Does Income Smoothing Really Create Value?

54 Pages Posted: 14 Mar 2011

See all articles by Alan Guoming Huang

Alan Guoming Huang

University of Waterloo

Sati P. Bandyopadhyay

University of Waterloo

Tony S. Wirjanto

University of Waterloo - School of Accounting and Finance; University of Waterloo, Department of Statistics & Actuarial Science

Date Written: March 11, 2011

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

Suggested Citation

Huang, Alan G. and Bandyopadhyay, Sati P. and Wirjanto, Tony S., Does Income Smoothing Really Create Value? (March 11, 2011). Available at SSRN: https://ssrn.com/abstract=1784017 or http://dx.doi.org/10.2139/ssrn.1784017

Alan G. Huang (Contact Author)

University of Waterloo ( email )

School of Accounting and Finance
Waterloo, Ontario N2L 3G1
Canada
519-888 4567 ext. 36770 (Phone)

Sati P. Bandyopadhyay

University of Waterloo ( email )

School of Accountancy
Waterloo, Ontario N2L 3G1
Canada
519-888-4567, ext. 2533 (Phone)
519-888-7562 (Fax)

Tony S. Wirjanto

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1
Canada
519-888-4567 x35210 (Phone)

HOME PAGE: http://https://uwaterloo.ca/statistics-and-actuarial-science/people-profiles/tony-wirjanto

University of Waterloo, Department of Statistics & Actuarial Science ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1
Canada
519-888-4567 x35210 (Phone)
519-746-1875 (Fax)

HOME PAGE: http://math.uwaterloo.ca/statistics-and-actuarial-science/people-profiles/tony-wirjanto

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