4-Income smoothing

4)- Income smoothing

The issue of income smoothing was already introduced in Chapter 6, and it takes all its significance in the context of earnings analysis. It is absolutely undeniable that since management is judged by the results it publishes, it will make all efforts to put them in the best light possible. The means to do so are at its disposal in choice of accounting method, most advantageous estimates (such as that of useful life of asset), and especially the discretionary items. Discovering instances of boosting income or reducing losses by management, can actually be highly revealing to an analyst because it shows what management thinks of the results and how far it will go to manipulate the image it projects.

On occasion, management may do the inverse of income smoothing. It is well known that investors react primarily to positive or negative changes in earnings, not so much to the size of the change. Thus, a year in which reporting a loss in unavoidable, may be the right time to recognize a major write-off or other loss. Indeed, deciding when to close down a slow operating plant and get rid of outdated equipment, is entirely a managerial prerogative, and can be postponed from year to year, until the right time. Moreover, putting the plant closure in a loss year can distract readers, and hide any marketing mistake that may be the real cause of poor results.

An example of recognition of a large expense in a year of poor results is offered by an accounting change at Dow Chemical Company. In 1992, Dow Chemical experienced the only loss of the past ten years: it reported a loss from continuing operations of $87 millions. This was also the year Dow Chemical chose to report the cumulative effect of an accounting change amounting to a loss of $765 millions. Together with a positive net result from discontinued operations, the net profit after tax was minus $496 millions. No effect of the accounting change was reported for any of the other ten years.

See review questions Q-13A4.1 through Q-13A4.4.

See research assignment R-13A4.1.

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