Operational smoothing results from a change in the economic transaction underlying an event, resulting in different appropriate accounting for it. In contrast accounting smoothing results from a change in the accounting for an unchanged economic event transaction.
The manager of a car dealership location (part of a large chain of dealerships) has experienced a great first eleven months of the current fiscal year. In fact, she has already met the income target that qualifies her for the yearly bonus amount. She is wondering how she might get some of the income she is expecting in the twelfth month into the first month of the next bonus period (next fiscal year).
1) Indicate what operational smoothing action she might take to get income into the following month.
2) What accounting smoothing technique would get income into the following month without changing operations?
3) Explain the relative legal merits of these two types of smoothing.
4) “Even if a smoothing method is legal it may be unethical.” Explain that in the context of this dealership example.
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.
