Income Smoothing
The purpose is to eliminate profit swings from one period to the next so that a firm has consistent earnings.
What is Income Smoothing?
Accounting strategies are used to smooth out swings in net income from one period to the next.
Companies engage in this approach because shareholders are more prepared to pay a premium for corporations with consistent and predictable earnings streams than for firms with more fluctuating earnings trends, which are considered hazardous.
The manipulation of benefits, creative accounting approaches, and widely recognized accounting principles are all part of stabilizing income fluctuations.
It encompasses all strategies for reducing excessive expenses and increasing sales or profits. The methods range from using suitable financial reporting to using reasonable thinking.
The purpose of income smoothing is to eliminate profit swings from one period to the next so that a firm has consistent earnings.
Understanding Income Smoothing
Income Smoothing's purpose is to smooth out periods of high income compared to periods of low income or periods of high spending compared to periods of low costs. Accountants accomplish this by legally shifting earnings and costs around.
Postponing revenue in a strong year if the next year is projected to be tough, or deferring expenditure recognition in a bad year if profitability is predicted to improve shortly, are examples of earnings procedures.
Companies may also postpone spending to attract funds from venture capital or private equity investors in particular years.
Tax avoidance can result in a high EBITDA, which can be translated into a high valuation using multiple EBITDA calculation methods.
While it may seem illogical to restrict revenue recognition in good years purposely, companies with predictable financial performance typically have cheaper borrowing costs.
As a result, it is common for a company to engage in some amount of accounting management. However, there is a thin line between using what the Internal Revenue Service (IRS) permits and flagrant dishonesty.
This is based on the latitude afforded by the GAAP definition rather than on "creative" accounting or misstatements that would be considered open fraud.
Example of Income Smoothing
Employee bonus plans, deferred profit-sharing plans, and/or charitable giving plans may all involve a deduction of 25% of pretax earnings. Furthermore, a U.S. bank's additional pretax earnings may be subject to a combined federal and state income tax rate of 25%.
These examples will smooth the firm's earnings by having higher costs when profits are higher and lower expenses whenever earnings are lower. (Negative profits may result in a negative tax bill.
Changing the provision for doubtful accounts to modify bad debt expenditure from one reporting period to the next is a typical example of revenue smoothing.
For example, a customer anticipates not receiving payment for specific items for two budget periods: $1,000 in the first period and $5,000 in the second.
If the first reporting period is likely to have a high income, the corporation may set aside $6,000 as an allowance for doubtful accounts.
This would result in a $6,000 rise in bad debt expenditure on the income statement and a $6,000 reduction in net income. This might balance out a time of high income by lowering income.
In a year with poor earnings, the company may cut personnel, postpone maintenance projects, limit research and development, and so on.
When earnings improve, the company will boost staff spending and catch up on maintenance that had been neglected.
The word income smoothing is more likely to refer to reporting false earnings, creative accounting, and aggressive application of accounting rules and ideas.
A corporation may only increase its tolerance for questionable accounts with a higher bad debt charge in profitable years. The corporation will then cut the allowance for dubious accounts and considerably reduce bad debt expenditure in a year with poor profitability.
A LIFO-using US firm will lower inventory amounts in low-profit years to dispose of the old LIFO layers with low unit prices.
With low sales and profits, another company may raise output to show a lower product cost on its income statement.
Smoothing income by misusing accounting standards' leeway is immoral and serves the financial statements' users poorly. Accountants should adhere to the following basic principles:
- Variety
- Comparability
- Opposition
- Complete transparency
Income Smoothing Strategies in Finance
Investors and creditors need to know how much money a firm makes. It is a key financial metric since it aids in determining a business's profitability.
Investors base their investment selections on a company's profits, which indicate its potential. Investors evaluate a company's financial status and decide whether or not to invest in its shares based on its financial results.
Because high-quality profits produce a higher yield, investors favor them. Dividend distributions are the form of yield. Dividends minimize investor uncertainty, leading them to discount a company's future profits at a lower rate, raising its value.
One of the aspects that influences profit quality is earnings management. Stabling income is one of the earning management strategies that have a direct influence on earnings quality. It also boosts long-term profitability.
Management's efforts to control reported earnings have helped to improve earnings quality. This indicates that an increase will be accompanied by a greater degree of wage improvements in healthcare.
Financial statement users think that stated results reflect organizational success and prospects. Other research has shown no link between income management and earnings quality. If executives do not grasp the sources of earnings, income smoothing does not affect value relevance.
Stabling income management is used by leadership with a high share of leverage on assets to enhance creditors' views of the bank's business risk and to keep within the leverage covenant. Managers can use income smoothing to lower their expectations for earnings variations.
