Discretionary earnings smoothing, credit quality, and firm value

Abstract

This paper examines the conditional association between earnings smoothing via discretionary accruals and firms’ credit quality and value. We argue that the information environment is important in how the market assesses earnings smoothing. We construct a smoothing index that measures the impact on reported earnings per share volatility from the use of accounting discretion. We find confirming evidence of a stronger association between discretionary earnings smoothing and firms’ cost of debt and Tobin's Q when the information environment for the firm is weaker. We also document that during the pre-Reg FD period smoothing firms with a low information environment appear more systematic, suggesting that managers of more opaque firms are more able to capture hidden cash flows when using accounting discretion to smooth earnings.