Accounting Cushion

What Is an Accounting Cushion?

An accounting cushion is a term used to portray an intentionally unreasonable expense reported on a company's financial statements to even out vacillations in earnings across periods.

Management can utilize these expanded numbers to artificially downplay income by exaggerating liability or allowance accounts. Making larger provisions for benefit disintegrating expenses presents an opportunity to limit them afterward, empowering the company to exaggerate income in a later period and give a cushion to future outcomes.

Income smoothing is widely practiced and metaphorically alluded to as earnings management.

Understanding an Accounting Cushion

You might be asking why any company would need to intentionally downplay its income and aggravate its financial performance than it really was. In reality, there's a truly simple justification for why such a strategy may be sought after. Basically, an accounting cushion gets profits from the great times and rearranges them to harder minutes, conceding tax liabilities and, maybe more critically, assisting with papering over the breaks of more fragile, impending trading periods and communicate something specific of consistency and stability.

Significant

Management deliberately exaggerates expenses fundamentally to assuage investor and analyst requests for entirely stable and unsurprising earnings.

Investors and analysts could do without earnings surprises and are substantially more satisfied when profits are consistent and unsurprising. For example, how about we accept that investors anticipate that company ABC's earnings should develop at 4% each period. In the event that the company rather develops 6% in the main period, surprises investors with a decline of 1% in the second, investors may be frightened and respond by driving down the value of the stock.

Perceptions of greater financial risk could likewise lead investors to require a higher risk premium, expanding the company's cost of capital. Some management groups would prefer to downplay the 6% growth in the main period and exaggerate income in the second one to accomplish an outcome more in accordance with consensus expectations and stay away from volatility in the stock price.

Tricky accountants have several devices at their disposal to exaggerate expenses. They incorporate pre-ordering inventory, completely funding employee pension funds, and exaggerating the [allowance for awful debts](/allowance-for-terrible debt). In examples where auditors or analysts discover income being managed, they ought to adjust amounts back to their legitimate levels.

Accounting Cushion Method

Terrible Debt

Companies can create an accounting cushion by expanding allowances for bad debts in the current period, despite everything having specific indications that the number of customers not paying what they owe will rise. The increased provision for awful debt would result in a downplayed accounts receivable (AR) amount in the current period.

The company could then compensate for it in the next period by exaggerating accounts receivable (AR).

Analysis of Accounting Cushions

Income smoothing through making an accounting cushion is just one type of a more extensive array of activities that fall under earnings management. This practice might appear to be less harmful than another manners by which managements trick investors. Nonetheless, it actually misleads the investing public about the true stability of a company's income stream.

While inescapable, and not necessarily unlawful, income smoothing ought to raise concerns regarding the quality of earnings a company produces. The U.S. Securities and Exchange Commission (SEC) has periodically made enforcement moves, giving infringement and imposing fines against what it considers "exorbitant" or "harmful" manipulation.

Features

• Downplaying earnings empowers companies to exaggerate them later on, giving a cushion to more vulnerable, impending trading periods and communicating something specific of stability.
• Income smoothing strategies incorporate pre-ordering inventory, completely funding employee pension funds, and exaggerating the allowance for awful debts.
• Accounting cushions help to mollify investor and analyst requests for truly stable and unsurprising earnings.
• An accounting cushion is the practice of a company making larger provisions for expenses in a single period so they can be limited later on.