Income smoothing technique in accounting.Creative accounting is a technique used by company managers to minimize fluctuations that occur over the results. In English it is known as earning smoothing.
Business results are exposed to a greater or lesser extent to the economic cycle (among other variables). Depending on this, the results may deviate to a greater or lesser extent than could be considered as the “ordinary results” of a company.
The volatility of a company’s results is something that markets generally don’t like. It generates tension, nervousness in uncertainty. Therefore, through the smoothing of results, companies try to stabilize the results through their accounting . In this way they reduce the deviations that these may have year to year or quarter to quarter.
Sawtooth vs. smoothing results
When expressing the results of a company in a graph, it would be normal for them to look like saw teeth. The results rise and fall and fluctuate around an average value. The variability of these is perceived as high. For an investor with risk aversion (the most common among investors) this variability is perceived as a company with unstable results and in which the risk when investing is greater.
However, when a company makes a smoothing of results, it tries to take its benefits towards a value or range of values on average. This ensures that the results have reduced variability. For that same investor with risk aversion, this lower variability is perceived as a company with more stable results and in which the risk when investing is lower.
Below are two graphs with examples of both.
Benefits with sawtooth appearance
As can be seen in the graph, the results range from 100 (minimum) to 170 (maximum). Therefore, when investors see such a chart, they perceive the results of a company as unstable and unpredictable. Based on this, you could decide not to invest in that company (investment in a more risky appearance).
Benefits after smoothing results
In the previous graph the results range from 120 (minimum) to 130 (maximum). In the sawtooth chart, the average result is 126.67. Therefore, after smoothing results, in the previous graph we see how the result fluctuates around that average, but with much less variability.
In conclusion we can see that the company’s profits on average are the same, but depending on how they are presented, they can be perceived in one way or another.
Accounting practices for Income smoothing technique
Given the flexibility in the application of accounting standards, companies can use various practices to smooth their results. The following are a couple of examples of the most common techniques.
- The amortization methods : Since companies can use different amortization methods, they can accommodate these based on their need to minimize the variability of the result.
- Recognition of expenses and income: Through this, companies can present a greater or lesser result (as they see fit at all times).