Stabling income is one of the earning management strategies that have a direct influence on earnings quality. While it may seem illogical to restrict revenue recognition in good years purposely, companies with predictable financial performance typically have cheaper borrowing costs. It encompasses all strategies for reducing excessive expenses and increasing sales or profits. The methods range from using suitable financial reporting to using reasonable thinking.
This has been documented in previous studies such as Ajekwe and Ibiamke (2017), Bao and Bao (2004), Chen et al. (2016), De Jong et al. (2013) and Yu et al. (2017). This study is built on agency theory being a theory of organizational process, behavior and outcome. Agency theory provides insight and understanding of corporate processes and designs to address emerging problems from the principal–agent relationship.
This was used in Cvetanovska and Kerekes (2015), Feihn and Struck (2011), and Huang (2011). The lawyers and staff at CunninghamLegal help people plan for some of the most critical times in their lives and then guide them through when those times come. Income smoothing is not a one-time event but rather a habit that builds over time. By understanding and implementing these strategies, you can potentially save a significant amount of money over the long term.
While deliberately slowing revenue recognition in good years may seem counterintuitive, in reality, entities with predictable financial results generally enjoy a lower cost of financing. But it’s a fine line between taking what the Internal Revenue Service (IRS) allows and outright deception. If the process is following the guidelines inventory to sales ratio of Generally Accepted accounting principles (GAAP), income smoothing doesn’t turn out to be illegal. Competent and skilled accountants can help adjust financial books in a way that makes sure that the income smoothing is nothing but viable. The excess of revenues over expenses, including the impact of income taxes.
Equity Risk Premium: Meaning and How to Calculate It
A company might engage in smoothing to enable better strategic business management. A company planning a major investment might suffer a major share price decline if the investment coincides with news of weak earnings, which might affect funding costs and investor appetite if a share placement is needed. The term refers to a wide range of good and bad practices such that it cannot be collectively termed as legal or illegal. 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. A business strategy a company can use when they have high profits is to increase expenses.
- This technique, implemented through various accounting methods, aims to present a more stable and predictable earnings stream.
- This latter topic is inserted in a broader context that is those of earnings quality management.
- Management typically engages in income smoothing to increase earnings in periods that would otherwise have unusually low earnings.
- Income that a company receives in the form of interest, usually as the result of keeping money in interest-bearing accounts at financial institutions and the lending of money to other companies.
Although deferring revenue recognition in excellent years may seem counterintuitive, firms with predictable financial outcomes can negotiate better credit conditions. If earnings are transferred to a later time, companies may be able to delay a hefty tax bill. Stabling income management is used by leadership with a high share of leverage on assets to enhance creditors’ views of the bank’s business risk and to keep within the leverage covenant.
This simply involves changing the assumptions a company makes about uncertain variables. The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper. In a year of low earnings, the corporation might eliminate jobs, defer maintenance projects, reduce research and development efforts, etc. Then when earnings are higher, the corporation will increase spending for personnel and get caught up on the maintenance it had put off. It is legal, and practically every publicly traded firm worth its salt in the United States does it.
What is income tax smoothing? Tax Bracket Arbitrage
This latter topic is inserted in a broader context that is those of earnings quality management. Moreover, this chapter explains the real earnings management policies such as income smoothing, big bath earnings management, and income minimization and income maximization policies. Perhaps a U.S. manufacturer using LIFO will deliberately reduce its inventory quantities in low profit years in order to liquidate the old LIFO layers containing low unit costs. Another manufacturer might increase its production when sales and profits are low in order for its income statement to report a lower amount of cost of goods sold. The standard corporation tax rate for company income is 25%, but if there is a progressive tax system, high-revenue-generating firms might pay as much as 40% of their profits in corporate tax.
What are the risks of income smoothing?
To smooth out the earnings, the company decides to recognize a portion of the holiday season sales in the non-holiday months. This way, the company can present a more consistent pattern of revenue throughout the year, providing stakeholders with a stable and reliable financial outlook. Imagine a retail company that experiences seasonal fluctuations in sales due to the holidays. During the holiday season, the company generates significant revenue, while in other months, the sales decline. Although a firm’s fair value accounting strategy may be legal, it may not be ethical.
How Does the U.S. Tax System Work?
Often, although not always, earnings management entails taking steps to reduce and �store� profits during good years for use during slower years. This more limited form of earnings management is known as income smoothing. An example of income smoothing in publicly-held companies involves manipulating the allowance for doubtful accounts to alter the bad debt expense from one period to another, thus influencing the reported income. It is critical for companies to navigate this technique within the boundaries of accounting standards, being cautious not to sidestep legality.
This can make a company’s financial health seem more consistent, potentially attracting investors who prefer lower-risk companies. The issue of financial manipulation and accounting fraud has long been felt in the public opinion for some years, following the known financial scandals that have occurred indiscriminately throughout the Western world. The financial statements, which should be a faithful mirror of business activity and a transparent guide to investors’ use, are so often the instruments to positively impact the markets to the detriment of true and trustworthy markets. There is the belief that managers engage in profit smoothing–taking actions that reduce fluctuations in firm’s reported earnings. It is more likely that the term income smoothing is used to mean reporting misleading earnings, creative accounting, and aggressive interpretation of accounting principles and concepts. Perhaps a company increases its allowance for doubtful accounts with an increased bad debts expense only in the years with high profits.
The effects of accounting comparability, income smoothing and engagement partners on audit risk
If a sufficiently large number of investors are of the uninformed variety and anticipate that they may need to sell at some point for liquidity reasons, an increase in earnings volatility will magnify the risk of future trading losses. In this view, shareholders will want managers to smooth earnings and compensate them accordingly. If a company expects sharply higher interest rates, deferring income and delaying tax payments can lower borrowing costs through the economic cycle. In other words, a company might smooth earnings to manage its cyclical interest rate expense. To the outside observer, the company now appears to have stable earnings and might be expected to be a relatively defensive investment during harsh economic times. An often-cited example of income smoothing is that of loan-loss provisions by banks since they have considerable leeway in determining this provision.
Businesses use hedging methods to get out of high tax levels, such as boosting loss provisions or increasing charitable contributions, among other things. It lowers the variability in earnings from one period to the next, giving the appearance of a stable business. As a result, it is common for a company to engage in some amount of accounting management.
