Hey Friends,
Perhaps you’ve read some of the research on the application of accounting rules to “smooth” earnings. What is meant by smoothing earnings? Here’s a good description:
“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.”
Go HERE for the source of the above quote and for additional definition.
Smooth earnings give investors the perception that there is less risk. That’s because greater volatility of earnings spells greater risk. Risk is uncertainty and in the world of publicly-traded stocks, the essence of risk assessment is attempting to determine the potential downside to stock prices.
In a stock market that has been soaring for an extended period of time on higher and higher earnings, keep in mind this earnings management practice because income smoothing intuitively implies an element of heightened risk, especially when the emphasis on stock valuation is perhaps already slanted toward the “reward” side.
Always remember that the balance sheet reveals the existing financial position of a business and is like the foundation to the financial house. The earnings are what are built upon that foundation but the foundation cannot be disregarded or how else can one determine the extent to which a structure has justifiably moved beyond its foundation?
Till next time,
Paul
Can the retail investor detect if smoothing is happening? Even if the balance sheet looks good, I would not want to own stock in a company that is “smoothing.”
It is very widespread and would be difficult to detect. You can read the corporate filings (10Qs and 10Ks) but it would be virtually impossible to determine for a given company. Research has looked, for example, at accounting practices that are most common among publicly-traded companies. Studies reveal that practices that smooth numbers are widely applied.
Income smoothing heavily depends on the accounting methods chosen. Here’s an example of an income smoothing accounting application (method). Consider depreciation expense. Note there’s not just one depreciation method everyone follows (one accounting standard that’s the same standard for all). There are a bunch of methods in accounting to be selected from and a different amount of depreciation expense will result in a given year based on which method is followed. The same total amount of depreciation will be taken on an asset across its life but the amount taken in a given accounting period will differ, depending on which method is followed.
Income smoothing would be made very difficult if there was a single method of accounting for each asset on the balance sheet (i.e. in the example of depreciation of fixed assets,if there were only one way to depreciate). But there are many. One method available under GAAP (generally accepted accounting principles) is “straight-line” depreciation. Straight line (equal depreciation each period) is the most widely used application of depreciation for GAAP reporting to the shareholder community. Taking the same amount of depreciation expense each accounting period has a smoothing effect on income. Yet, fixed assets actually don’t actually decline in usefulness equally over time. If they did, a machine would be produce as much in year 10 as in year 1. But fixed assets wear out with use just like the cars we drive. This means more depreciation would be taken in early years and less in later years to match with how the assets are actually used up. Yet, straight line (equal) depreciation is the method of choice by most publicly-traded companies.
Interestingly, the same company will frequently use a different depreciation method for tax reporting to the IRS. The goal is to have higher, smoother income for your investors and straight line depreciation fits the bill. However, the goal with taxes is to report lower taxable income so accelerated depreciation applications are favored. This multiple choice accounting applies to many areas of GAAP, not just depreciation.
Income smoothing is made possible via accounting rules that include multiple ways to expense assets. Companies can select ways that lead to smoothing income. My view is that it reveals that like rules and laws we all follow each day in society, they are often the result of a politicized (self-serving) process.
But the financial reports, albeit partly the byproduct of management practices like selecting accounting methods that may smooth the numbers, are the most fundamental (quantitative) vehicle we have for assessment.
So, again, just be aware it’s out there and very widespread, especially among the largest companies where executive managers have so much of their incentive packages (bonuses, stock options) tied to earnings performance. So, you know many of these companies are going to favor smoothing practices.
Where the market starts getting priced at a historically high P/E, the concern over the practice is elevated in my view. That partly explains my post today. We are seeing a strong P/E on macro corporate earnings. Income smoothing implies that the real P/E might be considerably higher. This says to me that in a very lofty market, I really need to find companies have a lot of solid equity to fall back on should a major correction come along.
Thanks for the explanation.
You’re welcome. I appreciate your interest. External owners (to be distinguished from insiders) surely make decisions with imperfect information. But in our efforts to analyze, we all work with the same imperfect information and hopefully that squares things up significantly.