- Income Smoothing is the use of accounting techniques to level out net income f
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Question
- Income Smoothing is the use of accounting techniques to level out net income fluctuations from one period to the next. Companies indulge in this practice because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams, compared with stocks whose earnings are subject to wild fluctuations. - An often-cited example of income smoothing is that of loan-loss provisions by banks, since they have considerable leeway in determining this provision. Banks may be tempted to understate annual loan-loss provisions in years of low profitability, and may be inclined to overstate them during highly profitable periods. - Given the latitude of the interpretation of generally accepted accounting principles, income smoothing actually IS NOT considered cheating. What do you have to say about this practice? Number your responses: (1) Does it pass the generalization test? (2) The utility test? (3) The virtue ethics test?
Explanation / Answer
This practice is done definitely to lure the investors. It will attract money from the investors when there is no sharp increase or decrease in the stocks value.
But this is a very bad practice as a whole. It will not give the actual picture of the situation. Particularly when the banking on lending on the basis of the income projected by the borrower, this will a false picture to the banks. Banks are always supposed to advance the customer, taking into consideration the lowest possible income from the borrower. Income smoothening takes the lowest most point away from the sight of the borrower.
It will pass the generalization test and the utility test. Because this takes into account the overall performance of the stock during the bull run and the bear period. But this will definitely fail the virtue ethics test. This is the act of hiding what has really happened and giving only the net result. Difficult times are hidden.
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