Evaluating the effects of income smoothing

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This essay will critically discuss and evaluate the effects of income smoothing, identifying arguments for and against this practice. The essay will examine the importance of financial reporting, problems of aggressive earnings management, arguments against and for income smoothing and the limitations of accounting regulations combating income smoothing.

Income smoothing is a process of creative accounting that manipulates financial statements to avoid any fluctuations, small or large. It manipulates the financial statements to show steady profits yearly. This process is to reduce the chances of income shock before occurring.

Financial reporting does not only include the financial statements but also the communication of financial information for example notes to the financial statement, director's report and auditor's report. The financial information allows external users such as potential investors or the government to analyse the company's financial position. Financial reporting is a source of information used by many users in assisting them to make decisions, financially or economically.

Countries have developed their own principles and regulations meaning no two or three countries have the same principles and regulations. Therefore, there are principles to ensure comparability and uniformity between financial statements from different countries. This principle is usually referred as GAAP, which are set of guidelines and regulations that are put into place to provide the foundation in preparation of financial statements.

Fraudulent activities do take place in financial reporting, usually by omission or by act resulting in misinterpretation of financial statements. Constant pressure on the management may lead to fraudulent financial reporting. External or internal auditor's report would not guarantee misinterpretation exist.

Earnings management is a procedure that is taken by managers to alter financial statements to mislead the end users because of economical or financial performance; it does not matter if the financial information is either good or bad. Aggressive earnings management is considered as a fraudulent activity - the use of false increases or decreases in profits and revenues through tactical accounting that is tactically aggressive and limited by GAAP.

Management tries to seek a loophole in the financial accounting standards by following a certain pattern, allowing adjustments to the financial numbers as much as possible to satisfy their predictions or criteria. Auditors can find errors in financial statements but earnings management involves fraudulent activities that can be very sophisticated that is concealed.

Aggressive earnings management is likely to be managed by large firms in comparison to small firms. There is much more pressure for large firms in comparison to small firms and large firms also has more influential power with auditors. Large firms have more assets, current and non-current in comparison to small firms' therefore higher probability to do earnings management. This can indicate that there is higher probability for large firms to manage earnings management in comparison to small firms.

Maintaining investors' confidence is crucial for businesses that are publishing shares to interested shareholders. Companies that cannot meet the investors target for earnings per share and dividends per share would see the company's market capitalization decline; therefore companies in situations similar to this would be motivated to alter financial numbers in the financial statements to indicate the company's healthy position, so investors are confident with the company's performance. However, companies that have excellent financial numbers published in financial statements are no exception to alter financial numbers. Companies in situation like this are likely to decrease the financial numbers to a certain level that still meets the investors' interest in earnings per share and dividends per share.

As the above paragraph indicates that investors are important to small and large companies because they invest money when needed and may help through difficult times. Investors are interested in annual statements because the financial numbers would indicate the company's position. If the company's annual statement shows good financial numbers then the investor would be happy. However, if company's annual statement shows financial numbers that are not good enough, then the investors would be unhappy and probably sell their shares. So, as the above indicates why there is a need to show good results in the annual statements to maintain investors' confidence - that is why many companies have to alter their financial numbers to maintain investors, good or bad.

The importance of performance evaluation in any company, small or large is to measure the actual performance with the resources designed to compare the utilization of resources and provide feedback for reporting. Management uses this technique to change the structure of the program, or to improve the company's performance. In the case of accounting, performance evaluation can improve the financial statements published annually because there is evident of sales and revenue. Companies can measure the amount of stock sold in the month for the next twelve months against the stock available and planned for the twelve months. This would give companies a more realistic financial numbers in comparison to earnings management, as there is no need to falsely increase or decrease financial numbers. If the company realise that expectations are not going to be met, performance evaluation allows the change of structure to the predictions.

There is no answer to the effectiveness of accounting regulation, as it depends on the companies' financial reporting requirements. The effectiveness of accounting regulation is very reliant to the companies' financial reporting requirements. There are still many accounting regulations in place, some countries are now following the international accounting standards, but many countries' still have its own accounting regulation. Accounting regulations have been updated every year, internationally and nationally, but financial scandals have taken place, which has made the accounting regulators update the regulations to avoid any more financial scandals. However, there are still loopholes in accounting regulations, which allows financial scandals to happen.

Accounting regulations have limitations; can only carry out something to the extent excepted by the regulator/s. Limited companies in the UK have the obligation to comply with the regulations set in the UK and all financial statements must be comparable and understandable. The regulation states that inventory/stock must be valued at the lower price, so limited companies can not set the value of inventory/stock at the selling price. There are limitations for large limited companies in the UK, where all published accounts must comply to the regulation whereas small companies do not have the tight regulation to follow, allowing some freedom in publish financial accounts.

After much examination into financial reporting, performance evaluation, aggressive earnings management and regulations and limitations of accounting regulation - income smoothing seems to relate with the subjects and there are reason for and against income smoothing.

Reasons why many companies are for income smoothing are to do with pressure to meet expectations and pressure from the external environment. As stated earlier, income smoothing techniques can help turn bad financial numbers to good numbers that may meet expectations, which would impress its investors and stakeholders. Manipulating the numbers to show steady profits annually indicates that the company are well positioned and financially doing well, bringing in more potential investors meaning money injection. There are not many reasons for income smoothing because it seems to be a selfish act by the company to subsequently hide the fear of bankruptcy or that the company have no money.

The first and main reason against income smoothing, it is not legal and many consider income smoothing as a fraudulent activity. The manipulation process does not show or indicate the correct growth of steady profits, or decrease of profits. Certain journal entries are estimations, judgements and predictions, not actual financial figures.

After much research and reading, I have come up with a conclusion. On the face of many internet websites and books, income smoothing seems bad and illegal. However, research showed that many companies in the world do some kind of creative accounting.

My research indicated to me that income smoothing is wrong and illegal because it involves manipulation of numbers, be it good or bad. However, I found that many companies decide to manipulate their numbers because of constant pressure to perform, or to avoid paying big dividends to shareholders.

From the above, I strongly believe that income smoothing is not ethical because of the manipulation process, but more worryingly the use of artificial numbers to increase or decrease profits. I believe the Companies Act 2006, Part 15; Chapter 12 ("Liability for false or misleading statements in reports") can support my statement.