The Importance of Interpersonal Communication Between Lenders and Borrowers

Abstract

Interpersonal communication between lenders and borrowers, the process by which information is related between parties, is extremely important. From the lender’s perspective it is essential that the bank communicate to a potential borrower the rules and regulations governing lending, fully disclose the terms of the loan, including the repayment schedule and interest rate, and ensure that they understand the borrower’s overall desires and goals. From the borrower’s perspective, they must communicate to the lender exactly what their purpose is in seeking financing, how quickly they are able to pay it off, and whether or not they possess alternative means of repayment (collateral). The borrower must also be sure that they understand the information transmitted to them by the lender regarding the terms of their loan.  Every element of interpersonal communication, including sending, encoding, messaging, decoding, receiving, and feedback, must be present in order for the effective transmittal of information. Without clear communication between these two parties, lending deals can sour quickly and the results may be disastrous for both the debtor and the bank. 

Keywords: interpersonal communication, banking, lending, debt, lender/borrower relationships.

 

“We all need to develop interpersonal communication skills,” insists psychology professor Ramaraju, “since interpersonal communication is woven through all aspects of living and is meaningful only in the context of living” (2012). The communication process of transmitting information between one party to another is one that individuals experience every day when they encode and interpret ideas. In a business context, as well as in social, personal, and community contexts, this communication is an essential aspect of building a well-functioning relationship, and also essential for achieving shared goals, purpose, and vision. Communication between business parties takes many forms, and can be transmitted back and forth between different kinds of parties – between employees and employers, companies and investors, manufacturers and consumers, employees and customers, and many other groups.

In the banking world, one of the most important relationships is the one cultivated between the lender and the borrower. The borrower is a bank customer who needs financing for one of several different kinds of activities: a construction project, a business venture, an agricultural development, or a personal investment, such as purchasing a home or a car. The lender is the banker, or loan officer, who will discuss the terms with the borrower, approve or deny the loan, and perhaps, if the loan exceeds a certain amount, bring it before the bank’s loan committee for approval. Clearly it is important for the lender and the borrower to communicate with one another through every step of this process in order to ensure that it proceeds smoothly.

            The steps of interpersonal communication that can be applied to the lender/borrower relationship are the same as those applied to any relationship – sending, encoding, receiving, decoding, and feedback. As Satterlee states, the sender of the message has to be aware of their desired meaning and also of their target audience, in order to encode their message into a meaningful language that the receiver will understand (2013, p.134). In the context of banking, the loan officer must be careful to ensure that they are not using banking terms that would confuse their customer, or complicated financial formulas that their client would not understand. On the other hand, lenders must also be careful not to make the mistake of underestimating their customer’s intelligence and knowledge, and thus patronizing them in a way that makes them feel condescended to. The loan officer can use his previous experience with and knowledge of the customer’s background in order to determine the best way to encode his message, and the perfect channel for sending that message (Satterlee, 2013, p.135). This balancing act of encoding their message simply yet intelligently is important to maintaining good customer relations.

            However, if the lender is appropriately encoding his message, but the borrower is not, there will still be problems in communication. The borrower also has a responsibility to communicate with his banker in such a way that his needs are clearly understood. Just as the loan officer must know how to ask the right questions, the customer must know how to anticipate those questions and answer them succinctly. This does not apply exclusively to the realm of oral communication, but applies to written communication as well. Usually the lender will ask for documents and paperwork to back up the borrower’s oral story, such as tax returns, income statements, receipts, balance sheets, credit reports, and bank statements. It is up to the borrower to ensure that he has these documents in hand or readily available for the banker. This is part of the borrower’s responsibility to encode his or her message appropriately so that the lender can understand exactly what is being asked of them.

