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Competition and Informational Consequences of Smoothing Firm Income
Mehmet Ozbilgin, Baruch College - City University of New York
ABSTRACT. Income smoothing by firms is prevalent and appears mostly in the form of managerial decisions that counterbalance extreme income realizations. In this study, I construct a model of competition between two firms and demonstrate that an important strategy for a firm aiming to prevent its rivals from discerning its operational performance through its financial reports is income smoothing. By smoothing its income, a firm improves the likelihood of its accounting system not revealing the type of extreme accounting profit numbers that would point more clearly to the success or failure of its operational strategy. A rival is then less able to tell whether a reported accounting profit derives from operational success or failure to inform its own operational decisions to outrival the firm. The model also identifies the conditions which encourage the firm to unsmooth its income and consequently release more informative accounting earnings to its rival yet still improve its expected profit.
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