Smoothing Measure

The TZ income smoothing method measures income smoothing by the negative correlation of a
companys change in discretionary accruals with its change in pre-managed earnings.
Discretionary accruals are measured by a modified version of the Jones Model (see model 2.0).
The non-discretionary accruals are the fitted values generated from model 2.0. The discretionary
accruals are the deviations between actual accruals and non-discretionary accruals. Pre-managed
earnings are determined by subtracting discretionary accruals from net income. The results for
the modified Jones Model are contained in Table 3.

A comparison of this studys Jones Model results with those of TZ (2006) follows. For TZs
1988 2000 study period, TZ reported the mean for each coefficient and R
2
. These results are:
a = 0.112, b = 0.013, c = 0.074, d = 0.457 and R
2
= 0.642 (Tucker and Zarowin 2006, p. 259).
On the one hand, the results in Table 3 are similar to TZs results. The coefficient c pertains to
gross property, plant and equipment and is negative. This is the expected result because gross
property, plant and equipment is negatively related to the accrual of depreciation expense (Jones
1991, p. 213). The coefficient d relates to return on assets and is positive. Again, this is an
expected result because total accruals increase with net income. TZs R
2
is higher for six of the
nine years of this study. On the other hand, the coefficient b is not consistently positive or
negative whereas TZs result is positive on average. This expected sign is more difficult to
predict because revenue increases affect accruals both positively and negatively. Jones (1991, p.
213) states, The expected sign for the change in revenues coefficient is not as obvious because a
given change in revenue can cause income-increasing changes in some working capital accounts
(e.g. increases in accounts receivable) and income-decreasing changes in others (e.g. increases in
accounts payable).
The TZ income smoothing rankings for each firm included in the sample are presented in
Appendix A, Table A.2. Using the results from the Jones Model to construct the correlations
between change in discretionary accruals and change in pre-managed earnings, rankings from
most negative (i.e., highest degree of income smoothing) to least negative (i.e., lowest degree of
income smoothing) are compiled for the years 1997 to 2001. Individual firms rankings span the
spectrum with some firms consistently ranked in the top quartile (i.e., ranking between 1 and 35,
e.g. Universal Health Services), others consistently ranked in the bottom quartile (e.g. Georgia
Pacific Corp.), and the majority of the firms possessing rankings within each of the four
quartiles. TZ do not present results on an individual firm basis, meaning there is no basis of
comparison with this study. However, disclosure of this data should provide useful information
for future studies.

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Table 3 Estimation of Discretionary Accruals

Statistics by Year:

a

b

c

d

R
2

1993 0.464 -0.082 -0.091 0.509 0.523

1994 -0.070 0.126 -0.094 0.432 0.666

1995 0.662 0.055 -0.095 0.500 0.542

1996 0.723 -0.028 -0.072 0.251 0.428

1997 -0.273 0.031 -0.085 0.511 0.426

1998 2.637 0.016 -0.088 0.373 0.525

1999 -1.374 -0.071 -0.064 0.417 0.722

2000 1.087 0.083 -0.104 0.548 0.519

2001 -0.570 0.011 -0.112 0.422 0.867

The Modified Jones Model:
Accruals
t
= a(1 / Assets
t-1
) + b #Sales
t
+ cPPE
t
+ d ROA
t
+ $
t
The table presents the statistics for the estimated coefficients and R
2
of the annual regressions.
For each year, n = 125. Variable definitions are:
Accruals
t
= total accruals in year t, that is net income minus cash flows from operations;
Assets
t-1
= total assets at (t 1);
#Sales
t
= sales in year t minus sales in year (t 1) scaled by total assets at (t 1);
PPE
t
= gross property, plant and equipment in year t scaled by total assets at (t 1); and
ROA
t
= return on assets in year t.

Income Smoothing? ProQuest LLC., 2012, Table 4.3, p. 61.
Albrecht and Richardson (AR) Income Smoothing Measure

The AR method uses the relationship between sales revenue and earnings variability to develop
their smoothing criterion (i.e., coefficient of variation ratio). Four measurements of income are
used because firms can choose to smooth various components of the income statement. The four
measurements of income are:
Operating income: sales minus cost of sales and operating expenses (excluding
depreciation and amortization);

Income from operations: operating income minus depreciation and amortization;

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Income before extraordinary items; and

Net income.

In prior research, if a firms ratio of coefficients of variation is less than one for any one of the
four income measures, then the firm is considered an income smoother. AR use their income
smoothing statistic to determine whether income smoothing is associated with particular
industries or economic sectors. They find no statistically significant association between sectors
and income smoothing behavior, but their classification of economic sectors relied on a system
developed in 1970 and is outdated in todays economy.

In this study, degrees of income smoothing are considered by ranking firms under each income
smoothing measure with the highest ranking indicating the highest degree of income smoothing.
This methodology provides additional information as to how firms smooth income (e.g. before or
after deducting depreciation and amortization; before or after deducting an extraordinary loss).
The results for the AR income smoothing rankings for the net income definition of earnings are
presented in Appendix A: Table A.3. The rankings for the remaining earnings definitions (i.e.,
operating income before depreciation and amortization; operating income after depreciation and
amortization; income before extraordinary items) are available from the author upon request.

From these results, firms can exhibit a greater (lesser) degree of income smoothing in the early
years of the study period and then a lesser (greater) degree of income smoothing in the latter
years of the study period (e.g. Flowserve Corp.). Further, firms may use a specific tool to
smooth earnings. For example, Ashland Inc.s average income smoothing rankings change
dramatically between the operating income before depreciation and amortization and operating
income after depreciation and amortization definition of earnings (see Figure 1.0). Ashlands
income smoothing behavior indicates its use of depreciation and amortization to smooth
earnings.

Overall, the TZ and AR income smoothing rankings provide useful insights into firms income
smoothing behavior.

Figure 1.0 Ashland Inc.s Average Income Smoothing Rankings
Income Smoothing? ProQuest LLC., 2012, Figure 4.2, p. 63.

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Results of Tucker-Zarowin (TZ) Income Smoothing Approach

Hypothesis 1 predicts the use of income smoothing as captured in the TZ income smoothing
rankings leads to a stronger relationship between current earnings and one period ahead
operating cash flows than the AR income smoothing rankings. This hypothesis is
operationalized by equations 3.0, 3.1, 3.2, and 3.3. First, equation 3.0 links current earnings to
one period ahead operating cash flows. Second, the additional power (if any) provided by the TZ
income smoothing measure in explaining the variation in operating cash flows is determined by
including the TZ income smoothing ranking as an explanatory variable (i.e., equation 3.1 is the
resulting equation). Next, the AR income smoothing rankings under each definition of earnings
(i.e., operating income before depreciation and amortization; operating income after depreciation
and amortization; income before extraordinary items; net income) are individually added as an
explanatory variable to equation 3.0 (i.e., equation 3.2 is the resulting equation) to determine the
additional power (if any) provided by the AR income smoothing measure. Then, a comparison
of the TZs and ARs informativeness is operationalized by including the two measures together
in one equation (i.e., equation 3.3 is the resulting equation) and examining the differences in
explanatory power between equation 3.3 and 3.2 (AR approach) or 3.1 (TZ approach).

