Income Smoothing and Causes

John Kling^*
*Correspondence: John Kling, Professor, Department of Economic Studies, Walden University, USA, Tel: + 17468958124, Email:

Editorial

Income smoothing uses accounting techniques to level out fluctuations in net from one period to subsequent. Companies enjoys this practice because investors are generally willing to pay a premium for stocks with steady and predictable earnings streams as against stocks whose earnings are subject to more volatile patterns, which may be considered riskier.

Income smoothing isn't illegal if the method follows generally accepted accounting principles (GAAP). Talented accountants are ready to adjust financial books in above-board thanks to make sure the legality of income smoothing. However, repeatedly income smoothing is completed under fraudulent methods.

The goal of income smoothing is to scale back the fluctuations in earnings from one period to a different to portray a corporation as if it's steady earnings. It's intended to smooth periods of high income vs. periods of low income or periods with high expenses vs. periods of low expenses. Accountants do that by traveling revenues and expenses during a legal fashion.

Examples of income smoothing techniques include deferring revenue during an honest year if the subsequent year is predicted to be a challenging one or delaying the popularity of expenses during a difficult year because performance is predicted to enhance within the near future.

Companies may additionally delay expenses in specific years with plans to boost funding from risk capital or private equity investors. Having a high EBITDA because of income smoothing might translate into high valuation through EBITDA multiple calculation methods.

While deliberately slowing revenue recognition in good years could seem counterintuitive, actually, entities with predictable financial results generally enjoy a lower cost of financing. So it often is sensible for a business to interact in some level of accounting management. But it is a fine line between taking what the interior Revenue Service (IRS) allows and outright deception.

Income smoothing doesn't believe "creative" accounting or misstatements which might constitute outright fraud, but rather on the latitude provided within the interpretation of GAAP. By managing expectations fairly and ethically, businesses that employ slightly of income smoothing don't generally raise a red flag.

Reasons for Income Smoothing

There are many reasons why a corporation would prefer to engage in income smoothing. These may include decreasing its taxes, attracting new investors, or as a part of a strategic business move.

Reduce Taxes

Depending on the country, companies pay a progressive corporate tax rate; meaning that the upper the income earned, the upper the taxes paid. To avoid this, companies may increase provisions put aside for losses or increase donations to charities; both of which might provide tax benefits.

Attract Investors

Investors search for stability in their investments. If a company's financials show volatile earnings, an investor could also be turned off by the danger and uncertainty of investing during this company. A firm which will show consistent returns from year to year is more likely to draw in investors who feel more comfortable once they see steady returns over a extended period of time.