1 Running Head: Smooth Earnings Across Time

Smooth Earnings Across Time

Course Project
Week 2
Deborah A. Whitt, RN, BSN
Everest University

2 Running Head: Smooth Earnings Across Time

We are first tasked to explain or define the meaning of Smoothing Earnings Across
Time. The best definition the way I understand it is that earnings are smoothed or for a better
term are traded off for how much earning will be reported in the current period and how much
earning will be reported in a future period. This definition makes it sound harmless and easy to
obtain. It is understating earnings in one period to shift the balance of those earnings to a future
period when earnings are low creating an even flow in income. It is not making up figures, and
they are actual earnings that are just shifted to create an illusion of steading earnings over time.
In an article that I researched by Goal and Thakor (2003), it refers to Smoothing Earnings
as a Manipulation of reported earnings so that it does not accurately represent economic
earnings at different points in time. This however does not sound so harmless. As I read this
definition, I began to wonder why someone would want to smooth or manipulate their earnings.
Making earnings appear less variable over time is the main reason for the smoothing of
earnings over time. Some of the articles that I read refer to different reasons why it occurs and I
will touch base on a few that appear to me as the main reasons it occurs.
The paper I read by Anand Goel and Anjan Thakor in 2003 for the University of
Michigan report that smoothing of earnings can be artificial or real. They report that real
earnings affect cash flows in ways such as changing the timing of investments, and providing
promotional discounts and or vendor financing to risky customers to pump up sales toward the
end of a quarter. It appears from their paper that this real smoothing has costs that are very
obvious and may be hard to hide in the smoothing efforts, such as an adjustment in an interest
rate.

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They also report that artificial smoothing of earnings does not affect cash flows, but
instead uses accounting flexibility as governed by the Generally Accepted Accounting Principles
(GAAP) and that it has costs that are much more subtle.
In the paper written by Brett Trueman, and Sheridan Titman in 1988, they report the
reason that companies engage in the smoothing of earnings is to omit fluctuations in their
publicly reported net income. When they smooth their earnings they create the illusion that their
company is on an upward trend which can then attract investors and increase sales of stock. This
illusion can be both a real upward trend but in some circumstances can be an overstatement of
actual earnings.
An overstatement of earnings brings me to the paper by Christa Bouman in 2012 where
she stated that when you have overly confident and very optimistic managers they tend to issue
overly optimistic forecasts in potential earnings to make themselves look great on paper, and
often are more than likely to have earnings that fall short of those forecasts. She reports they
may start off as unintentional acts that flip into intentional smoothing of earnings so that they can
demonstrate that they have met their goals or expectations. Many times meeting these sales
forecasts comes with bonuses, and the overly optimistic may do what they need to so they can
demonstrate their abilities or that they have actually met their overly optimistic forecasts.
Another view regarding managers and earnings smoothing is noted in the paper written
by Francois Brochet and Zhan in 2004, where they report that managers may resort to earnings
smoothing if they are concerned about their job security. If you forecast your earnings and
realize you are falling short you may resort as they stated to moving some income from a good
month to a slower month to show that you are meeting your goals or forecasts.

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The major reason that all of the papers share is that when you smooth income over time
to reflect a steady increase or growth, it can and will attract investors who see that upward climb
when the buying of stock is best and there is room for profit. This can affect the price of your
companys stock.
When you look at a company that is working in the conservative, the smoothing or
earnings may be used to shift the over forecasted amounts of income into other future periods
when earnings are lower to keep the public view of the business as stable. This aids in the
gaining of loans and investors which not only keep your business functioning, but also allows for
future growth which can maximize shareholder wealth.
Conservative approach will use real earnings but place those over- abundance of earnings
into less profitable periods to remain publicly stable.

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References

Goel, A., Thakor A., (2003), Why do firms smooth earnings?, Research Paper, University of
Michigan, captured from the world wide web, 06/16/2014
Allayanis, G., Simko, P., (2009), Earnings Smoothing Analyst Following, and Firm Value,
Research Paper, Daren Graduate School of Business Administration, capture from the world
wide web, 06/16/2014
Trueman, B., Titman, S., (1988), An explanation for accounting income smoothing, Journal
Article, Journal of Accounting Research, Vol 26, captured from the world wide web, 06/16/2014
Bouman, C., (2012), Managerial optimism and earnings smoothing, Journal article, Journal of
Banking and Finance vol 41 (2014) pgs 283-303, captured from the world wide web 06/16/2014
Brochet, F., Gao, Z., (2004) Mangerial entrenchment and earnings smoothing, Research paper,
New York University, Sterns School of Business, captured from the world wide web, 06/16/2014
Pratt, Jamie. (2014). Financial Accounting in an Economic Context (9th ed.). Hoboken, New
Jersey: Wiley and Sons