Earnings' Quality and Smoothing


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Abstract

We study a model of financial reporting involving discretion and private information. We show that a credible equilibrium exists and analyze the reported earnings in equilibrium.  We the reported earnings with earnings reported without discretion, and show that better informed managers report smoother earnings by smoothing the transitory component when news is good, while they report earnings that accentuate the intertemporal differences when news is bad. This reporting policy results in “higher quality earnings,” where quality is defined as a deviation from the long run value of the firm. We show that a very similar strategy is optimal when investors are naïve and act as if managers have no discretion. When the manager cannot distinguish among the value flow components or when he knows the components in both periods, this result no longer holds.  Our work supports and sheds light on a number of empirical phenomena, including: (i) documented differences between public forecasts, whisper forecast and reported earnings, (ii) claims that better firms report higher quality earnings and (iii) the assertion that positive earnings surprises are higher quality than negative surprises.
 
Contact information:
Paolo Perego
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