Managerial Accounting Assignment - Income Smoothing - Term Paper Example

Managerial Accounting Assignment: Income Smoothing Student’s Name Institution Introduction Income smoothing is defined as the immediate action adopted by managers in an attempt to utilise their reporting judgment to intentionally underpin the alterations, as brought about by fluctuations, of their respective companies’ earnings (Tucker & Zarowin, 2006). In fact, it involves the equalization of a firm’s income within specific operational periods to distinctive levels. This indicates that the smoothing mainly ascertains to limiting possible fluctuations in income and thus, results to the income approaching a degree whereby the overall management’s utility aspect is indeed maximized (Tucker & Zarowin, 2006). The focus of this paper is to examine income smoothing and it can be used to improve on earnings in-formativeness. Body It is important to note that managers use income smoothing technique in a way that allows their respective utility maximization; in truth, the management would make sure to reduce the level of posted income in the operational periods whereby company’s performance is deemed to be favorable and income is perceived to be comparatively high (Bartov & Mohanram, 2004). On the contrast, they engage in the creation of income in operational periods whenever firm’s performance is deemed to be unfavorable and thus, income perceived to be comparatively lower (Jacob & Jorgensen, 2003). Over years, most of researches have been conducted to figure out aspects that trigger this level of behavior amongst managers. Bartov & Mohanram (2004) notes that monetary compensation and degree of management’s reputation are some of the most notable factors associated with the practice. Income smoothing applications have also been fairly expounded from the view of economic rationalities, which basically means that the capital costs should, at all times, be expected to reduce in the event that the reported earnings have been subjected to the smoothing process (Graham, Harvey & Rajgopal, 2005). This is to say, investors would always engage in the rating of firm’s that depict insignificant fluctuations to be of higher earnings in comparison to ones that depict a significant degree of fluctuation in terms of their earnings. It thus goes without saying that investors will choose to avail lots of capital to companies that showcases a smoother earnings flow. Research indicates that the common origin of this diversified level of managers’ motivation rests with the psychological stipulations that persons would always tend to disassociate themselves from extreme uncertainties as well as complexities for that matter (Kothari, Leone & Wasley, 2005). In truth, most, if not all, companies depict a universal enticement to the aspect of income smoothing. The effect of income smoothing on earnings in-formativeness is not fairly known due to limited research (Hunt, Moyer & Shevlin, 2000). It is arguably right to note that income smoothing sets to improve on earnings in-formativeness especially in the event that managers engage in utilizing their respective inducement to provide efficient communication in relation to assessing future earnings (Hunt, Moyer & Shevlin, 2000). By contrast, income smoothing tends to make earnings much noisier in case when managers engage in intentional distortion of earnings figures within a given operational period. Graham et al (2005) notes that since managers depict a distinctive level of inducement over a given set of accounting choices they are likely to smooth report income and thus, improving on the rate of this earning significantly (Lambert,1984). Most of the surveys conducted on this matter postulates that managers would likely engage in smooth reported income in order to accomplish set bonus targets or even protect their reputation and thus, positions within a firm (Kirschenheiter & Melumad, 2002). A contracting theory ascertains that income garbling, which emanates from managers discrete behaviors, postulate an equilibrium solution given that the overall principal would otherwise compelled to pay-off a higher level of premium in order to compensate the underlying agent that enjoys surplus information advantage as they assume additional degree of risk (Lambert, 1984). In situation like this, even in the case where contract is deemed to be efficient, the distinctive nature of communication is perceived to having been garbled hence the reported income would be less informative in regards to a company’s immediate future revenues as well as cash flows (Suh, 1990). In difference, other numerous studies perceive income smoothing as a platform for which managers use in order to expose their respective private information, which could be either active or even passive in nature, on future earnings (Jones, 1991). Notably, the degree of reported income informs potential investors to a given firm, on the level of future permanent cash flows that might emanate from the investment activity (Barth, Landsman & Lang, 2008). In fact, possible fluctuations of any reported income would act to decrease investors’ level of confidence in relation to the inferred permanent aspect; dual responsibility compels managers to smooth income (Basu, 1997). The Spence’s signaling framework postulates that only those companies that enjoy a positive and favorable future prospect engage in smoothing of earnings since the process of borrowing from a possible future could prove to be a dangerous affair to a poorly performing company whenever the issue explodes in the near period (Basu, 1997). In particular situations, private information relating to future income can as well as be communicated in a passive manner. Managers engage in smooth income in order to foster smooth consumption; and by doing so, they make public private information on future income (Dechow, Sloan, & Sweeny, 1995). On the contrary, other studies note that even in the case where there is absence of incentives, possible future income will be partially communicated in an efficient contracting manner for the time managers utilize future earnings information to decide on whether they can promote underlying smooth current earnings. Remarkably, whether private information is passed on in active or passive manner, income smoothing could result to a company’s existing and previous income more informative in regards to future earnings and cash flows (Gassen, Fülbier & Sellhorn, 2006). It is important to understand that managers embrace many different ways of inducing numerous discretionary behaviors; and for this case, income smoothing. Technical accounting policies as well as material accounting policies are two classification methodologies that have been used to expound on the aforementioned methods as adopted by managers (Gassen, Fülbier & Sellhorn, 2006). The technical accounting policy framework indicate that managers will always seek to