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Optimal Smoothing of Profit Via Overhead Allocation

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  • Steve Yu Shuo Su

Abstract

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.

Suggested Citation

  • Steve Yu Shuo Su, 2007. "Optimal Smoothing of Profit Via Overhead Allocation," Abacus, Accounting Foundation, University of Sydney, vol. 43(2), pages 136-155, June.
    • Handle: RePEc:bla:abacus:v:43:y:2007:i:2:p:136-155
    DOI: 10.1111/j.1467-6281.2007.00223.x
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    References listed on IDEAS

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    1. Christos A. Grambovas & Begoña Giner & Demetris Christodoulou, 2006. "Earnings conservatism: panel data evidence from the European Union and the United States," Abacus, Accounting Foundation, University of Sydney, vol. 42(3‐4), pages 354-378, September.
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