I kindly ask for this to be answered with original thought, two previous tutors used the same exact works, word-for-word. Thank you.
A. 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.
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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.
B. 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.
Here are thoughts:
The key thing to consider in this problem is the fact that operations are supposed to mirror the accounting, which is why the rules are so stringent: they allow the investors to accurately understand what has happened operationally in the business during a specified year or quarter, or other period, as applicable.
In order to maintain the operational results the car dealership has, she is able to make an operational smoothing tactic by a few items. You should consider what would happen with the dates of the documents she signs. I will give an example to help you think about other possibilities: what if she were to date the sale (pink slip) of the cars she sells as a month later, in January perhaps? This would then allow her to meet the goal of the preceeding year with her sales through November but also allow a jump start on the next year. This is misleading to the budgeting committee as they set goals based on a full fiscal year. It, however, is advantageous to the manager of the car dealership as she is now maximizing her bonus potential by managing income in certain periods. There are other scenarios, but please use my example and brainstorm other possibilities on that. I would also encourage you to think about incentive programs that she can institute where the customers might come in in December and sign but don’t actually pick up the car until January?
For understanding the legal merits, you should think about the dates of these signed documents. Legally, if the documents are signed one day and dated another day (perhaps in January), and the customer leaves with the car… whose car is it actually in the remaining days of December? What if something happened to the car? Stolen ? Accident? How does it get insured. Also, should also consider if the customer is aware of these methods and the potential implications.
If managers are considering or would gainfully benefit from the smoothing, their incentives are not set correctly. In the dealership example, consider if they had tiered incentives. Instead of hitting one single metric at the end of November, what if she got a larger bonus for an increased sales of cars to another hurdle? And even a hurdle after that? She would be less likely to push into December. This is just one level of incentives: based on cars sold or sales metrics. There could be an entirely different bonus program to add to or replace the sales targets… for example, client satisfaction. If client satisfaction were put into place in this situation, there would be less incentive to smooth the customers in the way suggested above.