Managerial Ability and Income Smoothing

There are two views regarding income management. The first view aligns with good income management, whose arguments are based on blocked communication. According to this concept, managers have much information related to the company due to their expertise, but providing information directly to the public is very expensive. This prevents the direct presentation of information. In this view, income smoothing as one of the income management models can help the manager indirectly provide confidential information to users and reduce information asymmetry. However, the opposite point of view, whose arguments indicate bad income management, shows that managers use income smoothing for their personal interests, which aligns with opportunism. Managers with a high level of proficiency in improving company performance are typically expected to utilize smoothing to minimize information asymmetry. On the other hand, even managers with a lower level of ability in company performance may opt to employ smoothing techniques due to the required skill set and the potential negative consequences associated with poor smoothing decisions, such as financial abuses, damage to reputation, and job loss. Therefore, high-ability managers are generally expected to use their authority more effectively to disclose hidden information through smoothing techniques than their low-ability counterparts.Based on signaling theory and prior research on income smoothing and managerial ability, it is hypothesized that there is a relationship between managerial ability and income smoothing. Furthermore, it is expected that income smoothing, when associated with managerial ability, can enhance the informational value of income. Capable managers are expected to use income smoothing as a tool to communicate information to the market compared to weak managers; for this reason, they use more income smoothing, which leads to an increase in the informational content of income. Specifically, this study examines whether high-ability managers use income smoothing more than low-ability managers. It also examines whether smoothing by higher-ability managers increases the information of current earnings about future performance compared to earnings smoothing by lower-ability managers. 

The current research is applied in terms of purpose. Following the previous studies, ordinary least square regression correlation analysis was used to test the research hypotheses. The sample for this study comprises 791 firm-year observations from companies listed on the Tehran Stock Exchange from 2012 to 2018. 

Evidence shows that managerial ability has a positive relationship with earnings smoothing, and managers with high ability provide more forward-looking information through earnings smoothing, thereby increasing the information content of earnings about future performance. Indeed, smoothing by high-ability managers increases the ability of current earnings to predict future cash flows. In contrast, smoothing by managers with low ability reduces the ability of current earnings to predict future cash flows. This conflicting effect of smoothing by low-ability managers and reducing the informational content of earnings highlights the importance of considering management's ability to evaluate the usefulness of earnings smoothing. In the study, a common factor was used for smoothing at the company level based on three smoothing methods (1) the standard deviation of income divided by the standard deviation of operating cash flows; (2) the relationship between changes in accruals and changes in operating cash flows and (3) the correlation between changes in discretionary accruals and changes in earnings before management. MAScore has been used to measure managerial ability; MAScore is a measure of management team ability derived from data envelop analysis (DEA). 

Managers' ability can be considered one of the main factors in using income smoothing to communicate company information to the market. Capable managers use income smoothing to reduce information asymmetry and indirectly signal to the market. Managerial ability can be defined as the performance efficiency of managers compared to competitors in using the company's resources to create more Income. Evidence shows that capable managers use more income smoothing. Also, the evidence shows that capable managers use income smoothing to disclose the company's secret information to the market to reduce information asymmetry and indirectly signal to the market. High-ability managers have superior skills in evaluating the future performance of the firms under their management, so their smoothing of earnings increases the information content of earnings. High-ability managers smooth earnings to disclose information in current earnings. Therefore, they improve the information content of Incomes about future performance. These findings are consistent with the view that high-ability managers use their superior skills to predict their firms' economic prospects and use smoothing to transmit tacit information to the market. The results of this research can be useful for understanding the factors and benefits of income smoothing.