Listening is another key part of interpersonal communication between lenders and borrowers. Listening is the act of decoding the message, interpreting it, and then providing feedback. Once the receiver gets the message, they will use their personal mental model to interpret what the sender was trying to say, and respond accordingly. In a recent study conducted on the relations between auto lenders and dealers, Automotive News states: “As auto lenders seek to do a better job of serving dealers, there's no single solution, said Mark Kaczyn-ski, CEO of captive finance company Nissan Motor Acceptance Corp… ‘It's not just one silver bullet,’ Kaczynski told Automotive News. But his experience shows that listening to dealers’ suggestions is a good place to start” (2014). Just as encoding a message appropriately is an essential part of smooth communication, so is listening appropriately. Thus the lender has a responsibility to give careful consideration to his target audience, in this case, the customer seeking financing. The customer also has a responsibility to listen to his banker as he explains the lending options available and communicates the terms of the loan.

Once the lender has decoded his customer’s message, he will provide feedback, and the process of carrying on a business conversation has begun. While feedback is the last step in the communication process, it is the first step in the two-sided process of dialogue. When the sender hears feedback from his receiver, he is able to determine how effective he was encoding his message (Satterlee, 2013, p.135). For example, the potential borrower might have approached his banker about a $150,000 loan for a prospective construction project. The customer stated his request for a loan, outlined the details of the project, and summarized his plan for repayment. Then he supported his oral presentation with written communication in the form of two previous years’ tax returns and a blueprint for his construction plan. He has encoded and sent his message to the receiver, and it is up to the receiver, in this case the loan officer, to provide feedback.

As Vertino states in her article on interpersonal communication, “Because human beings are complex and each individual brings his or her own set of internal variables to every situation, the possibilities of interactional outcomes of any given communication can be exponential” (2014). In other words, there is no way to anticipate the outcome of the communication process. From the borrower’s perspective, after they have encoded and sent their message, all they can do is wait for feedback from their receiver. Depending on the circumstances of the proposal, the loan officer might respond positively or negatively – but in most cases, his feedback will take the form of more questions in order to better clarify the situation. He might ask the customer what types of collateral he is able to offer up in the event he defaults on the loan. He might ask if any other builders or homeowners are included in the construction project, and the extent of their financial involvement. He also might ask if the customer has any other outstanding debt elsewhere, and to provide documentation for these liabilities. When the customer begins to answer these questions, a two-sided dialogue, and thus interpersonal communication, has begun.

            From the lender’s perspective, why is it so important that the elements of interpersonal communication – sending, encoding, messaging, decoding, receiving, interpreting, and feedback – be present? To answer this question, the process of lending must be examined a little more carefully. A case study by Professor Koloor in the International Journal of Organization Leadership has found that in order to achieve the overall goal of successful banking, attracting and keeping customers and guaranteeing their loyalty are important drivers (Koloor, 2015). He points out that in today’s world, customers are viewed as the core and main structures of marketing activities, and thus the level of customer satisfaction is the service providers’ center of attention. “Success and survival of each industry and providing high level services for customers depend on evaluation of customers' demands and their expectations” (Koloor, 2015). In banking it is essential that not only loan officers, but customer service representatives, tellers, operations managers, cashiers, couriers, and credit officers keep the customers happy. They do so by answering customer inquiries, going above and beyond to meet their requests and needs, and ensuring that operations and communications run smoothly in all aspects. 

            Many people think that banks are simply for cashing checks and keeping their deposits safe. However banks make their money mainly through service fees and interest on loans. A loan, which is a liability to a customer, is an asset to a bank. Thus it is easy to see why banks are in the business of lending funds to customers at interest, and seek to ensure that it is as simple as possible for their customer to take out a loan. They also seek to maintain good relations with their clients. “Credibility,” points out an article on workplace communication, “is a perception that people have on the believability of information,” and if the audience values the communicator and respects the information given, the communication can be said to have high credibility (Saurabh & Chattopadhyay, 2013). Moreover, their case study shows that there is a significant positive relationship between communication credibility and communication satisfaction (Saurabh & Chattopadhyay, 2013). It is important for a bank to have credibility with its borrowers, because if the borrowers do not trust their bank to provide them with the best possible financing options, they will take their business elsewhere. And as the above case study argues, good credibility is symbiotically related to good communication.

