What is Income Smoothing and why do businesses use it?

Or, a company might alter the way it provisions for future option payments to its employees. Income smoothing is typically achieved by shifting revenue and expenses between periods. For example, a business may defer recognizing income in a profitable year to future years, or accelerate the recognition of expenses in a less profitable year. In the world of finance, income smoothing is a technique used by businesses to even out fluctuations in their earnings over time.

Examples of Income Smoothing

Technical accounting policy allows a company to achieve the same effect as discretionary action but does so in a less obvious way by changing the way that it measures revenue and expenses in its accounts. A company might engage in smoothing to enable better strategic business management. 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. 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. To smooth out the earnings, the company decides to recognize a portion of the holiday season sales in the non-holiday months.

• 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.
• Income smoothing uses accounting techniques to level out fluctuations in net income from one period to the next.
• To ensure a more consistent financial portrayal, the company strategically sets aside a portion of its profits (say 8%) instead of reporting them entirely within the current fiscal period.
• 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.
• Of course, income smoothing can be achieved by undertaking discretionary action.

Methods of Income Smoothing

By increasing or decreasing these accounts, companies can smooth out their income over time. For example, a company may increase its provision for bad debts in a good year to offset potential losses in the future. Expense capitalization involves treating certain expenses as assets and spreading their recognition over multiple periods.

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Hence, such a technique attracts investors who offer a premium for low-risk investments indicated through earnings stability and predictability. Income smoothing uses accounting techniques to level out fluctuations in net income from one period to the next. Manipulating financial results can be seen as a violation of accounting standards and securities laws. Companies found engaging in aggressive income smoothing may face regulatory investigations, fines, and reputational damage. While income smoothing can offer benefits, it has also been subject to criticism.

This adjustment is designed to preserve income objectives without adversely affecting shareholders. The decision comes on the grounds of heightened global market volatility driven by rising inflation and swift interest rate hikes by central banks. Notably, retail investors have responded cautiously, with fund sales experiencing a record year of net redemptions totaling £26 bn in 2022, according to the data from the Investment Association. Whiles they can be very high during certain periods, they can reach very low levels within the same financial year or subsequent years. By promoting transparency, accountability, and adherence to accounting principles, we can strive for a more reliable and trustworthy financial system that benefits all stakeholders. Companies often experience variations in their income due to several factors, including seasonal fluctuations, economic cycles, and unforeseen events.

Adjusting revenue recognition

Of course, the assets created by capitalization needed to be depreciated but this was a great way of deferring the costs of failed investments. A deferral is paying or receiving cash in advance without incurring expenses or revenue in the accounts. In other words, the payment of an expense is made in one period, but the reporting of the expense is made in some later period. Since earnings volatility equates to risk, smoothing makes a business appear less risky and thus more attractive to investors and to creditors. While it might be legal, provided you don’t get too aggressive with it, you’re still adjusting financial statements in a way that is at least somewhat misleading.

• If there is a personal conflict of interest involved, such as executive bonuses being tied to earnings, the use of income smoothing can be used to secure higher compensation.
• These may include decreasing its taxes, attracting new investors, or as part of a strategic business move.
• Of course, the assets created by capitalization needed to be depreciated but this was a great way of deferring the costs of failed investments.
• All things being equal, companies with stable earnings will tend to be more highly priced than companies with volatile earnings.
• One way companies can smooth their income is by manipulating the timing of revenue recognition.

Adjusting reserves and provisions

Others, such as fraudulent revenue recognition, misstatement of finances, or manipulation of reserves, can violate securities laws and put companies at serious legal risk. It encompasses all strategies used in hedging against high expenditure or cost and increasing business earnings or profit. These strategies range from acceptable accounting practices and generally accepted accounting principles, application of logical reasoning etc. Companies employ various methods to smooth their income, ranging from timing revenue recognition to manipulating reserves and provisions. However, these income smoothing describes the concept that practices can mislead investors, attract regulatory scrutiny, distort financial analysis, and contribute to systemic risks. Companies can also manipulate their reported earnings by adjusting reserves and provisions.

Financial reports are supposed to faithfully represent the financial performance of a company over the previous period. Income smoothing purposefully distorts this representation by artificially inflating or deflating earnings. Later, when economic conditions weaken, the bank reverses part of these provisions, thereby boosting reported income and maintaining a steadier financial performance. Finally, businesses can strategically structure tax expenses to reduce income fluctuations.

Either way, to the outside observer, this company has the appearance of highly cyclical earnings and would thus likely be perceived as a risky investment during an economic downturn. A subscription-based technology firm defers a portion of its subscription fees to future periods when sales are expected to slow. Multinational firms often allocate profits to different jurisdictions to achieve tax efficiency and income stability. A more practical method of smoothing income is to sell investments or assets in weak quarters to boost income artificially. Investors like companies with even and predictably growing earnings over multiple periods. This can simply be done by treating some of the land preparation cost of growing food as development costs.