Higher ERC or Higher Future ERC from Income Smoothness? - The Role of Information Environment

We examine the differential effects of income smoothness on value-relevance of current future earnings (termed as earnings response coefficient, ERC, and future earnings response coefficient, FERC, respectively) as affected by different information environments. In theory, if reported earnings are permanent, earnings should explain concurrent returns fully. In this case, the FERC should approach zero. However, a rich information environment provides more information that helps the market better assess the firm’s future profitability. To the extent that current permanent earnings cannot fully predict future realized earnings, we should find a positive FERC in rich information environment. Based on the premise that smoothing brings reported earnings closer to permanent earnings, we predict and find that for firms with poor information environment, income smoothness improves ERC but not FERC. For firms with superior information environment, income smoothness improves FERC. We also find higher FERC when earnings are less smoothed for firms in poorer information environment. Many recent studies have focused solely on FERC in assessing the informativeness of earnings. We remind researchers that theoretically more value-relevant earnings do not effectively improve FERC in an environment with little or no other information.