Can 'Big Bath' and Earnings Smoothing Coexist as Equilibrium Financial Reporting Strategies?

We study a model of financial reporting where investors infer the precision of reported earnings. Reporting a larger earnings surprise reduces the inferred earnings precision, dampening the impact on firm value of reporting higher earnings, and providing a natural demand for smoother earnings. We show that for sufficiently quot;badquot; news, the manager under-reports earnings by the maximum, preferring to take a quot;big bathquot; in the current period in order to report higher future earnings. If the news is quot;goodquot;, the manager smoothes earnings, with the amount of smoothing depending on the level of cashflows observed. He either over-reports or partially under-reports for slightly good news, and gradually increases his under-reporting as the news gets better, until he is under-reporting the maximum amount for sufficiently good news. This result holds both when investors are quot;naivequot; and ignore management's ability to manipulate earnings, or quot;sophisticatedquot; and correctly infer management's disclosure strategy