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Chapter: One


Income Smoothing simply signifies a process of manipulating earnings where incomes are either forwarded for the next periods in order to show a stable financial position. It is a common loophole used by the accounting professionals across the world. It is a systematic and very much deliberate process to make people eye wash about an organization. Sometimes it is truly meaningful and helpful for an organization but malpractice may lead great financial disaster. It is a great challenge to keep income smoothing such a tolerable level that will not make any party in jeopardize. With the change of economic situation business organizations are adopting new tools to drag the attention of investors as investors are the key for an organization who provide life blood. This study is attempted to find out the impact of income smoothing and how it can be used systematically for the betterment of the concerned parties.


Now-a-days education is not just confined to books and classrooms. In todays world, education is the tool to understand the real world and apply knowledge for the betterment of the society as well as business. This report is a partial requirement for the fulfillment of MBA course named Accounting Theory in the department of Accounting & Information Systems of Jagannath University.


The major purpose of the study is to examine the income smoothing being practiced in disclosing financial statement. At the same time the following also tried to be found:

1. To present an overview of Income Smoothing. 2. To identify the application of Income Smoothing in business world. 3. To reveal the impacts of Income Smoothing as a whole. 4. To measure the degree of Income Smoothing.


Both primary and secondary form of information was used to prepare this report. The details of these sources are highlighted below:

1. Primary sources: Interview of CEOs and other professionals.

2. Secondary sources: a) Books b) Articles c) Newspapers d) Websites


The present study has been carried out to evaluate the existence of Income Smoothing in corporate arena and the impact of it to the related parties in decision making. This study was confined to discover how Income smoothing is practiced by private and public limited companies enlisted under DSE and CSE.


The present study is not out of the questions in terms of limitations. A number of limitations pertain in it. First, the time period of the study was certainly a very short to reach a pure conclusion about any study. Second, the selected professionals and CEOs were too busy to give us schedule and thats why it was not ease to interview them all privately. We also tried to communicate personally and unofficially to get the real scenario of income smoothing. Next, though hardest effort was undertaken to make the respondents give unbiased and thoughtful responses, the survey might include some responses tainted by central tendency (avoiding of extreme choices) and acquiescence bias (always agreeing with statements as presented). Finally, as the number of business organization is huge simple random sampling was not possible and judgment sampling was used; this may cause some pitfalls in the findings.


This paper was organized in five chapters. The first chapter contained introduction including the background, origin, objectives. Second chapter included an in-depth literature review of income smoothing. In the chapter three the reasons of income smoothing, accounting procedure and some other contents were described. Later in chapter four included method of calculating income smoothing, positive and negative sides along with some other were depicted. Finally in chapter five followed by chapter four comprised with findings, recommendation and clear-cut conclusions.

Chapter: Two


The term Income smoothing has become a common managerial terminology in the arena of finance and company management. This term is more popular in the enlisted public limited companies in our county as well as all over the world. Management considers the Income smoothing as an effective tool to attract the new investors and to retain existing shareholders.


Income smoothing is recognized as attempts by management to influence or manipulate reported earnings by using specific accounting methods (or changing methods), recognizing one-time non-recurring items, deferring or accelerating expense or revenue transactions, or using other methods designed to influence short-term earnings. Before diving into what income smoothing is, it is important to have a solid understanding of what we mean when we refer to earnings. Earnings are the profits of a company. Investors and analysts look to earnings to determine the attractiveness of a particular stock. Companies with poor earnings prospects will typically have lower share prices than those with good prospects. Remember that a company's ability to generate profit in the future plays a very important role in determining a stock's price. (For more on this concept, check out our Stock basic tutorial.) That said income smoothing is a strategy used by the management of a company to deliberately manipulate the company's earnings so that the figures match a pre-determined target. This practice is carried out for the purpose of income smoothing. Thus, rather than having years of exceptionally good or bad earnings, companies will try to keep the figures relatively stable by adding and removing cash from reserve accounts which is known colloquially as "cookie jar" accounts). Following Healy and Wahlen (1999), we define income smoothing as the alteration of firms reported economic performance by insiders to either mislead some stakeholders or to influence contractual outcomes. We argue that incentives to misrepresent firm performance through income smoothing arise from a conflict of interest between the firms insiders and outsiders. Specifically, insiders use their control over the firms resources to benefit themselves at the expense of outsiders. If these private control benefits are detected, outsiders are likely to take disciplinary actions against insiders. Consequently, insiders have an incentive to conceal these

resource diversions from outsiders. We argue that insiders manipulate accounting reports of firm performance in an attempt to hide their private control benefits. For instance, insiders can use their discretion in financial reporting to overstate earnings and conceal unfavorable earnings realizations (e.g., losses) that would prompt outsider interference. Similarly, insiders can use accounting choices to understate earnings in years of good performance to create reserves for periods of poor future performance, effectively making reported earnings less variable than true firm performance. Outsiders ability to govern a firm is weakened when extensive income smoothing results in financial reports that inaccurately reflect firm performance. We also provide direct evidence that income smoothing is positively associated with the level of private control benefits enjoyed by insiders. The term Income smoothing is popularly known as income smoothing to the accounting concerned people.


Income smoothing may be viewed as the deliberate normalization of income in order to reach a desired trend or level. As far back as 1953, Heyworth observed more of the accounting techniques which may be applied to affect the assignment of net income to successive accounting periods for smoothing or leveling the amplitude of periodic net income fluctuations. What followed were arguments made by Mousen and Downs and Gordon that corporate managers may be motivated to smooth their own income, with the assumption that stability in income and rate of growth will be preferred over higher average income streams with greater variability. More specifically, Gordon theorized on income smoothing as follows: Proposition 1: The criterion a corporate management uses in selecting among accounting principles is the maximization of its utility of welfare. Proposition 2: The utility if management increases with (1) its job security, (2) the level and rate of growth in the managements income, and (3) the level and rate of growth in the corporations size.

