Income smoothing and the cost of debt

There are many reasons why a company would choose to engage in income smoothing. These may include decreasing its taxes, attracting new investors, or as part of a strategic business move. When a company uses a special charge such as restructuring costs and
shows a loss on the income statement, income may be manipulated
through
income statement classification shifting. Income smoothing is not illegal if the process follows generally accepted accounting principles (GAAP). Talented accountants are able to adjust financial books in an above-board way to ensure the legality of income smoothing. Categorizing operating expenses as nonoperating expenses is an example
of
income statement classification shifting.

Income smoothing is the method in which the company can avoid instabilities in the net income of the organization. The incentive is the bonus money given to the employee by the organization for the services provided by them. This is the extra payment provided by them as a result of the extra work done by the employees for the betterment of the organization as a whole. CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst. Often is estimated as the Blank 1 of 2 Blank 2 of 2 of
estimated future cash outflows. For financing activities, a cash ______ occurs when cash is borrowed from a
creditor; a cash ______ occurs when owners receive a dividend.

for sale. (Enter one word per blank)

Income smoothing is the shifting of revenue and expenses among different reporting periods in order to present the false impression that a business has steady earnings. Management typically engages in income smoothing to increase earnings in periods that would otherwise have unusually low earnings. The actions taken to engage in income smoothing are not always illegal; in some cases, the leeway allowed in the accounting standards allows management to defer or accelerate certain items.

So it often makes sense for a business to engage in some level of accounting management. But it’s a fine line between taking what the Internal Revenue Service (IRS) allows and outright deception. Companies might also delay expenses in specific years with plans to raise funding from venture capital or private equity investors. Having a high EBITDA thanks to income smoothing might translate into high valuation through EBITDA multiple calculation methods. Income smoothing uses accounting techniques to level out fluctuations in net income from one period to the next. The literature on income smoothing focuses on the effect of earnings smoothing on the equity market.

The correction of a material error in the prior year’s financial

The income statement has been ‘ and continues to be ‘ an extremely important and basic financial statement. We discussed its importance in previous chapters relative to predicting future cash flows and assessment … This practice is especially common in publicly-held companies, where investors are more likely to bid up the price of shares in a company that presents a reliable and predictable earnings stream over time. Of course, if its income smoothing practices are later made known to the investment community, they will probably drive down the price of its stock. Commonly used in income statement preparation; however, there are no
specific standards on how income from continuing operations must be
displayed. For example, the allowance for doubtful accounts can be manipulated to alter the bad debt expense from period to period, thereby altering the amount of income reported.

• CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
• Companies may also be able to defer a large tax liability if profits are moved to a future period.
• We also find that the effect of earnings smoothing on debt cost reduction is stronger in firms with more opaque information and greater distress risk.
• The income statement is considered most useful for predicting
  future profitability.
• The incentive is the bonus money given to the employee by the organization for the services provided by them.
• The techniques are conceived from appropriate accounting standards to the use of rational reasoning.
• Discontinued operations should be reported on the income statement
  net of tax below income from continuing operations.

Although purposely delaying the recognition of revenue in good years can sound counter-intuitive, in practice, companies with predictable financial results are able to negotiate better loan terms. Companies may also be able to defer a large tax liability if profits are moved to a future period. Income smoothing also involves https://accounting-services.net/income-smoothing-definition/ the manipulation of benefits, innovative accounting methods, and the implementation of generally accepted accounting rules. It includes all methods used to offset high costs and boost company sales or profits. The techniques are conceived from appropriate accounting standards to the use of rational reasoning.

options that can be converted to common stock

However, there is some flexibility in GAAP and IFRS accounting policies and professional judgment that would allow some forms of income smoothing. Income smoothing reduces the variability in earnings from one period to another in order to present an organization as one with stable earnings. It is meant to smoothen out periods of high income and periods of low income or periods of high spending and periods of low expenditure. Accountants do this by delaying or advancing the recognition of income and spending. Income smoothing does not rely on “creative” accounting or misstatements which would constitute outright fraud, but rather on the latitude provided in the interpretation of GAAP.

A business strategy a company can use when they have high profits is to increase expenses. In this case, it might increase bonuses paid out to employees or hire more workers to increase the cost of payroll. If income was expected to be lower for the year, they could employ the strategy in reverse; laying off workers or reducing bonuses to reduce expenses. These moves not only smooth out income but allow a company to operate more efficiently depending on the circumstances. If a company’s financials show volatile earnings, an investor may be turned off by the risk and uncertainty of investing in this company. A firm that can show consistent returns from year to year is more likely to attract investors who feel more at ease when they see steady returns over a longer time period.

provide information about cash disbursements that occurred during the

In other cases, the accounting standards are clearly being sidestepped in an illegal manner in order to engage in income smoothing. If the first reporting period is expected to have a high income, the company may include the total amount of $6,000 as an allowance for doubtful accounts in that reporting period. This would increase the bad debt expense on the income statement by $6,000 and reduce net income by $6,000. It’s important for companies to use judgment and legal accounting methods when adjusting any accounts.

An often-cited example of income smoothing is that of altering the allowance for doubtful accounts to change bad debt expense from one reporting period to another. For example, a client expects not to receive payment for certain goods over two accounting periods; $1,000 in the first reporting period and $5,000 in the second reporting period. The goal of income smoothing is to reduce the fluctuations in earnings from one period to another to portray a company as if it has steady earnings. It’s intended to smooth out periods of high income vs. periods of low income or periods with high expenses vs. periods of low expenses. Accountants do this by moving around revenues and expenses in a legal fashion. Discontinued operations should be reported on the income statement
net of tax below income from continuing operations.

changes in operating assets and liabilities during the period that affected

By managing expectations fairly and ethically, businesses that employ a touch of income smoothing do not generally raise a red flag. The general corporation tax rate is 25% for business income, however, if there is a progressive tax structure it may result in high income generating corporations paying as much as 40% of their income as corporate tax. Businesses seek to move out of the high tax brackets by employing hedge strategies, such as increasing loss provisions, or increasing contributions to charity, etc. Income smoothing is a term used to refer to the different strategies and approaches used by accountants and financial analysts to monitor or control the impact of high rises and sudden drops in corporate income. The Sarbanes-Oxley Act requires that if non-GAAP earnings are included in
a report or any public disclosure, the company must
provide a reconciliation with earnings according to GAAP. The income statement is considered most useful for predicting
future profitability.

• A firm that can show consistent returns from year to year is more likely to attract investors who feel more at ease when they see steady returns over a longer time period.
• In this case, it might increase bonuses paid out to employees or hire more workers to increase the cost of payroll.
• The practice provides comfort that the company will be able to meet its periodic obligations to fund its distributions to the investors.
• Income smoothing is not illegal if the process follows generally accepted accounting principles (GAAP).
• Income smoothing is a term used to refer to the different strategies and approaches used by accountants and financial analysts to monitor or control the impact of high rises and sudden drops in corporate income.
• An often-cited example of income smoothing is that of altering the allowance for doubtful accounts to change bad debt expense from one reporting period to another.