Does Real Earnings Smoothing Reduce Investors’ Perceived Risk?
Posted: 11 Jun 2019
Date Written: May 25, 2019
This study examines whether real earnings smoothing influences equity and credit investors’ perception of risk. Using a large sample of U.S. public firms during the period of 1996 through 2014, we find that real smoothing is negatively associated with option-implied volatility even after controlling for accrual-based smoothing and fundamental smoothing, suggesting that real smoothing lowers equity investors’ perception of risk. We also find that the association between real smoothing and equity investors’ perceived risk is stronger when dividend payouts are higher, balance sheet constraints are more severe, and accrual-based smoothing is greater. In addition, we find that real smoothing is negatively associated with CDS spreads, implying that real smoothing lowers creditors’ perception of risk as well. Our results are robust to a variety of sensitivity checks. Overall, our study documents a new factor that influences both equity and credit investors’ ex ante perception of risk.
Keywords: real earnings smoothing, accrual-based earnings smoothing, option-implied volatility, CDS spread, perceived risk
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