Higher ERC or Higher Future ERC from Income Smoothness? - The Role of Information Environment

52 Pages Posted: 16 Jan 2014

See all articles by C.S. Agnes Cheng

C.S. Agnes Cheng

Hong Kong Polytechnic University - School of Accounting and Finance

Joe Johnston

Illinois State University - Department of Accounting

Shuo Li

Western Washington University

Date Written: January 15, 2014

Abstract

We examine the differential effects of income smoothness on value-relevance of current future earnings (termed as earnings response coefficient, ERC, and future earnings response coefficient, FERC, respectively) as affected by different information environments. In theory, if reported earnings are permanent, earnings should explain concurrent returns fully. In this case, the FERC should approach zero. However, a rich information environment provides more information that helps the market better assess the firm’s future profitability. To the extent that current permanent earnings cannot fully predict future realized earnings, we should find a positive FERC in rich information environment. Based on the premise that smoothing brings reported earnings closer to permanent earnings, we predict and find that for firms with poor information environment, income smoothness improves ERC but not FERC. For firms with superior information environment, income smoothness improves FERC. We also find higher FERC when earnings are less smoothed for firms in poorer information environment. Many recent studies have focused solely on FERC in assessing the informativeness of earnings. We remind researchers that theoretically more value-relevant earnings do not effectively improve FERC in an environment with little or no other information.

Keywords: Income Smoothness, ERC, FERC, Information Environment

Suggested Citation

Cheng, C.S. Agnes and Johnston, Joseph Atkins and Li, Shuo, Higher ERC or Higher Future ERC from Income Smoothness? - The Role of Information Environment (January 15, 2014). 2014 Canadian Academic Accounting Association (CAAA) Annual Conference. Available at SSRN: https://ssrn.com/abstract=2379893 or http://dx.doi.org/10.2139/ssrn.2379893

C.S. Agnes Cheng (Contact Author)

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

M715, Li Ka Shing Tower
Hung Hom, Kowloon, Kowloon
Hong Kong

Joseph Atkins Johnston

Illinois State University - Department of Accounting ( email )

United States
309-438-3830 (Phone)

Shuo Li

Western Washington University ( email )

United States
3606503202 (Phone)

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