Earnings Smoothing as Information Signaling or Garbling: A Review of Literature

Abstract

Earnings smoothing, which refers to the action of managers managing earnings to reduce fluctuations of reported earnings, is a special type of earnings management because while earnings smoothing may be used to distort shareholders and creditors' view of corporate actual performance, it may also serve as a tool to communicate corporate private information of future earnings to the aforementioned stakeholders. Hence, it comes to no surprise when prior literatures reveal that the studies on the role of earnings smoothing are divided into two streams: as information signaling and information garbling. This paper aims to review prior literatures, specifically on the role of earnings smoothing either as information signaling or garbling based on four themes: firm value, financing need, compensation contract and outsiders' intervention. This paper reviews journal articles gathered from Web of Science database. Based on the shortcomings of prior literatures, this paper highlights avenue for future research.

Income Smoothing, Default Risk and Stock Price Crashes: The Moderating Effect of Manager Age

“…If the signal successfully changes the market's perception, then market value increases and stock price crashes can be suppressed. This argument is consistent with Shabani & Sofian (2018) who find a negative relationship between income smoothing and bankruptcy risk.…”

Income smoothing and firm value in a regulated market: the moderating effect of market risk

“…This implies that smoothing carried out by Nigerian firms appears to be deliberate rather than natural, and investors priced firms' shares that engaged in smoothing, particularly intentional smoothing low. Also, smoothening income reduces the shock/ surprise in the market when the reported income by managers meets investors' forecasted income (Baik et al, 2019;Bartov et al, 2002;Chen et al, 2016;Lyimo, 2014;Oler et al, 2016;Shabani and Sofian, 2018;Shubita, 2015). This result is similar to the findings of Chen et al (2016); Novianti and Firmansyah (2020); Susanto andPradipta, 2019, andYu et al (2017) which revealed that investors perceive smoothing as an increase in risk and a means of managerial opportunism resulting in reduced firm value.…”

The relationship between income smoothing and the cost of debt: evidence from the United Kingdom and Nigeria

“…This could be achieved by avoiding the disclosure of any financial losses and, consequently, efficiently attaining their strategic goals (Aflatooni and Nikbakht, 2010; Li and Richie, 2016). Hence, from this view, the presence of income smoothing could lead to distorted information, higher levels of information opacity and less informativeness of reported earnings, which precludes the process of depicting the true economic performance of the entity (Bhattacharya et al , 2003; Shabani and Sofian, 2018).…”