The Impact of Cost Stickiness on Financial Reporting: Evidence from Income Smoothing

Abstract

This study investigates the impact of cost stickiness on income smoothing. Prior literature at the intersection between management and financial accounting has understood changes in cost behavior as mere consequences of short-term earnings management incentives. By considering income smoothing as the more complex earnings management strategy, we argue that resource adjustment strategies underlying cost behavior might also have an impact on long-term financial reporting choices. Specifically, asymmetric reactions of costs to sales changes should increase earnings volatility and thus restrict managers’ capabilities to report smooth income streams, which is supported by our empirical results. Additional tests reveal that cost stickiness primarily restricts opportunistic income smoothing and that the relationship depends on other factors such as the level of adjustment costs.

Keywords: Cost Behavior; Income Smoothing; Managerial Discretion; Earnings Management; Resource Adjustments

JEL Classification: D22; G3; M41