What is Income Smoothing?

Income smoothing is the shifting of revenue and expenses among different reporting periods in order to present the false impression that a business has steady earnings. Management typically engages in income smoothing to increase earnings in periods that would otherwise have unusually low earnings. The actions taken to engage in income smoothing are not always illegal; in some cases, the leeway allowed in the accounting standards allows management to defer or accelerate certain items. In other cases, the accounting standards are clearly being sidestepped in an illegal manner in order to engage in income smoothing.

Income Smoothing in Public Companies

Income smoothing is especially common in publicly-held companies, where investors are more likely to bid up the price of shares in a company that presents a reliable and predictable earnings stream over time. Of course, if its income smoothing practices are later made known to the investment community, they will probably drive down the price of its stock. Thus, there is some risk in engaging in income smoothing.

Types of Income Smoothing

Here are several types of income smoothing that a management team might use:

Shifting revenue recognition. Income can be smoothed by accelerating or delaying the recognition of revenue. For example, a company may record revenue from a long-term contract earlier than it should to boost current period earnings. This practice may involve manipulating the percentage-of-completion method or billing customers ahead of delivery. While it can temporarily enhance profitability, it distorts the true financial position and violates accounting standards if not properly disclosed.
Deferring expenses. Companies may defer the recognition of certain expenses to future periods, making current earnings appear higher. This can be done by capitalizing costs that should be expensed immediately, such as R&D or maintenance. It allows the firm to spread out the cost over several years, reducing volatility in reported net income. However, it can mislead stakeholders about the company's operating efficiency and sustainability.
Use of reserves. Management can create excessive reserves in good years and draw on them in bad years to stabilize earnings. These reserves may relate to bad debts, inventory obsolescence, or warranty claims. By overestimating liabilities, profits are reduced initially, creating a cushion for future periods. This method can be legal if used within accounting guidelines, but becomes manipulative when used solely to manage earnings appearance.
Altering depreciation methods or estimates. Companies can change depreciation methods or useful life estimates to control how much expense is recorded in each period. For instance, switching from an accelerated to a straight-line method can reduce expense recognition in earlier years. This results in more consistent net income over time, even if asset usage patterns haven't changed. Such changes require justification and disclosure under accounting rules.
Channel stuffing. This technique involves shipping more products to distributors than they can sell, allowing the company to book revenue prematurely. It temporarily inflates sales and earnings figures, creating the illusion of strong performance. However, future periods may suffer as the channel is already full and product returns may increase. Channel stuffing is often viewed as unethical or fraudulent if done without proper disclosure.