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.

Example of Income Smoothing

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

Asset capitalization adjustment. The controller lowers the threshold at which expenditures are capitalized into fixed assets, thereby deferring the recognition of the related expense until depreciation is charged against these expenditures in later periods.
Reserve manipulation. The allowance for doubtful accounts is manipulated to alter the bad debt expense from period to period, thereby altering the amount of income reported.
Sales deferral. The sales manager delays a sales promotion until the third quarter, so that sales can be boosted in what is traditionally a slow quarter.