Table 4 provides the results for equation 3.0, the association between earnings and one period
ahead operating cash flows. The model is significant (F = 510.814, Adjusted R
2
= 0.930) with
the earnings coefficient significant at the 0.01 level of significance (&
1
= 1.009, t-statistic =
17.525). Also, significant are the size (&
2
= 0.040, t-statistic = 22.099), Mining industry segment
(&
7
= 426.358, t-statistic = 2.238), and Transportation, Communications, Electric, Gas and
Sanitary Services industry segment (&
10
= 1,405.151, t-statistic = 7.404).

For the earnings (&
1
) and total assets (&
2
) coefficients, a $1,000,000 increase in net income or
total assets results in $1,009,000 and $40,000 increases in one period ahead operating cash flows
respectively. The strong positive relation between earnings, assets, and operating cash flows is
expected because larger firms are expected to have larger earnings that translate into larger cash
flows. For the industry segments with significant coefficients (&
7
and &
10
), their significance
means the intercepts for firms in these segments increase by $426.358 million and $1,405.151
million respectively. The lack of significance for the remaining industry segments coefficients
(&
6
, &
8
,

&
9
, &
11
,

&
12
,

and &
13
) indicates these segments all have the same intercept of $141.908 (%).
The Services and Public Administration segment serves as the benchmark for the regression
model. Overall, the results for equation 3.0 indicate current net income is significantly
associated with one period ahead operating cash flows.

Table 5 shows the results for equation 3.1. This equation includes the TZ income smoothing
ranking as an explanatory variable, separately and in interaction form. The overall model (F =
463.494, Adjusted R
2
= 0.933) and the earnings-income smoothing interaction variable (&
3
) are
significant; however, the coefficient for income smoothing (&
2
) is not significant. This latter
result indicates income smoothing adds explanatory power to the model only when combined
with earnings. Essentially, income smoothing is a component of earnings that possesses an
informational content in explaining one period ahead operating cash flows. Overall, these results
support the body of academic literature of income smoothings informational usefulness (e.g.s
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5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, <B
Tucker and Zarowin 2006; Subramanyam 1996; Bao and Bao 2004). Also, the adjusted R
2

increases from 0.930 (see Table 4) to 0.933 (see Table 5). This result provides additional
evidence supporting the benefits of income smoothing in explaining one period ahead operating
cash flows.
Table 4 Current Earnings Association With One Period Ahead Operating Cash Flows
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% 141.908 0.998 &
5
-12.820 -0.777 &
10
1,405.151 7.404
***
&
1
1.009 17.525
***
&
6
-24.770 -0.065 &
11
-46.148 -
0.290
&
2
0.040 22.099
***
&
7
426.358 2.238
**
&
12
-8.095 -
0.042
&
3
0.062 0.068 &
8
172.138 0.448 &
13
40.986 0.207
&
4
-96.225 -0.624 &
9
-42.076 -0.422

CF
it
= % + &
1
EARN
i,t-1
+ &
2
SIZE
it-1
+ &
3
GROWTH
i,t-1
+ &
4
LEVERAGE
i,t-1
+ &
5

SEGNUM
i,t-1
+ &
6
D
1i-t-1
+ &
7
D
2i,t-1
+ &
8
D
3i,t-1
+ &
9
D
4i,t-1
+ &
10
D
5i,t-1
+ &
11
D
6i,t-1
+ &
12
D
7i,t-
1
+ &
13
D
8i,t-1
+ (
it

n = 500 Adj. R
2
= 0.930 Durbin-Watson = 2.032 F-statistic = 510.814***
* Significant at the % = .10 level of significance
** Significant at the % = .05 level of significance
*** Significant at the % = .01 level of significance
CF = the dependent variable, representing firms next period annual cash flow
from operations (millions $) for the periods 1998 to 2001
SIZE = firms total assets (millions $)
EARN = firms current net income (millions $)
book value of equity
LEVERAGE = firms debt to assets ratio
SEGNUM = number of operating segments reported by the firm
INDUSTRY = indicator variables representing the two-digit SIC code for industry types
and change in classification over the study period, otherwise = 0: (D1) 00 to 09,
Agriculture, Forestry and Fishing; (D2) 10 to 14, Mining; (D3) 15 to 17, Construction;
(D4) 20 to 39, Manufacturing; (D5) 40 to 49, Transportation, Communications, Electric,
Gas and Sanitary Services; (D6) 50 to 51, Wholesale Trade; (D7) 52 to 59, Retail Trade;
(D8) change in two-digit SIC code over the study period


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Table 5 TZ Income Smoothing Measure Association With One Period Ahead Operating
Cash Flows
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% 145.403 0.994 &
6
-128.920 -0.842 &
12
1,091.401 5.543
***
&
1
0.653 6.685
***
&
7
-25.293 -1.546 &
13
-27.836 -0.178
&
2
0.784 0.795 &
8
-66.615 -0.176 &
14
-44.635 -0.238
&
3
0.004 4.408
***
&
9
393.635 2.105
**
&
15
34.271 0.177
&
4
0.047 20.260
***
&
10
89.301 0.237
&
5
0.035 0.039 &
11
-41.312 -0.423

CF
it
= % + &
1
EARN
i,t-1
+ &
2
TZRANK
i,t-1
+ &
3
(EARN
i,t-1
* TZRANK
i,t-1
) +&
4
SIZE
it-1
+
&
5
GROWTH
i,t-1
+ &
6
LEVERAGE
i,t-1
+ &
7
SEGNUM
i,t-1
+ &
8
D
1i-t-1
+ &
9
D
2i,t-1
+ &
10
D
3i,t-1

+ &
11
D
4i,t-1
+ &
12
D
5i,t-1
+ &
13
D
6i,t-1
+ &
14
D
7i,t-1
+ &
15
D
8i,t-1
+ (
it

n = 500 Adj. R
2
TZRANK = firms annual rankings as an income smoother under the Tucker-Zarowin
approach with a ranking of 1 indicating the highest degree of income smoothing
GROWTH = market-to-book ratio as measured by the market value divided by the book
value of equity


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Results of Albrecht-Richardson (AR) Income Smoothing Approach

Using the same methodology as that for the TZ statistic, equation 3.0 is determined for the four
definitions of earnings used under the AR approach. These results are shown in Tables 6
(operating income before depreciation and amortization), 7 (operating income after depreciation
and amortization), 8 (income before extraordinary items), and 4 (net income).

Under each definition of earnings, the coefficient &
1
for the particular definition of earnings (i.e.,
operating income before depreciation and amortization; operating income after depreciation and
amortization; income before extraordinary items; and net income) has a positive and significant
association with one period ahead operating cash flows. Further, the size coefficient (&
2
) and
coefficients for the Mining (&
7
) and Transportation, Communications, Electric, Gas and Sanitary
service (&
10
) industry segments are significant and positive.

The significant difference across the four measures of earnings pertains to the number of
operating segments coefficient (&
5
). For the operating income before / after depreciation and
amortization definitions of earnings, coefficient &
5
is positive and significant; for the income
before extraordinary items and net income definitions the coefficient &
5
signs are negative and
insignificant.

