Income smoothing

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Income smoothing

Financial information is very important in a business/company as it's the heart of the company. It is crucial to analyse and understand financial information and statements to run a company effectively. Accounting is the understanding, summarising and recording of financial transactions and events to help make the management or board make better decisions.

Income smoothing is moving and adjusting a company's financial statements to show stable profits rather than great fluctuations. An example of income smoothing is spreading the cost of an asset over a longer period of time, this will make profits higher.

Income smoothing is usually used when companies come under pressure due to economic issues and want to change information and profit margins. Many managers use income smoothing as a tool for showing 'smoother incomes' to shareholders, as this will get rid of their fear of the company going bankrupt and showing good earnings. Income smoothing also improves a company's trade with suppliers and customers. Information presented is very important because this information will be used by different types of decision makers for example, banks will look if the company can repay the loan, and managers need to know the financial statement of the company. Income smoothing can be used without asking shareholders.

Profits are not a reliable measure of a companies performance. Companies can change and adjust profits to suit their needs and purpose by using provisions. A company cannot make cash but can boost profits, boosting of profits happens in book entries. Provisions are profits of the business which are set aside and to be used at a later date. Depreciation is the most common place where smoothing is put into practise. Companies will look at amortization and depreciating assets over a longer period of time to smooth income.

Income smoothing reduces volatility as reported income is increase or decreased properly. Income smoothing also smoothes debt and enhances cash flow to shareholders, this will make the company look attractive to future investors and will give everyone in the company confidence that the company is making steps in the right direction. Income smoothing may also help a company to meet targets with a steady earning rise, steady and stable profits make it easier and more reasonable to reach targets, and additionally it makes it easier to set targets for the next year.

Owners of the company will feel more comfortable with the position of the company because of stable earnings this will also make higher dividends rates. If a company is doing well then the prices of shares will rise as well as the payout to shareholders. Steady and stable incomes will make better relationships all round, from managers to investors, though to suppliers and customers. Income smoothing can be used to maximise the value of a company.

Smoothing a company's income will also reduce the tax weight of that company. Rather than a company paying high tax one year due to profits, they can spread the cost evenly over a period of time meaning they can tackle the tax burden of the company easier.

It is very vital to maintain the investors confidence because the information presented to them will make them know how stable and profitable a business is for them to invest their money in. Showing current investors stable profits will increase confidence and better relationships throughout the whole company, and there will be a sense of trust and security in place. Investors and stakeholders take all the risks because they put their capital into the business so it is crucial to let them know that they have made a wise and safe choice rather than showing them faults and flaws in the company.

Earnings are the profits of a business/company. Investors look at the earnings to see how attractive the business looks to invest in the stock. Companies with not very good earnings records will usually have low share prices. Earning management is a tool used by managers of a company to change and move earnings within a company to meet expectations and target figures. This is used by a company because instead of a company having a really profitable year and then a year that is not so good in earning wise, a company can just smooth and balance them both up and keep stable earnings, rather than high and low earnings.

There are obvious flaws to this strategy for example if a company does not accompany to the rules and regulations and decide to abuse the system, then they can get issued fines. Now if an individual investor decides to invest in the business based on the information given then there's nothing much they can do. This makes the life of an investor very hard as accounting rules are very complex and long, there's not much an investor can do if they don't find out about a scandal that's happened in an earlier date. So earning management is very vital to every company and especially to the managers of a company who want to attract new investors or get current ones to invest more. Furthermore it is very important to evaluate the performance of a company, this lets everybody connected to the business know how well they are doing, what position the company is at, how close they are to meeting targets and what are the next set of steps for the company.

Aggressive earnings management usually starts with the shareholders and investors being misled due to an entity's profitability and performance. Sometimes aggressive management and misleading information can lead to criminal offences, only courts can determine this. Aggressive management is usually done with economic climate is bad and the possibility of misleading information increases. Aggressive management is a type of fraud and is not a reporting mistake. Some types of aggressive earning management are to give inappropriate revenue recognition, estimates of liabilities and unsuitable accruals. 

The way to tackle aggressive earning management is to keep on developing good corporate governance and keep up to date accounting standards, furthermore good auditing standards also help to tackle this problem. Auditors at the end of the day give their opinion if they think what information given to them by the managers about financial statements is correct and reasonable.  I think the board, managers and investors should all sit down and discuss the financial statements of the company and then pass them on to auditors.

Limitations have obviously been put into practise by accounting standards, securities and boards. There have been large companies dragged into law suits because of the management not showing reasonable information and trying to abuse the system clearly. Managers will want to show good profits to achieve their own personal goals and promotion. Accounting standards have tried their best to give maintain their standards and have tried to update it from time to time but still and especially in this economic climate which we are in today you will still find some firms managers trying to bolster profits by income smoothing.