            Yet another reason why smooth interpersonal communication is essential from a banker’s perspective is that, due to the major financial crisis in 2008 that led to the failure of numerous banks, it has become increasingly more difficult for banks to earn their customers’ trust. Chamley, Kotlikoff, and Polemarchakis describe the effects of this crisis on the banking industry, stating that “trust in financial companies took a holiday,” and “those who knew the system best, the bankers, were the first to panic,” because they understood what everyone else soon learned – “that no one, not even the heads of the banks, including their own, owed and owned, and that, when push came to shove, no bank could trust any other bank” (2012). Many of the causes of bank failure are legitimately out of their control, as Haldane points out: “Events external to the banking system, such as recessions, major wars, civil unrest or environmental catastrophes, clearly have the potential to depress the value of a bank's assets so severely that the system fails” (2011). But banks mainly fail when customers react in fear and no longer trust their financial institutions. Now, with that crisis still fresh in everyone’s memory, lenders must work extra hard to earn back their borrowers’ faith in them. However, if lenders can effectively communicate to their customer that they are truly looking out for their best interest, that faith will be restored. 

            From the lender’s point of view, it is also essential that they maintain good communications with their customer for purely financial reasons. If there was a snag somewhere along the communication process, caused either by the sender, the receiver, or an external communication barrier, the consequences for both parties could be disastrous. For example, if the loan officer neglected to communicate that the loan’s interest rate was 4.5%, the borrower might mistakenly assume that their rate was much lower. When their monthly loan payment comes due, they will be surprised and probably angry that the balance they owe is higher than they anticipated. Or if the lender mistakenly told his client that his payment was due on the 16^th of every month, rather than the 6^th, the client’s payment would consequently be ten days late, the client would incur late fees, and his credit score would suffer. Since the miscommunication was the lender’s fault, the bank would seek to make up these losses to the customer, and this in turn would lead to a loss for the bank.

            Again, due to the financial crisis of 2008, disclosure regulations on banks have continued to pile up. “Market failures such as incomplete markets, moral hazard between banks' owners and depositors, and negative externalities (like contagion) have been used to explain this fragility. This has motivated government regulatory agencies or central banks to introduce several types of regulatory measures” (Tchana, 2014). Moreover, systemic risk has increased during the last thirty years, which had led regulators to formulate rules for analyzing information more efficiently (Paulet, 2011). From the banker’s point of view, this means that they have increasing amounts of paperwork to deal with when negotiating the terms of a loan. A good deal of that paperwork falls under the category of disclosure, which is a synonym for communication. Due to federal regulations, bankers are required by law to disclose and communicate every detail of the loan’s terms to the borrower. These disclosures also communicate to the customer what the bank will do with the customer’s personal financial statements, and that customer information will be kept completely private. If these disclosures are not properly explained to the client, or if the loan officer fails to adhere to them, the consequences would be serious. At that point, the bank would be violating federal law.

            Why is interpersonal communication so important from the borrower’s point of view? Because from his perspective, he needs the bank to make an investment, essentially in him and in his ability to repay the loan – he comes to the bank looking for financing. Just as the bank has to earn the trust and faith of their clientele, the customer in turn must earn the bank’s faith in him. Koloor observes that, “Nowadays, just having relationship with customers to have loyal customers is not enough. The quality of this relationship is also of great importance” (2015). Building a relationship between lender and borrower cannot be a one-sided endeavor, as both must put effort into clearly communicating their needs and expectations to one another. In the borrower’s circumstance, he is responsible for making a case for himself, and communicating to the lender just why the bank should invest in him. He needs to effectively communicate to the banker that, not only does he need the money for a worthy project, but that he is also able to repay it in a timely manner with interest. Moreover, when making his case, full disclosure is just as important to the borrower as it is to the lender. The borrower might not have federal agents swooping in on him if he leaves out a key piece of financial information during the lending process, but this lack of transparency will cause him nothing but disaster in the long run.

