Income smoothing is a term used to refer to the different strategies and approaches used by accountants and financial analysts to monitor or control the impact of high rises and sudden drops in corporate income.
Income smoothing also involves the manipulation of benefits, innovative accounting methods, and the implementation of generally accepted accounting rules. It includes all methods used to offset high costs and boost company sales or profits. The techniques are conceived from appropriate accounting standards to the use of rational reasoning.
Income smoothing refers to the different strategies and approaches used by accountants to control the impact of extreme volatility in corporate income.
The practice reduces the variability in earnings from one period to another in order to present stable earnings.
While income smoothing by a corporation may be legitimate, it may not be ethical.
Significance of Income Smoothing
Income smoothing reduces the variability in earnings from one period to another in order to present an organization as one with stable earnings. It is meant to smoothen out periods of high income and periods of low income or periods of high spending and periods of low expenditure. Accountants do this by delaying or advancing the recognition of income and spending.
Examples of income smoothing strategies include deferring sales during a successful year if the next year is anticipated to be tough, or delaying spending in a bad year when efficiency is expected to increase in the immediate future.
Although purposely delaying the recognition of revenue in good years can sound counter-intuitive, in practice, companies with predictable financial results are able to negotiate better loan terms. Companies may also be able to defer a large tax liability if profits are moved to a future period.
Income smoothing through the misuse of accounting policies, or through deception or misstatement is against professional standards and could be fraudulent. However, there is some flexibility in GAAP and IFRS accounting policies and professional judgment that would allow some forms of income smoothing.
Purpose of Income Smoothing
Accountants turn to income smoothing for a variety of reasons. Some of them are as follows:
1. Reduce tax burden
The general corporation tax rate is 25% for business income, however, if there is a progressive tax structure it may result in high income generating corporations paying as much as 40% of their income as corporate tax. Businesses seek to move out of the high tax brackets by employing hedge strategies, such as increasing loss provisions, or increasing contributions to charity, etc.
2. Attracting investors
Investors seeking a stable return from their investments, such as through dividends or interest payments, like to invest in companies with stable income. The practice provides comfort that the company will be able to meet its periodic obligations to fund its distributions to the investors.
3. Strategic business management
For business planning purposes including budgeting, it is more beneficial to generate steady earnings that will allow managers to plan for growth. It would be much harder to justify buying new machinery or hire additional staff if each quarter generates volatile profits or losses.
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