Does Real Earnings Smoothing Reduce Investors’ Perceived Risk?

Abstract

This study examines whether real earnings smoothing influences equity and credit investors’ perceptions of risk. Using a large sample of U.S. public firms, we find that real earnings smoothing is negatively associated with option-implied volatility, suggesting that real earnings smoothing lowers equity investors’ perceived risk. We also find that real earnings smoothing is negatively associated with credit default swap spread, implying that real earnings smoothing lowers credit investors’ perceived risk. Our results are robust to multiple sensitivity analyses and to various tests used to address potential endogeneity. Moreover, the effect of real earnings smoothing is greater than that of accrual-based smoothing, suggesting that real earnings smoothing is more difficult for investors to detect and unravel. Overall, our study documents a new factor that influences both equity and credit investors’ ex ante perceptions of risk.

Keywords: real earnings smoothing; accrual-based earnings smoothing; option-implied volatility; credit default swap spread; perceived risk; credit investors; equity investors

JEL Classification: G12, G32, M41