Income Smoothing and the Cost of Debt

Abstract:     
Using the Tucker-Zarowin (TZ) statistic of income smoothing, we find firms with higher income smoothing rankings exhibit lower cost of debt and higher credit ratings. Multivariate analysis reveals that firms with higher financial leverage and lower credit ratings experience are associated with higher borrowing costs, but that such borrowing costs can be reduced by smoothing reported income. Furthermore, larger firms and firms with greater stock return volatility and who exhibit higher income smoothing rankings experience relative higher borrowing costs. Results support the notion that for smaller firms with lower stock return volatility, income smoothing represents information signaling rather than garbling.

Number of Pages in PDF File: 28

Keywords: Income smoothing, earnings smoothing, garbling, credit spreads, credit ratings, cost of debt

JEL Classification: G12, G32, M41

working papers series