Proposition 3:

The achievement of management goals stated in proposition 2 is dependent in part on the satisfaction of stockholders with corporations performance; that is, other things being equal, the happier the stockholders, the greater the job security, income etc, of the government. Proposition 4: Stockholders satisfaction with a corporation increases with the average rate of growth in the corporations income and the stability of its income. This proposition is as readily verified as proposition 2. Theorem: Given that the above four propositions are accepted or found to be true, it follows that management would within the limits of its power, that is, the latitude allowed by accounting rules, to (1) smooth reported income, and (2) smooth the rate of growth in income. By smooth the rate of growth in income, we mean the following: if the rate of growth is high, accounting practices that reduce it should be adopted, and vice-versa. The best definition of income smoothing was provided by Beidelman as follows: Smoothing of reported earnings may be defined as the intentional dampening or fluctuations about some level of earnings that is currently considered to be normal for a firm. In this sense smoothing represents an attempt on the part of the firms management to reduce abnormal variations in earnings to the extent allowed under sound accounting and management principles. Given the above definition, what need to be explicated are the motivation of smoothing, the dimensions of smoothing and the instruments of smoothing.


As early as 1953 Heyworth claimed that motivations behind smoothing include the improvements of relations with creditors, investors and workers, as well as dampening of business cycles through psychological processes. Gordon proposed that: 1. The criterion a corporate management uses in selecting among accounting principles is to maximize its utility or welfare.

2. The same utility is a function of job security, the level and rate of growth of salary and the level and growth rate in the firms size. 3. Satisfaction of the shareholders with the corporations performance enhances the status and rewards of managers. 4. The same satisfaction depends on the rate of growth and stability of the firms income. These propositions culminate the need of smooth as explained in the following theorem: Given the above four propositions are accepted or found to be true, it follows that a management should within the limits of its power, i.e. the latitude allowed by accounting rules, (1) smooth reported income and (2) smooth the rate of growth in income. By smoothing the rate of growth in income we mean following: If the rate of growth is high, accounting practices which reduce it should be adopted and vice-versa. Beidelman considers two reasons for management to smooth reported earnings. The first argument rests on the assumption that a stable earnings stream is capable of supporting a higher level of dividend than a variable earnings stream, having a favorable effect in the value of the firms shares as overall riskiness of the firm is reduced. He states: To the extent that the observed variability about a trend of reported earnings influences in investors subjective expectations for possible outcomes of future earnings and dividends, management might be able favorably to influence the value of the firms shares by smoothing earnings. The second argument attributes to smoothing the ability to counter the cyclical nature of reported earnings and likely reduce the correlation of a firms expected returns with returns on the market portfolio. He states: To the degree that auto normalization of earnings is successful, and that the reduced covariance of returns with the market is recognized by investors and incorporated into their evaluation process, smoothing will have added beneficial effects in share values. In result from the need felt by management to neutralize environmental uncertainty and dampen the wide fluctuation in operation performance of the firm subject to an intermittent cycle of good and bad times. To do so, management may resort to organizational slack behavior, budgetary slack behavior or risk-avoiding behavior. Each of these behaviors

necessitates decision affecting the incurrence and allocation of discretionary expenses which result in income smoothing. In addition to the behaviors intended to neutralize environmental uncertainty, it is also possible to indentify organizational characterizations that differentiate among the effects of the separation of ownership and control on income smoothing, under the hypothesis that management controlled firms are more likely to be engaged in smoothing as a manifestation of managerial discretion and budgetary slack. Their results confirmed that income smoothing is higher among management controlled firms with high barriers to entry. Management was also assigned to circumvent news of constraints of generally accepted accounting principles by attempting to smooth income numbers so as to convey their expectations of future cash flows, enhancing in the process the apparent reliability of production based on the observed smoothing series of numbers. Three constraints are presumed to lead managers to smooth: 1. The competitive market mechanisms, which reduces the options available to management; 2. The management compensation scheme, which is linked directly to the firms performance; and 3. The threat of management displacement. This smoothing is not limited to high management and external accounting, it is also presumed to be used by lower-level management and in the form of organizational slack and slack budgeting. The terminology income smoothing is shown to be motivated by managements desire to increase annual income to influence proxy contests and the likelihood of foreign trade regulation.


The dimensions of smoothing are basically the means used to accomplish the smoothing of income numbers. Dascher and Malcolm distinguish between real smoothing and artificial smoothing as follows:

Real smoothing refers to the actual transaction that is undertaken or not undertaken on the basis of its smoothing effect on income, where artificial smoothing refers to accounting procedures which are implemented to shift cost and revenue from on period to another. Both types of smoothing may be indistinguishable. For example, the amount of reported expenses may be lower or higher than previous periods because of either deliberate actions on the level of the expenses or the reporting methods. For both types, an operational test proposed is to fit a: Curve to a stream of income calculated two ways, (a) Excluding a possible manipulative variable and (b) Including it. Artificial smoothing was considered by Copeland and defined as follows Income smoothing involves the repetitive selection of accounting measurement or reporting rules in a particular pattern, the effect of which is to report the stream of income with a smaller variation from trend than would otherwise have appeared. Besides real and artificial smoothing other dimension of smoothing were considered in the literature. A popular classification adds a third smoothing dimension, namely classificatory smoothing Barnes et al. distinguish among threes smoothing dimensions, as follows: 1. Smoothing through events occurrence and recognition: Management can time actual transactions so that their effects on reported income would tend to dampen its variations over time. Mostly, the planned timing of events would be a function of the accounting rules governing the accounting recognition of the events. 2. Smoothing through allocation over time: Given the occurrence and the recognition of an event, management has more discretionary control over the determination over the periods to be affected by the events quantification. 3. Smoothing through classification: when incomes statement statistics other than net income are the object of smoothing management can classify intra income statement items to reduce variations over time in that statistic.


Basically real smoothing corresponded to the smoothing through events occurrence and recognition, while artificial smoothing corresponding to the smoothing through the allocation over time.


