Incomes of business organizations do not enjoy a steady flow. Whiles they can be very high during certain periods, they can reach very low levels within the same financial year or subsequent years.
Knowing the adverse effects such fluctuations have on businesses, accountants and financial experts adopt the use of income smoothing strategies.
What is Income Smoothing?
Income smoothing is an umbrella term for the various techniques and methods used by accountants and financial experts for controlling or hedging the effects of high rises and sharp falls in corporate income. As is commonly used, income smoothing is often associated with clever manipulations of income or profit, creative accounting techniques and the application of generally accepted accounting principles.
However, real practice income smoothing goes beyond these. It encompasses all strategies used in hedging against high expenditure or cost and increasing business earnings or profit. These strategies range from acceptable accounting practices and generally accepted accounting principles, application of logical reasoning etc.
Examples of income smoothing techniques are; deferring business revenues during a positive year if the next year is predicted to be a tough one, choosing to recognize the expenses of a turbulent year in the next year if the next year promises to be more positive etc.
Is Income Smoothing legal or ethical?
The term refers to a wide range of good and bad practices such that it cannot be collectively termed as legal or illegal. Whiles one business organization is using strategic means and proper accounting methods for its income smoothing, another may be using dubious or unscrupulous means for hedging its income.
Though an income smoothing practice being used by a company may be legal, it may not be ethical. Accounting has its general guidelines such as neutrality, full disclosure, comparability, consistency etc. Any income smoothing practice which violates any of these would be unethical.
In a nutshell, income smoothing cannot be outrightly classified as an illegal or unethical act, only that some persons resort to using ill means to achieving the same goal.
Why do businesses do Income smoothing?
There are various reasons why accountants of business corporations resort to income smoothing. Some of these include:
- Reduce their tax burden: In many countries, there is a progressive system of taxation where companies which earn more income pay higher tax rates. Whiles the general company tax rate may be 25%, a progressive tax system could cause high income earning companies to pay as high as 40% of income as corporate tax. Businesses therefore try to escape such high tax rates by using hedging techniques such as increased provisions, donations to charities etc.
- Attract investors: Investors do not consider the high rate of returns alone when investing in companies. They seek for companies with attractive rates of return as well as a steady flow of earnings. Therefore, accountants who know what investors seek for use income smoothing techniques to hedge against these fluctuations so that the corporation’s financial reports do not show cases of extreme fluctuations.
- Strategic business management: Instead of reporting high profits which may attract higher rates of taxes, managements create other expenses which they know will improve the business’ operations. Example is; instituting or increasing employee bonuses or employing more workers. In the reverse of situations, when income is on a low, management may lay off some workers to reduce the weight of expenditure on profits.