Income Smoothing, Information Uncertainty, Stock Returns, and Cost of Equity

Abstract

This paper examines the effect of income smoothing on information uncertainty, stock returns, and cost of equity. I show that income smoothing through both total accruals and discretionary accruals tends to reduce firms’ information uncertainty, as measured by stock return volatility, analyst earnings forecast dispersion, and analyst earnings forecast error. Further, I provide evidence that stocks of income smoothing firms are priced with a premium. Controlling for earnings shocks and other firm characteristics, income smoothing firms have significantly higher abnormal returns around earnings announcement. In addition, I show that income smoothing reduces firms’ implied cost of equity or expected returns. The result is more robust over short horizons up to two years.

Keywords: Income smoothing, Information uncertainty, Stock returns, Cost of equity

JEL Classification: G12, G14, M41, M43