income smoothing methods

“How do you explain to an intelligent public that it is possible for two companies in the same industry to follow entirely different accounting principles and both get a true and fair audit report? ” – M.

Lafferty Nowadays, as our economy is facing possible everyday crises, managers undergo an increasing pressure in order to keep their company’s earnings stable. Shareholders and analysts expect companies to meet forecasted goals and not to deviate from these. Especially, reliable companies are to report positive results and shall not present any ‘surprises’.Managers therefore often turn to their accounting departments for help, whose job it then is to improve the bottom line by changing the information shown in financial statements and hence improve investor confidence.

This process is also called earnings management. Earnings management may be utilised in several different ways – facilitated by the flexibility of the US GAAP and the IFRS. These can be stated and interpreted in numerous ways whilst accountants work in the ‘gray zones’ of accounting principles.Profits can be changed easily by using certain accounting methods or manipulating accruals.

When discovered, this information will have a negative effect on a company’s share price and its reputation in general. Methods of Income Smoothing In order to present a more positive result to shareholders and a more favorable view of company’s results, numerous methods exist that can be used by accountants. Most methods are achieved by using book entries. The Depreciation Method The Depreciation Method is one of the most popular methods applied.

Hereby a company may change their method of depreciation from straight line to declining balance method or vice versa. Additionally a popular option exists to increase the useful life of an asset. (see Appendix A. 1) The Allowance Method Within the Allowance Method a company sets aside a certain percentage of their outstanding accounts receivable which they know will not be collected (allowance for uncollectable accounts / loans receivable).

These are recorded as an expense in the income statement and as a reduction of current assets on the balance sheet.As an example from a supplier bonus view, it is possible to book higher bonuses than actually expected (accounts receivable) and then debit/write-off the remaining amount within the next period. The higher the allowances, the higher the decrease in net profit, which can be used to smooth earnings (or decrease the tax load to be paid). By using factoring, which occurs when a business sells its accounts receivables to a third party at a lower price in exchange for immediate money, a company can accelerate incoming payments.

The Under or Over Provisions Method The Under or Over Provisions Method allows companies to smooth income depending on the level of cash flow observed. Provisions are liabilities which may or may not occur in the future and are used to cover these liabilities in the case of occurrence. Therefore it is a popular method to smooth earnings by increasing or decreasing the amount of provisions (e. g.

provisions for pensions) depending on whether income is to be increased or decreased respectively. The Accruals Method / The Reserves MethodAccruals are created through the retention of profits. They are used to prevent possible losses and therefore to protect the equity (Eigenkapital) of a corporate entity. Therefore “creative reserves” may be established that can be hidden during profitable years and then those earnings may reported during less profitable years.

The Amortization Method The Amortization Method includes amortization of prepaid insurances, pensions, leases and goodwill. Hereby the debt that incurs is paid-off on a regular basis.Amortization is used in the case of intangible assets (like depreciation for tangible assets) to “reduce the yearly income generated by the assets by their decreasing values so that the tax imposed upon the earnings of assets is less”. In theory, amortization is used as an expense in the income statement and accounts for the reduction in value of the intangible asset over its useful life.

However, many companies also amortize so-called ‘one-time expenses’ by listing them as a capital expense (on C/F) and paying the cost by amortization, hence improving the company’s net income. The Classification MethodThis method defines whether or not a transaction is classified as operating income or non-operating income. The Matching Book Method The Matching Book Method allows managers to decide in which period transactions are to be recorded. Thus, this method is the most powerful method in income smoothing.

The Channel Stuffing Method The Channel Stuffing Method is a tool used to inflate sales within a company by selling goods to customers that did not order them in first place. This leads to more positive sales figures at first (which can then be stated) but has several disadvantages in the long-run.Conclusion Smoothing of income is an undeniable practice used by accountants to favour the companies’ current needs, therefore it can be showing rather higher or lower earnings than the actual latter. There are several methods through which this practice is applied depending on the preferences as well as on the requirements of the people interested in the financial statements.

Approaching income smoothing from the legality perspective, one would surely come by – not only – examples of both legal and illegal aspects, but also by a gray area, where it is mostly unclear whether the act is a fraud or not.As companies step away from the legal frame, they are able to play with the numbers more; or vice versa. The understanding of legality depends firstly on the country level where the practice is taking place. As far as the law is concerned, there may or may not be space for flexibility of the accountants.

In case the standards for financial reporting are set by regulations, it is more difficult to come across ‘creative accounting’ in comparison to the existence of alternative choices.Taking all points mentioned above into consideration, all cases should be evaluated individually by the authorities when making the decision stating that it would be a crime. From the ethical point of view, fudging with the factual numbers is a question of a desire for self performance and higher economic goals, where accounting principles of fairness and reliability are being ignored. Accounting theoretical principles therefore stay contrary to accounting practices.

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