Income Smoothing Overview, Significance, Purpose

This way, the company can present a more consistent pattern of revenue throughout the year, providing stakeholders with a stable and reliable financial outlook. Imagine a retail company that experiences seasonal fluctuations in sales due to the holidays. During the holiday season, the company generates significant revenue, while in other months, the sales decline.

  • 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.
  • Earnings management occurs when accounts are manipulated so that they do not accurately represent a company’s true economic earnings.
  • To the outside observer, the company now appears to have stable earnings and might be expected to be a relatively defensive investment during harsh economic times.
  • So, for example, software companies receive annual prepayments for software which is used on a steady basis by customers.

In other cases, the accounting standards are clearly being sidestepped in an illegal manner in order to engage in income smoothing. It is more likely that the term income smoothing is used to mean reporting misleading earnings, creative accounting, and aggressive interpretation of accounting principles and concepts. Perhaps a company increases its allowance for doubtful accounts with an increased bad debts expense only in the years with high profits. Then in a year with low profits, the company will reduce the allowance for doubtful accounts and greatly reduce bad debt expense. 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.

Related Finance Terms

If executives do not grasp the sources of earnings, income smoothing does not affect value relevance. 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, or increasing contributions to charity, etc. 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.

Additionally, income smoothing can contribute to improved financial decision-making and reduce the financial risks that come with unpredictable income patterns. Consequently, this concept is vital in fostering long-term growth and stability for businesses and stakeholders alike. 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.

Everything You Need To Build Your Accounting Skills

Income smoothing reduces the variability in earnings from one period to another in order to present an organization as one with stable earnings. It is meant to smoothen out periods of high income and periods of low income or periods of high spending and periods of low expenditure. Accountants do this by delaying or advancing the recognition of income and spending. One of the basic financial statements; it lists the revenue and expense accounts of the company. A form of earnings management designed to remove peaks and valleys
from a normal earnings series. The practice includes taking steps to reduce and �store� profits
during good years for use during slower years.

Accumulated Other Comprehensive Income

Net earnings after all expenses for an accounting period are subtracted from all
revenues recognized during that period. That warranty represents a future expense and it should accrue as an expense in the same reporting period in which the related product sales are recorded. By the time of its demise, Enron had a lot of cancelled projects that investors believed were still being developed.

Understanding Income Smoothing

Furthermore, a U.S. bank’s additional pretax earnings may be subject to a combined federal and state income tax rate of 25%. The purpose of income smoothing is to eliminate profit swings from one period to the next so that a firm has consistent earnings. To smooth out the earnings, the company decides to recognize a portion of the holiday season sales in the non-holiday months.

Income Smoothing: Definition, Legality, Process, And Example

In some tax jurisdictions, a company might also be able to defer a large tax liability if current profits are moved to a future period. Tax payments impose a major drain on corporate liquidity, especially in companies with a high working capital requirement. Companies with predictable financial results are able to negotiate better loan terms than those with volatile earnings. All things being equal, companies with stable earnings will tend to be more highly priced than companies with volatile earnings. Alternatively, it might represent how earnings would have looked if the company maintained a constant accounting treatment throughout the period. Income smoothing, however, seeks to reduce the variability in reported earnings from one period to the next with the objective of presenting the appearance of stable earnings.

National Income

The techniques are conceived from appropriate accounting standards to the use of rational reasoning. 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.

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