Income Smoothing: The Death of Transparency


“In this world nothing can be said to be certain, except death and taxes.” - Benjamin Franklin

In modern times, we can add one more pillar to the figurative structure that is the certainty of human life—corporate income smoothing.

What is Income Smoothing and Why is it Used?

It was originally derived from tax avoidance strategies where companies and individuals paid less tax with a constant year-over-year income than annually jumping between tax brackets. In its evolved form, corporations now use income smoothing to increase earnings at a targeted marginal growth rate. The logic behind the strategy is a simple one:

  • Ease investor nausea over the volatility in corporate earnings and equity share prices

  • Meet quarterly earnings estimates without inflating future estimates to unachievable levels

 ‘Earnings Management’ Strategies

For what has become universally known as the euphemism for artificially inflating (or occasionally deflating) net income, the term “earnings management,” or commonly known as income smoothing, encompasses a wide variety of accounting techniques. Corporations often use the following accounts to meet quarterly earnings estimates and periodically to increase losses in a substantially down economic year, also known as “taking a bath”: 

  • Sales returns and allowances

  • Bad debt write-offs

  • Warranty costs

  • Pension expenses

  • Percentage of completion for long-term contracts

Additional strategies to artificially manipulate earnings include reclassifying the holding intent of a security to recognize unrealized gains or losses and creating an SPE (Special Purpose Entity) to buy assets from the parent company, thereby, immediately recognizing gains or losses on the assets.

Circumventing Auditors

In a 2013 article written by Geoffrey Senogles, and Maja Glowka, Vice President and Principal at Charles River Associates respectively, Senogles and Glowka noted that to get around auditor cut-off procedures companies began “channel stuffing,” where a company ships products in excess of a customer’s requirements towards the end of an accounting period in order to inflate revenues.

For example: an Eastern European company used large end-of-year discounts to entice customers to purchase products and then return them after year-end, classifying those returns on their financial statements as purchased finished goods and not returns and allowances. This allowed the business to increase revenue without raising any red flags in the auditing process.

Escalation

Escalation, where regulations to curb accounting manipulation are met with more complex ways to evade them in what amounts to a circular process, remains a form of kryptonite to the integrity of financial statement presentation. Companies are constantly searching for staying power in the grey area between aggressive, and fraudulent, accounting. However, it is a paradox that financial statements could both accurately reflect company performance and serve corporate objectives. In a world where financial statements are internally adjusted to smooth income, only substantive financial turbulence, much like that of the 2008 financial crisis, could bring about true clarity. That truly is the death of transparency.  

By: Todd Cheney, CPA, Accounting Policy and Practice Editor

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