By and large, the main techniques used to smooth income include provisioning, deferred accounting, and accrual accounting. Either way, to the outside observer, this company has the appearance of highly cyclical earnings and would thus likely be perceived as a risky investment during an economic downturn. In a year of low earnings, the corporation might eliminate jobs, defer maintenance projects, reduce research and development efforts, etc. Then when earnings are higher, the corporation will increase spending for personnel and get caught up on the maintenance it had put off.
Also called a busted convertible, a convertible security that is trading like a straight
security because the optioned common stock is trading low. (2009), “Corporative management and agency problem”, Faculty of Law, Belgrade, No. 1, pp. 5-25. Previous studies which used Tobin’s Q in the measuring firm value include, Feihn and Struck (2011), Huang et al. (2008), Makela (2012), Pandey and Sahu (2019), Rountree et al. (2008).
This is achieved via accounting techniques known as deferrals and accruals. If a company expects sharply higher interest rates, deferring income and delaying tax payments can lower borrowing costs through the economic cycle. In other words, a company might smooth earnings to manage its cyclical interest rate expense. Companies with predictable financial results are able to negotiate better loan terms than those with volatile earnings. All things being equal, companies with stable earnings will tend to be more highly priced than companies with volatile earnings. 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.
- Beidleman (1973) defined income smoothing as an attempt by management to reduce abnormal variations in earnings to the extent allowed under sound accounting and management principles.
- The result of the interaction of the variables arose from findings of previous studies on how environmental uncertainty might motivate income smoothing practice or behavior.
- It is calculated as the ratio of the market value of equity + long term debt to the book value of assets (Feihn and Struck, 2011; Huang et al., 2008; Rountree et al., 2008).
- Deferring sales during a successful year if the following year is likely to be difficult, or postponing expenditure in a poor year if productivity is expected to improve shortly, are examples of revenue-smoothing tactics.
- Depending on the country, companies pay a progressive corporate tax rate; meaning that the higher the income earned, the higher the taxes paid.
Net income is clearly the single most important number in business
financial reports. There are mixed results on the relation between the firm size and earnings quality (Cvetanovska and Kerekes, 2015; Feihn and Struck, 2011; Huang et al., 2008; Rountree et al., 2008). Testing the moderating effect of market risk on the relationship between income smoothing and firm value is unique to this study, particularly from a regulated security market and emerging economy.
Dividend income
The net income of a business, less the impact of any financial activity,
such as interest expense or investment income, as well as taxes and extraordinary
items. (2019), “Firm value, firm size and income smoothing”, Journal of Finance and Banking Review, Vol. This implies that volatility seem to enhance investment activity in the Nigerian market, thus, improving income smoothing describes the concept that stock returns. Firms’ valuations by investors have been plagued by a lack of relevant and reliable information, especially in developing economies such as Nigeria. The management of earnings through smoothing has made it difficult for investors to assess the underlying performance of firms, thus, limiting the ability of investors in valuing firms accurately.
The financial statements, which should be a faithful mirror of business activity and a transparent guide to investors’ use, are so often the instruments to positively impact the markets to the detriment of true and trustworthy markets. There is the belief that managers engage in profit smoothing–taking actions that reduce fluctuations in firm’s reported earnings. Earnings management (EM) and earnings quality (EQ) can be considered two related challenging issues in financial reporting as EM is an aspect influencing EQ. Managers can make discretionary accounting choices that are regarded as a practice of either efficient communication of private information or distorting disclosure.
3 Variable measurement
The purpose is to eliminate profit swings from one period to the next so that a firm has consistent earnings. This is a tax planning strategy of arranging for income to be transferred to family members who are in lower tax brackets than the one earning the income, thus reducing taxes. Even though attribution rules limit income splitting, there are still a number of legitimate ways to do so, such as through the use of spousal RRSPs.
Managers can use income smoothing to lower their expectations for earnings variations. This would result in a $6,000 rise in bad debt expenditure on the income statement and a $6,000 reduction in net income. These examples will smooth the firm’s earnings by having higher costs when profits are higher and lower expenses whenever earnings are lower. Examples of income smoothing strategies include deferring sales during a successful year if the next year is anticipated to be tough, or delaying spending in a bad year when efficiency is expected to increase in the immediate future.
National Income and Product Accounts
Recent academic literature suggests that firms with greater earnings volatility deliver an informational advantage to informed versus uninformed investors. This group raises awareness of “surprises” in financial statements and performance. Preparers, auditors, and investors need clarification about how much income smoothing is and what occurrences or conditions are considered ethical. In summary, income smoothing is not unlawful or unethical in and of itself; instead, some people turn to unethical measures to achieve the same aim. While one company organization may use strategic techniques and legitimate accounting processes to smooth out its profits, another may use questionable or unethical ways. Management’s efforts to control reported earnings have helped to improve earnings quality.
Companies with higher debt levels and solid financial success tend to have lower-quality financial reporting. In this scenario, the larger the debt ratio, the more likely management will be able to smooth out income. This argument demonstrates that leverage has a favorable impact on revenue smoothing.
Accrual accounting
These strategies range from acceptable accounting practices and generally accepted accounting principles, application of logical reasoning etc. The increase in firm value can be attributed to investors’ preference for more stable earnings. More so, this suggests that smoothen practices are seen to https://accounting-services.net/ signal private information by managers to investors, thus, income smoothing is perceived from the information view rather than the garbling (managerial opportunistic) view. From literature, the study expects a positive and significant relationship between profitability, firm size and firm value.
The study examined the influence of income smoothing and market risk on the value of Nigerian listed firms. The study found that majority of Nigerian firms smoothed their income, and this practice decreases the value of firms significantly. Also, the study found sufficient evidence to support the claim that market risk influences firm value.