Investors like companies with even and predictably growing earnings over multiple periods.
The problem is, most businesses don’t work like this.
Market competition, new technologies, economic conditions, and legislative changes can all have drastic impacts on revenue from one year to another.
As a solution, many businesses use an accounting strategy called income smoothing to level out fluctuations and make their earnings appear more stable.
In this guide, we’ll explore the ins and outs of income smoothing, discussing when it's useful, how it works, and the benefits and risks associated with this financial practice.
What is income smoothing?
Income smooth is an accounting strategy that some businesses use to level fluctuations in their earnings across multiple periods.
The idea is to make the company’s financial performance appear more stable and predictable than it actually is, rather than showing dramatic fluctuations in income. This is favorable for investors, as it demonstrates less risk.
Income smoothing involves legal (though sometimes questionable and ethically problematic) financial reporting techniques to reduce variability in reported profits.
Why use income smoothing?
So, why do finance teams and accountants engage in income smoothing in the first place?
Attracting investors
This is the primary reason for using income smoothing.
Investors prefer companies with consistent earnings. This signals financial stability and reliability.
So, companies use income smoothing to make their earnings appear less volatile, enhancing stock price stability and making the company look like a safer bet for long-term investment.
Reducing tax liability
By shifting income and expenses across periods, businesses can optimize their tax burden by reducing taxable income in high-profit years and deferring it to lower-income years.
This can help reduce overall tax exposure.
Strategic business reasons
Some less common but still valid reasons for using income smoothing include:
- Helping to meet financial benchmarks like debt covenants or executive bonus targets
- Improving relationships with lenders to reduce borrowing costs
- Prevent stock price drops caused by poor quarterly earnings reports (for publicly traded companies)
How most income smoothing works
How do companies actually smooth income? There are six common methods employed. Let’s explore.
1. Adjusting revenue recognition
Accountants can either recognize revenue earlier than earned to boost earnings in a weaker period or defer revenue recognition to a future period to offset future declines.
2. Managing expenses
Similarly, businesses can accelerate or defer expenses to impact profitability. They may delay recognizing costs in weak earnings periods and accelerate them in strong ones to offset tax liabilities and smooth out income.
Accountants may also switch between amortization policies and depreciation methods to adjust expense timing.
3. Adjusting reserves and provisions
Finance teams can overestimate bad debt expenses in profitable periods and reverse them later to reduce net income. They can also increase or decrease warranty provisions or record large one-time charges such as restructuring expenses to create an artificial boost in future earnings.
4. Inventory valuation techniques
Companies can switch inventory accounting methods between periods to manage costs and taxable income and adjust the timing of inventory write-downs to smooth earnings.
5. Use of non-operating income and one-time gains
A more practical method of smoothing income is to sell investments or assets in weak quarters to boost income artificially.
Accounting teams can also use derivatives and other financial instruments to offset earnings volatility.
6. Tax planning strategies
Finally, businesses can strategically structure tax expenses to reduce income fluctuations.
Multinational firms often allocate profits to different jurisdictions to achieve tax efficiency and income stability.
Income smoothing examples
To get a better idea of how income smoothing works in practice, here are a few real-world examples
Adjusting revenue recognition
A subscription-based technology firm defers a portion of its subscription fees to future periods when sales are expected to slow.
This approach ensures that revenue appears more consistent over time, reducing the volatility of reported earnings during unpredictable market cycles.
Managing expenses
A manufacturing company switches its depreciation method from an accelerated schedule to straight-line depreciation during periods of high profit.
By delaying the recognition of some expenses in strong periods and then reverting to less aggressive expense timing when profits decline, the company smooths its net income across different quarters.
Adjusting reserves and provisions
A bank overestimates its loan loss reserves during booming economic periods to lower current earnings.
Later, when economic conditions weaken, the bank reverses part of these provisions, thereby boosting reported income and maintaining a steadier financial performance.
Benefits and risks of income smoothing
Like most financial practices, income smooth offers both advantages and disadvantages.
Advantages of income smoothing for businesses
When businesses apply income smoothing practices, it can:
- Enhance investor confidence by reducing the perception of risks
- Reduce earnings volatility, thereby protecting the business from negative market reactions due to temporary losses or downturns
- Improve access to capital as banks and lenders prefer companies with stable earnings
- Help maintain employee and stakeholder confidence when financial reports show steady growth
Potential risks and drawbacks associated with income smoothing
There are some pretty big drawbacks and risks associated with income smoothing, however.
The biggest one is the ethical concern.
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.
This can lead:
- A lack of investor faith in the accuracy of financial reports
- Increased scrutiny from authorities like the SEC and the potential for fines, audits, and reputation damage
- Potential financial mismanagement, as leaders focus on short-term earnings rather than long-term profitability and underinvestment in necessary areas like R&D, employee development, or infrastructure
- Risk of future financial instability, as an overuse of income smoothing techniques like deferring expenses can lead to a buildup of hidden liabilities
Ethical and legal considerations of income smoothing
Investors and stakeholders rely on financial statements to make informed decisions.
If businesses use income smoothing to artificially inflate or deflate earnings, this can be seen as deceptive, meaning that those financial statements are no longer informative.
While income smoothing might provide a temporary benefit, it can harm the company’s credibility if exposed, especially if the practices are very aggressive.
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. This brings with it an obvious ethical concern.
Many income smoothing methods are legal and part of standard financial reporting, such as depreciation adjustments. Others, such as fraudulent revenue recognition, misstatement of finances, or manipulation of reserves, can violate securities laws and put companies at serious legal risk.
Publicly traded companies in particular are subject to strict accounting standards (e.g. GAAP) and are constantly monitored by regulatory bodies (e.g. SEC and FASB) for excessive income smoothing.
If regulators find that income smoothing crosses into earnings manipulation or fraud, companies can face heavy fines, lawsuits, and loss of investor trust.
Financial transparency through automation
Income smoothing is a debated and arguably questionable practice.
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.
Instead, financial leaders would do better to improve their ability to forecast cash flow, track and adjust budgets, and get spending under control.
With BILL’s integrated financial operations platform, you can:
- Access lines of credit when you need them
- Track cash flow and forecast in real time
- Integrate with the rest of your finance tech stack
- Use Spend & Expense to monitor and limit employee spending
FAQ
How does income smoothing affect financial statements?
Income smoothing impacts all three of the major financial statements:
- Income statement. Revenue may be artificially adjusted to show consistent growth expenses may be shifted across periods to reduce profit volatility, and non-operating gains may be used to balance weaker financial periods.
- Balance sheet. Asset valuation methods may be adjusted to align with income-smooth goals and provisions for doubtful accounts and restructuring costs can be manipulated to alter profit trends.
- Cash flow statement. Cash flows from operating activities may not accurately reflect business performance, and some companies may show discrepancies between reporting earnings and actual cash flow if they are using aggressive income-smoothing tactics.
How does income smoothing change tax liabilities?
Generally speaking, companies can either defer revenue or accelerate expenses to lower taxable income in a year with high earnings.
Some can also use deferred tax assets (DTAs) and deferred tax liabilities (DTLs) to shift tax burdens across different periods, allowing them to offset future taxable income.
