Topics: Probability density function, Random variable, Probability theory Pages: 42 (18566 words) Published: May 28, 2014
Anand Mohan Goel
Anjan V. Thakor
University of Michigan

Why Do Firms Smooth Earnings?*



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)
᭧ 2003 by The University of Chicago. All rights reserved.

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 trade in the
future for liquidity reasons, an increase in the
volatility of reported
earnings will magnify
these shareholders’ trading losses. They will,
therefore, want the manager to smooth reported
earnings as much as possible. Empirical implications are drawn out that link earnings smoothing
to managerial compensation contracts, uncertainty
about the volatility of
earnings, and ownership


Journal of Business

and Newman 1996; Subramanyam 1996). Moses (1987) studies how various firm-specific factors affect the extent of earnings smoothing. This raises the question we address: why is earnings smoothing so prevalent? If earnings are being smoothed, reported earnings must be sometimes higher than economic earnings and sometimes lower. It is not difficult to see why managers may want to report inflated earnings. But it is a lot harder to explain why a manager reports lower earnings than what he observes. Yet, numerous such instances have recently been discussed. For example, in 1998, the SEC delayed approval of the acquisition of Crestar Financial Corporation by SunTrust Banks, Incorporated until the company agreed to reduce loan loss reserves by $100 million and restate higher earnings for the past 3 years.2 The SEC also criticized W. R. Grace and Company for underreporting its 1998 profits by $20 million. The SEC alleged that the company was attempting to exploit apparently diminishing marginal returns to reported earnings. When reported earnings are high, reporting even higher earnings tends to elicit a relatively small positive market reaction. The company may therefore want to “hide” some of its current earnings for reporting in a future period when earnings are lower and the marginal impact of a higher report is greater.3 Earnings smoothing can be either “artificial” or “real.” Real smoothing involves decisions that affect cash flows and dissipate firm value. Examples include changing the timing of investments and providing promotional...

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