These results are interpreted as follows. First, current earnings possess significant explanatory
power of one period ahead operating cash flows as evidenced by the significant &
1
coefficients.
Second, larger firms (i.e., proxied by the &
2
coefficients) possess strong association with one
period ahead cash flows. That is, larger firms are expected to have larger cash flows. Third, the
Mining (&
7
) and Transportation, Communications, Electric, Gas and Sanitary Services (&
10
)
industry segments possess a stronger association with one period ahead operating cash flows
than with firms in the Services and Public Administration segment. This is evidenced by the
increase in the intercepts in the amount of the respective coefficient terms &
5
and &
10
. Note that
the one industry segment not assigned an indicator variable (i.e., Services and Public
Administration) serves as the benchmark for these regression models. Fourth, firms
organizational structure (i.e., proxied by the number of operating segments) is positively
associated with one period ahead operating cash flows, but only under the operating income
before / after depreciation and amortization definitions of earnings. This result indicates non-
recurring or unusual items found in the lower half of the income statement offset the income
smoothing effects of the association between organizational structure and operating income.
Overall, the results for equation 3.0 for the four definitions of earnings under the AR income
smoothing approach indicate current earnings are significantly associated with one period ahead
operating cash flows.

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(Operating Income Before Depreciation and Amortization)

Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% -9.486 -0.058 &
5
55.076 3.010
***
&
10
1,752.393 8.041
***
&
1
0.218 10.609
***
&
6
1.610 0.004 &
11
-73.668 -
0.402
&
2
0.050 26.439
***
&
7
410.220 1.870
*
&
12
126.253 0.575
&
3
0.291 0.277 &
8
195.770 0.443 &
13
0.178 0.001
&
4
-199.699 -1.126 &
9
-94.775 -0.825

CF
it
= % + &
1
EARN
i,t-1
+ &
2
SIZE
it-1
+ &
3
GROWTH
i,t-1
+ &
4
LEVERAGE
i,t-1
+ &
5

SEGNUM
i,t-1
+ &
6
D
1i-t-1
+ &
7
D
2i,t-1
+ &
8
D
3i,t-1
+ &
9
D
4i,t-1
+ &
10
D
5i,t-1
+ &
11
D
6i,t-1
+ &
12
D
7i,t-
1
+ &
13
D
8i,t-1
+ (
it

n = 500 Adj. R
2
EARN = firms current operating income before depreciation and amortization
(millions $)

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5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, =<
(Operating Income After Depreciation and Amortization)

Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% -14.728 -0.086 &
5
63.856 3.346
***
&
10
2,138.889 9.709
***
&
1
0.226 7.895
***
&
6
-8.767 -0.019 &
11
-82.472 -0.431
&
2
0.054 26.937
***
&
7
442.934 1.933
*
&
12
143.455 0.625
&
3
0.371 0.338 &
8
233.577 0.506 &
13
-0.810 -0.003
&
4
-210.580 -1.136 &
9
-94.068 -0.784

CF
it
= % + &
1
EARN
i,t-1
+ &
2
SIZE
it-1
+ &
3
GROWTH
i,t-1
+ &
4
LEVERAGE
i,t-1
+ &
5

SEGNUM
i,t-1
+ &
6
D
1i-t-1
+ &
7
D
2i,t-1
+ &
8
D
3i,t-1
+ &
9
D
4i,t-1
+ &
10
D
5i,t-1
+ &
11
D
6i,t-1
+ &
12
D
7i,t-
1
+ &
13
D
8i,t-1
+ (
it

n = 500 Adj. R
2
EARN = firms current operating income after depreciation and amortization
(millions $)

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5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, ==
(Income Before Extraordinary Items)

Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% 138.541 0.966 &
5
-11.553 -0.695 &
10
1,440.214 7.541
***
&
1
1.022 17.147
***
&
6
-23.850 -0.062 &
11
-45.573 -0.284
&
2
0.040 21.359
***
&
7
426.963 2.222
**
&
12
-3.117 -0.016
&
3
0.058 0.064 &
8
212.040 0.548 &
13
41.392 0.208
&
4
-98.819 -0.635 &
9
-46.267 -0.460

CF
it
= % + &
1
EARN
i,t-1
+ &
2
SIZE
it-1
+ &
3
GROWTH
i,t-1
+ &
4
LEVERAGE
i,t-1

+ &
5
SEGNUM
i,t-1
+ &
6
D
1i-t-1
+ &
7
D
2i,t-1
+ &
8
D
3i,t-1
+ &
9
D
4i,t-1
+ &
10
D
5i,t-1
+ &
11
D
6i,t-1
+ &
12

D
7i,t-1
+ &
13
D
8i,t-1
+ (
it

n = 500 Adj. R
2
EARN = firms current income before extraordinary items (millions $)

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5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, =>
Any additional explanatory power provided by the AR regression models in explaining the
variation in operating cash flows will be shown in the results for equations 3.2. Tables 9 to 12
show the results for equation 3.2 for the four definitions of earnings under the AR approach. For
the operating income before depreciation and amortization definition of earnings (Table 9, the
overall model is significant F = 340.968; Adjusted R
2
= 0.911) and the interaction variable
between earnings and income smoothing is negative and significant (&
3
= -0.001; t-statistic = -
4.628). The adjusted R
2
increases from 0.907 (see Table 6) to 0.911 (see Table 9). The negative
sign on &
3
indicates income smoothing (as measured by the operating income before depreciation
and amortization definition of earnings) is less informative. That is, this particular AR measure
captures less informative income smoothing behavior. Also, the separate income smoothing
coefficient (&
2
) is not significant indicating income smoothing provides informational value in
explaining operating cash flows only when earnings are present. Income smoothing is a
component of earnings and these results support the strong earnings-income smoothing link.

Taken together, these results for the operating income before depreciation and amortization
earnings definition show two distinctly different results. On the one hand, income smoothing
possesses additional informational value when combined with earnings as evidenced by the
increase in adjusted R
2
(e.g.s, see Tables 6 and 9). On the other hand, the negative sign for the
earnings-income smoothing interaction coefficient (&
3
) indicates this AR measure captures less
informative aspects of income smoothing.

For the operating income after depreciation and amortization definition of earnings results are
shown in Table 10. These results mirror the results for the operating income before depreciation
and amortization earnings definition. That is, the adjusted R
2
increases from 0.899 (see Table 7)
to 0.902 (see Table 10) and the earnings-income smoothing coefficient (&
3
) is negative when
income smoothing variables are added as explanatory variables.

The results for the income before extraordinary items and net income versions show non-
significant earnings-income smoothing interaction coefficients (i.e., coefficients &
3
in Tables 11
and 12 respectively). Also, the respective adjusted R
2
show no increases. The lack of increase in
adjusted R
2
is intriguing and suggests transactions contained in the lower half of the income
statement offset income smoothing transactions contained in the upper half of the income
statement. This matter is discussed further below.

Operating income (either before or after depreciation and amortization) is located in the upper
half of the income statement. Sales, cost of goods sold, and operating expenses are included in
this upper section. The lower section of the income statement contains non-recurring items such
as discontinued operations and extraordinary items. Transactions from the lower section are
affecting income smoothing as measured by the AR approach to such a degree that income
smoothing provides no additional explanatory power of one period ahead operating cash flows.

