Income Smoothing And The Cost Of Debt

This study attempts to critically examines, investigates, and finds out the factors that are responsible for increasing practice of Income Smoothing by firms in Nigeria, and to suggest ways and means of reducing or eliminating this ugly trend. A hypothesis is a clear and specific declaration statements of a conjectural nature whose validity is to be established recourse to empirical findings . In the cases above, the use of financial statements by managements as a means of discharging their fiduciary duties have exploited the flexibilities of GAAP in the preparation and presentation of financial statements.

  • Myers and Skinner believes that companies usually use accrued items to smooth their cash flow.
  • 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.
  • Conventional wisdom suggests that fluctuation in earnings denotes greater equity risk.
  • It can be seen from the results as presented in Column that the coefficient of idiosyncratic risk is 0.576 and is obviously positive.
  • For example, a 1994Wall Street Journal article detailed the many ways in which General Electric smoothed earnings, including the careful timing of capital gains and the use of restructuring charges and reserves.
  • However, sometimes directors can non to the full run into these prognosiss and they decide to smooth income.

Using the negative skewness of stock return distributions, the authors find evidence that earnings smoothing increases stock price crash risk. My experience with this paper along with my earlier paper on Income smoothing in the pre1964 literature represents a case study of a situation where there is a long literary history of recognition of a phenomenon that is ignored in modern investigations of that phenomenon. This is consistent with Bricker’s finding that earlier literature is rarely cited in contemporary literature. Bricker [1988, p. 94] limited his speculation on why early literature is infrequently cited in modern literature to the observation, “accounting academicians moved away from a practice orientation, towards a social science model of research.

The first two hypotheses mean that company managers have motivation to increase current earnings and reduce the risk of being dismissed in short term by transferring future earnings to current ones. And this motivation will be enhanced with the decrease in company’s current performance. The third hypothesis means that company managers have motivation to Certified Public Accountant transfer part of current earnings, if current earnings are good, to a future period the performance of which is bad in order to decrease the probability of being dismissed. This is because company managers are not worried about being dismissed when company performance is good, while they are worried about being dismissed when company performance is bad.

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This information should not be considered complete, up to date, and is not intended to be used in place of a visit, consultation, or advice online bookkeeping of a legal, medical, or any other professional. Determining the value of an item, asset, stock, and even a company can be a difficult task.

It is computed as the difference between the total sales revenue and the overall expenses incurred by the company. For that ground, it is critical to keep investor ‘s assurance in published one-year studies, as this will help towards growing of the house.The Auditing Practices Board can step in to take action on aggressive net incomes direction and income smoothing. They can assist to do certain the fiscal income smoothing definition statements comply with the Company ‘s Act 2006 and besides, it can help the hearers to be more watchful and understand how they can better scrutinizing for future, by placing and reacting to aggressive net incomes and income smoothing faster. Grant Overall, the direction should see all stakeholders ‘ position and any determinations made should profit the house and guarantee the house will go on in being.

One nuance in the definition of income is whether or not monthly fluctuations in income are „smoothed“ in determining monthly eligibility. Through the state-specific program rule ApplyIncomeSmoothing, TRIM can simulate one type of „smoothing“– smoothing out variations in earnings received in a particular month that are due solely to the receipt of weekly or biweekly paychecks. Table 7.8 presents the predictive power of the independent variables on the dependent variable. The Thomson One Banker 2011 database is used to gather the data for the empirical research. The operationalization of this model and the research results are commented on in chapter 7.

Conventional wisdom suggests that fluctuation in earnings denotes greater equity risk. One view is that managers smooth earnings to avoid earnings volatility and to signal their private information to investors What is bookkeeping about future performance, minimizing uninformed investors’ anxieties about future losses. The second theory is that managers smooth earnings to hide bad news for their own opportunistic purposes.

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What benefits will be brought to company managers when income is smoothed by decreasing current earnings? High earnings will result in rise of dividend, while the marginal utility of shareholder satisfaction with dividend drops gradually. Therefore, when earnings are high, shareholder satisfaction with dividend has been very high, and the utility of more dividend distribution will be unobvious. When earnings are poor, shareholder satisfaction with dividend is low, and the utility of more dividend distribution will be more obvious.

The literature on income smoothing focuses on the effect of earnings smoothing on the equity market. Using the Tucker–Zarowin statistic of income smoothing, we find that firms with higher income smoothing rankings exhibit lower cost of debt, suggesting that the information signaling effect of income smoothing dominates the garbling effect. 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.

