Income smoothing is a term used to refer to the different strategies and approaches used by accountants and financial analysts to monitor or control the impact of high rises and sudden drops in corporate income.
What is Income Smoothing?
Income smoothing is the shifting of revenue and expenses among different reporting periods in order to present the false impression that a business has steady earnings. Management typically engages in income smoothing to increase earnings in periods that would otherwise have unusually low earnings.
The actions taken to engage in income smoothing are not always illegal; in some cases, the leeway allowed in the accounting standards allows management to defer or accelerate certain items. In other cases, the accounting standards are clearly being sidestepped in an illegal manner in order to engage in income smoothing.
During economic turbulence, companies are under pressure that makes them turn to the accounting department in an attempt to control the frustrations by changing the financial information to their desired level. When the management oversees that the targeted level cannot be managed from the initial planning, they result to decree the figure in earning.
This type of management practice to change the accounting records is called income smoothing. When other conditions are identical, the management usually prefers smoothed income to genuine income that fluctuates greatly. Smoothed income allows the firms to evade discounting in the capital market that brings undesirable consequences to the stakeholders. Income smoothing or earning management can be classified into real discretion and technical accounting policy.
In real discretion, the management achieves the targeted number of figures by changing transactions between the firm and stakeholders. Technical accounting policy allows the management to change the accounting estimates or accounting policies. In this paper, the concept of income smoothing will be analyzed, and the term “big baths” used to leeway information presented in the financial statements will be shown.
Example of Income Smoothing
An often-cited example of income smoothing is that of altering the allowance for doubtful accounts to change bad debt expenses from one reporting period to another. For example, a client expects not to receive payment for certain goods over two accounting periods; $1,000 in the first reporting period and $5,000 in the second reporting period.
If the first reporting period is expected to have a high income, the company may include the total amount of $6,000 as an allowance for doubtful accounts in that reporting period.
This would increase the bad debt expense on the income statement by $6,000 and reduce net income by $6,000. This would thereby smooth out a high-income period by reducing income. It’s important for companies to use judgment and legal accounting methods when adjusting any accounts.
Purpose of Income Smoothing
Accountants turn to income smoothing for a variety of reasons. Some of them are as follows:
Reduce tax burden
The general corporation tax rate is 25% for business income, however, if there is a progressive tax structure it may result in high-income generating corporations paying as much as 40% of their income as corporate tax. Businesses seek to move out of the high tax brackets by employing hedge strategies, such as increasing loss provisions, increasing contributions to charity, etc.
Investors seeking a stable return from their investments, such as through dividends or interest payments, like to invest in companies with stable income. The practice provides comfort that the company will be able to meet its periodic obligations to fund its distributions to the investors.
For business planning purposes including budgeting, it is more beneficial to generate steady earnings that will allow managers to plan for growth. It would be much harder to justify buying new machinery or hiring additional staff if each quarter generates volatile profits or losses.