What is Income Smoothing
Income smoothing uses deceptive accounting techniques to level out fluctuations in net income from one period to the next. Companies indulge in this practice because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams. In contrast to stocks whose earnings are subject to more volatile patterns — which can be regarded as riskier.
Examples of income smoothing techniques include deferring revenue during a good year if the following year is expected to be a challenging one, or delaying the recognition of expenses in a difficult year because performance is expected to improve in the near future. While deliberately slowing revenue recognition in good years may seem counterintuitive, in reality, entities with predictable financial results generally enjoy a lower cost of funds. So it often makes sense for a business to engage in some level of accounting management. But it's a fine line between taking what the IRS allows and outright deception.
BREAKING DOWN Income Smoothing
Income smoothing does not rely on "creative" accounting or misstatements which would constitute outright fraud, but rather on the latitude provided in the interpretation of GAAP.
Example of Income Smoothing
An often-cited example of income smoothing is that of loan-loss provisions by banks since they have considerable leeway in determining this provision. Banks may be tempted to understate annual loan-loss provisions in years of low profitability and may be inclined to overstate them during highly profitable periods.
In a sense, some of the concerns with income smoothing can be managed with effective PR efforts: open and transparent accounting methodologies are always welcomed by journalist, investors and regulators. By managing expectations in a fair and ethical way, businesses who employ a touch of income smoothing do not generally raise a red flag. Certain watchdog groups and the explosion of financial bloggers can go a long way in helping keep income smoothing in-check.