Smoothing Earnings Business Literacy Institute Financial Intelligence

Show bioRebekiah has taught college accounting and has a master's in both management and business. Firm profitability and financial leverage showed a positive significant effect on firm value, while, firm size is insignificant. The efficiency of this relationship is mostly affected by the individuals and opportunistic interests held by each party. This created an agency problem and costs, which includes nonalignment of the agents’ interest with owners' interest (Nyberg et al., 2010). By appointing agents, the owners expect the agents to act in their interest, but the interests of the principals and the agents are not always aligned . Common stock with a high dividend yield and few profitable investment opportunities. This type of fund invests primarily in government, corporate and other types of bonds, debt securities, and other income producing securities and in certain circumstances can also hold common and preferred shares.

Now that you're familiar with some of the reasons why earnings management occurs, let's look at some of the legal techniques that are used. Though there are a number of these techniques, for this lesson, we're only going to look at the top five. The proxy for measuring firm value in this study is the average share price. This has been documented in previous studies such as Ajekwe and Ibiamke , Bao and Bao , Chen et al. , De Jong et al. and Yu et al. . The terms income tax expense and income tax provision are used interchangeably. Formally called a consolidated earnings statement, it covers a period of time such as a quarter or a year. Financial Intelligence takes you through all the financial statements and financial jargon giving you the confidence to understand what it all means and why it matters.

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Consumption smoothing allows them to control their spending so that they can meet their various obligations when income is fluctuating. To achieve consumption smoothing, most people plan and try to stick to a budget so that they can pay their bills when they come due. Consumption smoothing can also be used in economics to explain consumers’ responses to increasing prices or inflation. If a household recognizes an increase in the price of certain goods and services throughout the economy, they may smooth out consumption by spending less in other areas. The idea of consumption smoothing has been reinforced by a few economists over the years. He developed the life-cycle hypothesis, which explains how individuals keep their consumption steady over time by borrowing when income is low and saving when income is high.

This is a tax planning strategy of arranging for income to be transferred to family members who are in lower tax brackets than the one earning the income, thus reducing taxes. Even though attribution rules limit income splitting, there are still a number of legitimate ways to do so, such as through the use of spousal RRSPs. Extraordinary items, and the cumulative effect of changes in accounting principle. Of current-period originations and reversals of temporary differences. Extraordinary gains and losses that should be recorded in the period).

Income smoothing and the cost of debt

Often times, the company has set its own internal goals, such as departmental budgeting, and wants to be sure to meet those goals. No department wants to be the one to blow the proposed budget, so earnings management techniques are used to balance this out. Leverage is negatively significant to firm value; this depicts that increase in https://accounting-services.net/ debt capital, reduces firm value. This finding is consistent with Bao and Bao , Chen et al. , Feihn and Struck , Huang et al. , and Makela which documented negative relationship between financial leverage and firm value. On the other hand, Cvetanoska and Kerekes ; Demerjian et al., ; Yang and Zhu , and Yu et al. found contrary results.

• More so, this suggests that smoothen practices are seen to signal private information by managers to investors, thus, income smoothing is perceived from the information view rather than the garbling view.
• If income was expected to be lower for the year, they could employ the strategy in reverse; laying off workers or reducing bonuses to reduce expenses.
• There are many reasons why a company would choose to engage in income smoothing.
• Since the decision of when revenue was earned and expenses incurred can vary based on individual opinion, this earnings management technique, like the others, is legal.
• Looking for training on the income statement, balance sheet, and statement of cash flows?
• Then when earnings are higher, the corporation will increase spending for personnel and get caught up on the maintenance it had put off.

Whiles one business organization is using strategic means and proper accounting methods for its income smoothing, another may be using dubious or unscrupulous means for hedging its income. Restructuring CostsRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements.

Net income

This implies that volatility seem to enhance investment activity in the Nigerian market, thus, improving stock returns. Thus, capital market pressure to report smooth earnings that meet performance benchmarks is one key reason for managers to engage in smoothing that resulted from manipulations (Graham et al., 2005).

After all, the financial statements are what potential investors and creditors look at when they make the decision whether or not to lend the company money or to become an investor. Purpose – This study aims at investigating whether income smoothing helps to reduce volatility in reported earnings and which firms are more inclined to be engaged in income smoothing. Earnings management has a negative effect on earnings quality, and Income Smoothing Definition may weaken the credibility of financial reporting. Furthermore, in a 1998 speech Securities and Exchange Commission chairman Arthur Levitt called earnings management "widespread". Despite its pervasiveness, the complexity of accounting rules can make earnings management difficult for individual investors to detect. Generally, the result of this study reveals the perception of investors on the value of Nigerian listed firms.

Income fund

Literature reveals that investors react negatively to unstable reported earnings. The profit a company makes after cost of goods sold, expenses, and taxes are subtracted from net sales. Difference between revenues and expenses) of a corporation over some period of time. Though an income smoothing practice being used by a company may be legal, it may not be ethical. Accounting has its general guidelines such as neutrality, full disclosure, comparability, consistency etc.

Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life to account for declines in value over time. FREE INVESTMENT BANKING COURSELearn the foundation of Investment banking, financial modeling, valuations and more.

Underwriting income

In high market volatility, investors' prefer stable earnings as this gives assurance to investors on the financial position of the firms (Chen et al., 2020; Cvetanovska and Kerekes, 2015; Habib et al., 2011; Jung et al., 2020; Takasu and Nakano, 2012). This practice is especially common in publicly-held companies, where investors are more likely to bid up the price of shares in a company that presents a reliable and predictable earnings stream over time. Of course, if its income smoothing practices are later made known to the investment community, they will probably drive down the price of its stock. Revenue recognition – In this earnings management technique, the timing of when revenue is recognized is manipulated. Since the decision of when revenue was earned and expenses incurred can vary based on individual opinion, this earnings management technique, like the others, is legal.

Furthermore, one of the factors that explain firm value is market risk. This concept of market risk is reflected in the volatility of the market. Chung and Chuwonganant studied the relationship between sensitivity of stock returns and market volatility and found a negative shock on stock returns in high volatility. As such, Pereira and Zhang posit that investors adapt their trading strategy to the volatility in the market.

It has called on standard-setters to make changes to accounting standards to improve financial statement transparency, and has called for increased oversight over the financial reporting process. The SEC has also pressed charges against the management of firms involved in fraudulent earnings management. Beidleman defined income smoothing as an attempt by management to reduce abnormal variations in earnings to the extent allowed under sound accounting and management principles. Income smoothing is a form of earnings management (Agrawal and Chatterjee, 2015; Demerjian et al., 2020; Tabassum et al., 2015). Managers either use their discretion to alter earnings by different accounting choices or change operations for the sake of earnings targets .