What is income smoothing?

This has been documented in previous studies such as Ajekwe and Ibiamke (2017), Bao and Bao (2004), Chen et al. (2016), De Jong et al. (2013) and Yu et al. (2017). This study is built on agency theory being a theory of organizational process, behavior and outcome. Agency theory provides insight and understanding of corporate processes and designs to address emerging problems from the principal–agent relationship.

The answer is yes, as long as it is done ethically and in compliance with accounting standards and regulations. A measure of profit that equals sales revenue for the period minus cost-of-goods-sold expense and all operating expenses�but before deducting interest and income tax expenses. It is a measure of the operating profit of a business before considering the cost of its debt capital and income tax. Accountants make this possible by moving expenses and revenues around legally. It’s important to note that while income smoothing can improve the appearance of a company’s financial performance, it doesn’t actually improve the company’s underlying profitability or financial health.

Related Terms

Adjusted cash flow provided by continuing operations divided by adjusted income from continuing operations. GDP with some adjustments to remove items that do not make it into anyone's hands as income, such as indirect taxes and depreciation. The last line of the income Statement; it represents the amount that the company earned during a specified period. For an insurance company, the difference between the premiums earned and the costs of settling claims.

• Income smoothing is a form of earnings management (Agrawal and Chatterjee, 2015; Demerjian et al., 2020; Tabassum et al., 2015).
• The purpose of income smoothing is to present a more appealing financial picture to shareholders, creditors, and potential investors by reducing the fluctuations and volatility often seen in a firm’s earnings.
• It allows you to fill up lower tax brackets with the converted amounts, optimizing the tax benefits of your retirement savings.
• Capital gains tax applies to the profit made from selling an asset like stock or real estate.

That portion of the total income tax provision that is the result of current-period originations and reversals of temporary differences. Income that a company receives in the form of interest, usually as the result of keeping money in interest-bearing accounts at financial institutions and the lending of money to other companies. The profit remaining after debits and credits usage rules examples summary deducting from profit a notional cost of capital on the investment in a business or division of a business. The U.S. tax system is progressive, impacting Income Smoothing as the strategy depends on managing income to stay within favorable tax brackets. Income Smoothing is a strategy that shifts income to different tax years to minimize overall tax impact.

The reasons for income smoothing include reducing taxes, attracting investors, and as part of a business strategy. Income smoothing is a practice used by companies to level out fluctuations in net income from one period to another. This technique, implemented through various accounting methods, aims to present a more stable and predictable earnings stream.

Fiduciary Meaning in Accounting, Types, and Examples

Income smoothing involves reducing the fluctuations in a corporation's earnings. The reductions in fluctuations can result from some legitimate business methods to fraudulent ones. However, GAAP and IFRS accounting regulations and expert opinions allow for income smoothing, and accountants use them for several reasons. Management's efforts to control reported earnings have helped to improve earnings quality.

Is earnings management impacted by audit fees and auditor tenure? An analysis of the Big Four audit firms in the US market

The result contradicts the findings of Allayannis and Simko (2009), Fiehn and Struck (2011), Makela (2012), and Monjed and Ibrahim (2020) that found a positive relationship between earnings smoothing and firm value. If the first reporting period is expected to have a high income, the company may include the total amount of $6,000 as an allowance for doubtful accounts in that reporting period. This would increase the bad debt expense on the income statement by $6,000 and reduce net income by $6,000.

Accumulated Other Comprehensive Income

These moves allow for smoother income patterns and aid in effective business planning. By strategically managing their financials, companies can align their income with their broader business goals and objectives. Another significant reason for income smoothing is to attract investors. Stability and predictability are highly valued by investors looking for steady returns on their investments. By presenting consistent earnings, companies can instill confidence in potential investors that they will meet their obligations to distribute profits.

The idea of joint-stock companies resulted in the separation of owners from management, which defined a principal–agent relationship. In such a relationship, the principals are the owners of the firms, while the agents are the managers. A Two-Year Installment Sale Strategy involves the sale of property using a trust and an installment note. The idea is to sell a property to a trust and in return, take back an installment note.

If executives do not grasp the sources of earnings, income smoothing does not affect value relevance. One of the aspects that influences profit quality is earnings management. Stabling income is one of the earning management strategies that have a direct influence on earnings quality. While it may seem illogical to restrict revenue recognition in good years purposely, companies with predictable financial performance typically have cheaper borrowing costs. It encompasses all strategies for reducing excessive expenses and increasing sales or profits. The methods range from using suitable financial reporting to using reasonable thinking.

Executive overconfidence and the slippery slope to financial misreporting

Income smoothing also involves the manipulation of benefits, innovative accounting methods, and the implementation of generally accepted accounting rules. It includes all methods used to offset high costs and boost company sales or profits. The techniques are conceived from appropriate accounting standards to the use of rational reasoning.

We also conduct an additional test that controls for the potential influence of “managerial ability” on income smoothing (Baik et al., 2020; Demerjian, Lewis-Western, & McVay, 2020). Moreover, we include both the performance-adjusted discretionary accruals (Kothari, Leone, & Wasley, 2005) and the earnings conservatism score as calculated in Khan and Watts (2009) to control for a firm's financial reporting quality. Finally, we examine whether the main results differ between the pre- and post-SOX environment and find that SOX does not appear to have a significant effect on the relationship between income smoothing and audit fees.