Income smoothing is an active manipulation of earnings toward a predetermined target. It involves taking steps to reduce and store earnings during the good years and defer them for use during the business-downturn years, removing volatility in earnings (Healy & Wahien, 1999). The application of income smoothing can also be referred to as earnings management or creative accounting.
Regulatory framework provides legislations which govern financial reporting (i.e. The Companies Act 2006) and Accounting standards, which are detailed rules governing the accounting treatment of transactions, and other items shown in the statements. Income smoothing though very commonly used, is not an accepted practice and must be looked out for by auditors. In the 1960's the financial sector of the UK economy lost confidence in the accounting profession, as internationally known UK based companies were seen to publish financial data that was materially incorrect. There were two big scandals, the first being the General electric company (GEC) takeover of AEI. Pre takeover accounts prepared stated profit forecasts of £10 million differing materially from the post takeover accounts, which showed a loss of £4.5 million. These differences arose from differences in 'judgement' i.e. the new directors took a different view to the value of stock.
The second was Pergamon Press Ltd which showed a profit of £2million, where an independent investigation by Price Waterhouse suggested profits should be lowered by 75% because of a failure to reduce certain stock at the lower of cost and net realisable value. These two real life examples highlighted aggressive earnings management and how easily mislead stakeholders were.
It is important to ensure accounts give a 'true and fair view' as there are many different stakeholders. Investors need to know how profitable/stable a company is before investing. Lenders and banks need to be sure the company will be able to repay loans, so need to be able to trust reported figures. Despite the need for accounts to satisfy stakeholder needs, the economic downfall has increased pressures on every dimension, so management altering impressions about their firm's business performance has increased. The Auditing Practices Board (APB) (2001) stated 'when economic conditions become difficult, the likelihood of aggressive earnings management and misleading financial reporting increases.' An important aspect of financial reporting is presenting information about a company's performance shown by measures of earnings and their components (Kirschenheiter & Melumad, 2002). Income smoothing influences information regarding the company's performance. The final figures published need to be useful to the readers of the financial statements. This relates to the reliability of the accounts. Reliability is the quality of information that assures information is reasonably free from error and bias and represents what it seeks out to represent. (Kirschenheiter and Melumad, 1997:50). When smoothing happens, the information may not be reliable or free from bias, again not being of use to the stakeholders. Another accounting policy that needs to be followed when preparing accounts is relevance.
Income smoothing can occur in many different ways, with book entries being used to manipulate profits. These entries stretch accounting principles to their limit and compromise the integrity of any information based on such entries. Ellis and Williams (1993:169) state profits are not a reliable measure of a company's performance as companies adjust profits to suit their own purposes by using provisions. The most common area where smoothing is applied is depreciation. Companies can change the method of deprecation and alter the useful lives of fixed assets.
Another common area open to manipulation is stock valuation which was made clear in the case of Pergamon Press Ltd (mentioned above). The 'allocation' book entry groups together the assignment of costs of depreciable assets to manufactured inventories, period expenses, and amounts reported on year end balance sheets. Costs of inventories and supplies are assigned to period expenses and closing inventories (Thomas, 1975). The 'matching' book entry deals with whether a transaction should be recorded during the current period or the next leaving it down to managerial decision rather than an accounting choice. (Wolk, Francis and Tearney, 1992).
There are many reasons for income smoothing, which can be associated with the size of the company and the deviation from actual earnings from forecasts. Reasons could include ensuring the survival of the organisation, whilst others could be due to the existence of bonus incentive schemes, where managers have more incentive to smooth earnings to project a better than expected level of performance, in order to gain a bonus themselves. In relation to this, smoothing may increase a manager's compensation if tied to reported earnings (Wild et al. 2001). Another reason for smoothing income is to lower a company's tax burden (Getschow 1986). If profits are projected as low, the amount to be paid to the tax office will consequently be lower. Management need to ensure smoothing is done for the good of the organisation (i.e. its survival) and does not jeopardise minority stakeholders or employees. If management want to reach certain goals to the damage of the outside stakeholders, it could be perceived as self beneficial, unethical and fraudulent (Chong, 2006). An example could be if a process is implemented to meet targets due to poor management. If management consistently act self beneficially, shareholders and relevant other stakeholders will lose faith in the organisation and unwanted media and investor attention could occur.
