Research has shown that numerous companies manage their earnings. A variety of earnings management techniques are available ranging from income smoothing to outright fraud. Define income smoothing and explain how it is implemented

Answer 1

Income smoothing is the careful timing of the recognition of revenues and expenses in order to reduce the volatility of income. Managers of many companies seek to report gradual and continual increases in income in the belief that investors view an erratic earnings trend as being more risky than a smooth trend. These managers fear the economic consequences of lower earnings in the form of reduced stock prices, higher borrowing costs, or possible technical default as a result of noncompliance with debt covenants.

Income smoothing can be implemented in a number of ways. Large corporations with diverse operating units can match a large one-time loss for one operating unit with a large one-time gain of another operating unit to achieve the desired earnings result. Careful timing of the recognition of such gains and losses can eliminate much of the volatility in earnings. Other means of smoothing include deferring revenues from sales to a later period or accelerating the recognition of sales revenue to the current period. Prices of products also can be lowered to facilitate additional sales that otherwise might not have occurred.

Expenses can be used to smooth income as well. A purchaser can persuade a supplier to split a single purchase order into several orders with invoice dates in more than one accounting period. Bad debt expense, warranty expense, and other estimated expenses can be manipulated to reach a desired earnings goal. Oil and gas companies have particular flexibility in their choice of when to declare a dry well as unsuccessful thus timing needed reductions in income to suit their needs.