Conclusion
In a recent survey by Graham et al. (2005), 78 percent of CFOs admit to taking value-destroying real economic actions to achieve smoother earnings paths. Recently, Acharya and Lambrecht (2015) analytically show that real smoothing is used to manage investors’ expectations to deflect intervention. Although real smoothing has the potential to impair shareholder value, prior studies have not empirically examined its value implications to shareholders. In this study, we investigate whether and when real smoothing influences stock price crash risk. Using U.S. data for 1993 through 2014, we find a robust, positive association between real earnings smoothing and stock price crash risk over and above discretionary accruals. This result suggests that real smoothing enables managers to hide bad news, continue poor-performing projects, conceal asset diversions, and engage in ineffective risk management. However, we find the effect of real smoothing on crash risk is mitigated when firms’ credit ratings shift from minus to middle notch ratings, suggesting that real smoothing can be informative when firms have less pressure to use it to meet credit rating goals. We also find the impact of real smoothing on crash risk is more pronounced when firm uncertainty is higher, product market competition is lower, and balance sheet constraint is higher. Overall, our results highlight the adverse effect of real earnings smoothing on shareholder value. An important question unanswered in our study is the relation between real earnings smoothing and accrual earnings smoothing. It is possible that firms resort to real smoothing when they face higher costs or more constraints in undertaking accrual-based smoothing. Future research may benefit from considering the pecking order, if any, between real smoothing and accrual smoothing.
