Definition of Income Smoothing
Income smoothing involves reducing the fluctuations in a corporation’s earnings. The reductions in fluctuations can result from some legitimate business methods to fraudulent ones.
Examples of Income Smoothing
A corporation’s employee bonus plan, a deferred profit sharing plan, and/or a charitable giving plan may require an expense of 25% of its pretax profits. In addition, a U.S. corporation might have a combined federal and state income tax rate of 25% on its incremental pretax profits. These examples will smooth the corporation’s earnings by having larger expenses when earnings are larger, and less expenses when earnings are less. (Negative losses may even result in negative income tax expense.)
In a year of low earnings, the corporation might eliminate jobs, defer maintenance projects, reduce research and development efforts, etc. Then when earnings are higher, the corporation will increase spending for personnel and get caught up on the maintenance it had put off.
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.
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. Another manufacturer might increase its production when sales and profits are low in order for its income statement to report a lower amount of cost of goods sold.
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 the profession’s basic guidelines including:
- Consistency
- Comparability
- Neutrality
- Full disclosure
