Income Smoothing as a Form of Accounting Policy by Managers

Abstract

Firms often attempt to control fluctuations in reported earnings and steer them to levels they consider desirable. Either managing reported figures to increase earnings when management thinks its initially planned term-end settlement targets (smoothing level figures) cannot be achieved or managing reported figures to decrease earnings when achievement of earnings higher than planned is certain may be implemented during a given fiscal period. This type of management accounting behavior is called income smoothing or income smoothing behavior. Provided that other conditions are identical, managers prefer smoothed income to income that fluctuates greatly. Smoothed income enables a firm to avoid discounting in the capital market owing to business performance fluctuation and simultaneously brings about desirable consequences with respect to institutional contracts the firm has entered into with stakeholders (financial covenants, delisting requirements, management compensation contracts, etc.). Although there are various forms of earnings management, broadly speaking they can be divided into 1) technical accounting policy and 2) real discretion. Technical accounting policy refers to the practice by which management achieves its targeted figures in the settlement of accounts by changing accounting policies or accounting estimates. Real discretion refers to the practice by which management achieves its targeted figures in the settlement of accounts by changing contracts or transactions between the firm and its stakeholders. In this case study, we consider the possibility that Onward Kashiyama, one of Japan's leading general apparel wholesalers, engages in income smoothing by means of accounting policy changes, a form of technical discretion. This case will make it possible to study the significance of accounting bias introduced by management and learn ways of removing that bias and linking that knowledge to financial analysis, the next step in corporate analysis. The purpose of this case study is to acquire the ability to eliminate bias incorporated into settlement figures and close in on the “true situation” in firms as a preliminary step to financial ratio analysis and enterprise value assessment.