What if opportunistic accounting choices increase shareholder value?

We have an ongoing question in Financial Statement Analysis that I would like to share.

Suppose a company “manages” earnings. Nothing illegal, but cookie jar reserves and other techniques just happen to deliver nice smooth earnings for a company. These smoothed-out earnings make the company look more solid than perhaps they really are and hence enhance the stock price. Some accounting judgments might be considered opportunistic, yes, but they also improve the market value of the company as a whole.

Good or bad?

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About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

4 comments

  1. I don't think smoothing is necessarily a bad thing. Sometimes smoothing can make financial reports more predicable and give a better picture of the company for investors. If the numbers are reasonable, then there is no problem. If earnings start to trend towards being unreasonable then it would be a bad thing. Ultimately I would look at it case by case and the auditor would have to decide reasonableness.

  2. Agreeing with the comment above, each auditor should decide reasonablenes based on the specifics of each case. However, I think smoothing is sometimes necessary in this market. Lets take channel stuffing for example: although sellers capture buyers with ridiculous offers of credit and enticing return policies, at the end of the day it is the buyers fault for purchasing this stuff. After all, the sellers really don't know for sure that they will have a plentitude of returned merchandise. Yes these techniques, are opportunistic but as long as the company is sticking to being opportunistic and not crossing the fine line to fraud, then I do not necssarily think it is a bad thing.

  3. I can see the benefits of smoothing for a company having a bad year. They take out cash from reserve accounts to give the impression of a more stable company, "income smoothing." The risk here is what if it's not just a single year. What if they excessively manage their earnings? This could be dangerous for investors, and is the reason why investors often don't pick up on these accounting scandals.

  4. I do not think that income smoothing is always a bad thing because it reduces volatility of earnings and the perceived riskiness of a company. Income smoothing can be a useful management tool when companies are having a bad year and management projects a turnaround in the future. However, income smoothing can be bad if it is abused and management has crossed the line from opportunistic to intentional fraud in an effort to control the numbers. I think that it just depends on the degree and reasonableness of the income smoothing and how long companies intend to report their intentions, versus the actual numbers.

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