Income smoothing is an unusual type of earnings management.
Earnings management occurs when accounts are manipulated so that they do not accurately represent a company’s true economic earnings. In most instances, companies manage earnings to inflate their perceived profitability.
Income smoothing, however, seeks to reduce the variability in reported earnings from one period to the next with the objective of presenting the appearance of stable earnings.
Thus, smoothing lowers reported earnings versus economic earnings during periods of strong revenue growth or low expenditure, and boosts reported earnings versus actual when revenue is weak or expenditure is high.
Figure 1: Smoothed versus economic earnings
Source: Transparently.AI
The effect of income smoothing is shown in Figure 1. The black line represents economic earnings. Alternatively, it might represent how earnings would have looked if the company maintained a constant accounting treatment throughout the period.
Either way, to the outside observer, this company has the appearance of highly cyclical earnings and would thus likely be perceived as a risky investment during an economic downturn.
The red dashed line shows reported earnings after smoothing. To the outside observer, the company now appears to have stable earnings and might be expected to be a relatively defensive investment during harsh economic times.
Why companies engage in income smoothing
Companies engage in income smoothing for four possible main reasons:
1. Makes it appear less risky
Since earnings volatility equates to risk, smoothing makes a business appear less risky and thus more attractive to investors and to creditors.
Companies with predictable financial results are able to negotiate better loan terms than those with volatile earnings. Investors prefer companies with stable earnings and dividend growth. All things being equal, companies with stable earnings will tend to be more highly priced than companies with volatile earnings.
As a consequence, smoothing can help a company can lower its cost of capital, potentially boosting earnings over the long term.
2. Reduces taxes
A company might smooth earnings to reduce taxes, especially in countries with a progressive corporate tax structure, or to smooth the liquidity burden associated with tax payments.
In some tax jurisdictions, a company might also be able to defer a large tax liability if current profits are moved to a future period. Tax payments impose a major drain on corporate liquidity, especially in companies with a high working capital requirement.
If a company expects to suffer reduced earnings in the near future, it might delay earnings to ensure lower taxes and thus higher liquidity when difficult times arrive and access to borrowing becomes more difficult.
If a company expects sharply higher interest rates, deferring income and delaying tax payments can lower borrowing costs through the economic cycle. In other words, a company might smooth earnings to manage its cyclical interest rate expense.
3. To allow better planning and management
A company might engage in smoothing to enable better strategic business management. A company planning a major investment might suffer a major share price decline if the investment coincides with news of weak earnings, which might affect funding costs and investor appetite if a share placement is needed.
4. Better investor relations
Recent academic literature suggests that firms with greater earnings volatility deliver an informational advantage to informed versus uninformed investors.
If a sufficiently large number of investors are of the uninformed variety and anticipate that they may need to sell at some point for liquidity reasons, an increase in earnings volatility will magnify the risk of future trading losses. In this view, shareholders will want managers to smooth earnings and compensate them accordingly.
Whatever the motive, income smoothing is very common.
Types of income smoothing
For our purposes, income smoothing refers to a range of accounting practices used to reduce the variability in corporate earnings from one period to the next.
By and large, the main techniques used to smooth income include provisioning, deferred accounting, and accrual accounting. Each of these deserves an article in its own right. This article merely introduces the concepts.
Since companies that manipulate their accounts to artificially inflate earnings also use these techniques, sometimes it can be difficult to assess which is occurring. Abnormal use of accruals, for example, might flag as suspicious accruals or as smoothing activity in fraud detection software.
Of course, income smoothing can be achieved by undertaking discretionary action. For example, in a year of low earnings, a company might eliminate jobs, defer maintenance or reduce R&D spending. These measures would lower costs and thus boost earnings.
A company’s ability to smooth earnings using accounting policy is limited only by the imagination of its accountants
Or, for example, a manufacturer based in the US where LIFO accounting is allowed might deliberately reduce its inventory in low profit years to liquidate the old LIFO layers containing low unit costs. In another example, a company might offer discounts or increase advertising to boost sales.
Some kinds of discretionary efforts to boost revenue or cut costs are considered illegal. For example, with channel stuffing a business forces its distribution channel to take more products than could be sold within a reasonable period. Since it artificially inflates sales, channel stuffing is deceptive and is illegal.
The problem with discretionary action is that it is easy to see and thus flags to investors that a firm is in trouble or that management is not doing a good job at maximizing profit.