Unsuitable revenue recognition Inappropriate accruals and estimates of liabilities Excessive provisions and generous reserve accounting Intentional minor breaches of financial reporting requirements that

aggregate to a material breach.


Personal incentives Bonus-related pay Benefits from shares and share options Job security Personal satisfaction Cover-up Fraud


A number of phases have been used to describe income smoothing activities: - Income smoothing - Accounting hocus-pocus - Financial Statement management - The numbers game - Aggressive Accounting - Reengineering the income statement - juggling the books

- Creative accounting - Financial Statement manipulation - Accounting magic - Borrowing income from the future - Banking income for the future - Financial shenanigans - Window dressing - Accounting alchemy The use of accounting techniques to level out net income fluctuations from one period to the next one. Companies indulge in this practice because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams, compared with stocks whose earnings are subject to wild fluctuations. Examples of income smoothing techniques include deferring revenue during a good year if the following year is expected to be a challenging one, or delaying the recognition of expenses in a difficult year because performance is expected to improve in the near future.


An Earnings Statement is a standard financial document that summarizes a company's revenue and expenses for a specific period of time, usually one quarter of a fiscal year and the entire fiscal year. It is important that both investors and company managers be able to read and understand this document in order to understand the company's financial condition.


The practice of inappropriately misconstruing income statements for the purpose of pleasing investors and inflating stock prices Hiding losses within subsidiary companies, not capitalizing expenses, and accounting revenues are only some of the examples of "cooking the books."


Aggressive accounting has been in the recent spotlight as companies are being caught attempting to increase revenue inappropriately.


Reengineering the income statement means increase or decrease the net income or loss for smoothing the earnings by manipulation of accounts. In this case net come of a particular period of an entity has changed the real accounts by engineering the income statement.


Accounting practices that follow required laws and regulations, but deviate from what those standards intend to accomplish. Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company. Although creative accounting practices are legal, the loopholes they exploit are often reformed to prevent such behaviors. A primary benefit of public accounting statements is that they allow investors to compare the financial health of competing companies. However, when firms indulge in creative accounting them often distort the value of the information that their financials provide. Creative accounting can be used to manage earnings and to keep debt off the balance sheet.


Financial statement manipulation or fraud is any disclosure that is omitted or improperly reported on any of the four financial statement components (balance sheet, income statement, cash flow statement and shareholder's equity). This can consist of such things as purposefully misreporting the exact amount of cash sales or other revenue earned for the period (in an attempt to mislead the Internal Revenue Service during tax-reporting time, since companies are taxed on sales; not profit earned); the inaccurate reporting of the information presented on the shareholder's equity statement (in order to persuade bankers or investors that a company is more profitable than is really accurate, which can result in additional loan approvals); and even purposefully misrepresenting the exact amount of liabilities (what a company owes) for the period, in an effort to persuade company leaders to agree to take on more debt (or make expansions that put the company more at financial risk).



Shenanigans are actions or omissions designed to hide or distort the real financial performance or financial condition of a company.


A strategy used by mutual fund and portfolio managers near the year or quarter end to improve the appearance of the portfolio/fund performance before presenting it to clients or shareholders. To window dress, the fund manager will sell stocks with large losses and purchase high flying stocks near the end of the quarter. These securities are then reported as part of the fund's holdings. Performance reports and a list of the holdings in a mutual fund are usually sent to clients every quarter. Another variation of window dressing is investing in stocks that don't meet the style of the mutual fund. For example, a precious metals fund might invest in stocks that are in a hot sector at the time, disguising the fund's holdings, so clients really have no idea what they are paying for. Window dressing may make a fund appear more attractive, but you can't hide poor performance for long.


Chapter: Three



For a listed company, a late filing is a violation of the listed rules which would raise great negative result, the worst of which is delisting from that exchange. I have asked one auditor, If the management would not intend to manipulate earning, say all the auditor adjustments are completely accepted, then the audit can be completed in the planned time schedule and late filing would not happen. Is it true? Absolutely, the auditor said. However, the management would not give up the efforts to manipulate earning. As a result, the audit is doomed to be a battle between the management and the auditors, and the result (the audit report) is a compromise between them. As a result, management has great motivation to manipulate the earnings. There are two directions to earning manipulation. One is borrowing income from future (increasing current revenue or decreasing current expenses); the other is banking income for the future (decreasing current revenue or increasing current expenses). To better analysis the earning quality, so as to recognize the possible earning manipulation, you should follow the following advices: Understand the business Understand the accounting policy Understand the business areas where accounting quality is most doubtful Understand situations in which management are particularly tempted to manipulate Under some Institutional Situations where Manipulation is More Likely, I list some below: The firm is in the process of raising capital or renegotiating borrowing. IPO; SEO Debt covenants are likely to be violated A management change An auditor change Management rewards (like bonuses) are tied to earnings A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all Management buyout


Transactions are with related parties rather than at arm's length Special events such as union negotiations and proxy fights The firm is "in play" as a takeover target The firm engages in exotic arrangements (structured off-balance-sheet vehicles) Finally, I would like to say that, for an auditor, earning manipulation is the greatest challenges in their career life. They must seek the balance between GAAP and the clients demand. They should know clearly when they should insist, and when to compromise. Its both art and science.


"Income smoothing" occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or influence contractual outcomes that depend on reported accounting numbers.

Income smoothing usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures through aggressive accounting tactics. Aggressive income smoothing is a form of fraud and differs from reporting error. Management wishing to show earnings at a certain level or following a certain pattern seek loopholes in financial reporting standards that allow them to adjust the numbers as far as is practicable to achieve their desired aim or to satisfy projections by financial analysts. These adjustments amount to fraudulent financial reporting when they fall 'outside the bounds of acceptable accounting practice'. Drivers for such behaviour include market expectations, personal realisation of a bonus, and maintenance of position within a market sector. In most cases conformance to acceptable accounting practices is a matter of personal integrity. Aggressive income smoothing becomes more probable when a company is affected by a downturn in business. Income smoothing is seen as a pressing issue in current accounting practice. Part of the difficulty lies in the accepted recognition that there is no such thing as a single 'right' earnings


figure and that it is possible for legitimate business practices to develop into unacceptable financial reporting. It is relatively easy for an auditor to detect error, but income smoothing can involve sophisticated fraud that is covert. The requirement for management to assert that the accounts have been prepared properly offers no protection where those managers have already entered into conscious deceit and fraud. Auditors need to distinguish fraud from error by identifying the presence of intention.


