Accounting

Anand Mohan Goel
Anjan V. Thakor
University of Michigan

Why Do Firms Smooth Earnings?*

I.

Introduction

Corporate earnings management has been much in the news lately. For example, Business Week has recently run two cover stories, one titled “Who Can You Trust?”
(October 5, 1998) and the other titled “The Numbers
Game” (May 14, 2001), that suggest that the credibility of earnings reports is being eroded by earnings management. Arthur Levitt, Jr., chairman of the Securities and Exchange Commission (SEC), commented in 1998:
“Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation.”1
Earnings management means manipulating reported earnings so that they do not accurately represent economic earnings at every point in time. Earnings smoothing is a special case of earnings management involving intertemporal smoothing of reported earnings relative to economic earnings; it attempts to make earnings look less variable over time. Earnings smoothing is extensively documented (see Beidlerman 1973; Bannister

* The authors thank Sugato Bhattacharyya, Ronen Israel, David
Hirshleifer, participants at a finance workshop at the University of
Michigan Business School, and three anonymous referees for their helpful comments.
1. See CPA Journal (December 1998), pp. 14–19, quote on p.
14. See also Collingwood (2001) for a discussion of the evidence on earnings management.
(Journal of Business, 2003, vol. 76, no. 1)
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We explain why a firm may smooth reported earnings. Greater earnings volatility leads to a bigger informational advantage for informed investors over uninformed investors. If sufficiently many current shareholders are uninformed and may need to

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