When a firm announces layoffs or a cut in R&D, for example, it sends a signal that it is experiencing difficulties. Or if a company suddenly announces a huge jump in discretionary expenses, it raises questions about management.
Technical accounting policy allows a company to achieve the same effect as discretionary action but does so in a less obvious way by changing the way that it measures revenue and expenses in its accounts.
In general, a company’s ability to smooth earnings using accounting policy is limited only by the imagination of its accountants and the degree to which management is willing to test the latitude of accounting principles.
Aggressive income smoothing is regarded as unethical because it misrepresents a company’s true financial position to investors and creditors.
Provisions in accounting
Provisioning is the simplest way for a company to smooth its earnings. This simply involves changing the assumptions a company makes about uncertain variables.
In a year of high profits, for example, a company might increase its allowance for doubtful accounts with an increased bad debts expense. In a tough year, the company might reduce the allowance for doubtful accounts to reduce bad debt expense. Or, a company might alter the way it provisions for future option payments to its employees.
By far, the most common ways that companies smooth income is by either delaying or advancing the recognition of income and spending. This is achieved via accounting techniques known as deferrals and accruals.
Deferral accounting
Deferred accounting is a fundamental concept in financial reporting that involves the recognition of revenue and expenses at a later date rather than when the corresponding cash flow occurs. A deferral is recorded in the income account only sometime after payment or receipt has occurred.
A deferral is paying or receiving cash in advance without incurring expenses or revenue in the accounts. In other words, the payment of an expense is made in one period, but the reporting of the expense is made in some later period.
For a detailed explanation of deferral accounting, click here.
Until the expense is recognized, it sits on the balance sheet as an asset. Simple examples of deferred expenses might include insurance, rent, supplies or equipment.
Deferred revenue used to be known as unearned revenue. It occurs when the company has been paid but has yet to deliver goods or services to the customer. Until the revenue is recognized, it sits on the balance sheet as a liability.
Because it converts items on the income statement into balance sheet items, the process of deferral is frequently referred to as the capitalization of expenses or revenues.
The deferral method leads to a decrease in the item being capitalized. Accountants capitalize revenue to lower earnings and capitalize expenses to boost earnings. Items can be decapitalized at a future date as required, thus facilitating smoothing.
The use of deferrals is particularly common in leasing and licensing. So, for example, software companies receive annual prepayments for software which is used on a steady basis by customers. Rather than book the sale all at once, the company will normally treat it as a deferred revenue on the balance sheet and transfer the revenue each month.
The Enron snowball
Some companies that simply wish to inflate earnings push the idea of capitalizing expenses to an extreme degree. Enron, for example, made a habit of booking costs of cancelled projects as assets, with the rationale that no official letter had stated that the project was cancelled. This method became known as "the snowball.”
Although it was initially dictated that such practices be used only for projects worth less than US$90 million, it was later increased to US$200 million and was a key tool used by Enron to grossly misstate its accounts.
By the time of its demise, Enron had a lot of cancelled projects that investors believed were still being developed. Of course, the assets created by capitalization needed to be depreciated but this was a great way of deferring the costs of failed investments.
In another example, one seldom finds farming businesses listed on exchanges. That’s because it is difficult to tell whether a farming concern is ploughing a field to grow a crop or making genuine improvements on the land.
If the latter, the cost can be capitalized as an improvement. But let’s suppose a farmer wished to inflate profit. This can simply be done by treating some of the land preparation cost of growing food as development costs. By this sleight of hand, the farmer’s margin and profit are greatly improved and the farmer’s land is possibly worth more.
Accrual accounting
Accrual accounting focuses on recognizing revenue and expenses when they are incurred, regardless of when the cash flows occur. An accrual occurs before payment or receipt. Companies that heavily smooth their earnings typically demonstrate abnormally high use of these techniques.
Chinese property companies were notorious for their use of accruals. The larger names would book billions of apartment sales each year, often with only a small deposit having been paid.
A good example of an accrued expense is a warranty policy. Many businesses, especially auto companies, have warranty policies, under which they promise to repair or replace certain types of damage to its products within a certain period following the sale date.
That warranty represents a future expense and it should accrue as an expense in the same reporting period in which the related product sales are recorded.
By doing so, the financial statements most accurately represent all costs associated with product sales, and therefore indicate the true profitability associated with those sales. This, of course, requires the company to reasonably estimate the amount of warranty claims likely to arise.
As you might imagine, auto companies have a lot of latitude for estimating warranty costs.
