Everyone likes to see a steady upward trend line for profit; no one likes to see a profit curve that looks like a roller coaster. Most investors want a smooth journey and don’t like putting on their investment life preservers.
Managers can do certain things to deflate or inflate profit (net income) recorded in the year, which are referred to as profit smoothing techniques. Other names for these techniques are income smoothing and earnings management. Profit smoothing is like a white lie told for the good of the business and perhaps for the good of managers as well. Managers know that there’s always some noise in the accounting system. Profit smoothing muffles the noise.
The general view in the financial community is that profit smoothing is not nearly as serious as cooking the books, or juggling the books. These terms refer to deliberate, fraudulent accounting practices such as recording sales revenue that hasn’t happened or not recording expenses that have happened. Nevertheless, profit smoothing is still serious and, if carried too far, could be interpreted as accounting fraud. Managers have gone to jail for fraudulent financial statements.
Theoretically, having an audit by a CPA firm should root out any significant accounting fraud when the business is knowingly perpetrating the fraud or when it’s an innocent victim of fraud against the business. But in fact, there continue to be many embarrassing cases in which the CPA auditor failed to discover major fraud by or against the business.
The pressure on public companies
Managers of publicly owned corporations whose stock shares are actively traded are under intense pressure to keep profits steadily rising. Security analysts who follow a particular company make profit forecasts for the business, and their buy/hold/sell recommendations are based largely on these earnings forecasts. If a business fails to meet its own profit forecast or falls short of stock analysts’ forecasts, the market price of its stock shares usually takes a hit. Stock option and bonus incentive compensation plans are also strong motivations for achieving the profit goals set for the business.The evidence is fairly strong that publicly owned businesses engage in some degree of profit smoothing. Frankly, it’s much harder to know whether private businesses do so. Private businesses don’t face the public scrutiny and expectations that public corporations do. On the other hand, key managers in a private business may have bonus arrangements that depend on recorded profit. In any case, business investors and managers should know about profit smoothing and how it’s done.
Compensatory effects
Most profit smoothing involves pushing some amount of revenue and/or expenses into years other than those in which they would normally be recorded. For example, if the president of a business wants to report more profit for the year, he or she can instruct the chief accountant to accelerate the recording of some sales revenue that normally wouldn’t be recorded until next year or to delay the recording of some expenses until next year that normally would be recorded this year.Managers choose among alternative accounting methods for several important expenses. After making these key choices, the managers should let the accountants do their jobs and let the chips fall where they may. If bottom-line profit for the year turns out to be a little short of the forecast or target for the period, so be it. This hands-off approach to profit accounting is the ideal way. However, managers often use a hands-on approach — they intercede and override the normal methods for recording sales revenue or expenses.
Both managers who do profit smoothing and investors who rely on financial statements in which profit smoothing has been done must understand one thing: These techniques have compensatory effects. The effects next year offset and cancel out the effects this year. Less expense this year is counterbalanced by more expense next year.
Sales revenue recorded this year means less sales revenue recorded next year. Of course, the compensatory effects work the other way as well: If a business depresses its current year’s recorded profit, its profit next year benefits. In short, a certain amount of profit can be brought forward into the current year or delayed until the following year.Management discretion in the timing of revenue and expenses
Several smoothing techniques are available for filling the potholes and straightening the curves on the profit highway. Most profit-smoothing techniques require one essential ingredient: management discretion in deciding when to record expenses or when to record sales. See the sidebar “Case study in massaging the numbers.”A common technique for profit smoothing is to delay normal maintenance and repairs, which is referred to as deferred maintenance. Many routine and recurring maintenance costs required for autos, trucks, machines, equipment, and buildings can be put off, or deferred, until later. These costs are not recorded to expense until the actual maintenance is done, so putting off the work means recording the expense is delayed.
Here are a few other techniques used:
- A business that spends a fair amount of money for employee training and development may delay these programs until next year so the expense this year is lower.
- A company can cut back on its current year’s outlays for market research and product development (though this could have serious long-term effects).
- A business can ease up on its rules regarding when slow-paying customers are written off to expense as bad debts (uncollectible accounts receivable). The business can, therefore, put off recording some of its bad debts expense until next year.
- A fixed asset out of active use may have very little or no future value to a business. But instead of writing off the undepreciated cost of the impaired asset as a loss this year, the business may delay the write-off until next year.
- Keep in mind that most of these costs will be recorded next year, so the effect is to rob Peter (make next year absorb the cost) to pay Paul (let this year escape the cost).
Clearly, managers have a fair amount of discretion over the timing of some expenses, so certain expenses can be accelerated into this year or deferred to next year in order to make for a smoother year-to-year profit trend. But a business doesn’t divulge in its external financial report the extent to which it has engaged in profit smoothing. Nor does the independent auditor comment on the use of profit-smoothing techniques by the business — unless the auditor thinks that the company has gone too far in massaging the numbers and that its financial statements are downright misleading.
