Corporate Income Smoothing Tied To Ceo Stocks And Options
Recent theory argues that concern about job security creates an incentive for managers to smooth earnings in consideration of both current and future relative performance. Our evidence suggests that when current earnings are ‘poor’ and expected future earnings are ‘good’, managers ‘borrow’ earnings from the future for use in the current period. Conversely, when current earnings are ‘good’ and expected future earnings are ‘poor’ managers ‘save’ current earnings for possible use in the future. However, sensitivity analysis indicates that we cannot rule out selection bias as a potential alternative explanation for our findings.
These strategies range from acceptable accounting practices and generally accepted accounting principles, application of logical reasoning etc. This practice is especially common in publicly-held companies, where investors are more likely to bid up the price of shares in a company that presents a reliable and predictable earnings stream over time. Of course, if its income smoothing practices are later made known to the investment community, they will probably drive down the price of its stock. 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. Knowing the adverse effects such fluctuations have on businesses, accountants and financial experts adopt the use of income smoothing strategies.
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Businesses seek to move out of the high tax brackets by employing hedge strategies, such as increasing loss provisions, or increasing contributions to charity, etc. Income smoothing through the misuse of accounting policies, or through deception or misstatement is against professional standards and could be fraudulent. However, there is some flexibility in GAAP and IFRS accounting policies and professional judgment that would allow some forms of income smoothing. Income smoothing also involves the manipulation of benefits, innovative accounting methods, and the implementation of generally accepted accounting rules.
An increase of one standard deviation in the extent of income smoothing results in a 37 bp decrease in the cumulative raw stock returns over the subsequent quarter, or an 11.4% decrease relative to the sample mean. Further tests show that negative effects are reduced with analyst coverage and institutional ownership, indicating that sophisticated investors play an important role in monitoring managers’ self-serving behavior and opportunistic financial reporting. Prior research has offered two competing explanations for corporate income-smoothing, note co-authors Sydney Qing Shu of San Diego State University and Wayne B. Thomas of the University of Oklahoma. The authors find evidence of adverse downside consequences of earnings smoothing, indicating that managers’ opportunistic motivations are more prevalent than their desire to signal private information and resulting in economically significant stock price deterioration. The negative impact is reduced when analysts and institutional owners effectively monitor firms.
Income smoothing is the shifting of revenue and expenses among different reporting periods in order to present the false impression that a business has steady earnings. Management typically engages in income smoothing to increase earnings in periods that would otherwise have unusually low earnings. The actions taken to engage in income smoothing are not always illegal; in some cases, the leeway allowed in the accounting standards allows management to defer or accelerate certain items. In other cases, the accounting standards are clearly being sidestepped in an illegal manner in order to engage in income smoothing.
Why Do Businesses Do Income Smoothing?
Companies who engage in income smoothing by reporting fluctuations in revenue and expenses over time in a way that makes the earnings growth look steady across quarters may be reflecting the CEO’s holdings of stocks and stock options, according to a new study. For example, a corporation might have an employee bonus plan, a deferred profit sharing plan, and a charitable giving plan that will result in expenses that total 25% of its pretax profits. In addition, a U.S. corporation might have a combined federal and state income tax rate of 40% on its incremental pretax profits. These examples will smooth income by causing huge expenses when profits are huge, and will result in little expense when profits are little. (Losses could actually result in a negative income tax expense.) In a year of low profits a corporation might eliminate jobs and postpone maintenance expenses. When profits are higher the corporation will add jobs and perform the maintenance that it had avoided. It encompasses all strategies used in hedging against high expenditure or cost and increasing business earnings or profit.
Is reporting company earnings so as to smooth them out over time a blameworthy practice? If so, corporate managers hardly think so, as a survey of several hundred executives some years ago found an overwhelming preference for smoothing for a whole variety of good reasons. Yet, as a new study in a leading accounting journal begins by pointing out, the practice is widely frowned upon. Income smoothing refers to the different strategies and approaches used by accountants to control the impact of extreme volatility in corporate income.
