Income Smoothing: Definition, Legality, Process, and Example

What Is Income Smoothing?

Income smoothing uses 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 as opposed to stocks whose earnings are subject to more volatile patterns, which can be regarded as riskier.

Income smoothing is not illegal if the process follows generally accepted accounting principles (GAAP). Talented accountants are able to adjust financial books in an above-board way to ensure the legality of income smoothing. However, many times income smoothing is done under fraudulent methods.

Key Takeaways

  • Income smoothing is the act of using accounting methods to level out fluctuations in net income from different reporting periods.
  • The process of income smoothing involves moving revenues and expenses from one accounting period to another.
  • Though legal if performed within the guidelines of GAAP, income smoothing can be done fraudulently.
  • Reasons for income smoothing include reducing taxes, attracting investors, and as part of a business strategy.

Understanding Income Smoothing

The goal of income smoothing is to reduce the fluctuations in earnings from one period to another to portray a company as if it has steady earnings. It's intended to smooth out periods of high income vs. periods of low income or periods with high expenses vs. periods of low expenses. Accountants do this by moving around revenues and expenses in a legal fashion.

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.

Companies might also delay expenses in specific years with plans to raise funding from venture capital or private equity investors. Having a high EBITDA thanks to income smoothing might translate into high valuation through EBITDA multiple calculation methods.

While deliberately slowing revenue recognition in good years may seem counterintuitive, in reality, entities with predictable financial results generally enjoy a lower cost of financing. 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 Internal Revenue Service (IRS) allows and outright deception.

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. By managing expectations fairly and ethically, businesses that employ a touch of income smoothing do not generally raise a red flag.

Reasons for Income Smoothing

There are many reasons why a company would choose to engage in income smoothing. These may include decreasing its taxes, attracting new investors, or as part of a strategic business move.

Reduce Taxes

Depending on the country, companies pay a progressive corporate tax rate; meaning that the higher the income earned, the higher the taxes paid. To avoid this, companies may increase provisions set aside for losses or increase donations to charities; both of which would provide tax benefits.

Attract Investors

Investors look for stability in their investments. If a company's financials show volatile earnings, an investor may be turned off by the risk and uncertainty of investing in this company. A firm that can show consistent returns from year to year is more likely to attract investors who feel more at ease when they see steady returns over a longer time period.

Business Strategy

A business strategy a company can use when they have high profits is to increase expenses. In this case, it might increase bonuses paid out to employees or hire more workers to increase the cost of payroll. If income was expected to be lower for the year, they could employ the strategy in reverse; laying off workers or reducing bonuses to reduce expenses. These moves not only smooth out income but allow a company to operate more efficiently depending on the circumstances.

Example of Income Smoothing

An often-cited example of income smoothing is that of altering the allowance for doubtful accounts to change bad debt expense 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.

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