Income smoothing activities may occur for the following reasons: (1) Managers have flexibility in making accounting or operating choices. (2) Managers are trying to convey private information to financial statement users. It is important for readers of financial statements to determine which type is being practiced and to understand its significance. Some examples are given bellow:

Flexible accounting or operating choices: Managers may adopt a depreciable life for a new computer chip plant that is at the high end of industry norms in order to lower depreciation expense and thus maximize reported earnings for future periods. The aim here is to manage earnings (and thus share prices) in a direction desired by current shareholders.

Private information: Managers may adopt a depreciable life for a new computer chip plant that is substantially less than industry norms because anticipated technological changes make it likely that the plant will be obsolete sooner than has been the norm for the industry. The motive here is to give stakeholders information not otherwise available so they can adjust their expectations appropriately. Careful release of such information may lower earnings and the share price for the company, but if the information conveys significant new news to analysts and other users of financial statements, they may also adjust earnings estimates (and share prices) downward for other companies in the industry, so that the company revealing the information may actually feel some positive impact on its share prices because it is perceived as having a higher quality of earnings.



Earnings quality, in accounting, refers to the overall reasonableness of reported earnings. It is an assessment criterion for how "repeatable, controllable and bankable" a firm's earnings are, amongst other factors. It recognizes the fact that the economic impact of a given transaction will vary across firms as a function of their fundamental business characteristics, and has variously been defined as the degree to which earnings reflect underlying economic effects, are better estimates of cash flows, are conservative, or are predictable. So, how do investors identify a firm with quality earnings? When analyzing quarterly reports, investors should ask themselves three simple questions: Are the company's earnings repeatable? Are they controllable? And finally, are the earnings bankable? These crucial questions are answered and depicted below-


Consider Motorola's 2001 third-quarter earnings, which demonstrated the importance of repeatability. In spite of a slowing economy and sales shrinkage, the technology giant posted earnings of four cents a share, well ahead of Wall Street estimates. Some of those earnings came by way of job cuts, and a sizable chunk came also from the sale of investments. In the weeks following, the stock dropped by 15% because the market realized that Motorola's earnings quality was questionable: the sale of assets is never repeatable. Once sold, assets cannot be sold again to produce more earnings. At first, investors were unwilling to pay for high quarterly earnings, but found later that the company would never be able re-produce such future earnings. Sales growth and cost cutting are the best routes to high-quality earnings. Both are repeatable. Sales growth in one quarter is normally (albeit not all the time) followed by sales growth the next quarter. Similarly, costs, once cut, typically stay that way. Repeatable and fairly predictable earnings that come from sales and cost reductions are what investors prefer.


There are many factors affecting earnings that companies cannot control. Consider the effects

of exchange rates. For example, if a company must convert its European profits back into the U.S. dollar, a dollar that is falling against the euro will boost the company's earnings. But, management has nothing to do with those extra earnings or with repeating them in the future. On the other hand, if the dollar moves upwards, earnings growth could come in lower. There are other uncontrollable factors that can raise earnings. Inflation, for instance, can give companies a brief profits boost when products in inventory are sold at prices increased by inflation. The price of inputs is another uncontrollable factor: falling jet fuel prices, for example, can improve airline industry profits. Even changes in the weather can boost earnings growth. Think of the extra profits that electrical utilities enjoy when temperatures are unusually hot or cold. Let's face it, the highest-quality earnings go straight to the bank. Indeed, cash sales - which the company does control - are the source of the highest-quality earnings; investors should seek firms with earnings figures that closely resemble cash that is left after expenses are subtracted from revenues.


Most companies, however, must wait before they can deposit revenues in the bank. Cash payments often arrive later than receivables, so most companies, at times, enter sales as revenues, even though no money has exchanged hands. The fact that customers can cancel or refuse to pay creates large uncertainties, which lower earnings quality. At the same time, generally accepted accounting principles give room for choices about what counts as reliable revenues and earnings.


The above factors lead to investors needing to assess the extent to which a firm's reported earnings are free from mistake or manipulation, i.e. the quality of the firm's earnings. Other ways accounting choices can lower a firm's earnings quality include

Recording revenue too soon or of questionable quality, Recording fictitious revenue,


Boosting income with one-time gains, Shifting current expense to a different period, Failing to record or improperly reducing liabilities, Shifting current revenue to a later period, and Shifting future expenses to the current period as a special charge


While the criteria for earnings to be considered high-quality differ between authors, sustainability of earnings may be the underlying concept.


It is very difficult to detect income smoothing, since managers are using the flexibility in the accounting standards to manage the earnings. It is common to use accrual models to detect income smoothing. Accruals are best defined as the difference between the results and the cash flow (Ronen and Yaari, 2008). The cash flow that a company generates is the basis of every company. For small companies the cash flows are often easy to oversee. Large companies, however, requires more information than cash based information. Stakeholders of large companies often want more information on the overall situation of the company and want to know what the future will hold. Accrual-based accounting is introduced to help create this information. Accrual-based accounting is the most accepted way of accounting, and is required by IFRS, US GAAP and other standards. Accruals occur when revenues and expenses are recognized when they are accrued. Managers can manipulate accruals at the end of the financial year. Manipulations in accruals are a suitable form of income smoothing, because it will not direct affect the cash flow. In contrast to the accrual manipulation, real activity manipulation has influence on both cash flows and accruals (Roychowdhury, 2003). With real income smoothing the underlying operations of the firms are changed (Gunny, 2005). An example of real income smoothing is to cut prices toward the end of a year to speed up sales from the next fiscal year into the current year. Real income smoothing is harder to detect than accrual management, because it is more difficult to distinguish real income smoothing activities from business activities, which is why this study will focus on accrual management. Accruals are normally divided in two groups, non-


