Do Smooth Earnings Lower Investors’ Perceptions of Investment Risk?

February 25, 2011 @ 1:30 pm – 3:00 pm America/New York Timezone
Georgia State University
35 Broad Street Northwest, Atlanta, GA 30303

CEAR Seminar Room – RCB 1120 – from 1:30 – 3:00

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Prior research provides mixed evidence concerning whether smooth earnings lower investors’ perceptions of investment risk. In this paper, we use two experiments to examine whether and why the presence of smooth earnings lowers investors’ risk judgments. In our first experiment, participants perceived a firm with smooth earnings to have lower investment risk when the earnings line item was present than when absent. This finding is consistent with investors’ focused attention on earnings driving the relation between smooth earnings and risk judgments, as proposed by Hirshleifer and Teoh’s [2009] ‘limited attention’ hypothesis. In a second experiment, we consider whether investors’ perceptions of managers’ reporting discretion broaden their attention beyond smooth earnings. We find that the risk judgments of participants who perceived management to have more reporting discretion were less influenced by the presence of smooth earnings. Overall, our study indicates that smooth earnings lower investors’ risk judgments due to earnings’ role as a summary statistic. However, factors that lead investors to focus on the separate components of earnings, such as the availability of reporting discretion to managers, mitigate the impact of smooth earnings on investors’ risk judgments.