What Is an Accounting Cushion?
Management can use these inflated numbers to artificially understate income by overstating liability or allowance accounts. Making larger provisions for profit-eroding expenses presents an opportunity to minimize them afterward, enabling the company to overstate income in a later period and provide a cushion for future results.
Income smoothing is widely practiced and euphemistically referred to as earnings management.
- An accounting cushion is the practice of a company making larger provisions for expenses in one period so that they can be minimized later on.
- Understating earnings enables companies to overstate them in the future, providing a cushion for weaker, forthcoming trading periods and sending a message of stability.
- Accounting cushions help to appease investor and analyst demands for very stable and predictable earnings.
- Income smoothing tactics include pre-ordering inventory, fully funding employee pension funds, and overstating the allowance for bad debts.
Understanding an Accounting Cushion
You may be wondering why any company would want to intentionally understate its income and make its financial performance seem worse than it actually was. In reality, there’s a really simple reason why such a strategy might be pursued. Essentially, an accounting cushion borrows profits from the good times and redistributes them to tougher moments, deferring tax liabilities and, perhaps more importantly, helping to paper over the cracks of weaker, forthcoming trading periods and send a message of consistency and stability.
Management purposely overstates expenses mainly to appease investor and analyst demands for very stable and predictable earnings.
Investors and analysts don’t like earnings surprises and are much more content when profits are steady and predictable. For instance, let’s assume that investors expect company ABC’s earnings to grow at 4% every period. If the company instead grows 6% in the first period, then surprises investors with a decline of 1% in the second, investors might be spooked and react by driving down the value of the stock.
Perceptions of greater financial risk might also lead investors to require a higher risk premium, increasing the firm’s cost of capital. Some management teams would rather understate the 6% growth in the first period and overstate income in the second one to achieve a result more in line with consensus expectations and avoid volatility in the stock price.
Crafty accountants have several tools at their disposal to overstate expenses. They include pre-ordering inventory, fully funding employee pension funds, and overstating the allowance for bad debts. In instances where auditors or analysts discover income being managed, they should adjust amounts back to their proper levels.
Accounting Cushion Method
Companies can generate an accounting cushion by increasing allowances for bad debts in the current period, with or without having specific indications that the number of customers not paying what they owe will rise. The increased provision for bad debt would result in an understated accounts receivable (AR) amount in the current period.
The company could then make up for it in the next period by overstating accounts receivable (AR).
Criticism of Accounting Cushions
Income smoothing through creating an accounting cushion is just one type of a broader array of activities that fall under earnings management. This practice may seem less harmful than some other ways in which managements deceive investors. However, it still misleads the investing public about the true stability of a company's income stream.
While widespread, and not necessarily illegal, income smoothing should raise concerns regarding the quality of earnings a company generates. The U.S. Securities and Exchange Commission (SEC) has periodically taken enforcement actions, issuing violations and levying fines against what it deems “excessive” or “abusive” manipulation.