These results are corroborated by other researchers findings (e.g. Dechow et al. 1998 and Barth
et al. 2001b). First, Dechow et al. (1998) find earnings is a better predictor of future cash flows
than prior years cash flows. Next, the earnings information contained in the TZ and AR
measures possesses informational value as evidenced by the results in this study. However,
"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, =?
earnings that are not decomposed into its components (i.e., accruals and cash based transactions)
mask information in predicting future cash flows (Barth et al. 2001b). Thus, the strength of the
TZ accruals-based model in explaining one period ahead operating cash flows is not unexpected.
Although the AR based measures include accruals as a component of each earnings definition
(i.e., operating income before depreciation and amortization; operating income after depreciation
and amortization; income before extraordinary items; and net income), these earnings
definitions also include cash-based transactions that are either noisy or deceptive. It is this
noise or deception that reduces the explanatory value of earnings.

Overall, the AR results do not support a strong informative aspect of income smoothing. The
AR approach captures transactions that do not strengthen the association between earnings and
one period ahead operating cash flows. These transactions represent either noise or deliberate
deceptive transactions.
Table 9 AR Income Smoothing Measure Association With One Period Ahead Operating
Cash Flows (Operating Income Before Depreciation and Amortization)
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% -63.312 -0.368 &
6
-175.517 -1.008 &
12
1,478.818 6.661
***
&
1
0.314 10.798
***
&
7
45.976 2.548
**
&
13
-69.884 -0.388
&
2
0.881 0.791 &
8
31.083 0.072 &
14
121.961 0.566
&
3
-0.001 -4.628
***
&
9
407.597 1.892
*
&
15
2.241 0.010
&
4
0.051 27.339
***
&
10
185.477 0.428
&
5
0.246 0.239 &
11
-83.038 -0.736

CF
it
= % + &
1
EARN
i,t-1
+ &
2
ARRANK
i,t-1
+ &
3
(EARN
i,t-1
* ARRANK
i,t-1
) +&
4
SIZE
it-1
+ &
5

GROWTH
i,t-1
+ &
6
LEVERAGE
i,t-1
+ &
7
SEGNUM
i,t-1
+ &
8
D
1i-t-1
+ &
9
D
2i,t-1
+ &
10
D
3i,t-1
+ &
11
D
4i,t-
1
+ &
12
D
5i,t-1
+ &
13
D
6i,t-1
+ &
14
D
7i,t-1
+ &
15
D
8i,t-1
+ (
it

n = 500 Adj. R
2
CF = the dependent variable, representing firms next period annual cash flow from
operations (millions $) for the periods 1998 to 2001
ARRANK = firms annual rankings as an income smoother under the Albrecht-Richardson
approach with a ranking of 1 indicating the highest degree of income smoothing (earnings
defined as operating income before depreciation and amortization)
EARN = firms current operating income before depreciation and amortization
(millions $)
"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, =@
GROWTH = market-to-book ratio as measured by the market value divided by the book value
of equity
INDUSTRY = indicator variables representing the two-digit SIC code for industry types and
change in classification over the study period, otherwise = 0: (D1) 00 to 09, Agriculture, Forestry
and Fishing; (D2) 10 to 14, Mining; (D3) 15 to 17, Construction; (D4) 20 to 39, Manufacturing;
(D5) 40 to 49, Transportation, Communications, Electric, Gas and Sanitary Services; (D6) 50 to
51, Wholesale Trade; (D7) 52 to 59, Retail Trade; (D8) change in two-digit SIC code over the
study period

Cash Flows (Operating Income After Depreciation and Amortization)

Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% -78.220 -0.435 &
6
-192.153 -1.052 &
12
1,950.088 8.802
***
&
1
0.404 7.999
***
&
7
57.569 3.057
***
&
13
-83.628 -0.442
&
2
0.992 0.844 &
8
18.412 0.041 &
14
1,447.783 0.641
&
3
-0.002 -4.261
***
&
9
429.519 1.897
*
&
15
10.274 0.044
&
4
0.052 26.422
***
&
10
217.525 0.479
&
5
0.306 0.283 &
11
-94.942 -0.803

CF
it
= % + &
1
EARN
i,t-1
+ &
2
ARRANK
i,t-1
+ &
3
(EARN
i,t-1
* ARRANK
i,t-1
) +&
4
SIZE
it-1
+ &
5

GROWTH
i,t-1
+ &
6
LEVERAGE
i,t-1
+ &
7
SEGNUM
i,t-1
+ &
8
D
1i-t-1
+ &
9
D
2i,t-1
+ &
10
D
3i,t-1
+ &
11
D
4i,t-
1
+ &
12
D
5i,t-1
+ &
13
D
6i,t-1
+ &
14
D
7i,t-1
+ &
15
D
8i,t-1
+ (
it

n = 500 Adj. R
2
ARRANK = firms annual rankings as an income smoother under the Albrecht-Richardson
defined as operating income after depreciation and amortization)
EARN = firms current operating income after depreciation and amortization (millions $)
"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, =A
of equity
(D5) 40 to 49, Transportation, Communications, Electric, Gas and Sanitary Services;
(D6) 50 to 51, Wholesale Trade; (D7) 52 to 59, Retail Trade; (D8) change in two-digit SIC code
over the study period

Cash Flows (Income Before Extraordinary Items)
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% 148.960 0.980 &
6
-101.123 -0.647 &
12
1,465.338 7.581
***
&
1
1.048 15.342
***
&
7
-12.739 -0.763 &
13
-44.340 -0.275
&
2
-0.067 -0.067 &
8
-21.904 -0.056 &
14
-3.109 -0.016
&
3
-0.001 -0.881 &
9
428.056 2.223
**
&
15
35.891 0.178
&
4
0.040 20.805
***
&
10
210.610 0.543
&
5
0.065 0.071 &
11
-44.077 -0.437

CF
it
= % + &
1
EARN
i,t-1
+ &
2
ARRANK
i,t-1
+ &
3
(EARN
i,t-1
* ARRANK
i,t-1
) +&
4
SIZE
it-1
+ &
5

GROWTH
i,t-1
+ &
6
LEVERAGE
i,t-1
+ &
7
SEGNUM
i,t-1
+ &
8
D
1i-t-1
+ &
9
D
2i,t-1
+ &
10
D
3i,t-1
+ &
11
D
4i,t-
1
+ &
12
D
5i,t-1
+ &
13
D
6i,t-1
+ &
14
D
7i,t-1
+ &
15
D
8i,t-1
+ (
it

n = 500 Adj. R
2
ARRANK = firms annual rankings as an income smoother under the Albrecht- Richardson
defined as income before extraordinary items)
EARN = firms current income before extraordinary items (millions $)
of equity
"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, =B
study period


Cash Flows (Net Income)
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% 143.548 0.950 &
6
-94.259 -0.608 &
12
1,395.613 7.246
***
&
1
0.996 14.826
***
&
7
-12.391 -0.748 &
13
-45.072 -0.282
&
2
-0.080 -0.081 &
8
-20.802 -0.054 &
14
-7.142 -0.037
&
3
0.000 0.365 &
9
426.783 2.233
**
&
15
39.898 0.200
&
4
0.040 21.332
***
&
10
172.275 0.448
&
5
0.066 0.072 &
11
-42.346 -0.423

CF
it
= % + &
1
EARN
i,t-1
+ &
2
ARRANK
i,t-1
+ &
3
(EARN
i,t-1
* ARRANK
i,t-1
) +&
4
SIZE
it-1
+ &
5