discretionary accruals and discretionary accruals (or abnormal accruals). Non-discretionary accruals are accruals where normally a manager is not able to manipulate it. Discretionary accruals, in contrast, are possible to be controllable for the manager. An example of a discretionary accrual is the account provision for bad debtors, since the assessment of this account is very subjective. In the literature several models are developed to separate the discretionary and the non-discretionary accruals. With the accrual models income smoothing can be defined as the activity between the estimated discretionary accruals, based on the information of last year, and the actual discretionary accruals. Because discretionary accruals are not directly observable, proxies are used for discretionary accruals. In the literature several models are discussed to detect income smoothing through discretionary accruals. The discretionary accruals models look at the differences that exist between the cash flow of a company and its net income. To measure the discretionary accruals, first the total accruals (the sum of the discretionary and the non-discretionary accruals) need to be determined. Then the discretionary accruals are separated from the nondiscretionary accruals. In 1995 Dechow, Sloan and Sweeney published an article that discussed several models used to detect income smoothing through accruals and also created a model with more power that the models tested. In their study they discussed the following five accruals models; Healy (1985), DeAngelo model (1986), Jones model (1991), the modified Jones model, and the Industry model (1991). Healy (1985) and DeAngelo (1986) were the first in measuring income smoothing with use of total accruals and the change in total accruals; they also measured managements judgment over earnings. The Jones model is using a regression approach to measure non discretionary accruals. According to the Jones model there is a linear relation between the total accruals and the change in sales and property, plant and equipment (PPE). Dechow et al. (1995) developed a modified version of the Jones Model. According to the modified Jones model the changes in revenues are adjusted for the change in receivables in the event period. The industry model (1991) focus on a specific industry and use internal knowledge from companies within the industry to determine how the discretionary and non-discretionary components behave.


Chapter: Four



Income smoothing can be either good or bad depending on the application and implementation by the decision makers. A simple discussion about this is given below that will reveal the positive side and negative side of income smoothing as well.


There is definitely a good side of income smoothing if it is properly practice for the benefits of the companies prior to achieving the key performance objective of the companies. Good income smoothing means reasonable and proper practices. Accounting Subjectivity and Income smoothing: A Preparer Perspective referred by Parfet (2000 p. 487) contends: calls attention to the context in which decisions are made, where subtle effects from human perceptions and peer pressures, the complexity of combined factors, and a high-stakes business environment all impact good people who are trying to do their jobs with integrity. Arguments given by Robert C. Lipe (2001) in favor of income smoothing can be briefly describe-from contracting perspective income smoothing was anticipated by the principal when the bonus contract was being negotiated, so that it is allowed for in setting the bonus rate. Firstly, lowering contracting costs in the face of rigid and incomplete contracts. Secondly, income smoothing can reveal inside information to investors. One of the example usually referred to is General Electric Co. (GE) as simple announcement by GE of its persistent future earnings is blocked.


Bad income smoothing means intervention to hide real operating performance. Some of the techniques used that will influence bad income smoothing is as follow below-

From a contracting perspective, we can think that managers manage earnings to opportunistically maximize their utilities. Healy (1985) examines that managers act on their self-interest when their bonus schemes are tied to the reported net incomes. However, managers not only manage earnings for self-interests but also manage earnings for an efficient contracting. Healy (1985) found that managers utilize such information superiority to maximize their wealth on their bonus scheme which suggests that managers might possibly manage

earnings to protect their bonuses. This is the contract between the firm and the managers. It is found in research examining that accrual information is a key determinant of the earnings manipulation (Dechow, Sloan and Sweeney, 1996). Therefore, it is reasonable to assume that earnings restatement firms can be characterized as firms who knowingly and intentionally engaged in earnings manipulation.


Based on Hanna (1999) article in CA magazine review, important point to get across from this article is that management is tempted to provide excessive unusual, non-recurring and extraordinary charges, to put future earnings in the bank. Furthermore, these future earnings are buried in operations. This makes it difficult for investors to diagnose the reasons for subsequent earnings increases. Investors and analysts look to core earnings, ignoring extraordinary and non-recurring items implies manager not penalized for non-core charges, such as write-downs, provisions for restructuring. But current non-core charges increase core earnings in future years, through lower amortization and absorption of future costs. As a result, managers tempted to overdose on non-core charges, thereby putting earnings in the bank also called cookie jar accounting. Finally it is obvious that income smoothing can be applied as a safe guard but excessive manipulation can deteriorate the quality of financial report and bring adverse consequences to the financial market as a whole. So management should be aware about all sides.


Accounting choices should be made within the framework of generally accepted accounting principles. GAAP are the set of rules, practices, and conventions that describe what is acceptable financial reporting for external stakeholders. The main source of GAAP for public companies are the Financial Accounting Statements (FAS) of the FASB, although there are also several other sources. Some people find it quite surprising that a single, normal, everyday accounting choice may be either legal or illegal. The difference between a legal and an illegal accounting choice is often merely the degree to which the choice is carried out. To better understand this, think about driving a ear. Driving is inherently neither legal nor illegal. Much depends on the law in the jurisdiction in which you are driving. If the speed limit is 65 mph, for instance, and your speed is 60 mph, your driving is within the legal limits. On the

other hand, if your speed is 100 mph, you are clearly driving illegally. The problem with many accounting choices is that there is no clear posted limit beyond which a choice is obviously illegal. Thus, a perfectly routine accounting decision, such as expense estimation, may be illegal if the estimated amount is extreme but perfectly legal if it is reasonable. GAAP does not tell managers what specifically is normal and what is extreme. It is more like a speed limit sign that just says Dont Drive Too Fast! Product warranty cost estimation is an example of an accounting decision many managers have to make. GAAP normally requires that this estimate be recorded as an expense in the same fiscal year as the revenue from the product is recorded: If you sell a hair dryer for $30 and offer a free refund or replacement if it breaks within one year from date of purchase, you should estimate this warranty cost and record it as an expense in the same fiscal year as the $30 revenue from the hair dryer. This follows a basic accounting concept of matching expenses with related revenue. If you assume that warranty cost averages $2.75 per unit sold, the items on the income statement would look something like this: Revenue Less: Warranty expense Income $30.00 2.75 $27.25

