Do Investors Perceive Low Risk When Earnings are Smooth Relative to the Volatility of Operating Cash Flows? Discerning Opportunity and Incentive to Report Smooth Earnings

Posted: 11 May 2017

See all articles by Devon Erickson

Devon Erickson

Utah State University - Huntsman School of Business

Max Hewitt

University of Arizona - Eller College of Management

Laureen A. Maines

Indiana University - Kelley School of Business - Department of Accounting; PricewaterhouseCoopers

Date Written: May 2017

Abstract

A fundamental accounting question is whether investors perceive low risk when earnings are smooth relative to the volatility of operating cash flows. We conduct two experiments to examine this question. Absent additional information concerning the likelihood of earnings management, our first experiment finds that investors give managers the benefit of the doubt and perceive low risk when earnings are relatively smooth. Given this finding, our second experiment examines whether additional information that supports investors' suspicions of earnings management affects investors' risk judgments when earnings are relatively smooth. We find that investors no longer give managers the benefit of the doubt when additional information suggests that managers have either the opportunity or the incentive to report smooth earnings. Our study provides important insights to the literature concerning both "whether" and "when" relatively smooth earnings affect investors' risk judgments.

Keywords: Smooth Earnings, Earnings Management, Opportunity, Incentive, Risk Judgments

Suggested Citation

Erickson, Devon and Hewitt, Max and Maines, Laureen A., Do Investors Perceive Low Risk When Earnings are Smooth Relative to the Volatility of Operating Cash Flows? Discerning Opportunity and Incentive to Report Smooth Earnings (May 2017). The Accounting Review, Vol. 92, No. 3, 2017. Available at SSRN: https://ssrn.com/abstract=2965692

Devon Erickson (Contact Author)

Utah State University - Huntsman School of Business ( email )

3540 Old Main Hill
Logan, UT 84322-3540
United States

Max Hewitt

University of Arizona - Eller College of Management ( email )

School of Accountancy
1130 E. Helen Street
Tucson, AZ 85721
United States
(520) 621-4805 (Phone)

Laureen A. Maines

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States
812-855-2611 (Phone)
812-855-4985 (Fax)

PricewaterhouseCoopers

1301 Avenue of the Americas
New York, NY 10019
United States

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