GROWTH
i,t-1
+ &
6
LEVERAGE
i,t-1
+ &
7
SEGNUM
i,t-1
+ &
8
D
1i-t-1
+ &
9
D
2i,t-1
+ &
10
D
3i,t-1
+ &
11
D
4i,t-
1
+ &
12
D
5i,t-1
+ &
13
D
6i,t-1
+ &
14
D
7i,t-1
+ &
15
D
8i,t-1
+ (
it

n = 500 Adj. R
2
ARRANK = firms annual rankings as an income smoother under the Albrecht- Richardson
defined as net income)
of equity
"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, =C
study period


Results of Testing H1 Combined Approach

Hypothesis 1 predicts the TZ income smoothing rankings capture a stronger relationship between
current earnings and one period ahead operating cash flows than the AR income smoothing
rankings. For the TZ income smoothing rankings, the earnings measure used in its determination
are pre-managed earnings. Pre-managed earnings are calculated by subtracting discretionary
accruals from net income. For the AR income smoothing measure, four definitions of earnings
are used operating income before depreciation and amortization; operating income after
depreciation and amortization; income before extraordinary items; and net income. The common
earnings definition for both income smoothing approaches is net income. Thus, in testing the
combined strength of the TZ and AR approaches in explaining one period ahead operating cash
flows, only the net income-based income smoothing statistics are included in equation 3.3.

Equation 3.3 is used to test H1 and includes the TZ and AR income smoothing rankings as
explanatory variables in explaining one period ahead operating cash flows. The income
smoothing rankings are included in the regression model as individual and interaction variables.
The relationship between income smoothing and one period ahead operating cash flows is
strengthened only if the adjusted R
2
increases from the individual TZ (equation 3.1) and AR
(equation 3.2) regression models.

Results for H1 are shown in Table 13. The overall model is significant (Adjusted R
2
= 0.933; F
= 408.303). The coefficients of interest are earnings)TZ income smoothing ranking (&
3
= 0.004;
t-statistic = 4.506) and earnings)AR income smoothing ranking (&
5
= 0.001; t-statistic = 1.064)
coefficients. The earnings)AR income smoothing coefficient (&
5
) is not significant at the 0.10
level of significance.

In assessing whether the link between earnings and cash flows is strengthened with the two
income smoothing measures present, any increase in adjusted R
2
from the TZ or AR models
provides the necessary evidence of additional explanatory power. The TZ and AR regression
models are represented by equations 3.1 and 3.2 respectively. The models used to test the TZ,
AR, and combined measures have the same dependent variable (i.e., one period ahead operating
cash flows) and sample size (i.e., n = 500). Thus, comparing adjusted R
2
between models is
justified with these conditions present (Gujarati 2003, p. 219).

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, =D
Table 14 summarizes the overall results. Results for the TZ-based and AR-based models are
carried forward from Tables 5 and 12 respectively. From Table 14, adding the AR income
smoothing measure to the TZ-based model results in an unchanged adjusted R
2
of 0.933.
However, adding the TZ income smoothing measure to the AR-based model results in increasing
the adjusted R
2
from 0.930 to 0.933. Overall, the TZ income smoothing rankings possess a
stronger association with one period ahead operating cash flows than the AR income smoothing
rankings, providing strong evidence that the TZ-based measure possesses greater power in
explaining the informative role of income smoothing.

Industry Association with Income Smoothing and Informativeness

Michelson et al. (2000, p. 148) find firms in the Mining and Transportation, and
Communications (TransComm) segments possess a higher likelihood of being classified as an
income smoother than a non-smoother. The results in this study indicate two industry segments
display a statistically significant association with operating cash flows (see Table 13). These
segments are: (i) Mining; and (ii) Transportation, Communications, Electric, Gas, and Sanitary
Services. Combining the results from the two studies suggest income smoothing firms in the
Mining and TransComm sectors possess a greater likelihood of displaying informative income
smoothing behavior when compared to firms in other segments.

Table 13 Results of H1 Tests TZ and AR Income Smoothing Measures, Association With
One Period Ahead Operating Cash Flows (Net Income)
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
Parameter
Estimate

t-stat
% 156.057 1.023 &
6
0.046 20.068
***
&
12
87.965 0.233
&
1
0.604 5.594
***
&
7
0.048 0.053 &
13
-41.742 -0.426
&
2
0.759 0.759 &
8
-122.153 -0.795 &
14
1,054.974 5.254
***
&
3
0.004 4.506
***
&
9
-24.495 -1.494 &
15
-23.814 -0.151
&
4
-0.298 -0.306 &
10
-50.860 -0.133 &
16
-41.541 -0.221
&
5
0.001 1.064 &
11
395.049 2.109
**
&
17
29.076 0.149

CF
it
= % + &
1
EARN
i,t-1
+ &
2
TZRANK
i,t-1
+ &
3
(EARN
i,t-1
* TZRANK
i,t-1
) + &
4
ARRANK
i,t-1
+ &
5

(EARN
i,t-1
* ARRANK
i,t-1
) +&
6
SIZE
it-1
+ &
7
GROWTH
i,t-1
+ &
8
LEVERAGE
i,t-1
+&
9
SEGNUM
i,t-1

+ &
10
D
1i-t-1
+ &
11
D
2i,t-1
+ &
12
D
3i,t-1
+ &
13
D
4i,t-1
+ &
14
D
5i,t-1
+ &
15
D
6i,t-1
+ &
16
D
7i,t-1
+ &
17
D
8i,t-1
+
(
it

n = 500 Adj. R
2
"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, >E
TZRANK = firms annual rankings as an income smoother under the Tucker-Zarowin
approach with a ranking of 1 indicating the highest degree of income smoothing
ARRANK = firms coefficient of variation ratio of annual change in earnings to sales
under the Albrecht-Richardson approach (earnings defined as net income)
of equity
study period


Table 14 Assessing the Relative Strength of the Income Smoothing Measures TZ and AR
Income Smoothing Measures
Adjusted R
2
1. Strength of TZ based Model

TZ model, Table 5 0.933
Combined TZ and AR model, Table
13
0.933
Increase in Adjusted R
2
By Adding AR 0.000

2. Strength of AR based Model

AR model, Table 12 0.930
Combined TZ and AR model, Table
13
0.933
Increase in Adjusted R
2
By Adding TZ 0.003

CONCLUSION

This study compares the informativeness of two income smoothing measures (i) Tucker and
Zarowin (TZ); and (ii) Albrecht and Richardson (AR). Using rankings to compare the measures,
"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, ><
results show the TZ approach possesses a stronger association with informative income
smoothing. Informativeness is defined as the association between earnings and one period ahead
operating cash flows. Greater association between the two indicates a higher degree of
informativeness. Researchers in prior studies have defined the information content of earnings in
a similar manner (e.g., Barth et al. 2001b; Dechow and Dichev 2002; Kim and Kross 2005).
Accounting academics should find these results useful in developing their income smoothing
studies as they can more effectively match the objectives of their studies (i.e., either informative
or deceptive income smoothing purpose) with the appropriate income smoothing measure (i.e.,
either TZ or AR measure).

