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One reason accounting earnings might not be a realistic measure of economic income is the...

Question:

One reason accounting earnings might not be a realistic measure of economic income is the incentive and ability of business managers to manipulate reported profits for their own benefit. This may be particularly true when their company has an incentive compensation plan that is linked to reported net income.

The manipulation of earnings, known as earnings management, commonly involves income smoothing. Income smoothing has been defined as the dampening fluctuations about some level of earnings that is considered normal for the company. Research has indicated that income smoothing occurs because business managers prefer a stable rather than a volatile earnings trend.

Required:

a) Why do business managers prefer stable earnings trends?
b) Discuss several methods business managers might use to smooth earnings.

Income Smoothing:

Income smoothing is a method used by a company to transfer income from one period to another in order to reach a desired outcome, usually to make the business appear to have a steady, rising income.

Answer and Explanation:

a)

Business managers prefer stable earnings trends for a number of reasons. These include:

  • Being able to hit targets period-on-period
  • Meeting shareholder expectations period on period
  • Creating confidence within shareholders by not having volatile earnings
  • Lowering unrealistic expectations by investors

b)

Managers can smooth income through a variety of methods depending on the nature of their business. Often these methods relate to judgements made by a manager. The following methods may be used to smooth income:

  • Use of provisions:

By creating a new provision, a manager may expense an item in the current period rather than in the future period. This will reduce the income in the current period and increase the income in the future period.

  • Judgemental revenue streams (ie. deferred revenue):

Where project accounting is used or deferred revenue exists and is released over a long period of time, a manager may use an incorrect percentage of completion for the project. For example, 35% of a project may have been completed, however, a manager will elect to release 37% or 33%. A small percentage change in a large balance can result in higher or lower revenue in the current period and subsequently a higher or lower amount in a future period.

  • Use of discount rates or other rates:

Where multiple rates exist, or large debate exists around the rate at a select date, a manager may choose a favourable rate which results in an increase or decrease in income for the period. For example, foreign exchange rates often have multiple sources quoting slightly different rates. A small difference in the rate can make a material difference to the final income figure.


Learn more about this topic:

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What Is Net Income? - Definition & Formula

from OSAT Business Education (CEOE) (040): Practice & Study Guide

Chapter 69 / Lesson 5
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