Once the borrower has made his case, he waits for feedback from the receiver, in this instance, the loan officer. At this point it is vitally important that the borrower listen to the lender, just as the lender listened to him. There are five elements of active listening implemented by effective communicators; paying attention, showing that they are listening, providing feedback, deferring judgment, and responding appropriately (Satterlee, 2013). If the borrower neglects to carry out any one of these steps and listen actively, he has the potential to miss out on something important the lender has to say about his loan, such as the exact interest rate, required forms of collateral, payment due dates, payment amounts, credit check procedures, and privacy disclosure details.

            In conclusion, interpersonal communication is a vital aspect of maintaining smooth relations and operations between lenders and borrowers in the banking industry. As Vertino insightfully points out:

Communication is an integral part of life; without it, we would not survive. Verbal and non-verbal communication begins at birth and ends at death. We need communication not only to transmit information and knowledge to one another, but more importantly, to relate to one another as human beings around the world in the context of relationships, families, organizations, and nations. The how, what, why, and wherefore of communication can either edify or harm us, as individuals, cultures, religions, and governments of countries… What we say, how we say it, and what we mean by it are extremely important, and can be life-changing. (2014)        

 

            Clearly in the banking realm, as well as in every aspect of the business world, interpersonal communication is important. Good communication is conducted with honesty, intelligence, patience, and clarity. If both lenders and borrowers bring these attributes to the negotiating table, along with understanding and an open mindset, the lending process will be that much smoother, simpler, and rewarding.

References:

 

Chamley, C., Kotlikoff, L.J., & Polemarchakis, H. (May 2012). Limited-purpose banking – moving from “trust me” to “show me” banking. The American Economic Review. Vol. 102, No. 3. pp. 113-119. Published by the American Economic Association. Stable URL: http://www.jstor.org/stable/23245514

Haldane, A. G., & May, R. M. (2011). Systemic risk in banking ecosystems. Nature, 469(7330), 351-5. Retrieved from http://ezproxy.liberty.edu:2048/login?url=http://search.proquest.com/docview/847540953?accountid=12085

Koloor, H.R. (2015). Developing a communication model between banking services quality via mediating variables of quality of relationship with customers and satisfaction

with customer loyalty: A case study of Tejarat Bank. International Journal of Organizational Leadership 4, 86-99. Retrieved from www.aimijournal.com

Lenders listen to satisfy dealers: finance companies keep communication open, see survey results improve. (2014, August 4). Automotive News, 88(6632), 0010. Retrieved from http://ezproxy.liberty.edu:2048/login?url=http://ic.galegroup.com/ic/bic1/MagazinesDetailsPage/MagazinesDetailsWindow?failOverType=&query=&prodId=&windowstate=normal&contentModules=&display-query=&mode=view&displayGroupName=Magazines&dviSelectedPage=&limiter=&currPage=&disableHighlighting=&displayGroups=&sortBy=&zid=&search_within_results=&p=BIC1&action=e&catId=&activityType=&scanId=&documentId=GALE%7CA377652009&source=Bookmark&u=vic_liberty&jsid=d04d1e72084f3ba7150f8841d3362685

Paulet, E. (2011). Banking ethics. Corporate Governance, 11(3), 293-300. doi: http://dx.doi.org/10.1108/14720701111138715

 

Ramaraju, S, MA, MP. (2012). Psychological perspectives on interpersonal communication. Researchers World, 3(4), 68-73. Retrieved from http://ezproxy.liberty.edu:2048/login?url=http://search.proquest.com/docview/1284725619?accountid=12085

Satterlee, A. (2013). Organizational management & leadership: A Christian perspective (2nd ed.). Raleigh, NC: Synergistics International Inc.

