Earnings' Quality and Smoothing

Abstract

We study a model of financial reporting and show that a credible equilibrium may exist where, compared to earnings reported without discretion, better informed managers report smoother earnings by smoothing the transitory component when news is good and report earnings that accentuate the intertemporal differences when news is bad. This policy results in smoother earnings being of higher quality, when quality is defined as a lower deviation from the long run value of the firm. We show that a very similar strategy is optimal when investors are naive and act as if managers have no discretion. Our results on earnings quality hold because a pooling equilibrium exists when the manager can distinguish only between the first period permanent and transitory earnings components. When the manager cannot distinguish among the components or when he knows the components in both periods, our results fail to hold, as we show that the equilibria in these cases are partially or fully separating ones. Furthermore, our work supports and explains a number of empirical phenomena, including alleged differences between public forecasts, whisper forecast and reported earnings, claims that better firms report higher quality earnings and the assertion that positive earnings surprises are higher quality than negative surprises.