However, the fact that warranty costs will be $2.75 per unit is not always so clear. Assume that for the past five years, average unit warranty costs for the hair dryer have ranged from $2.50 to $2.80, with no specific pattern being apparent. A financial manager who wanted to report the highest possible current period income would be justified in using $2.50 per unit for the current years expense estimate even though $2.50 is the bottom of the historical range. That same manager might even be justified in using $2.25 per unit if there was evidence that improved quality control during the current fiscal year would lower future warranty costs. But what if that manager used $1.25 per unit simply because that figure for warranty expense would make it possible to achieve a desired net income target for the fiscal year? Since the $1.25 has no reasonable support, using it would be crossing the line to financial fraudeven though GAAP does not draw that clear a line.


Financial fraud has been defined by the National Association of Certified Fraud Examiners as the intentional, deliberate misstatement or omission of material facts, or accounting data, which is misleading and, when considered with all the information made available,

would cause the reader to change or alter his or her judgment or decision. Income smoothing is at the legal end of a continuum. Financial fraud is at the illegal end. Fraud clearly violates GAAP, since the FASB has said, Accrual accounting uses accrual, deferral, and allocation procedures whose goal is to relate revenue, expenses, gains, and losses to periods to respect an entitys performance during a period (emphasis added). The key concept in this definition is that GAAP-based accounting is supposed to reflect, not distort or obscure, true economic performance. GAAP may also be violated by actions that do not sink to fraud, such as overly aggressive accounting because that may distort or obscure the true economic performance of a business. Using data from our previous warranty expense estimation example, Figure 1.1 illustrates the concept of a reported earnings continuum from merely conservative to fraudulent. Figure 1.1 assumes there was evidence that quality control improvements could lower warranty costs to $2.25. Figure 1.1.The Income smoothingFraud Continuum

As our assumptions change, the interpretation changes. Assume there was absolutely no evidence, merely management optimism, that quality control changes during the year would lower future warranty costs under the historical $2.50 to $2.80 range. Now management has no real support for estimating that product warranty costs will be $2.25 per unit. The $2.25 figure should now be considered overly aggressive and beyond the bounds of GAAP. This scenario is illustrated as under. Figure 1.2. Overly Aggressive Earnings on the Continuum

It is clear from the two figures that there is no bright line in GAAP to tell managers what is and what is not acceptable. Management is simply expected to make choices that

appropriately reflect a companys economic performance. What is appropriate for one company may not be appropriate for another.


Earnings quality has usually been associated with the use of conservative accounting policies. It has, however, been noted that conservatism in the current financial periods may allow aggressiveness in future financial periods. For example, choosing an "accelerated" depreciation method, or one that allocates a large amount of depreciation expense at the beginning of an asset's useful life, allows the firm to present abnormally high expenses for a given financial period and abnormally low expenses for future financial periods: conservatism, followed by aggressiveness. In other words, conservative decisions by management in a single period should not be used as sole proof of earnings quality.


Auditors play an important role whenever there is a separation of ownership and control. They constitute an important interface between what happens within the firm and outside investors. If auditors do their job well, investors are subject to less risks of earnings manipulation, but global corporate scandals have shed doubt on the trustworthiness of auditors. The SarbanesOxley Act strengthens auditor independence and makes it harder to strike side deals (Section 201); auditors are not allowed to provide consulting services to their clients. It requires higher quality standards of auditing, and imposes new and more effective sanctions against auditors that fail to supervise their clients, both intentionally or in repeated instances of negligent conduct, resulting in a violation of the applicable statutory, regulatory, or professional standard (Sec. 105.) These changes may indeed increase the effort of auditors and, in turn, improve incentives within the firm. This becomes clear from the following modified framework of our model. Prior to the bargaining stage between CEO and division managers, an auditor receives the report that CEO plans to send to investors. The auditor either rubberstamps it or checks whether division outputs are in line with the report. Presume that the auditor learns the true division output with some probability and that this probability is concave in the auditors effort, which is unobservable. Hence the auditor may shirk, and just cash in the auditing fee without doing their job. At the end of the second period, the true value of the firm is revealed. This allows imperfect inference on whether there has been earnings manipulation in the first period; even

an auditor who exerts high effort, may be unlucky and learn nothing. Clearly, when penalties are more severe, auditors have better incentives to monitor. Furthermore, when the effort of auditors increases, the odds to penalize an innocent auditor decrease. Hence, higher quality standards and harsher penalties reinforce each other. This also implies that, ceteris paribus, the costs of auditing increase a point that has been made before, for instance, by Holmstrom and Kaplan (2003) and by practitioners. Higher auditor effort can increase the incentives in the firm. If the auditor exerts high effort and learns the true output, he joins the bargaining table between top management and the division manager. But, as we discussed above (see III.H), it becomes more likely that bargaining collapses when there is an additional party that needs to be pacified. In that case, the auditor will always be interested in reporting earnings manipulation to the outside world in order to avoid being penalized. Beyond the simple fact that an informed auditor adds an additional person to the bargaining problem, auditors will demand a higher bribe than division managers because of the very fact that they can be penalized by law (while this may be harder to do in the case for division managers) and because the side payments to auditors are now more costly. Thus, we can expect that Sarbanes-Oxley increases auditor effort both through its higher quality standards and harsher penalties that reinforce each other, and by inducing collapse of bargaining between informed insider parties, which in turn reduces returns to earnings manipulation and leads to better information for outside parties. However, we should also expect an increase in regulatory burden so the net welfare effects are not clear. 4.6. SHAREHOLDERS BENEFITS AND INFLUENCE OF INCOME SMOOTHING . As we know the primary focus of income smoothing is to balance the level of earnings to maintain consistency which helps to continue business operation even in critical situations. A moderate level of income smoothing helps a business for its long run success. Income smoothing also plays a crucial role in some other aspects too. The investors sometimes significantly influence income smoothing as to secure their benefits. But the level of influence and benefits are not equal as it depends on the types of shareholders. Different authors defined and explained different ways. A renowned author named Arya, Glover, and Sunder stated: That income smoothing reduces transparency is a simplistic idea. A fundamental feature of decentralized organizations is the dispersal of information across people. Different people

