Why Do Firms Smooth Earnings?
55 Pages Posted: 11 Jul 2000
We develop a model that explains why the manager of a firm may smooth reported earnings by reducing its variability through time. Greater earnings volatility leads to a bigger informational advantage for informed investors over uninformed investors. If a sufficient number of current shareholders are uninformed and face some likelihood of trading in the future for liquidity reasons, then an increase in the volatility of reported earnings will magnify the trading losses these uninformed shareholders perceive. They will, therefore, want their firm's manager to produce as smooth a reported earnings stream as possible. Interestingly, it is a concern with long-term stock price performance rather than a preoccupation with the short-term performance that causes smoothing. Empirical implications are drawn out that link earnings smoothing to managerial compensation contracts, uncertainty about the volatility of earnings and the ownership structure.
JEL Classification: G34, M41, M43, J33
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