Wha Is Income smoothing?
Income smoothing smooths out changes in net income between periods using accounting techniques. Companies use this approach because investors value stable, predictable earnings streams over variable, riskier ones.
Following widely accepted accounting rules (GAAP) makes this permissible. Talented accountants can legally change financial books to smooth income. However, this concept of ironing income is often dishonest.
Understanding Income Smoothing
Income smoothing reduces profit volatility to make a company appear stable. To smooth out times of high income and low income or high expenses and low expenses. Accountants move revenues and expenses legally.
The tactics include deferring revenue during a successful year if the following year is predicted to be problematic or delaying expense recognition in a challenging year due to expected future performance improvement.
Companies seeking venture capital or private equity funds may defer spending in specific years. High EBITDA from income smoothing may translate to high valuation using numerous calculation methodologies.
Slowing revenue recognition in good years may seem contradictory, but predictable financial results minimize borrowing costs. Thus, accounting management is typically wise for businesses. However, there is a delicate balance between following IRS guidelines and lying.
Income smoothing does not involve “creative” accounting or fraud but instead relies on the flexibility of GAAP interpretation. By managing expectations properly and ethically, businesses that use income plaining rarely generate concerns.
Reasons for Income Smoothing
There are several reasons a corporation would smooth income. It may lower taxes, recruit investors, or make a strategic business move.
Reduce taxes
Companies pay progressive corporate taxes based on income, with higher taxes paid in certain countries. To mitigate this, corporations might increase loss provisions or charitable donations, which offer tax benefits.
Draw Investors
Investors want stability. Investing in a company with variable profitability may deter investors due to the risk and uncertainty involved. A company with regular returns year after year is more likely to attract investors who feel more comfortable.
Strategic Business
A company with substantial profitability can increase expenses. For example, it could raise employee bonuses or hire additional staff to raise payroll costs. They could lay off staff or cut bonuses to cut costs if they predicted lesser annual income. Depending on the situation, these changes smooth income and improve corporate efficiency.
Example of Income Smoothing
A typical example of revenue smoothing is adjusting the allowance for doubtful accounts to adjust bad debt expense between reporting periods. The client expects not to be paid for products for two accounting periods, $1,000 and $5,000, respectively.
The corporation may include $6,000 as an allowance for dubious accounts in the first reporting period if it expects substantial income. This would increase the income statement’s lousy debt expense by $6,000 and lower the net income by $6,000. This would smooth a high-income era by lowering income. Companies should alter accounts using judgment and lawful accounting.
Conclusion
- Income smoothing uses accounting strategies to smooth net income changes across reporting periods.
- It includes transferring revenues and expenses between accounting periods.
- Though permissible under GAAP, income smoothing can be done fraudulently.
- Income smoothing can reduce taxes, attract investors, and boost business.
