Accounting Cushion

An accounting cushion is a term used to describe an intentionally excessive expense reported on a company’s financial statements in order to even out fluctuations in their earnings across periods. Company management can use these inflated numbers to artificially understate income in a current period by overstating liability or allowance accounts. Doing this will give the company the ability to overstate income in a later period.

Companies can generate an accounting cushion by increasing allowances for bad debts in the current period, with or without having specific indications that bad debts will actually rise. The Increased provision for bad debt would result in an understated accounts receivable amount in the current period. The company could then make up for it in the next period by overstating accounts receivable. These types of income smoothing activities are methods of earnings management. In instances where auditor or analysts discover income being managed, they should adjust amounts back to their proper levels.

Income smoothing through creating an accounting cushion is just one type of a broader array of activities that fall under earnings management. You may be wondering why any company would want to intentionally understate its income in any period. The reason some management’s resort to income smoothing include analyst and stockholder expectations for very stable, and predictable earnings. Investors may expect company ABC’s earnings to grow at 4% every period. If the company instead grows 6% in the first period, then surprises investors with a decline of 1% in the second, investors might be spooked and react by driving down the value of the stock. Perceptions of greater financial risk might also lead investors to require a higher risk premium, increasing the firm’s cost of capital. Some managements would rather understate the 6% growth in the first period and overstate income in the second period to achieve a result more in line with consensus expectations — avoiding volatility in the stock price.

This may seem less harmful than some other ways in which managements deceive investor. However, it still misleads the investing public about the true stability of a company's income stream. Income smoothing is widely practiced and euphemistically referred to as earnings management. While widespread, and not necessarily illegal, income smoothing should raise concerns regarding the quality of earnings a company generates. The U.S. Securities Exchange Commission (SEC) has periodically taken enforcement actions, issuing violations and levying fines, against what it deems “excessive” or “abusive” manipulation.