Does Income Smoothing Really Create Value?

Abstract

Extant literature suggests that income smoothing, as measured by unit-free measures such as the correlation between pre-managed earnings and discretionary accruals, creates value. We recognize that income smoothing also drives up the volatility of discretionary accruals due to larger dollar amounts of smoothing efforts. We find that although the unit-free aspect of income smoothing is associated with higher future returns, the volatility aspect is associated with lower future returns. Taken together, high levels of future returns associated with the correlation measure are completely offset by negative future returns associated with the volatility measure over one-month to five-year horizons. These findings are robust to a battery of control variables and to different measures of income smoothing, and robust for industry groupings and firms adopting similar income-smoothing practices. Our results cast doubts on the ability of income smoothing to create value for shareholders over time. In particular, although the literature suggests that investors value smooth firm performance, artificially dampening the variabilities of reported earnings over time does not fool investors. Instead, income smoothing destroys value because investors are more sensitive to the increase in information asymmetry brought about by the volatility measure than to the decrease in information asymmetry brought about by the correlation measure.

Keywords: Income Smoothing, Pre-Managed Earnings-Discretionary Accruals correlation, Accrual Volatility, Return, Value, Information Signaling

JEL Classification: G12, G14, M41