Saurabh, S., & Chattopadhyay, T. (2013). Auditing communication satisfaction among banking professionals: An approach to managing workplace communication. International Journal of Marketing & Business Communication, 2(2), 1-9. Retrieved from http://ezproxy.liberty.edu:2048/login?url=http://search.proquest.com/docview/1478016779?accountid=12085

Tchana, F. T. (June 2014). The empirics of banking regulation. Emerging Markets Review. Published by Elsevier. Retrieved from http://rx9vh3hy4r.search.serialssolutions.com/?ctx_ver=Z39.88-2004&ctx_enc=info%3Aofi%2Fenc%3AUTF-8&rfr_id=info:sid/summon.serialssolutions.com&rft_val_fmt=info:ofi/fmt:kev:mtx:journal&rft.genre=article&rft.atitle=The+empirics+of+banking+regulation&rft.jtitle=Emerging+Markets+Review&rft.au=Fulbert+Tchana+Tchana&rft.date=2014-06-01&rft.pub=Elsevier+BV&rft.issn=1566-0141&rft.eissn=1873-6173&rft.volume=19&rft.spage=49&rft_id=info:doi/10.1016%2Fj.ememar.2014.04.003&rft.externalDocID=3392660711&paramdict=en-US

Vertino, K. A., DNP,P.M.H.N.P.-B.C., C.A.R.N.-A.P. (2014). Effective interpersonal   communication: A practical guide to improve your life. Online Journal of Issues in Nursing, 19(3), 19-30. Retrieved from http://ezproxy.liberty.edu:2048/login?url=http://search.proquest.com/docview/1710043963?accountid=12085

 

 

 

 

Case Overview – Hannington v. University of Pennsylvania, 809 1. 2d 406 (Pa. Super. 2002)

 

Hannington was a graduate student at the University of Pennsylvania and brought suit against the University for breach of contract. Hannington’s attorney sent Penn’s attorney a draft of a settlement agreement, which Penn signed and sent back to Hannington. But Hannington then refused to sign the settlement agreement, hired a new attorney, and opted to proceed to trial. The trial court refused to allow Hannington’s case to go forward, holding that Hannington’s former attorney had had “apparent authority” to settle the case. Hannington appealed, and the Superior Court of Pennsylvania affirmed the trial court’s decision, ruling in favor of Penn (Melvin and Katz, 2015).

From a legal aspect, this case involves the liability of the principal for acts of the agent, specifically touching on authority, and, in this case, apparent authority. The legal definition of apparent authority is when “an agent may also gain power to bind the principal from the appearance of legitimate authority to a third party,” and the key to understanding this party is “to determine whether a third party was objectively reasonable in her belief that the apparent agent is in fact authorized to act for the principal” (Melvin and Katz, 2015). The innocent party in this case, the University of Pennsylvania, had reasonable cause to believe that Hannington’s attorney was authorized to draft a settlement agreement. This led to their decision to rely on his attorney as an agent, and to thus agree with the terms of the settlement and sign it. As The National Public Accountant states, this type of liability can arise when either a former or current employee undertakes tasks which the firm does not sanction, endorse, or normally practice, but which appear to a 3rd party to constitute services approved and endorsed by the principal (1997). In these types of cases, the client (grad student Hannington,) usually asserts that he wouldn’t have entered into business with the agent and didn’t grant him the authority to make the settlement, in spite of the fact that the situation’s appearance suggested otherwise.

From a social aspect also, Hannington does not have the right in this case. The third party, Penn’s legal representatives, had every reason to believe that Hannington’s lawyer was acting as an agent with authority for his principal (Hannington.) He had apparent authority legally to offer the settlement, but it was also obvious from the social circumstances that the lawyer was Hannington’s agent. Penn had no reason to believe that Hannington’s lawyer was acting against his client’s wishes, because an attorney does not usually do this. Nor is Penn responsible for the situation between Hannington and his attorney. All they know is that an agent with apparent authority gave them a settlement agreement, and they wanted the settlement to happen, so they signed it.