The possible limitations of this study include threats to external validity. The calculation of the
AR and TZ income smoothing rankings for each year requires data for five years. Data for ten
consecutive years is required to produce the results for the entire study period. Thus, the
extended time series of data required by the study likely creates a survivorship bias in the
sample. Firms that exist for ten consecutive years tend to be established and successful, meaning
the sample lacks representation of startup firms.

Another potential limitation on external validity involves the requirement for consecutive
quarters without a break in the continuity between year-ends. Oyer (1998) finds firms typically
manage earnings in the last quarter of the fiscal period. This restriction eliminates many firms
subject to merger or acquisition with shortened fiscal periods and further reduces the
representativeness of the sample.

The period from 1997 to 2001 was predominantly a period of economic growth until the
recession of 2001 (National Bureau of Economic Research 2008). The economic circumstances
of this particular time period may influence accounting managers accounting choices with
regard to income smoothing. Results may not be applicable to a period of differing economic
circumstances (e.g. prolonged recessionary period). Other events subsequent to the study period
affect external validity. The more stringent statutory corporate governance requirements (e.g.
audit committee membership of a financial expert became mandatory) of the SOX commenced
in 2002, meaning this study predates this legislation. Extrapolating results outside the period of
study could lead to drawing erroneous conclusions.

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, >=
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Future Earnings? The Accounting Review, 71(3), July 1996, pp. 289-315.
Subramanyam, K.R., The Pricing of Discretionary Accruals, Journal of Accounting and
Economics, 22(1-3), August-December 1996, pp. 249-281.
Sun, J., The Effect of Analyst Coverage on the Informativeness of Income Smoothing, The
International Journal of Accounting, 46, pp. 333-349.
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5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, >?
Tucker, J.W., and Zarowin, P.A., Does Income Smoothing Improve Earnings
Informativeness?, The Accounting Review, 81(1), January 2006, pp. 251-270.
U.S. District Court, District of New Jersey, SEC v. Bristol-Myers Squibb Company (BMS),
August 4, 2004.

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Table A.1 Alphabetical List of Sample Firms
Name Name
1 7-Eleven Inc 27 Carlyle Industries Inc
2 Ackerley Group Inc 28 Carpenter Technology Corp
3 Airgas Inc 29 Cellstar Corp
4 Alliance Gaming Corp 30 Chart Industries Inc
5 Alltel Corp 31 Chemed Corp
6 Alpha Technologies Group Inc 32 Coherent Inc
7 Alpharma Inc 33 ConocoPhillips
8 Anadarko Petroleum Corp 34 Crown Cork & Seal Inc
9 Analytical Surveys Inc 35 Cypress Semicconductor Inc
10 Angelo & Maxies Inc 36 Devon Energy Corp
11 Anixter International Inc 37 Digi International Inc
12 Applebees International Inc 38 Dillards Inc
13 Applied Materials Inc 39 Dimon Inc
14

Apria Healthcare Group 40 Dow Chemical
15

Aptargroup Inc 41 Du Pont E I de Nemours
16

Ashland Inc 42 Edac Technologies Corp
17

AT&T Corp 43 EMS Technologies Inc
18

Atlantis Plastics Inc 44 Epresence Inc
19 Baxter International Inc 45 Esterline Technologies Corp
20 Beckman Coulter Inc 46 Fibermark Inc
21 Becton Dickinson & Co 47 First Data Corp
22 Belden Inc 48 Fleetwood Enterprises
23 Brown (Tom) Inc 49 Fleming Companies Inc
24 Brunswick Corp 50 Flowserve Corp
25 Burlington Resources Inc 51 Fuller H. B.
26 Caraustar Industries Inc 52 Genentech Inc

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, >A
Table A.1 (continued)
Name Name
53 General Electric Co 80 NACCO Industries
54 General Mills Inc 81 NCT Group Inc
55 Genzyme Corp 82 Networks Associates Inc
56 Georgia-Pacific Corp 83 Nobility Homes Inc
57

Gerber Scientific Inc 84 Nortek Holdings Inc
58

Haemonetics Corp 85 Novell Inc
59

Halliburton Co 86 Oakwood Homes
60

Harrahs Entertainment Inc 87 OM Group Inc.
61

Hasbro Inc 88 Owens & Minor Inc
62

Home Products Intl Inc 89 Owens Illinois Inc.
63

International Paper Co

90 Parker Hannifin Corp.
64

Intl Specialty Products Inc

91 Penford Corp
65

Ionatron Inc

92 Pharmacia Corp
66

Iteris Holdings Inc

93 Phelps Dodge Corp
67

Kadant Inc

94 Piccadilly Cafeterias Inc
68

Katy Industries Inc

95 Playtex Products Inc
69

Kellogg Co

96 Praxair Inc
70

Laboratory CP of Amer Hldgs

97 Pride International Inc
71

Lancaster Colony Corp

98 Qualcomm Inc
72

Lockheed Martin Corp

99 Raytheon Co
73

Lone Star Technologies

100 Res-Care Inc
74 Lyondell Chemical Co

101 Robotic Vision Systems Inc
75 Mattel Inc

102 Rohm & Haas Co
76 MGM Mirage

103 SBC Communications Inc
77 Mikohn Gaming Corp

104 Science Applications Int'l
78 MTR Gaming Group Inc

105 Service Corporation Int'l
79 MTS Systems Inc

106 Smurfit Stone Container Corp

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, >B
Name
107 Snap-On Inc
108 Spherion Corp
109 Standard Motor Products Inc
110

Stewart Enterprises Inc
111

Stryker Corporation
112

Sun Microsystems Inc
113

Synagro Technologies
114

T-3 Energy Services Inc
115

Temple Inland Inc
116

Terex Corp
117

Terra Industries Inc
118

Thermo Electron Corp
119

Unisys Corp
120

United Parcel Service
121

Universal Health Services
122

U.S. Airways Group Inc
123

Varian Medical Systems Inc
124

VCA Antech Inc
125

Xerox Corp

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, >C
Table A.2 Tucker and Zarowin (TZ) Income Smoothing Rankings
1997 1998 1999 2000 2001 Average
Ranking Ranking Ranking Ranking Ranking Ranking
7-Eleven Inc 114 117 95 3 1 66.00
Ackerley Group Inc 34 65 89 100 98 77.20
Airgas Inc 68 80 73 79 12 62.40
Alliance Gaming Corp 110 115 120 120 77 108.40
Alltel Corp 102 1 94 103 114 82.80
Alpha Technologies Group Inc 60 16 93 123 122 82.80
Alpharma Inc 119 114 116 65 72 97.20
Anadarko Petroleum Corp 49 14 19 104 108 58.80
Analytical Surveys Inc 44 36 30 74 78 52.40
Angelo & Maxies Inc 125 125 124 122 116 122.40
Anixter International Inc 86 50 35 37 28 47.20
Applebees International Inc 74 26 25 54 46 45.00
Applied Materials Inc 88 90 103 113 106 100.00
Apria Healthcare Group 122 111 122 124 124 120.60
Aptargroup Inc 50 45 45 45 27 42.40
Ashland Inc 94 79 9 88 89 71.80
AT&T Corp 115 107 107 72 74 95.00
Atlantis Plastics Inc 104 104 85 66 53 82.40
Baxter International Inc 83 68 84 107 69 82.20
Beckman Coulter Inc 117 109 111 108 57 100.40
Becton Dickinson & Co 42 116 99 73 64 78.80
Belden Inc 81 83 79 80 65 77.60
Brown (Tom) Inc 80 108 68 93 84 86.60
Brunswick Corp 76 32 42 39 67 51.20
Burlington Resources Inc 103 93 71 81 76 84.80
Caraustar Industries Inc 41 29 22 40 50 36.40
Carlyle Industries Inc 120 119 92 89 87 101.40
Carpenter Technology Corp 89 9 118 62 51 65.80
Cellstar Corp 39 56 58 84 34 54.20
Chart Industries Inc 51 51 86 109 117 82.80
Chemed Corp 33 54 61 11 38 39.40
Coherent Inc 69 91 64 27 25 55.20
ConocoPhillips 99 88 76 28 15 61.20
Crown Cork & Seal Inc 30 24 17 13 60 28.80
Cypress Semicconductor Inc 21 84 104 96 63 73.60
Devon Energy Corp 29 64 90 61 55 59.80
Digi International Inc 38 53 52 50 75 53.60
Dillards Inc 82 78 40 24 17 48.20
Dimon Inc 72 47 43 21 42 45.00
Dow Chemical 109 69 20 18 61 55.40

