Income smoothing refers to reducing the fluctuations in a corporation's earnings. Income smoothing can range from good business methods to fraudulent reporting.
Some business practices are ethical and will result in income smoothing. For example, a corporation might have an employee bonus plan, a deferred profit sharing plan, and a charitable giving plan that will result in expenses that total 25% of its pretax profits. In addition, a U.S. corporation might have a combined federal and state income tax rate of 40% on its incremental pretax profits. These examples will smooth income by causing huge expenses when profits are huge, and will result in little expense when profits are little. (Losses could actually result in a negative income tax expense.) In a year of low profits a corporation might eliminate jobs and postpone maintenance expenses. When profits are higher the corporation will add jobs and perform the maintenance that it had avoided.
The term income smoothing is more likely associated with the manipulation of earnings, creative accounting and the aggressive interpretation and application of generally accepted accounting principles. Perhaps a company will increase its allowance for doubtful accounts with a significant charge to bad debts expense in the years with high profits. Then in years of low profits, the company will reduce the allowance for doubtful accounts. Perhaps a U.S. manufacturer using LIFO will deliberately reduce its inventory quantities in low profit years in order to liquidate the old LIFO layers containing low unit costs. Other manufacturers might increase production when sales and profits are low in order to have lower unit costs.
Smoothing income by abusing the leeway in accounting principles is unethical and does a disservice to the users of the financial statements. Accountants should follow their general guidelines such as consistency, comparability, neutrality, full disclosure and conservatism.
