Aurora Borealis
1 September 2017 CFA Institute Journal Review

Earnings Smoothing: Does It Exacerbate or Constrain Stock Price Crash Risk? (Digest Summary)

  1. Marla Howard, CFA
Earnings smoothing by management is commonplace. The authors find evidence of adverse downside consequences of earnings smoothing, indicating that managers’ opportunistic motivations are more prevalent than their desire to signal private information and resulting in economically significant stock price deterioration. The negative impact is reduced when analysts and institutional owners effectively monitor firms.

What’s Inside?

Conventional wisdom suggests that fluctuation in earnings denotes greater equity risk. There are two views on why managers smooth earnings. One view is that managers smooth earnings to avoid earnings volatility and to signal their private information to investors about future performance, minimizing uninformed investors’ anxieties about future losses. The second theory is that managers smooth earnings to hide bad news for their own opportunistic purposes.

The authors contribute to the existing literature by finding that the greater the earnings smoothing, the greater the stock price crash risk—supporting the idea that managerial opportunism prevails over private information signaling. Stock price crash risk is reduced when there are more analysts following the firm, fewer cumulative discretionary accruals, and greater institutional ownership.

How Is This Research Useful to Practitioners?

Managers have asymmetrical incentives to hide bad news and accelerate the release of good news. Using discretionary accruals is one way that managers take advantage of accounting flexibility to hide bad news, with the hope that the situation will turn around in the future—contrary to conservative accounting practices. Hoarding bad news cannot continue indefinitely; it is eventually revealed, causing a stock price crash. Using the negative skewness of stock return distributions, the authors find evidence that earnings smoothing increases stock price crash risk.

Firms that are likely to conceal information have a stronger stock price crash risk impact from income smoothing than firms that are more likely to signal private information about future earnings. The authors also show that bad corporate social responsibility (CSR) firms smooth earnings to hide bad news, which is not the case with good CSR firms.

Accrual accounting provides a means for managers to manipulate earnings; abnormal accruals and income smoothing may be used for managers’ private gains. Investors should be aware of the abrupt and significant downside equity risk of opportunistic smoothing and of the role that institutional owners and analysts play in reducing these negative effects.

How Did the Authors Conduct This Research?

Past researchers have focused on pooled regressions of earnings smoothing effects on the mean (ex postrealized cost of capital) and variance of stock returns. Recognizing the importance of negative tail risk, the authors use firm-specific return distributions and negative skewness to measure stock price crash risk in the quarter after the earnings smoothing. Using regression analysis, they find that their measure of earnings smoothing (the correlation between the changes in pre-managed accrual earnings and abnormal accruals) has a significant negative impact, at the 1% level, on three different measures of subsequent-quarter stock price crash risk. The results suggest that managers tend to use smoothing to hide poor performance and that this motivation is more prevalent than the private information signaling motivation for smoothing. These results hold even when controlling for firm-specific attributes related to stock price crash risk, including information opacity measured as the moving sum of discretionary accruals over 12 quarters, tax avoidance, and accounting conservatism. Opaque financials suggest a higher possibility for future downside risk, whereas conservative accounting practices offset the negative effects of smoothing.

The value destruction of earnings smoothing is economically significant for stockholders. An increase of one standard deviation in the extent of income smoothing results in a 37 bp decrease in the cumulative raw stock returns over the subsequent quarter, or an 11.4% decrease relative to the sample mean. The effect is similar during extreme events. Further tests show that negative effects are reduced with analyst coverage and institutional ownership, indicating that sophisticated investors play an important role in monitoring managers’ self-serving behavior and opportunistic financial reporting.

The data are from 6,627 nonfinancial, nonutility firms over 19 years (1993–2011), for a total of 157,722 firm-year observations.

Abstractor’s Viewpoint

The flexibility of financial accounting lends itself to manipulation. The authors’ sample reveals significant value deterioration caused by abnormal accruals and earnings smoothing. Although accrual accounting, which recognizes revenue when earned and records expenses when incurred, is logical, investors and analysts may wish to continue placing greater emphasis on objective, identifiable cash flow and thus avoid the discretionary accrual problem of financial reporting.

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