Income Smoothing and Big Bath

1 January 2017

The accounting literature provides broad evidence that managers use discretion in financial statements for purposeful adjustments of earnings figures beyond the true and fair view (Leuz et al. 2003, cited by U. Schaffer et al. , 2012). There are two methods which are Income Smoothing and Big Bath. “Income Smoothing involves taking steps to reduce the good years and defer them for use during the business down-turn years” (Gin Chong, 2006). In comparison, Big Bath manipulation in the financial statistics indicates a great fluctuation.

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However, Income Smoothing is more ethical in accounting practice than Big Bath due to the reasons compared below. Income Smoothing has been applied in financial accounting because of its value. At first, a company uses it as a method to avoid a significant drop in its stake price due to missing a predetermined target. This method can be achieved in the annual financial reporting by accounting measures, like delaying current advertisements fee from the current to the forthcoming period, or gaining the provision of arrangements of bad debts.

Managers sometimes have to do this; they make a bit change on the financial statements in order to avoid an obvious market reaction in a particular period. Furthermore, if a company’s developing-line fluctuates frequently up and down, its stakeholders and managers will lose their passion or confidence in the long run. “An overwhelming 96. 9% of the survey respondents indicate that they prefer a smooth earnings path”(Graham et al. , 2005, cited by Tucker and Zarowin, 2006).

In most cases, management seeks to have a steady and predictable growing rate, with the hope that the market will associate smooth earnings with lower risk and higher stock prices and managers may personally benefit if incentive plans reward smoother earnings. At last, the theory of Income Smoothing is suitable to the current social trend. Therefore, it is considered to be a creative accounting method and has been widely applied in the company operation. Though Income Smoothing has a few advantages, Big Bath is also ethical in practice and one commonly cited incentive for Big Bath behavior is a change in management.

A Big Bath is a way to blame prior management for problems when there is a management change. Prior research shows evidence consistent with incoming executives managing accruals to decrease earnings in the year of the change with a turnaround in earning the following year. Besides this, with big behavior, management delays recognition of discretionary losses and then takes them when earnings are below benchmarks. In summary, Income Smoothing is a more ethical practice than Big Bath since it is applied more widely for three reasons, meeting the forecasts, welcome by managers and apt to social trends.

On one hand, income smoothing could be widely adopted by company managers to undergo financial crisis in a particular period. On the other hand, managers should operate within the legal and ethical boundaries, at the same time, they should adopt a strategy that could systematically undermine the quality of financial reporting and manipulate accounting information.

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