From a business perspective, “the best first step for an association to take in protecting itself from unknowingly bestowing apparent authority upon volunteers is to adopt an official policy as to who may speak for the association” (Webster, 1996). A common business example of the relationship between an agent and a principal is the bond between employer and employee. Essentially, this is what Hannington’s attorney is to Hannington. These two allowed their miscommunication issues to affect their business relationship with a third party, the University of Pennsylvania, which was bad business conduct on their part. Hannington and his attorney could have avoided putting Penn into this position altogether if they had clearly expressed to Penn the type of authority that Hannington’s attorney actually had, or adopting “an official policy as to who may speak for the association,” as Webster suggests above. In a business context, the authority of the principal over the agent is an important concept, one that can endanger their relationships with each other, their business, and their relationships with third parties. It is best that this authority is clearly defined so that these types of issues don’t happen.

From an ethical standpoint also, Hannington has no right to bring a case against the University of Pennsylvania for signing a settlement agreement that they had every reason to believe was approved by Hannington himself. Giving off the impression that someone has the authority to act for you when they don’t, endangers your business relationship with them, as well as their trust in your authority. The Bible speaks to the principles of authority, which ability Hannington in effect gave to his attorney when he hired him. Penn reasonably assumed that Harrington’s attorney had authority – and due to their limited knowledge of the true situation, they cannot be held liable for signing a document that the principal did not approve, since they had every reason to assume he had.

            1.) Suppose in the middle of settlement negotiations, Hannington becomes frustrated with the impasse. He hires his neighbor, another attorney not yet involved in the case, to draft a settlement agreement and sends it to Penn. Is apparent authority created in this circumstance? Explain.

 

           Apparent authority would still be created in this circumstance, seeing as how Penn would still reasonably assume that Harrington’s new lawyer has authority to act as an agent for his principal by drafting a settlement agreement. Whether or not the lawyer was already involved in the case is a moot point, because either way the attorney is currently acting as an agent with authority for his principal Hannington.

            2.) Since Hannington never actually signed the agreement, was it reasonable for Penn to assume that Hannington’s attorney had obtained his express consent to the terms? Has the court effectively deprived Hannington of his right to proceed to trial?

           

           Even though Hannington’s signature was not on the settlement document, Penn could still reasonably assume that the attorney had obtained his client’s consent to the terms – he was, after all, acting as an agent for Hannington, meaning that he had appearance of authority to draft documents and speak for his client. Just because Hannington did not agree, does not mean that Penn is held liable. Hannington thus had no right to proceed to trial against Penn, since Penn was acting on the apparent authority assumption of Hannington’s relationship with his attorney.

Reference:

“Apparent authority". (1997). The National Public Accountant, 42(10), 6-8. Retrieved from http://search.proquest.com/docview/232353633?accountid=12085

Melvin, Sean P. and Katz, Michael A. (2015). The Legal Environment of Business: A Managerial Approach: Theory to Practice, 2^nd Edition. McGraw-Hill Education LLC.

The Bible. KJV. Retrieved from www.biblegateway.com

Webster, G. D. (1996). Apparent authority. Association Management, 48(7), 147. Retrieved from http://search.proquest.com/docview/229293862?accountid=12085

Income Smoothing - A Question of Right and Wrong

Since I am a junior accounting student, I'm going to bore you all with an accounting research paper on income smoothing. (Also because it's my blog and I can.) I hope you find it somewhat interesting, because I certainly did. 

One of the most important functions of an accountant is his or her ability to accurately report financial information. A vital characteristic of that function is what is defined as “earnings quality,” or “the ability of reported earnings (income) to predict a company’s future earnings” (Spiceland, Sepe, & Nelson, 2013). Important decisions about the prospects of a company are based on its financial reports, such as the income statement, statement of cash flows, and the statement of owners’ equity. External users of this information, like outside investors, look at these reports to determine how well the company is doing, whether or not to continue investing in its stock, and to make their own financial decisions based upon this reported data. Internal users of the information also make important decisions about the future of their company using these financial statements, such as whether or not to expand in certain sectors, whether or not they should adjust their business methods, and where changes need to be made. If this vital financial information is understated, overstated, or distorted in any way, it is considered dishonest financial reporting. Although GAAP (Generally Accepted Accounting Principles) sets high standards to ensure that financial information is reported as accurately and honestly as possible, managers have still found ways under GAAP to slip through the cracks.

