Both “income smoothing” and “taking a bath” are sometimes characterized as resul

Question

Both “income smoothing” and “taking a bath” are sometimes characterized as resulting from managers’ incentive problems. Explain the incentive problem. Explain what part/conditions of managerial incentive/compensation lead to each of these “gaming the numbers”. For managers to engage in such games, they must hold some beliefs that cause them to believe that the games are effective. Explain what assumptions managers must hold for them to engage in income smoothing or taking a bath as solutions to their incentive problems.

Explanation / Answer

Both Income smoothing and taking a bath are earning management techniques frequently used by managers to manage their own incentives. The source of the problem is incentive structure itself. Managers get incentives when the net income is above a lower limit (bogey) and the incentives grow with growing net income upto a maximum net income level called Cap. Managers do not get any incentive when the net income is lower than bogey or highre than cap.

This structure leads to the earning management techniques to manipulate incentives of current and future years.

In any year when the net income is lower than bogey , managers try to improve the earnings by income smoothing and show higher earnings by borrowing from future earnings. Similarly in a good year when net income is above the cap, managers do not want to lose the additional net income and do income smoothing by lowering the income by deferring revenue for future year. Similarly managers take a bath to increase accrual expenses in a year to reduce net income level and to reduce amortization of expenses next year to have a higher net income next year.

Therefore managers tend to do earning management in a way that maximizes the incentive by playing within the bogey and cap limits of net income of current and future year.

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