Often, it is very difficult for users of the accounts to be able to tell if income smoothing has occurred, as they rely on the auditor's report and presume all accounting standards and practices have been put into place and followed. Many times however, income smoothing has occurred in flexibility of the generally accepted accounting principles (GAAP) and with the many possible interpretations of some of the principles put forward. Getschow (1986), stated the Union Carbide Corporation increased their first quarter profit (without adding cash) by applying more liberal accounting methods for depreciation, investment tax credits and interest cost incurred during construction. This was referred to as 'Accounting magic' as it was done within the rules of GAAP. Yoon and Miller 2002 argue managers wilfully manipulate reported profits to fit their own intentions by selecting certain accounting policies, changing accounting estimates and manipulating accruals. As this is all done within GAAP, a large responsibility lies with the auditors who must give an independent opinion on whether directors give a 'true and fair view' and recognise these 'magic tricks' commonly used, increasing the subjectivity of financial statements. The APB (2001) highlights the need for auditors to act with greater professional scepticism, and understand the pressures on directors and management to deliver specific levels of earnings. Understanding the approaches and frequency could facilitate the identification of internal players of an organisation. (Nelson, Elliot & Tarpley, 2003).
As income smoothing/ creative accounting is perceived as deceitful practice, ways to prevent it should be considered. An example of this can involve requiring regular revaluations, so gains/losses are identified each year as they occur, rather than appearing in total in the year of disposal.
Overall, the nature of financial reporting involves producing final accounts showing the current position of a given company. Users of the accounts (including investors, lenders, customers etc) realise the importance of performance evaluation and recognise the higher the levels of profits, the better the company is doing. Keeping investor's confidence high is extremely important and the need to maintain that is even higher. Income smoothing can be bad as well as a good thing. Good income smoothing occurs when management create a stable financial performance by acceptable and voluntary business decisions (Chong, 2006) A little window dressing may be harmless so long as it does not harm any of the stakeholders. Bad income smoothing occurs when management creates artificial accounting entries or stretches estimates beyond reasonable limits (Parfet, 2000). In many situations the line between good and bad income smoothing is very shaded. Management need to take into account situations that may change and review options based on the current and future business legal environment. The key element here, to ensure income smoothing remains 'good', is to ensure actions are for the benefit of the company, (its stakeholders), and not an individual manager or a specific stakeholder group, and that legal and ethical grounds are kept within.
Finally, accounting regulation is set out to prevent fraudulent and unethical behaviours, however, book keeping entries are allowing the smoothing of income within all grounds of the GAAP, so auditors need to be overly sceptic. Despite income smoothing being labelled as a negative phenomenon, management will continue to smooth income, with the knowledge that it may harm investors, so long as they believe they will not get caught or it will be of benefit to them.
References:
Chong, G., (2006). Is income smoothing ethical? Journal of Corporate Accounting. 18 41-44
Elliott, B., Elliot, J., (2009). Financial Accounting and Reporting. 13th Edition Harlow: Pearson Education Ltd.
Ellis, J., Williams, D., (1993) Corporate strategy and financial analysis. London: Pitman Publishing.
Getschow, G., (1986). Paper profits. In: the accounting sampler. 4th Edition. New York: McGraw Hill.
Healy, P. M., & Wahien, J. M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons. 13 365-383.
Kirschenheiter, M., Melumad, N.D., (2002). Can 'big bath' and earnings smoothing co exist as equilibrium financial reporting strategies? Journal of Accounting Research. 40 (3), 761-797.
Kirschenheiter, M., Melumad, N.D., (2002). Earnings Quality and smoothing. Working paper. Draft: June 2002
Nelson, M. W., Elliot, J. A., & Tarpley, R. L. (2003). How are earnings managed? Examples from auditors. Accounting Horizons, 17 17-26.
Parfet, W. (2000). Accounting subjectivity and earnings management: A preparer's perspective. Accounting Horizons, 14 481-488.
The Auditing Practices Board. (2001). Aggressive Earnings management. [online] Available from: <www.frc.org.uk/images/uploaded/documents/aggrressive.pdf > [Accessed 3rd April 2010]
Thomas, A.L., (1975). The allocation of fallacy and financial analysis. Financial Analyst Journal. 1 (5), 37-41
Wild, J.J., Bernstein, L.A., Subramanyam., K.R., (2001). Financial Statement Analysis. 7th Edition. New York: McGraw -Hill Higher Education.
Wolk, H.L., Francis, J.R., Tearney, M.G., (1992). Accounting theory - A conceptual and institutional approach. 3rd Edition. Ohio: South Western Publishing.
Yoon, S.S., Miller, G.A., (2002) Cash from operations and earnings management in Korea. The international journal of Accounting. 37 (4), 395-412.
