A Bellman's Equation for the Study of Income Smoothing

Some authors distinguish between ``earnings management and ``income smoothing. The former occurs when the manager reports a number different from ``actual earnings to shareholders without facing intertemporal restrictions on the discretionary amount that she reports. In contrast, income smoothing requires the reported earnings figure to ``add up to the actual earnings figure over a period of time. Among the methods typically used to smoothe income are: early/late write down of inventory estimates of bad debt expense and write down hereof the application of the revenue recognition method (under, for example, the completed contract method it is easy to delay recognizing revenue by leaving a minor part of the project unfinished until the next fiscal year). The model allows the manager to recognize a fraction of next period's income in this period (i.e., ask the customers to pay in advance for deliveries in January and recognize revenue on a cash basis) and to postpone the recognition of some income items (for example, bill the customers in January for shipments made in December and recognize revenue on a cash basis). For companies that produce to order it is not unreasonable to assume the company knows next period's revenue when periods are relatively short. Defense contractors, for example, know relatively well what next quarter's revenue will be. Hence the model describes income smoothing rather than earnings management.