Among several of the methods for doing this is a managerial tactic known as “income smoothing,” a form of income manipulation. As CPA Larry B. Godwin points out in The CPA Journal, managers have a strong incentive to manipulate income because it minimizes uncertainty in the eyes of the investing public about the future performance of the company. He states correctly that, “A company whose progress is predictable is capable of attracting capital more easily than one that moves forward by fits and starts” (Godwin, 1977). Investors and creditors are not looking to invest their money or credit in a company whose income seems to vary wildly from year to year – they are looking for “safe” investments in companies that are stable and have relatively comparative profits and losses from year to year. C.R. Beidelman expounds on this in the “Accounting Review” as well, explaining that smoothing represents an attempt on the part of management to reduce “abnormal variations in earnings” as far as they’re allowed under accounting guidelines (Beidelman, 1973). According to Beidelman, there are three relevant questions one must ask regarding income smoothing: is it desirable for management to have smooth earnings? If desirable, can management create the appearance of smooth earnings? And thirdly, if desirable and possible, do firms succeed in their attempt to normalize reported income? (1973).

However, the most important question does not seem to be whether or not this tactic is desirable, possible, or feasible, but simply, whether or not it is right. Income smoothing has been a controversial topic for many years, and it is one that’s still under debate today. As Spiceland et al. point out, many believe that manipulating income in this way reduces an important aspect of financial reporting – earnings quality (Spiceland et al., 2013). This is because it can mask permanent earnings. The former Chairman of the SEC, Arthur Levitt, Jr., criticizes income manipulation by managers rather harshly by claiming that, “In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking maybe be winning the day over faithful representation” (as cited in Spiceland et al., 2013, p. 178). He goes on to say that because of this obsession with “smooth” income, the accounting world is witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting – “managing maybe be giving way to manipulation; integrity may be losing out to illusion” (2013).

These are rather powerful charges to bring against managers who are simply trying to make their companies look more stable by evening out profits and loss. And yet, when the actual methods of income smoothing are analyzed, Levitt’s harsh words and calls for accounting reform seem justified, by all ethical standards. There are two main methods of manipulating, (and therefore smoothing) income. These are income shifting, and income statement classification. Income shifting is when the recognition of revenues or expenses before or after they’ve actually occurred. Income statement classification manipulation, (also referred to as “big bath” accounting) involves the inclusion of recurring operating expenses in special charge categories such as “restructuring costs.” These “restructuring costs” cause reductions in income that might appear as normal operating expenses in future years (Spiceland, Sepe, & Nelson, 2013).

The first method of income smoothing, income shifting, is clearly at odds with one of the most fundamental principles of accounting – the matching principle, which states that expenses must be reported on the income statement in the same period as revenues. The motivation behind this principle is the same behind all financial reporting guidelines – to ensure transparency in financial reporting. It is not so much the technical violation of the matching principle that matters in income shifting. Rather, it is the fact that the underlying reason of implementing the matching principle in the first place is being violated when income is shifted in such a manner to “even out” gains and losses.

“Big bath accounting” is not much better in terms of ethical motivation. In the Journal of Business Finance and Accounting, Walsh, Craig, and Clarke state that, “Big bath accounting has been used to describe large profit reducing write-offs, or ‘income-decreasing discretionary accruals’ in profit and loss statements,” and furthermore that, “particular companies are reported to have cleansed their corporate souls by engaging in the practice” (1991). It is called “big bath” as a reference to cleaning up company balance sheets, and is simply another way to even out a business’ costs in order to make it look like they weren’t higher or lower in one year than in another (Spiceland et al., 2013).  