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, >D
1997 1998 1999 2000 2001 Average
Du Pont E I de Nemours 112 75 98 116 101 100.40
Edac Technologies Corp 40 59 70 95 90 70.80
EMS Technologies Inc 6 23 26 17 3 15.00
Epresence Inc 70 57 78 33 68 61.20
Esterline Technologies Corp 101 48 57 77 45 65.60
Fibermark Inc 67 30 13 2 97 41.80
First Data Corp 25 21 63 119 125 70.60
Fleetwood Enterprises 31 39 87 91 109 71.40
Fleming Companies Inc 2 89 114 114 111 86.00
Flowserve Corp 48 35 32 34 31 36.00
Fuller H. B. 95 92 38 31 23 55.80
Genentech Inc 43 25 123 121 118 86.00
General Electric Co 54 37 3 8 2 20.80
General Mills Inc 64 101 106 58 66 79.00
Genzyme Corp 107 118 113 101 81 104.00
Georgia-Pacific Corp 105 110 112 106 105 107.60
Gerber Scientific Inc 13 12 33 43 48 29.80
Haemonetics Corp 10 86 102 110 121 85.80
Halliburton Co 53 95 110 105 52 83.00
Harrahs Entertainment Inc 27 6 2 98 107 48.00
Hasbro Inc 19 8 4 32 43 21.20
Home Products Intl Inc 106 40 72 76 85 75.80
International Paper Co 85 94 101 1 93 74.80
Intl Specialty Products Inc 4 61 18 7 7 19.40
Ionatron Inc 113 99 34 5 49 60.00
Iteris Holdings Inc 46 20 36 30 13 29.00
Kadant Inc 79 105 59 59 19 64.20
Katy Industries Inc 121 123 66 64 103 95.40
Kellogg Co 45 34 15 69 73 47.20
Laboratory CP of Amer Hldgs 59 63 51 57 88 63.60
Lancaster Colony Corp 28 3 16 16 20 16.60
Lockheed Martin Corp 23 41 108 52 39 52.60
Lone Star Technologies 35 120 117 99 94 93.00
Lyondell Chemical Co 84 43 44 29 32 46.40
Mattel Inc 98 96 55 47 80 75.20
MGM Mirage 62 49 46 87 62 61.20
Mikohn Gaming Corp 20 62 60 97 86 65.00
MTR Gaming Group Inc 78 82 96 70 91 83.40
MTS Systems Inc 5 27 28 22 24 21.20
NACCO Industries 18 4 31 68 92 42.60
NCT Group Inc. 123 124 125 125 123 124.00

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, ?E
1997 1998 1999 2000 2001 Average
Networks Associates Inc 90 81 65 53 47 67.20
Nobility Homes Inc 15 31 37 25 37 29.00
Nortek Holdings Inc 97 18 12 10 14 30.20
Novell Inc 111 71 41 85 59 73.40
Oakwood Homes 1 11 29 48 18 21.40
OM Group Inc. 16 10 14 14 6 12.00
Owens & Minor Inc 22 19 6 4 5 11.20
Owens Illinois Inc. 66 106 75 83 104 86.80
Parker Hannifin Corp. 116 97 5 19 33 54.00
Penford Corp 24 22 10 36 26 23.60
Pharmacia Corp 47 28 88 86 99 69.60
Phelps Dodge Corp 75 66 81 90 82 78.80
Piccadilly Cafeterias Inc 73 60 74 92 113 82.40
Playtex Products Inc 118 67 11 42 56 58.80
Praxair Inc 63 42 21 20 11 31.40
Pride International Inc 61 77 77 94 70 75.80
Qualcomm Inc 55 38 24 38 102 51.40
Raytheon Co 36 33 8 15 22 22.80
Res-Care Inc 92 102 97 6 4 60.20
Robotic Vision Systems Inc 52 87 100 115 110 92.80
Rohm & Haas Co 57 15 67 78 96 62.60
SBC Communications Inc 124 122 83 51 40 84.00
Science Applications Int'l 3 2 1 44 58 21.60
Service Corporation Int'l 14 17 109 111 112 72.60
Smurfit Stone Container Corp 58 55 47 41 29 46.00
Snap-On Inc 8 58 62 55 35 43.60
Spherion Corp 7 13 7 9 21 11.40
Standard Motor Products Inc 26 74 56 56 36 49.60
Stewart Enterprises Inc 87 100 80 71 120 91.60
Stryker Corporation 37 52 54 82 100 65.00
Sun Microsystems Inc 17 44 39 49 8 31.40
Synagro Technologies 77 70 69 60 30 61.20
T-3 Energy Services Inc 71 7 48 67 95 57.60
Temple Inland Inc 56 85 23 23 9 39.20
Terex Corp 96 121 115 46 44 84.40
Terra Industries Inc 12 73 50 35 41 42.20
Thermo Electron Corp 11 46 82 75 71 57.00
Unisys Corp 100 112 119 117 115 112.60
United Parcel Service 32 98 105 112 119 93.20
Universal Health Services 9 5 27 26 16 16.60
U.S. Airways Group Inc 93 103 91 102 79 93.60
Varian Medical Systems Inc 65 72 53 63 54 61.40

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, ?<
1997 1998 1999 2000 2001 Average
VCA Antech Inc 108 113 121 118 83 108.60
Xerox Corp 91 76 49 12 10 47.60

