Measuring investors’ assessment of earnings persistence: do investors see through smoothed earnings?

Measuring investors’ assessment of earnings persistence: do investors see through smoothed... 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. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Measuring investors’ assessment of earnings persistence: do investors see through smoothed earnings?

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Publisher
Springer US
Copyright
Copyright © 2013 by Springer Science+Business Media New York
Subject
Economics / Management Science; Finance/Investment/Banking; Accounting/Auditing; Econometrics; Operations Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1007/s11156-013-0358-8
Publisher site
See Article on Publisher Site

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.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Mar 6, 2013

References

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