What is Income Smoothing?

"Income smoothing" is a broad term used to describe accounting techniques that aid in managing fluctuations in net income from one period to the following period. Unlike creative or cookie jar accounting, income smoothing is not a practice that has the intention of hiding or massaging accounting information to create a more favorable view of the company finances. Instead, the idea is to allow for the fluctuations while still having an accurate snapshot of how the company is performing over subsequent periods.

Among the different strategies that may be classed as income smoothing is the approach deferring the recognition of revenue that is received in one period until a subsequent period that is anticipated to generate a smaller amount of collected revenue. Using this approach can effectively help manage net income in a manner that prevents the business from spending the cash flow now, holding it for the later period when that cash flow will be less prolific. A similar approach would be to defer recognition of certain expenses during a slump in collected revenue and choose to account for them during a later period when income levels have increased.

It is important to understand that income smoothing does operate within the boundaries of what is considered generally accepted accounting principles, in that all income and expenses are accounted for in some manner. This makes it highly unlikely for the deferred income or expenses to be overlooked during audits or the preparation of financial reports to investors. The idea is to arrange finances in a manner that is in the best interests of the company, while avoiding any type of creative accounting that would create a false impression of the actual financial stability of the business.

In some cases, the income smoothing may mean leveling out income fluctuations by reporting income earned during a busy season of the year during a later period that is considered to be a slow season for the business. There are also situations in which a company may choose to defer income from one business year to an upcoming year, if there is anticipation the business will experience a decrease in sales or some other factor would hinder revenue generation during that year. Banks may also engage in income smoothing, often making use of loan-loss provisions by understating amounts during years with relatively low profitability and overstating them during periods that generate higher levels of profits, effectively leveling out the income over the long-term.