Aside from these two prominent income-smoothing tactics are several others, as outlined by Godwin in The CPA Journal: the most obvious one is switching up accounting principles to even out profit and loss. Another involves changes in accounting estimates. A more flexible smoothing device involves timing of sales investments. Yet another method of smoothing involves timing of shipments of products at the end of an accounting period (Godwin, 1977). Obviously managers who manipulate income using these tactics have discovered multiple means of bending the rules and working in the gray. They may not be expressly violating any GAAP rules – but they are violating the spirit of honest financial reporting that led to these regulations being set in place. 

As mentioned above, Levitt expresses a call for change by standard setters to “improve the transparency of financial statements” – not to eliminate necessary flexibility in financial reporting, but to make it easier for financial statement users to “see through the numbers” (as cited in Spiceland et al., 2013). It should be easy for any user, whether it is an employee looking for financial information about his company, or an investor looking for a return on his capital, to look at a company’s income statement, balance sheet, and statement of cash flows and “see through the numbers.” This is the entire purpose of lucid, accurate financial reporting. When income is shifted and balance sheets are “cleaned up,” it becomes difficult to muddle through the numbers and attempt to interpret the data correctly. This in turn can lead to misconceptions about the company’s actual financial standing, and to bad decisions on the part of both external and internal users.

One would think that managers would want to manipulate income by maximizing it to make it look higher than it really was, but this is not the primary incentive to managers who utilize income-smoothing tactics. Rather, their main purpose is implied in the name – to smooth income so that profits and losses appear to stay consistent from year to year. “Smoothing,” explains Ronald Copeland, former assistant professor at Pennsylvania State University, “moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods” (Copeland, 1968). This lowers the peaks and lifts the troughs, effectively creating an even income stream and making earnings fluctuations less volatile. According to Chambers in The Accounting Review as cited by Copeland, managers have more choices than they perhaps realize when it comes to their methods of financial reporting – he calculated that “it is possible to measure a given firm’s income as any one of 30,000,000 figures, all determined according to generally accepted accounting principles” (as cited by Copeland, 1968). This is a wide scope of responsibility indeed. Even under GAAP, managers have considerable leeway when it comes to their methods. This leeway, as lamented by individuals such as Levitt, can lead to dabbling in less-than-honest income manipulation methods when managers try a little too hard to make their company look, not merely profitable, but stable.

In conclusion, income smoothing is a tactic utilized by company managers to shift profits and losses and make their company appear to be a safe investment. While flexibility in reporting is not necessarily dishonest, as any manager should have the option of deciding his own accounting methods, this type of manipulation is, for Hashem states unequivocally that, “The L-rd detests dishonest scales, but accurate weights find favor with Him…The integrity of the upright guides them, but the unfaithful are destroyed by their duplicity” (Proverbs 11:1-3). 

References:

              Arthur Levitt, Jr., “The Numbers Game,” The CPA Journal, December 1998, p. 16.

             

              Beidleman, C. R. (1973). Income Smoothing: The Role of Management. Accounting Review, 48(4), 653-667.

Chambers, R. J. (1966). “A Matter of Principle.” The Accounting Review. 41 (July 1966). P. 443-57       

Copeland, R.M. (1968). “Income Smoothing.” Journal of Accounting Research. Vol. 6, Empirical Research in Accounting: Selected Studies 1968 pp. 101-116. Published by: Wiley on behalf of Accounting Research Center, Booth School of Business, University of Chicago. Retrieved from http://www.jstor.org/stable/2490073

Godwin, L. B. (1977). Income smoothing. The CPA Journal (Pre-1986), 47(000002), 27. Retrieved from http://search.proquest.com/docview/211776350?accountid=12085

Spiceland, J. D., Sepe, J. F., & Nelson, M. W. (2013). Intermediate accounting (7th ed.,combined ed.). New York: McGraw-Hill Irwin.

Walsh, P., Craig, R., & Clarke, F. (1991). “ ‘Big Bath Accounting’ Using Extraordinary Items Adjustments: Australian Empirical Evidence.” Journal Of Business Finance & Accounting, 18(2), 173-189.