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Optimal Smoothing of Profit Via Overhead Allocation
Author(s) -
Shuo Su Steve Yu
Publication year - 2007
Publication title -
abacus
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.632
H-Index - 45
eISSN - 1467-6281
pISSN - 0001-3072
DOI - 10.1111/j.1467-6281.2007.00223.x
Subject(s) - smoothing , parallels , econometrics , economics , profit (economics) , depreciation (economics) , earnings , earnings management , volatility (finance) , rationalization (economics) , accounting method , conservatism , microeconomics , accounting , mathematics , operations management , statistics , capital formation , financial capital , politics , political science , law
Income smoothing, as defined in Statistical Activity Cost Theory (SACT), is the rational statistical adjustment of periodic accounting earnings to reduce their time volatility around average long‐term profit per period. This article demonstrates how overhead cost allocations can be applied to smooth accounting earnings optimally in accordance with this definition. Such an approach parallels earlier work, such as that by Lane and Willett (1997, 1999), in which a depreciation formula was derived and applied for this purpose. In particular, it is shown that, to realize an income smoothing effect in profit making firms, the usual optimal strategy is to over‐allocate costs, giving support to the accounting principle of conservatism.