know different things and nobody knows everything. In such an environment, a managed earnings stream can convey more information than an unmanaged earnings stream. A smooth car ride is not only comfortable, but it also reassures the passenger about the drivers expertise. Though a moderate level of income smoothing can be helpful for long run success but it is quite difficult to demonstrate equity. As there is no clear indication of income smoothing in accounting standard and international financial reporting standard it is difficult to draw standard. We can simplify our discussion classifying the investors which is shortly depicted belowA. LARGE SHAREHOLDERS: Simply large shareholders refer those who belongs large portion of total number of share and also invest for a long term. Where the long term investors means those investors either individual or institutions invest for a period of five or more than five years with a view to achieve its long term goals. As this type of investors buy a huge number of shares they have enough influencing power in income smoothing. Even they get the privilege to have fruits of income smoothing. Large shareholders includes the follows groupsi.

Sponsor Shareholders: These types of shareholders are the initiator of the business

who hold a handsome number of shares and have control over management. As management always wants to increase the value of the shares in stock market, when it is found that current earnings are poor and expected future earnings are good, managers make income-increasing discretionary accruals in the current period. Conversely, when current earnings are good and expected future earnings are poor, managers make incomedecreasing discretionary accruals in the current period and that income smoothing behavior likely increases managers wealth at the expense of outside shareholders.

Institutional Investors: Different financial and nonfinancial institutions invest for a

long term. These types of shareholders hold a good numbers of shares. They also have influencing power in income smoothing and they get benefit as they hold their shares for a long time. Institutional investors includes-banks, non banking financial institutions, insurance company, pension fund, mutual funds and other foreign institutions. As long term investors always pursue their own goal thats why they always focus on long run strategy by earnings manipulation in expense of small investors. Because small investors always


concern about current performance. If the performance falls then they sell their shares which force to decrease share price. B. Small investors: Small investors are short term investors who buy shares for a short period. They are actually the ordinary shareholders. The minority shareholders face the possibility of being exploited by large shareholders. When actual income is adjusted with future expenses during current year the actual profit ultimately decrease. Then the minority shareholders sell their shares and this way always the minority shareholders are deprived of actual return. Basically minority shareholders have no influencing power in income smoothing rather they are the victim of manipulation. Sometimes minority shareholders get benefit when current earnings are poor and expected future earnings are good, managers make income-increasing discretionary accruals in the current period.

C. Dedicated Investors: Dedicated investors have low portfolio turnover and they hold their
shares for long-term. They have almost influencing power. Such investors may get benefits in a long run.

D. The quasi-indexers: These investors have high portfolio diversification and a low
portfolio turnover. They buy a handsome number of shares of different company. They hardly exercise influencing power. Finally it is obvious that as the standard of income smoothing is not scaled thats why it is difficult to ensure the benefits specially the benefits of small investors whereas the large shareholders always get advantages of income smoothing. So to ensure the benefits of minority a guideline is to be drawn by the accounting body.


It is very important to compute income smoothing. Here the five accruals models of Healy, DeAngelo, Jones, Modified Jones, and the industry model will be addressed shortly; but also a two recent models; one from Peasnell et al., the margin model (2000), and the other from Kothari et al. (2005), the performance-matched model, will be discussed also.

4.7.1. THE HEALY MODEL (1985)

Healy (1985) was one on the first researchers in trying to detect income smoothing, by estimating deviations from the average. This model was different because it assumes that

systematic income smoothing takes place in every period. Healy (1985) starts with total working-capital accruals. Total accruals (TAt) are defined by:

Healy parts his sample by comparing three groups. In one group income smoothing is presumed to be managed upwards and in the other two groups earnings are presumed to be managed downwards. The group of observation where it is presumed that earnings are to be managed upwards are treated as the estimation period and the group of observations where it is presumed that earnings are to be managed downwards are treated as the event period. The mean total accruals from the estimation period then represent the measure of nondiscretionary accruals (NDA). This leads to the following model for determining NDA (Dechow et al.,1995).

Discretionary accruals are the result of deducting the nondiscretionary accruals from the total accruals. Income smoothing is seen as any deviation from the average (Praag,van; 2001).


4.7.2 DEANGELO (1986)

The DeAngelo (1986) model does not differ much from the Healy model. In the DeAngelo model the period of estimation for non discretionary accruals is focused on the prior year observation. The total accruals of the previous year are the measure of non discretionary accruals. This means that non-discretionary are equal to the total accruals of the last period (Bartov et al., 2000).

The changes between this period and the previous period are seen as discretionary accruals. Both the Healy and the DeAngelo model assume that nondiscretionary accruals are constant over time, and that changes can only be discretionary. If nondiscretionary accruals are constant over time and discretionary accruals have a mean of zero in the estimation period then the model will measure nondiscretionary accruals without error (Bartov et al., 2000). If nondiscretionary accrual will vary over time, then the both models will measure nondiscretionary accruals with error. (Dechow et al., 1995).