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, ?=
Table A.3 Albrecht and Richardson (AR) Income Smoothing Rankings Net Income
1997 1998 1999 2000 2001 Average
7-Eleven Inc 32 123 119 70 119 92.60
Ackerley Group Inc 83 71 125 3 76 71.60
Airgas Inc 98 81 68 108 94 89.80
Alliance Gaming Corp 112 52 117 120 58 91.80
Alltel Corp 65 34 21 47 89 51.20
Alpha Technologies Group Inc 123 86 89 4 86 77.60
Alpharma Inc 120 94 51 71 112 89.60
Anadarko Petroleum Corp 81 5 122 31 95 66.80
Analytical Surveys Inc 23 18 91 17 40 37.80
Angelo & Maxies Inc 5 83 96 103 55 68.40
Anixter International Inc 94 58 38 68 102 72.00
Applebees International Inc 31 28 17 11 26 22.60
Applied Materials Inc 44 96 50 39 110 67.80
Apria Healthcare Group 57 21 36 59 61 46.80
Aptargroup Inc 55 55 39 63 62 54.80
Ashland Inc 64 48 25 78 48 52.60
AT&T Corp 102 7 42 16 11 35.60
Atlantis Plastics Inc 103 99 41 87 68 79.60
Baxter International Inc 88 15 37 112 120 74.40
Beckman Coulter Inc 62 106 105 109 116 99.60
Becton Dickinson & Co 110 61 76 74 81 80.40
Belden Inc 20 115 116 106 39 79.20
Brown (Tom) Inc 28 57 108 72 67 66.40
Brunswick Corp 73 70 94 24 22 56.60
Burlington Resources Inc 113 42 74 60 82 74.20
Caraustar Industries Inc 84 97 112 94 20 81.40
Carlyle Industries Inc 114 60 104 28 73 75.80
Carpenter Technology Corp 107 47 121 107 60 88.40
Cellstar Corp 89 118 92 102 123 104.80
Chart Industries Inc 40 33 102 125 114 82.80
Chemed Corp 10 112 12 75 14 44.60
Coherent Inc 46 95 123 88 25 75.40
ConocoPhillips 47 113 46 35 83 64.80
Crown Cork & Seal Inc 74 121 79 37 38 69.80
Cypress Semicconductor Inc 80 20 83 61 23 53.40
Devon Energy Corp 39 73 78 38 118 69.20
Digi International Inc 50 66 56 9 69 50.00
Dillards Inc 121 122 75 101 66 97.00
Dimon Inc 85 80 109 56 101 86.20
Dow Chemical 9 2 2 18 41 14.40

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, ?>
1997 1998 1999 2000 2001 Average
Du Pont E I de Nemours 54 6 8 90 105 52.60
Edac Technologies Corp 1 51 65 118 51 57.20
EMS Technologies Inc 96 84 111 95 117 100.60
Epresence Inc 30 67 86 21 70 54.80
Esterline Technologies Corp 75 32 20 19 42 37.60
Fibermark Inc 38 36 66 82 75 59.40
First Data Corp 105 78 32 66 97 75.60
Fleetwood Enterprises 36 50 53 123 5 53.40
Fleming Companies Inc 21 8 61 110 124 64.80
Flowserve Corp 19 13 98 84 54 53.60
Fuller H. B. 125 109 87 93 24 87.60
Genentech Inc 79 62 59 116 125 88.20
General Electric Co 48 16 67 40 16 37.40
General Mills Inc 60 25 34 85 79 56.60
Genzyme Corp 116 105 110 114 113 111.60
Georgia-Pacific Corp 86 43 35 83 90 67.40
Gerber Scientific Inc 69 117 70 99 45 80.00
Haemonetics Corp 76 38 73 55 34 55.20
Halliburton Co 18 92 54 42 30 47.20
Harrahs Entertainment Inc 68 65 26 96 98 70.60
Hasbro Inc 95 116 107 29 9 71.20
Home Products Intl Inc 45 102 40 65 107 71.80
International Paper Co 106 114 100 48 32 80.00
Intl Specialty Products Inc 49 110 84 92 50 77.00
Ionatron Inc 93 82 80 105 47 81.40
Iteris Holdings Inc 100 10 1 36 18 33.00
Kadant Inc 70 44 27 10 10 32.20
Katy Industries Inc 92 90 69 26 37 62.80
Kellogg Co 78 17 9 7 93 40.80
Laboratory CP of Amer Hldgs 61 103 97 79 29 73.80
Lancaster Colony Corp 59 45 44 73 78 59.80
Lockheed Martin Corp 41 54 19 12 13 27.80
Lone Star Technologies 22 41 6 57 65 38.20
Lyondell Chemical Co 34 108 3 80 53 55.60
Mattel Inc 97 46 60 8 96 61.40
MGM Mirage 63 26 90 41 52 54.40
Mikohn Gaming Corp 119 79 99 67 74 87.60
MTR Gaming Group Inc 82 31 48 51 64 55.20
MTS Systems Inc 72 72 114 104 121 96.60
NACCO Industries 7 27 14 27 12 17.40

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, ??
1997 1998 1999 2000 2001 Average
NCT Group Inc. 15 37 4 15 35 21.20
Networks Associates Inc 108 64 23 44 100 67.80
Nobility Homes Inc 104 77 62 5 103 70.20
Nortek Holdings Inc 35 30 29 46 77 43.40
Novell Inc 2 1 113 49 28 38.60
Oakwood Homes 25 87 72 13 2 39.80
OM Group Inc. 11 11 7 6 8 8.60
Owens & Minor Inc 118 125 47 25 80 79.00
Owens Illinois Inc. 27 63 49 76 104 63.80
Parker Hannifin Corp. 58 59 71 86 92 73.20
Penford Corp 115 9 95 45 19 56.60
Pharmacia Corp 4 4 88 122 21 47.80
Phelps Dodge Corp 87 119 5 2 4 43.40
Piccadilly Cafeterias Inc 8 104 77 98 27 62.80
Playtex Products Inc 117 39 81 50 108 79.00
Praxair Inc 17 14 16 64 49 32.00
Pride International Inc 52 74 58 111 85 76.00
Qualcomm Inc 37 40 30 30 59 39.20
Raytheon Co 111 93 85 20 17 65.20
Res-Care Inc 99 56 124 117 88 96.80
Robotic Vision Systems Inc 77 75 82 124 1 71.80
Rohm & Haas Co 29 3 106 97 84 63.80
SBC Communications Inc 124 49 33 32 44 56.40
Science Applications Int'l 67 24 22 62 57 46.40
Service Corporation Int'l 26 29 103 14 15 37.40
Smurfit Stone Container Corp 6 88 55 119 115 76.60
Snap-On Inc 14 100 118 121 87 88.00
Spherion Corp 42 35 15 23 6 24.20
Standard Motor Products Inc 3 85 10 81 72 50.20
Stewart Enterprises Inc 71 111 115 77 43 83.40
Stryker Corporation 13 124 43 69 63 62.40
Sun Microsystems Inc 66 53 57 54 109 67.80
Synagro Technologies 122 120 63 43 33 76.20
T-3 Energy Services Inc 51 19 45 22 111 49.60
Temple Inland Inc 91 101 101 89 106 97.60
Terex Corp 101 22 24 58 99 60.80
Terra Industries Inc 56 107 18 34 31 49.20
Thermo Electron Corp 33 91 13 1 36 34.80
Unisys Corp 53 76 11 33 71 48.80
United Parcel Service 90 69 120 91 91 92.20

"#$%&'( #) *&+,%-./0.1(.&'%2 3$/.&,// 4+$-.,/

5#61'%.&7 +8, *&)#%6'+.9,&,//: ;'7, ?@
1997 1998 1999 2000 2001 Average
Universal Health Services 24 12 31 52 46 33.00
U.S. Airways Group Inc 43 68 64 100 3 55.60
Varian Medical Systems Inc 12 23 28 53 56 34.40
VCA Antech Inc 109 98 93 115 122 107.40
Xerox Corp 16 89 52 113 7 55.40

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