What is Accounting Cushion?

An accounting cushion is the recognition of an excessively large expense reserve in the current period. This is primarily done to smooth out earnings, so that excessively high earnings in one period are pushed down, and excessively low earnings in another period are bolstered. The resulting consistent earnings level is attractive to investors, who do not like earnings surprises. They then bid up the price of the company's stock. This can be an advantage for the company’s managers, since the value of their stock holdings in the business will then be increased.

Another advantage of an accounting cushion is that a firm’s taxable income is reduced in the current period, thereby deferring a certain amount of income tax liability. By deferring the payment of taxes, a business has access to these funds for an additional year, allowing it to generate a return on the funds.

Problems with an Accounting Cushion

An accounting cushion represents incorrect accounting practice, since it misleads the readers of a company's financial statements in regard to actual changes in its profit levels from period to period. Consequently, the Securities and Exchange Commission brings enforcement actions against those publicly-held companies that it finds have engaged in accounting cushion activities to an egregious extent.

Accounting Cushion Examples

There are several areas in which a business can build up an accounting cushion. Here are several examples:

Bad debt reserve. A business can generate an accounting cushion by aggressively increasing the size of its bad debt reserve. It may take a long time to draw down this reserve balance as receivables become uncollectible, allowing the firm to make smaller additions to the reserve in future periods.
Warranty claims reserve. A business can increase the size of its warranty claims reserve. It may take a long time to draw down the reserve as customers make warranty claims, which allows the organization to make smaller additions to the reserve in later periods.
Fixed asset salvage value. A company eliminates the inclusion of a presumed salvage value from its fixed asset depreciation calculations. This means that the organization is recognizing a larger-than-necessary depreciation expense in the current period, while it will eventually recognize a gain on the sale of these assets some years in the future, when it sells them.