Companies having a high overall debt-to-asset ratio want to lower their borrowing costs. One method is to increase profit stability. Lenders will use liability design to tighten lending contracts when borrowing businesses have poor accounting quality.
It enables managers to smooth out income variations and lessen the risk of bankruptcy, cutting the cost of debt.
External parties cannot examine the company's activities and cannot guarantee the company's profit-shifting flexibility.
Users of financial statements may notice the smoothed income flow, but they need to know whether this was done on purpose or due to low volatility. Companies having much flexibility will move earnings across periods to reduce reported earnings volatility.
Creditors push management to keep revenues flowing smoothly. In this scenario, the larger the debt ratio, the more likely management will be able to smooth out income. This argument demonstrates that leverage has a favorable impact on revenue smoothing.
The debt ratio has been shown in research to support income smoothing. Companies with higher debt levels and solid financial success tend to have lower-quality financial reporting.
The findings show that corporations have a vested incentive to conceal their performance in the face of increased bank debt.
Creditors are exposed to increased risk as leverage increases. Creditors also demand assurances that the business will survive. Management handles revenue allocation to prevent these pressures.
Significance of Income Smoothing
It lowers the variability in earnings from one period to the next, giving the appearance of a stable business.
Its purpose is to smooth out times of high and low income and periods of high spending and low spending. Bankers do this by deferring or accelerating the recognition of income and expenditure.
Deferring sales during a successful year if the following year is likely to be difficult, or postponing expenditure in a poor year if productivity is expected to improve shortly, are examples of revenue-smoothing tactics.
Although deferring revenue recognition in excellent years may seem counterintuitive, firms with predictable financial outcomes can negotiate better credit conditions. If earnings are transferred to a later time, companies may be able to delay a hefty tax bill.
Income smoothing via the abuse of accounting principles and dishonesty or misrepresentation is unethical and perhaps fraudulent.
However, GAAP and IFRS accounting regulations and expert opinions allow for income smoothing, and accountants use them for several reasons.
Here are a few examples:
1. Lower the tax burden
The standard corporation tax rate for company income is 25%, but if there is a progressive tax system, high-revenue-generating firms might pay as much as 40% of their profits in corporate tax.
Businesses use hedging methods to get out of high tax levels, such as boosting loss provisions or increasing charitable contributions, among other things.
2. Obtaining funding
Investors who want a consistent return on their investments, such as dividends or interest payments, prefer to invest in firms that provide a consistent income. The approach ensures the firm can satisfy its regular obligations to support its investor dividends.
3. Business strategy management
It is more helpful to create consistent revenues for company planning objectives, such as budgeting so that management may plan for growth.
If each quarter yields unpredictable earnings or losses, justifying the purchase of new machinery or hiring more workers becomes considerably more difficult.
Is Income Smoothing legal or ethical?
The word encompasses various excellent and harmful actions that cannot be classified as legal or criminal altogether.
While one company organization may use strategic techniques and legitimate accounting processes to smooth out its profits, another may use questionable or unethical ways.
Although a firm's fair value accounting strategy may be legal, it may not be ethical. General accounting principles include neutrality, complete disclosure, comparability, and uniformity. Any income-smoothing strategy that breaks one of these rules is immoral.
Summary
In summary, income smoothing is not unlawful or unethical in and of itself; instead, some people turn to unethical measures to achieve the same aim.
Both income smoothing and being ethical have ambiguous definitions, which might be problematic in particular instances.
Preparers, auditors, and investors need clarification about how much income smoothing is and what occurrences or conditions are considered ethical.
The problem will only be solved if the profession properly describes and instruct us on preventing conflicts between these two.
Most publicly traded corporations, at least in the United States, favor consistency over inconsistency when presenting financial results. They prefer it because the community of financial professionals who review their findings acts as investors' regulators.
This group raises awareness of "surprises" in financial statements and performance.
Corporations prefer regular patterns in presenting their results over inconsistent "plot twists" because accounting decisions are usually never black-and-white and because of the analyst backlash when companies declare a financial surprise.
As a result of this inclination, "income smoothing" occurs inexorably by "income smoothing," which means making reasonable accounting decisions—those backed by facts and circumstances—that demonstrate a pattern in outcomes, which is generally upward-sloping.
It is legal, and practically every publicly traded firm worth its salt in the United States does it. It is not unethical at all. It is about accounting decisions, which are rarely cut-and-dry and black-and-white, contrary to common assumptions.
To be sure, poor decisions will get criticism from the analyst community, as they should. On the other hand, income flattening allows markets to perform better and corporations to gain investor trust.
Researched & Authored by Abdelmoussaour
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