Communication and income smoothing through accounting method choice

This paper shows how accounting income smoothing could arise as rational equilibrium behavior. A two-period agency model is developed in which an agent obtains, after the first period’s production operation, private information regarding future productivity of the operation. Direct communication of the agent’s private signal yields a strict Pareto improvement over no-communication in this two-period world since it allows the agent to achieve signal-contingent interperiod consumption smoothing. Delegation of accounting method choice to the agent is shown to be an alternative, Pareto-equivalent mechanism to direct communication in this paper. Thus, accounting method choice is one way to achieve interperiod signal-contingent consumption smoothing by smoothing accounting income. One such accounting choice which arises from the structure of the problem is the choice of depreciation method.