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Why Do Firms Smooth Earnings?

  • Anand Mohan Goel

    (University of Michigan)

  • Anjan V. Thakor

    (Olin School of Business, Washington University)

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 structure.

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Paper provided by EconWPA in its series Finance with number 0411021.

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Length: 42 pages
Date of creation: 10 Nov 2004
Date of revision:
Handle: RePEc:wpa:wuwpfi:0411021
Note: Type of Document - pdf; pages: 42
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  1. Boot, Arnoud W A & Thakor, Anjan, 1995. "Financial System Architecture," CEPR Discussion Papers 1197, C.E.P.R. Discussion Papers.
  2. Franklin Allen, . "Stock Markets and Resource Allocation (Reprint 036)," Rodney L. White Center for Financial Research Working Papers 15-92, Wharton School Rodney L. White Center for Financial Research.
  3. DeFond, Mark L. & Park, Chul W., 1997. "Smoothing income in anticipation of future earnings," Journal of Accounting and Economics, Elsevier, vol. 23(2), pages 115-139, July.
  4. Boot, Arnoud W A & Thakor, Anjan V, 2001. "The Many Faces of Information Disclosure," Review of Financial Studies, Society for Financial Studies, vol. 14(4), pages 1021-57.
  5. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  6. Fudenberg, Drew & Tirole, Jean, 1994. "A Theory of Income and Dividend Smoothing Based on Incumbency Rents," IDEI Working Papers 34, Institut d'Économie Industrielle (IDEI), Toulouse.
  7. Michael J. Brennan & Anjan V. Thakor, 2004. "Shareholder Preferences and Dividend Policy," Finance 0411017, EconWPA.
  8. Subramanyam, K. R., 1996. "The pricing of discretionary accruals," Journal of Accounting and Economics, Elsevier, vol. 22(1-3), pages 249-281, October.
  9. Boot, Arnoud W A & Thakor, Anjan V, 1993. " Security Design," Journal of Finance, American Finance Association, vol. 48(4), pages 1349-78, September.
  10. Kreps, David M & Wilson, Robert, 1982. "Sequential Equilibria," Econometrica, Econometric Society, vol. 50(4), pages 863-94, July.
  11. Allen, Franklin & Gale, Douglas, 1998. "Diversity of Opinion and Financing of New Technologies," Working Papers 98-29, C.V. Starr Center for Applied Economics, New York University.
  12. Dechow, Patricia M., 1994. "Accounting earnings and cash flows as measures of firm performance : The role of accounting accruals," Journal of Accounting and Economics, Elsevier, vol. 18(1), pages 3-42, July.
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