manipulate the underlying accounting numbers posted without any need to alter actual business operations (Beidleman, 1973). Needless to say, in those cases whereby there is a high number of accounting policies that could be adopted and their selection is deemed to be permissible as an accounting practice, managers will be compelled to choose one of the policies at hand or even set to alter operations from a single policy to another or rather engage in the immediate manipulation of inter-period apportionment of numerous accounting postings (Gassen, Fülbier & Sellhorn, 2006). On the contrary, material accounting policies adopt an indirect manipulation of all accounting postings while still making sure to indirectly control business operations as well. Iñiguez and Poveda (2004) notes that some of the notable engagement adopted by managers to ensure smooth income can be perceived in the direction of stiffing to most of the subsidiaries and affiliates, improving or even diminishing operational expenditures in relation to advertising and publicity costs, Research & Development costs among others (Martinez & Castro, 2011). Most of the accounting data, which can be in the form yearly security or financial reports, summary of financial results or even in other cases; annual cases are utilized for purposes of external evaluations of the accounting policies at hand (Martinez & Castro, 2011). In other cases, income smoothing is embraced in accounting in order to decrease the variability of annul financial results (Valipour, Talebnia, & Javanmard, 2011). Notwithstanding, top notch inducement is never adopted in results management only since it can be depicted in the level of conservatism of companies (Ryan, 2006). In consequence, companies can showcase a more or less conservative approach in their respective accounting practices while that level of conservatism allowed directly affecting the overall accounting outcomes (Valipour, Talebnia, & Javanmard, 2011). Markedly, it is noted that most of these conservative firms fails to disclose optimistic financial statements. By not doing so, these firms eliminate or rather decrease underlying level of current profits (Valipour, Talebnia, & Javanmard, 2011). Over-engaging in the manipulation of reporting financial outcomes acts to deceive the existing shareholders since it misrepresents an economic reality of a business operation, which might even results to a prevention of possible increase in the level of profits (Valipour, Talebnia, & Javanmard, 2011). Research indicates it is almost imperative for most managers to engage in the reduction of uncertainties or even risk measures that are perceived by potential investors’ s being an enormous concern for economic and financial situations of companies they ought to manage (Watts, & Zimmerman, 1986). One of the notable uncertainty embraced by these managers involve the variation of income over a specified period of time, which can as well; be reduced using different smoothing approaches aimed at, and within the statutory accounting frameworks, to reduce the degree of dispersion of overall accounting outcomes (Watts, & Zimmerman,1986). Numerous metrics have been put forward to expound on verification of income smoothing. One of the most notable metric is Eckel’s mode and another developed by Leuz; the latter uses a series of standard deviation of operating earnings that is then divided by the standard deviation of operating cash flows in order to come up with a new variable that sets to accumulate all observations made within a company over a specified number of years (Leuz, Nanda & Wysocki, 2003). Eckel’s model stipulates income smoothing can be easily practiced using a specified set of accounting processess that could include; recognition, measurement as well as final disclosures (Eckel, 1981). Artificial income smoothing is practiced with the adoption of accruals. These accruals do not alter the level of cash flow and is not focused on economic stipulations as such but rather; it is deemed to be of similar attribute as anticipated revenues as well as expenditures (Healy, 1985). On the contrast, real income smoothing basically embraces different economic events like the sale or even purchase of a firm’s fixed assets thus affecting cash flow levels (Myers, & Skinner, 2002). It is thus evident that the process of income smoothing a company’s reported earnings will always integrate a managers’ private knowledge about the company’s expected income degree (Demski, 1998). The aforementioned private information is deemed to be important and valuable to any potential investor in evaluating a company’s future performance. Until recently, studies indicate that income cannot result to negative phenomenon at all times. In essence, few analytical studies have shown that under specific set of assumptions, income smoothing could be purportedly beneficial to existing shareholder as it improves on their underlying wealth (Wang &Williams, 2006). It thus means that the rational shareholders would trigger the element of income smoothing amongst managers whenever they smoothed numbers are a potential of attracting new and prospective investors. Wang and Williams (2006) argue that smoothed income figures are perceived in a positive way by the securities market. The security market response to earnings for companies with distinctive smooth income trends is deemed to be significantly larger in comparison to its counterparts since they are seen as being less risky by prospective investors. Conclusion To sum up the discussion above, it can be noted that income smoothing is indeed a formulation of management of a given company to ensure that earnings are represented in such a way that would attract potential investors. It is the immediate action adopted by managers in an attempt to utilise their reporting judgment to intentionally underpin the alterations, as brought about by fluctuations, of their respective companies’ earnings. It involves the equalization of a firm’s income within specific operational periods to distinctive levels. Numerous studies perceive income smoothing as a platform for which managers use in order to expose their respective private information, which could be either active or even passive in nature, on future earnings. In other cases, income smoothing is embraced in accounting in order to decrease the variability of annul financial results. Real income smoothing basically embraces different economic events like the sale or even purchase of a firm’s fixed assets thus affecting cash flow levels. References Bartov, E., & Mohanram, P. (2004). Private information, earnings manipulations, and executive stock option exercises, The Accounting Review 79 (4), 889–920. Barth, M., Landsman, W., & Lang, M. H. (2008). International Accounting Standards and accounting quality. Journal of Accounting Research, 46 (3), 467-728 Basu, S. (1997). 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