Income Smoothing

Case 5-1 Income Smoothing a. Firstly, investors tend to invest in companies with stable earnings rather than one with volatile earnings. With stable earnings, there will be more likely an issuance of dividends and investors could easily predict the company’s future earnings compared to one with unstable earnings. With consistent earnings generated, it gives investors a secured feeling that it will again generate earnings as predicted. Confidence in the growth of rate of earnings is crucial because stable earnings growth further may increase further business prospective and are translated into higher stock and dividend returns. It is also crucial to have stable earnings as the growth in stock price is closely dependent on the growth of its earnings per share, a main indicator which investors used to invest in a company. b. Step-1: Massaging the numbers or income smoothing Business managers can control the timing of some expenses and sales revenue to some extent and therefore boost or dampen recorded profit for the year. In this way managers ”put a thumb on the scale”, the scale being net income for the year. When managers cross the line and go too far it’s called cooking the books. Cooking the books constitutes fraud and is probably illegal. The most common way of massaging the numbers involves the discretionary expenses of a business. Consider repair and maintenance expenses, for instance. Until the work is done, no expense is recorded. A manager can simply move back or move up the work orders for these expenditures, and thus either avoid recording some expense in this period or record more expense in the period. In this way the manager controls the timing of these expenses. Managers control the timing of discretionary expenses, it is thought, to smooth profit from period to period. Instead of permitting the profit numbers to pop out of the process of the accounting system, and letting the chips fall where they may, managers ask the