4.7.3. THE JONES (1991)

The Jones model (1991) improves the models of Healy and DeAngelo by controlling the effects of changes in a firms economic circumstances on nondiscretionary accruals. Jones abandoned the assumption that non-discretionary accruals remain constant. The Jones model takes the change in revenues (thus also the growth of the firm) into account and adds the total amount of property, plant and equipment. The Jones model includes the change in revenue and the total amount of property, plant and equipment; because Jones recognized that accruals depend on the business activities of a firm. The Jones model for determining non discretionary accruals is:


Where TA stands for total accruals scaled by lagged total assets, while, a1, a2, and a3 denote the ordinary least squared estimates of _1, _2, and _3. In the Jones model the predicted value of the regression is the normal level of accruals and is referred to as non discretionary accruals (NDA). Discretionary accruals (DA) are the residual of TA and NDA. In this way, income smoothing activities can be found. A limitation of the Jones model is the fact that earnings could be managed through influencing revenues, e.g. by adding revenue at the end of the year that are not earned yet and for which no cash has been received. The Jones model will then be biased to zero and will make an incorrect assumption that there is no case of income smoothing. (Dechow et al., 1995).


Dechow, Sloan and Sweeney (1995) adjusted the Jones Model to eliminate the limitation of the original Jones model. The modified Jones model estimates nondiscretionary accruals during the period in which income smoothing is assumed as:

In this formula the variable

is added, which stands for net receivables in year t less

receivables in year t-1 scaled by total assets at year t-1.


Estimates of the

are generated in the same way as in the original Jones model.

The modified Jones model assumes that all variations in the credit sales in the event period are a sequence from income smoothing. The reason behind this is that it is easier to manage earnings over the recognition of revenue on cash sales. If this adjustment in the Jones model is a success, than the detection of income smoothing should no longer be biased towards zero as it was in the original Jones model. (Dechow et al., 1995).

4.7.5. THE INDUSTRY MODEL (1991)

The industry model (1991) developed by Dechow and Sloan assume like the Jones model that non discretionary accruals change over time. They assume, however, that the change is industry dependent. They eliminate the amount of change that is common within the industry and leave in this way the firm-specific change in accruals as a result. The Industry model for non discretionary accruals is:

The firm-specific parameters y1 and y2 are estimated using ordinary least square on the observation in the estimation period.

4.7.6. THE MARGIN MODEL (2000)

Peasnell et al. (2000) examines a new cross-sectional model to estimate abnormal accruals. In comparison to the Jones model and the modified Jones model, they estimate abnormal accruals using a two-stage procedure. Abnormal accruals are being estimated by regressing the accruals on a vector of explanatory variables to capture the accruals that are unmanaged (Peasnell et al., 2000). The explanatory variables are the same as used in the model of Dechow et al. (1995) linking sales, accruals and earnings. This model is based on working capital accruals; depreciation is locked out as the measure of accruals, because they assume that depreciation is unlikely to represent systematic income smoothing (Peasnell et al., 2000). The margin model is presented as follow:

Comparing the Jones model and the modified Jones model with the margin model, Peasnell et al. (2000) and Alcarria Jaime & Albornoz Noguer (2003) found that the margin model is powerful in detecting non-bad debt expense manipulation. However, Peasnell et al. (2000) and Alcarria Jaime & Albornoz Noguer (2003) also show that the Jones model and the modified Jones model are superior at detecting revenue and bad debt manipulation.


The performance-matched model developed by Kothari et al. (2005) is actually an adjustment to the modified Jones model. To measure the discretionary accruals an additional variable Return On Asset (ROA) has been added to the modified Jones model. ROA is included because ROA can control the effect of performance on accruals (Kothari et al., 2005). To estimate the discretionary accrual models, they define total accruals (TA) as the change in non-cash current assets minus the change in current liabilities ruling out portion of long-term debt, minus depreciation and amortization, scaled by lagged total assets (Kothari et al., 2005). Finally it can be seen that considering the situation and other relative issues the above models are used. So the above models are very crucial to determine the income smoothing within an organization.


Chapter: Five



After thorough analysis the facts are found about income smoothing practice are shortly depicted below1. It is very common in large and medium size business organizations. 2. Management considers the term income smoothing as a protective tool. 3. Management uses the loop hole of rules and regulations. 4. In short run income smoothing may result well for the management but in long run it fails to rescue.

There is no clear dictation about income smoothing in company law, GAAP and IFRS.

On the basis of findings the following recommendations are drawn-

1. The tendency of manipulation by large and medium business organization should be

brought under control.

2. Income smoothing should be applied effectively so that the investors and other related

parties can be benefited. 3. The legal loop holes should be curved through new amendments. 4. Managements should consider the long run sustenance of the business not the short run. 5. In Company Act, GAAP and IFRS a clear dictation about income smoothing should be included. It is very important to protect the investors and other related parties from the grab of management and their personal interest and to do so an up-to-date regulation should be introduced by the regulatory body regarding income smoothing.


Finally it is obvious that in our study, we have seen that the term Income Smoothing is a popular term in modern management arena. Income smoothing may be viewed as the deliberate normalization of income in order to reach a desired trend or level. The nature and the relevance, procedure and the aspects are discussed in the concerning chapters. Whether income smoothing is good or bad this dilemma has been solved in the discussion. Most of the time management argues that income smoothing is an important tool to protect the firm from the sudden fall. Though it does not compliance with the law but it is widely used in the corporate world for maintaining stability in their earnings presentation. Typically, income smoothing does not signify the managerial proficiency rather it hides ineptness of management. Apparently, income smoothing helps the management to present the firm in a furnished way before the investors as well as other related parties that actually mislead the investment decisions and tax authorities and other interested parties. Sometimes management does it with their ill motives. It also creates the agency problem more complex. The study shows various models of income smoothing. Every model represents some concealments and miss-presentation in various statements. Theoretically accounting should ensure the fair presentation in its statements. Though income smoothing makes benefits to the management but harms the other parties. At the end of the study, it can be concluded that income is the major factor of investing and financing decision so the management should much more ethical and careful in the presentation of income in various financial statements and financial reports. Truth is always truth. Sometimes it may go against the interest of management or the owners of the company. Since the investors are the key parties of any organization so management should emphasis more to protect the interest of the investors.


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