Accountants do this by delaying or advancing the recognition of income and spending. The practice reduces the variability in earnings from one period to another in order to present stable earnings. When analyzing an entity, it is important to assess the quality of its income as the entity can use different accounting procedures to report higher or lower income.

The interest and the growth rate affect individual hence influence the tax benefit of income smoothing. When a person has a positive interest, his objective is to minimize the value to be taxed. Interest brings investment income that top up smoothing bracket for lower income earners. Income growth and the interest of a person moves the smoothing accrues in an opposite road.

When only income smoothing is taken into account, the coefficient of income smoothing is −0.16 and is obvious. This shows that income smoothing has more direct adverse influence on chairman turnover. After introducing idiosyncratic risk, the absolute value of the coefficient of income smoothing becomes smaller and is unobvious. This shows that the direct influence of income smoothing on chairman turnover is diluted.

Income Smoothing And The Cost Of Debt

If management wants to reach certain strategic goals to the detriment of the outside stakeholders, it will possibly be seen as fraud and certainly as self beneficial. If the information portrayed in the financial statements is changed to the detriment of the outside stakeholders, the integrity of the information may be impaired. Companies indulge in the practice of Income Smoothing because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams, compared to stocks whose earnings are subject to wild fluctuations.

Even more as of late, Michelson et al. returned to their investigation of 1995 to check whether the bookkeeping execution measures are identified with pay smoothing, however this time utilizing unusual returns. The consequences of this strategy depend on the aggregation of anomalous returns utilizing number-crunching arrangement. The outcomes demonstrated that smoothers have an altogether higher anomalous return than non-smoothers. The smoothers, as per the market estimation of fluid resources, were greater than non-smoothers. Stall et al. considered the Finnish market to check whether irregular return, as got from income divulgences, was diverse between organizations that do and do not demonstrate smoothing conduct, in light of the variety coefficient technique. The outcomes demonstrated that smoothers had a tendency to be greater than non-smoothers, and the previous likewise had littler betas than their partners.

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For example, Cendant manipulated its cancellation and commission reserves downward at a time when revenues were increasing. Lucent manipulated its pension reserves and significantly inflated earnings by changing its accounting policies. One of the most obvious warning signs that companies are engaging in improper revenue recognition is a lack of correlation between cash flow from operations and earnings. If revenue is properly recognized, cash flows should closely follow revenue recognition; that is, the business cycle will be completed and cash will be available for reinvestment when customers discharge their obligations in a timely manner.


If a company manager is forced to resign, its reputation will be damaged, which will increase its difficulty in finding a satisfactory job. In addition, M&A market will pay close attention to the performance of company managers. Scott pointed out that the higher shareholder dissatisfaction with managers of a company is, the higher the possibility that the company is acquired is. When a company is acquired, the managers of the company will generally be replaced.


Based on this, great earnings fluctuation may increase idiosyncratic risk and further increase the probability that CEO will be dismissed. For this reason, CEO has motivation to decrease idiosyncratic risk by reducing earnings fluctuation, i.e., income smoothing, in order to reduce the probability of being dismissed. This article is helpful for understanding the direct influence of income smoothing upon CEO turnover. Consistent with many existing studies, this article found that income smoothing will decrease the probability of CEO turnover. This article is also helpful for understanding the direct influence of income smoothing upon idiosyncratic risk.

Read on to know more about the advantages and disadvantages of the historical cost concept in accounting. Read this lesson to learn how unusual events used to be recorded on financial income statements.

So that the next financial year will be profitable, this is an example of The BIG BATH type of earnings management. When economic conditions are unstable, it can be assumed that houses would be more likely to utilize aggressive net incomes direction and income smoothing.Firms would be demoing one-year positive fiscal statements. In UK, harmonizing to the accounting ordinances “ Companies Act 2006 ” , when fixing one-year histories, an hearer is responsible for corroborating whether histories comply with the accounting criterion and demo “ a true and just position of the company ” . The benefit of holding this ordinance, so that histories comply with regulations and income smoothing can be stopped. Accounting ordinances will hold a immense impact on the house ‘s histories, as some concerns will non follow with the international criterions due to frequent alteration. Accounting organic structures want to accomplish convergence in future, by making one worldwide set of criterions, which will be more compatible.Stakeholders like stockholders would be trusting on this type of information, as they would be interested in puting in the company.

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