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Smoothing Income and Future Earnings in Accounting Case Study

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Updated: Jul 15th, 2020

Introduction

It is commonly known that when managers intend to smooth the earnings of their companies, they make discretionary decisions regarding the information in the financial reports. Thus, it is important to provide the theoretical background of the reasons and incentives that make managers apply the income smoothing (DeFond and Park 116). First of all, the performance of the managers is partially evaluated based on the positive profit of the company and the smoothness of the earnings. Therefore, out of the consideration for the job security and personal benefits, it is tempting for the managers to discrete some information in the financial reports presented to the external audience.

On one hand, when the anticipations about the company’s performance are too optimistic, the managers might be tempted to be able to meet the expectations. Thus, when it is not possible through real economic actions, the other option is to smooth the income by using discretionary actions. On the other hand, when the business is not expected to be successful in the upcoming fiscal year, the managers are concerned that they could be dismissed, which also creates an incentive for the income smoothing.

Income smoothing and expected earnings

While traditionally, income smoothing is associated with the factor of the company’s current performance, it is also important to distinguish the correlation with the forecasts about the company’s future and the anticipations of the external audiences as a matter of impact on the managers. Three assumptions prove the expectations about the company’s future performance to be an important incentive. Firstly, as it was previously mentioned, the managers themselves, in many ways, depending on the company’s performance (DeFond and Park 117). Their benefits are not monetary, but their very position in the firm stands in the direct correlation with the profits of the company.

Moreover, the second assumption concerns the fact that any lack of success of the company or not meeting the expectations can result in the manager’s dismissal (Hand 590). The poor performance of the firm can be the result of numerous factors, but it is commonly linked to the effectiveness of the managers.

Thirdly, when dealing with a large amount of structured information in the financial reports, the audience gives more weight to the current performance than to the same data in the past (Schipper 96). Thus, it creates the situation, in which, first of all, the consistency of the company’s performance, in general, and the manager’s routine, in particular, are disvalued. Furthermore, it gives the managers the incentive to smooth the earnings using the discretion of information in their financial accruals.

Based on those assumptions, there are some patterns concerning the correlation between the current performance of the company, the expected performance in the future, and the degree of smoothing the income. Firstly, the companies with the current poor level of financial performance and anticipation for the increase in it in the future are more likely to be involved in the income smoothing practices (Kothari and Sloan 155).

Thus, in those cases, the managers borrow the profits from the expected cash flow in the future or report the expected profits as the already received ones. However, there is an opposite option, in which companies with successful performance in the present and the anticipation for it to worsen, try to postpone reporting their current earning to the future, to make the overall situation look more consistent.

Data and variables estimation

To carry out the analysis, the study by DeFond and Park (1997) relies on using such variables as changes in current assets, current liabilities, cash flow and cash equivalents, debt in the current liabilities, and depreciation and amortization of expenses (DeFond and Park 120). The total accruals are defined as the change in the current assets minus all the other figures. With such a model, the researchers can estimate the unmanaged accruals. Furthermore, the discretionary accruals are distinguished as the difference between those unmanaged total accruals and the value of the profits and cash flow in the reports that have undergone the discretionary procedure (Healy 98).

Analysis Data and main empirical results

The best option to minimize the unfortunate consequences of the income smoothing, there should be a model of forecasting the performance of the company more effectively. The system of forecasting has to be sensible, to analyze the information and to put it into the database quite quickly, and to consider the fact that some managers disclose the reports on the performance later than expected (White 825).

The main issue is that both too optimistic and too pessimistic forecasts of the analysts give the incentives for the increase in the earnings management. Also, the main correlation is that the degree of income smoothing increases in the correlation to the gap between the current earnings and the anticipations of the analysts, when the income is either quite low or relatively high with the opposite forecasts.

Summary

The main incentive of smoothing income is the role of the positive earnings and income anticipations in the evaluation of the company’s performance. Thus, both too optimistic and too pessimistic forecasts of the analysts give the incentives for the increase in the earnings management. The main correlation is that the degree of income smoothing increases in the correlation to the gap between the current earnings and the anticipations of the analysts.

Works Cited

DeFond, Mark L., and Chul W. Park. “Smoothing income in anticipation of future earnings.” Journal of accounting and economics 23.2 (1997): 115-139. Print.

Hand, John RM. “1988 Competitive Manuscript Award: Did Firms Undertake Debt-Equity Swaps for an Accounting Paper Profit or True Financial Gain?” Accounting Review 1.1 (1989): 587-623. Print.

Healy, Paul M. “The effect of bonus schemes on accounting decisions.” Journal of accounting and economics 7.1 (1985): 85-107. Print.

Kothari, Stephen P., and Richard G. Sloan. “Information in prices about future earnings: Implications for earnings response coefficients.” Journal of Accounting and Economics 15.2 (1992): 143-171. Print.

Schipper, Katherine. “Commentary on earnings management.” Accounting Horizons 3.4 (1989): 91-102. Print.

White, Halbert. “A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity.” Econometrica: Journal of the Econometric Society 1.2 (1980): 817-838. Print.

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IvyPanda. 2020. "Smoothing Income and Future Earnings in Accounting." July 15, 2020. https://ivypanda.com/essays/smoothing-income-and-future-earnings-in-accounting/.

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IvyPanda. (2020) 'Smoothing Income and Future Earnings in Accounting'. 15 July.

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