Measuring investors' assessment of earnings persistence : Do investors see through smoothed earnings?

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review

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Original languageEnglish
Pages (from-to)691-708
Journal / PublicationReview of Quantitative Finance and Accounting
Volume42
Issue number4
Online published6 Mar 2013
Publication statusPublished - May 2014

Abstract

Prior studies document that investors value persistent earnings more than transitory earnings. This argument offers incentives to managers to smooth their reported earnings and make them look more persistent. This study examines whether investors are misled by management's income-smoothing behavior and whether they can correctly assess the persistence of smoothed earnings. Using a simple theoretical model, this paper shows that investors' assessment of earnings persistence can be derived from their reactions to reported earnings, which is the ratio of the coefficient on earnings change relative to the coefficient on earnings level in the return-earnings relation. Empirical results show that investors' assessment of earnings persistence is negatively associated with the level of income smoothing after controlling for time-series persistence of earnings and hence suggest that investors understand that the high persistence of smoothed earnings is not real and they discount the persistence of smoothed earnings when they react to such earnings news. © 2013 Springer Science+Business Media New York.

Research Area(s)

  • Earnings persistence, Income smoothing, Time-series earnings process, Valuation of earnings