Income Smoothing and Sophisticated Investor Preferences

Abstract

This paper investigates whether sophisticated market participants, namely institutional investors and financial analysts, value smoothness in earnings. In particular, I investigate whether these market participants value smoothness in earnings differently depending on the source of such smoothness, i.e., depending on whether the income streams are naturally smooth versus whether they have been manipulated by firms to appear smooth using real or artificial smoothing techniques ('managed' income smoothing). Further, I examine whether the smoothing decisions made by firms are consistent with the preferences of institutional investors and analysts. The evidence indicates that analyst following is positively associated with natural smoothness in income, and both analyst following and institutional investment are negatively associated with managed smoothness in income. The results also indicate that income smoothing is less prevalent in firms with higher analyst following and institutional investment. I interpret the above evidence as indicative of managers' tendencies to smooth income less using real and artificial techniques, given that such activities are penalized by sophisticated market participants. The evidence presented here also signifies the importance of capital market considerations in managers' reporting decisions.