Handbook of Asset and Liability Management: From models to optimal return strategies

29

Income Smoothing Strategies

Petit gain est bel quand il vient souvent. (13th century)

One of the A/L manager's objectives is not only to limit financial risk but also to limit accounting risk: the company is seen more stable (by rating agencies, regulators, etc.) when the income is not volatile over time.

The accounting risk imposes constraints on economic value management; income smoothing strategies reduce this risk.

However, the A/L manager will have to make sure he is not to confusing income smoothing with fraud.

29.1 IMPORTANT PRELIMINARY COMMENT ABOUT INCOME SMOOTHING AND FRAUD

Sometimes, even in a Basel II Pillar 3 or in an IAS 32 framework, there is an information asymmetry between the A/L managers and the analysts. Some income smoothing strategies may benefit from this asymmetry and this could be considered reasonably to be a fraud by auditors or by the law.

A/L managers will have to distinguish between income smoothing that includes a risk limitation objective and income smoothing that hides information deliberately from the financial analysts: this second type of income smoothing can be considered to be fraud.

The fraud is characterized by a deliberate will to circumvent the regulation.

As an example, we may cite the structure developed in 2001 by an American gas company we will call Company X, in order to smooth its income. The “Alpha project” was based on the creation of a Special Purpose Entity (SPE) with two stages:

• Stage one: the SPE borrows money from banks, ...