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Please explain me the logic behind (with quantitative example if possible) the following situation:
“Before IAS 37, there was standard to deal with provisions. Companies wanting to show their results in most favourable light used to make large one off provisions in years where a high level of underlying profits were generated. These provisions, often known as big bath provisons , were then available to sheild expenditure in future years when perhaps profits were not as good. Provisions were used for profit smoothing, which is misleading.”
Plz reply as soon as possible.
In times of plenty, create a provision. That has the effect of reducing this year’s high profits ( and of therefore holding some profits back )
In times of poverty, release the provision back to Income Statement. That has the effect of increasing this year’s low profits.
In total, by providing in good times and releasing in bad times, profits are artificially manipulated.
The directors and senior managers of large companies often want to show steady growth in earnings over time in order to keep the confidence of investors and potential investors. They generally don’t want large swings in earnings and earnings per share between years.In the past therefore it was in the interests of directors to try to smooth the flow of earnings in order to post smooth profits growth. This could be achieved by creating general provisons for things such as general reorganisational or restructuring costs.
I am going to give an example of how this may have been achieved.Firstly, I will give the example where no provisions were created in my imaginary company.
Year 1 200 million profit
Year 2 110 million profit
year 3 122 million profit
year 4 135 million profit
year 5 150 million profitNow I am going to consider how creating a general provision could help smooth profiits.
In year one a general provison or provisons could have been created by charging the income statement with 100 million and entering 100 million provision in the statement of financial position (anachronistic language as it would have been called the balance sheet before IAS 37 was introduced).
Double entry debit income statement 100 million
credit general provision 100 million
This would have the effect of reducing the profit made in year one to 100 million.
In future years they could drw on this provison in order to artificially inflate profits in following years.
In year two
DOuble entry Debit provision 10 million
Credit income statement 10 million
In year 3 Double entry Debit provision 20 millionIn continuation of my earlier response which I accidently posted
In year 3 credit income statement 20 million
in year 4 debit provision 30 million
credit income statement 30 million
In year 5 debit provison 40 million
credit income statement 40 million
The above will give the following profits as a result of the smoothing that has taken place of profits.Continued next post.In continuation of my earlier post:
Year 1 100 million
year 2 120 million
year 3 142 million
year 4 165 million
year 5 190 million
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