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When entities experience exogenous or endogenous shocks they turn to the finance department to resolve the issue, due to financial instability. It is important to know what income smoothing is and the benefits and costs it can bring to a business. This essay will critically evaluate and identify the nature and effects of income smoothing. What is income smoothing and what are the nature and effects of it? Income smoothing is defined as, "the process of manipulating the time profile of earnings to earning reports to make the reported income less variable, while not increasing reported earnings over the long-run" Riahi-Belkaoui (2007).
Income smoothing would be used by firms to remove volatility in earnings by balancing the fluctuated peaks over the years. Its primary objective is to smooth income variability, by lowering income during good years and as a result defer them for use during the bad years, Beidleman (1973). Beidleman suggested two reasons why management would want to smooth income. Firstly, a stable earning can support a higher level of dividends than a variable earnings stream. Secondly, the ability to counter the cyclical nature of reported earnings are likely to reduce the correlation of a firms expected returns with returns on the market portfolio. This shows that income smoothing will benefit firms in the short term as it can help the firm achieve a stable financial position. Companies can retain their reputation and accomplish company objectives, such as short run profit maximisation (MC=MR). This can be achieved by altering some accounting policies and manipulating accruals. However, in the long run firms will be highly risky and may face liquidation problems. If a firm wants to smooth its income, it needs to be consistent? However, one may ask is this achievable? It is not achievable because there are other factors, which would need to be considered which could influence a firm's decision.
Income smoothing can be traced back to the book of entries, and will be internally done by management, as this is the initial point of income smoothing. Firms may also manipulate inventory figures to smooth income. It is important that the inventories amounts are accurate, and comply with the relevant accounting standards (IAS2). "...the define practices, to narrow the differences and variations in those practices and to ensure adequate disclosure in the accounts" Elliot & Elliot (2007).
The nature of income smoothing can be identified by applying the Eckel's (1981) "Income variability method of analysis". The method makes two distinctions. First distinction is made between an intentional or designed smoothing and a natural smoothing. The second distinction is to classify the intentional or designed smoothing with either an artificial smoothing or a real smoothing, Riahi-Belkaoui (2007). Eckel's suggested that income smoothing can occur due to "window-dressing" figures. This shows that income smoothing will not take into effect external influences and will not have any effect on cash, because figures are simply manipulated, which means there is a shift in costs and/or revenue from one period to another. He suggested that income smoothing can be accomplished by "choices and timing of purchasing, hiring production investment, sales, capital budgeting, research and development, advertising and other decisions" Ibid (2007). From a firm's perspective, a firm may alter its income, in order to improve their performance for future, based on their past performances during the financial period.
Also, the government would want to know how the firms are performing, due to taxation purposes. Firms may want to understate profits, so they can reduce taxation liabilities. By manipulating data, the firm can be in more danger and they could be in a tax fraud.
In an article "Is income smoothing ethical," Gin Chong has identified three areas where income smoothing can benefit firms. Firstly, firms will have to meet demand, and this can be achieved through forecasting. As a result, meeting forecasts will benefit the firm in short term, as they can make sure that demand is being met. A manager's objective may be to earn higher income, by expanding the business. However, sometimes managers cannot fully meet these forecasts and they decide to smooth income. If income smoothing is managed efficiently in achieving the firm's objectives, then this would allow managers to earn higher earnings and bonuses. Nevertheless, if there is an organisational structure change, where management is rotated, and then management would change. Therefore the decisions and management styles and techniques would change as managers would have new objectives for how they want the firm to be managed. Furthermore, there are several aspects which can prevent managers from income smoothing. This can be like external influences like competitive markets, which would reduce the firm's chances of income smoothing.
Secondly, firms will need to meet performance objectives. The importance of performance evaluation is that it can aid the firm to meet goals of the business which are required to be to find alternative methods of accounting for transaction. If managers are seeking to earn higher earnings, then they can manipulate the figures, so that the statements show that the firm is performing well. This would provide managers with a higher income salary, which would be an incentive for them. Therefore, from the manager's perspective, they have the authority and control to transform the earnings, so that they can earn a higher bonus. However, this top-down approach can be seen as unfair for others who are at lower levels. As they could be working hard to achieve the firms objectives and they would receive low incentives and cause de-motivation.
Finally, firms would need to avoid violations of debt arrangements. The firm would have to take actions in order to avoid debt arrangement. If a breach is found, then the other party may increase interest rate and demand their money back immediately. This would cause short-term cash flow issues for the firm and in the long run it can cause the "going concern concept" for the organisation. This can be avoided by smoothing income, by increasing earnings. This would benefit firms as it can help them survive in the short term.
Aggressive earnings management is a key issue which would need to be considered. Firms may have commercial pressure, which may force firms to manipulate data to make accounts look good. For example, the importance of meeting targets to ensure job security for directors, management and employees would enable the management to smooth income. However, this problem with aggressive earnings management could be that the capital markets would be misled into the firm's performance and profitability. This is because revenue will not be recognised accurately, accruals will be misleading and liabilities will be estimated. When economic conditions are unstable, it can be assumed that firms would be more likely to use aggressive earnings management and income smoothing.
Firms would be showing annual positive financial statements. In UK, according to the accounting regulations "Companies Act 2006", when preparing annual accounts, an auditor is responsible for confirming whether accounts comply with the accounting standard and show "a true and fair view of the company". If accounts are not complying, then firms are breaching the legislations. The benefit of having this regulation, so that accounts comply with rules and income smoothing can be stopped. Accounting regulations will have a huge impact on the firm's accounts, as some businesses will not comply with the international standards due to frequent change. Accounting bodies want to achieve convergence in future, by creating one worldwide set of standards, which will be more compatible.
Stakeholders like shareholders would be relying on this type of information, as they would be interested in investing in the company. The high returns from the company would provide incentives for them to invest, as they would be able to receive higher dividends. Income smoothing would have a negative impact for shareholders, as they will get a false impression that the company is performing well. This would not benefit them as they would have taken a high-risk by investing into a company which manipulated data. This would mean they would be highly likely to lose the amount they invested into the company, if the firm went into receivership. For that reason, it is vital to maintain investor's confidence in published annual reports, as this will aid towards growth of the firm.
The Auditing Practices Board (APB) can intervene to take action on aggressive earnings management and income smoothing. They can help to make sure the financial statements comply with the Company's Act 2006 and also, it can aid the auditors to be more alert and understand how they can improve auditing for future, by identifying and responding to aggressive earnings and income smoothing faster. Grant (2001)
Overall, the management should consider all stakeholders' perspective and any decisions made should benefit the firm and ensure the firm will continue in existence. However, in the real life, it would be difficult to find whether any income smoothing methods have taken. Also, to what extent the figures have been manipulated would be hard to measure. Good income smoothing will take place if the management will be able to create a stable financial performance by considering all business objectives and taking into stakeholders needs, without breaching any legislations.