Intermediate accounting week 4
6-4. “Income Smoothing and an IPO” In the normal operations of the company, profits usually move up and down i. e. are volatile due to many factors which may be beyond the company’s control. In the case above, to the ordinary investor, Clark Company is the most attractive investment because its income is consistently rising as compared to Durfee profits which are extremely volatile. It is possible that Clark Company has used a creative accounting term called income smoothing.
Income smoothing is a process of removing the volatility in profit by leveling off the ups and raising the downs of profits over a period of time. Profits are reserved in good years to be used in years of depressed profits. Income smoothing can mislead investors if used as a strategic tool. It is part of what is called earnings management. Therefore, the investors should carefully examine the books of the two companies to determine whether any earnings management was used. If there is none, then Clark Company is the most attractive because of its stability and increment of earnings.
The investor can look in to the movement of good will, depreciation, interest costs, tax credit, cash flows and assets written off. The investor should examine the profit reserves and seek explanations for any unusual retention of profit. They could also examine the average earnings of the industry that the two companies operate in. 6-8. “If It Isn’t Fraud, Then It’s Ethical” Earning management is the intentional manipulation of the company’s profits by the management usually to portray the performance of the company other wise.
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Some of the types of earnings management techniques include income smoothing and big bath. These techniques are used by management to deceive the investors and usually affect the financial statements significantly. The big bath is where the company reports large losses in one quarter and huge profits in the next due to the company suffering quarterly profit decline that cannot be eliminated. GAAP’S flexibility allows management to use earning management the varied interpretation of the GAAP principles results in the different ways of book entries.
The matching and conservatism concept also has loopholes where earnings management can be used. It should be understood that as long as an action leads to investors being mislead, it is unethical and should not be used even if it is not illegal. Therefore earnings management should not be abused. 6-8. “If It Isn’t Fraud, Then It’s Ethical” From the scenario above, it is clear that the detection risk of the audit firm is high and therefore it should re-examine its internal processes so as to reduce the levels of detection risk.
As a senior member of the SEC, I would order the audit firm to adjust its level of detection risk by e. g. looking at competence of employees. I would also order them to redo the audit and ensure that the income recognized using a non-GAAP is not reported as profit. The misstatement is material and therefore the audit firm’s ability to perform the audit of such companies should also be reviewed. 6-11. “I Didn’t Do It on Purpose! ” In Accounting, there is a concept called prudence which states that in case of uncertainty the worst possible situation should be reported.
In scenario1, the earnings are high and therefore expected bad debts are high and the economic condition is bad. In this case, the company should use 4% on its bad debts according to prudence concept in order to avoid understatement of debtors in future years. In scenario 2, the earnings are low and therefore the expected bad debts are low and the management expects the turnaround of the economy. The company should also use the 4% according to prudence concept to avoid overestimation of debtors. The company may overstate or understate the level of debtors and hence the assets of the company.
If it overstates the debtors, then, the level of bad debts provision is high hence low reported profits. In the case of understatement of debtors, the provision will be low and hence large reported profits. 6-15. “Loading Up the Cookie Jar! ” As seen earlier in the discussion, it is obvious that some GAAP principles allow for diverse interpretation which may result in different results. Faced with this situation, I would explain the various interpretations of GAAPS to the shareholders and the effects on reported profits.
I would also explain to them that as long as an assumption used leads to the reporting of the company’s earnings as true and fair, then it can be used in the books. I would also explain that any assumption taken should not mislead the shareholders. Some unforeseen risks that could have occurred during the year could cause the differences in expected earnings.
Reference: Poll V (2007) Chapter 5 – the role of book entries in income smoothing and big baths University of Pretoria eTD retrieved on 17/11/2007 from http://upetd. up. ac. za/thesis/available/etd-03032004-115957/unrestricted/05chapter5. pdf.