Accounting cushion – What is an accounting cushion?
The term ‘accounting cushion’ is used to refer to an intentionally excessive expense that’s reported on a company’s financial statement so as to even out fluctuations in their earnings across a longer period.
With Debitoor invoicing software, it’s easy to manage your business’ finances. Try Debitoor today for free with a 7 day trial period.
An accounting cushion works like an iron. It smooths out earnings so that excessively high earnings in one accounting period are pushed down and excessively low earnings in another period can be lifted. If a company uses an accounting cushion, it results in consistent earnings that are then very attractive to investors.
How does an accounting cushion work?
If a company reports a large expense on their financial statements, they are able to artificially understate income at a time when earnings are extraordinarily high. By doing this, it will give them excess money that they’ll then be able to use to overstate income at a later period.
A company is able to create an accounting cushion by increasing allowances for bad debts in the present period, without needing to have definite indications that bad debts will actually occur. By over-accounting for bad debts, the company’s accounts will therefore not show all of the profit that has been made in the present period. In the following quarter, if the profits are not as high, the company could then make up for this by overstating what was earned.
This may be described as ‘income smoothing’ and it’s a form of earnings management. Even though using an accounting cushion can enhance the perceived stability of earnings, it may consequently weaken the financial credibility of the company.
How to assess what is a reasonable amount for an accounting cushion
Every business is different. Each business has its own risks, priorities and management style, and no two business owners are alike. Therefore, there’s no generalisable amount for a cushion that is applicable to all companies. However, there are a few things that you can do to help assess whether the accounting cushion you have in place is a reasonable amount.
- Work off any financial projections that you have already made.
- Assess how long you would expect a dip in revenue to last. Some companies may use an accounting cushion to even out one month’s dip in earnings, others may use it to support longer periods.
- Assess your business expenses. You should ask yourself what the total cost will be to run your business and compare this to your financial projections.
Once you have these numbers you will be in a better position to assess when, and for how long, your business’ earnings may be down. It will then be up to you to calculate how much of an accounting cushion may be necessary and reasonable.