Income smoothing may result in increased perceived riskiness: Evidence from bid-ask spreads around loss announcements

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Prior studies suggest that income smoothing may be used as an earnings management tool by managers, and is associated with stock price declines when companies subsequently break smoothing patterns. We contend that investors' negative reaction in these situations is also driven by their magnified concerns about firm information risk, in addition to their decreased earnings expectations. Consistent with this argument, we find that bid-ask spreads around unexpected loss announcements are greater when preceded by higher levels of income smoothing. Furthermore, total spreads before the loss announcements were not greater for firms that exhibited higher income smoothing but had not reported earlier losses. This suggests that investors had difficulties seeing through managerial opportunistic motives before the unexpected loss announcements. Additionally, we find that institutional ownership and sell-side analyst coverage appear to moderate the positive association between income smoothing and bid-ask spreads, consistent with the monitoring role institutional investors and financial analysts play in constraining managerial opportunism. We also detect a significant decrease in the extent of income smoothing following loss announcements. Overall, our results are consistent with the view that income smoothing may be viewed by investors as being motivated by managerial opportunism instead of as communicating the true earnings results. Further analysis suggests that pursing a moderate amount of volatility in reported earnings may be the optimal financial reporting policy.