Is Real Earnings Smoothing Harmful? Evidence from Firm‐Specific Stock Price Crash Risk

Abstract

This study examines whether and when real earnings smoothing influences firm‐specific stock price crash risk. Using a sample of U.S. public firms for the years 1993 through 2014, we find real earnings smoothing to be positively associated with firm‐specific stock price crash risk. This finding is consistent with the view that real earnings smoothing helps managers withhold bad news, keep poor‐performing projects, conceal resource diversion, and engage in ineffective risk management, which increases crash risk. Further, we find a stronger relation between crash risk and real earnings smoothing when firm uncertainty is higher, product market competition is lower, and balance sheet constraint is higher. Overall, our study suggests that real earnings smoothing destroys shareholder value in that it increases stock price crash risk.

Earnings Smoothing as Information Signaling or Garbling: A Review of Literature

“…In line with this argument, Chen et al (2017), Khurana et al (2017) and Yu et al (2017) find that managers use earnings smoothing as a mean to hide or withhold bad news from shareholders. As a consequence, firms are exposed to a greater stock price crash risk, especially when the accumulated bad news burst.…”

“…Based on the view that earnings smoothing is used to garble information by managers, Khurana et al (2017) find positive association between real earnings smoothing and firm-specific stock price crash risk. Real earnings smoothing allows managers to conceal firm's actual performance.…”

“…Only very few studies measure earnings smoothing using real smoothing, such as Dhole et al (2016), Francis et al (2016), Huang et al (2009) and Khurana et al (2017). Therefore, this section is contributed to the studies that examine real smoothing activities while the rest of the paper i.e.…”

“…Bhattacharya et al (2003) argue that earnings smoothing resulted in reported earnings not depicting the true underlying economic performance of the firm, and hence reducing the informativeness of reported earnings and increasing information opacity. Earnings smoothing as information garbling is usually associated with managers' concerned on compensation contract (Das et al, 2013;Defond & Park, 1997;Grant et al, 2009) as well as to avoid outsiders' intervention in management (Acharya & Lambrecht, 2015;Khurana et al, 2017).…”

“…Accordingly, managers have to report an earnings figure that corresponds to outside shareholders' expectation rather than true income, to avoid Asian Journal of Finance & Accounting ISSN 1946-052X 2018 outsiders' intervention. Specifically, during bad times, managers use smoothing to conceal unfavourable earnings realizations and create reserves for future periods by understating earnings during good times (Acharya & Lambrecht, 2015;Khurana et al, 2017). Generally, investors give managers the benefit of the doubt and perceive low risk when earnings are relatively smooth.…”