In a nutshell, income smoothing cannot be outrightly classified as an illegal or unethical act, only that some persons resort to using ill means to achieving the same goal. A global survey of investment professionals covers accounting for goodwill, related disclosures, and how those issues are affecting analysis and investment decision-making. Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes. The practice reduces the variability in earnings from one period to another in order to present stable 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. Harold Averkamp has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
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Accrual accounting provides a means for managers to manipulate earnings; abnormal accruals and income smoothing may be used for managers’ private gains. Investors should be aware of the abrupt and significant downside equity risk of opportunistic smoothing and of the role that institutional owners and analysts play in reducing these negative effects. The authors contribute to the existing literature by finding that the greater the earnings smoothing, the greater the stock price crash risk—supporting the idea that managerial opportunism prevails over private information signaling. Stock price crash risk is reduced when there are more analysts following the firm, fewer cumulative discretionary accruals, and greater institutional ownership. The study’s findings derive from analysis of 17 years’ worth of information involving about 1,700 companies, drawn from a large database of corporate finance and another of executive compensation. Income-smoothing is measured by changes in firms’ net income compared to changes in discretionary accruals – non-cash accounting items that typically involve some element of uncertainty and thereby particularly lend themselves to manipulation.
It includes all methods used to offset high costs and boost company sales or profits. The techniques are conceived from appropriate accounting standards to the use of rational reasoning. Though an income smoothing practice being used by a company may be legal, it may not be ethical. Accounting has its general guidelines such as neutrality, full disclosure, comparability, consistency etc.
What Is Income Smoothing?
Past researchers have focused on pooled regressions of earnings smoothing effects on the mean and variance of stock returns. Recognizing the importance of negative tail risk, the authors use firm-specific return distributions and negative skewness to measure stock price crash risk in the quarter after the earnings smoothing.
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So which motive drives income-smoothing, a desire to cover up or a wish to inform? The study concludes that to a considerable extent the answer depends on the nature of executive compensation, specifically the relative size of the CEO’s holdings of company stocks and stock options. The term refers to a wide range of good and bad practices such that it cannot be collectively termed as legal or illegal. Whiles one business organization is using strategic means and proper accounting methods for its income smoothing, another may be using dubious or unscrupulous means for hedging its income. Although purposely delaying the recognition of revenue in good years can sound counter-intuitive, in practice, companies with predictable financial results are able to negotiate better loan terms. Companies may also be able to defer a large tax liability if profits are moved to a future period.
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Opaque financials suggest a higher possibility for future downside risk, whereas conservative accounting practices offset the negative effects of smoothing. Managers have asymmetrical incentives to hide bad news and accelerate the release of good news. Using discretionary accruals is one way that managers take advantage of accounting flexibility to hide bad news, with the hope that the situation will turn around in the future—contrary to conservative accounting practices.
- Conventional wisdom suggests that fluctuation in earnings denotes greater equity risk.
- The cloud-based financing system for accounting firms has grown to include a business term loan option for firms’ small business clients.
- Past researchers have focused on pooled regressions of earnings smoothing effects on the mean and variance of stock returns.
- It encompasses all strategies used in hedging against high expenditure or cost and increasing business earnings or profit.
- One view is that managers smooth earnings to avoid earnings volatility and to signal their private information to investors about future performance, minimizing uninformed investors’ anxieties about future losses.
Hoarding bad news cannot continue indefinitely; it is eventually revealed, causing a stock price crash. Using the negative skewness of stock return distributions, the authors find evidence that earnings smoothing increases stock price crash risk.
Earnings Smoothing: Does It Exacerbate Or Constrain Stock Price Crash Risk? Digest Summary
The cloud-based financing system for accounting firms has grown to include a business term loan option for firms’ small business clients. Investors seeking a stable return from their investments, such as through dividends or interest payments, like to invest in companies with stable income. The practice provides comfort that the company will be able to meet its periodic obligations to fund its distributions to the investors. It may result in high income generating corporations paying as much as 40% of their income as corporate tax.
