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Why Do Firms Smooth Earnings?

Author

Listed:
  • Anand Mohan Goel

    (University of Michigan)

  • Anjan V. Thakor

    (Olin School of Business, Washington University)

Abstract

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.

Suggested Citation

  • Anand Mohan Goel & Anjan V. Thakor, 2004. "Why Do Firms Smooth Earnings?," Finance 0411021, EconWPA.
  • Handle: RePEc:wpa:wuwpfi:0411021 Note: Type of Document - pdf; pages: 42
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    References listed on IDEAS

    as
    1. Brennan, Michael J & Thakor, Anjan V, 1990. " Shareholder Preferences and Dividend Policy," Journal of Finance, American Finance Association, vol. 45(4), pages 993-1018, September.
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    4. Boot, Arnoud W A & Thakor, Anjan V, 1993. " Security Design," Journal of Finance, American Finance Association, vol. 48(4), pages 1349-1378, September.
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    7. Boot, Arnoud W A & Thakor, Anjan V, 1997. "Financial System Architecture," Review of Financial Studies, Society for Financial Studies, pages 693-733.
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    12. Franklin Allen, "undated". "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.
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    14. DeFond, Mark L. & Park, Chul W., 1997. "Smoothing income in anticipation of future earnings," Journal of Accounting and Economics, Elsevier, pages 115-139.
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    JEL classification:

    • G - Financial Economics

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