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.
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