The authors also show that bad corporate social responsibility firms smooth earnings to hide bad news, which is not the case with good CSR firms. The value destruction of earnings smoothing is economically significant for stockholders.
The findings come from an analysis of 17 years’ worth of information involving approximately 1,700 companies, drawn from a large database of corporate finance and another of executive compensation. The researchers found that for the sample as a whole, a pattern of income-smoothing in the five years prior to a given year increases the predictability of earnings in the three years subsequent to that focal year. But, when the analysis takes into account compensation of company CEOs in focal years, stock holdings and option holdings yield opposite results. Firms that are likely to conceal information have a stronger stock price crash risk impact from income smoothing than firms that are more likely to signal private information about future earnings.
The authors’ sample reveals significant value deterioration caused by abnormal accruals and earnings smoothing. 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 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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- Investors should be aware of the abrupt and significant downside equity risk of opportunistic smoothing and of the role that institutional owners and analysts play in reducing these negative effects.
- 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.
- Income smoothing refers to the different strategies and approaches used by accountants to control the impact of extreme volatility in corporate income.
- Is reporting company earnings so as to smooth them out over time a blameworthy practice?
- 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.
- Hoarding bad news cannot continue indefinitely; it is eventually revealed, causing a stock price crash.
The paper’s findings should also be of value to investors unsure what to make of a company pattern of smoothly rising earnings over the years. Accounting Today is a leading provider of online business news for the accounting community, offering breaking news, in-depth features, and a host of resources and services. Pointing to the growing tendency in recent years for companies to grant restricted stock, which cannot be sold for a certain period of time, the researchers tested the relationship with income-smoothing and found it to be similar to unrestricted common stock.
The results suggest that managers tend to use smoothing to hide poor performance and that this motivation is more prevalent than the private information signaling motivation for smoothing. These results hold even when controlling for firm-specific attributes related to stock price crash risk, including information opacity measured as the moving sum of discretionary accruals over 12 quarters, tax avoidance, and accounting conservatism.
Advantages of having a smooth earnings stream cited by executives in prior research include lower costs of equity, higher credit rating, greater assurance among customers and suppliers about terms of trade, and anticipation of higher growth prospects among investors. The advantages of having a smooth earnings stream cited by executives in previous research include lower costs of equity, a higher credit rating, greater assurance among customers and suppliers about the terms of trade, and anticipation of higher growth prospects among investors. 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. Smoothing income by abusing the leeway in accounting principles is unethical and does a disservice to the users of the financial statements. Accountants should follow their general guidelines such as consistency, comparability, neutrality, full disclosure and conservatism. Examples of income smoothing techniques are; deferring business revenues during a positive year if the next year is predicted to be a tough one, choosing to recognize the expenses of a turbulent year in the next year if the next year promises to be more positive etc.
Noting the growing tendency in recent years for companies to grant restricted stock, which can’t be sold for a specified period of time, the professors test its relationship to income-smoothing and find it to be similar to that of unrestricted common stock. What about performance shares, which are granted conditional on companies’ reaching specified targets and which also have increased in popularity? While archival data is lacking to study their effect, Prof. Shu surmises that, given the similarity of their risk/reward profile to that of stock options, the effect on income smoothing would be much the same.
The researchers found that tendency only increases when CEOs had the additional authority of serving as board chairmen, or when they were relatively new to the job and under pressure to prove themselves, or when their options are out of the money . Income smoothing reduces the variability in earnings from one period to another in order to present an organization as one with stable earnings. It is meant to smoothen out periods of high income and periods of low income or periods of high spending and periods of low expenditure. Accountants do this by delaying or advancing the recognition of income and spending. To monitor or control the impact of high rises and sudden drops in corporate income. Whiles they can be very high during certain periods, they can reach very low levels within the same financial year or subsequent years. The data are from 6,627 nonfinancial, nonutility firms over 19 years (1993–2011), for a total of 157,722 firm-year observations.