Income Smoothing and Idiosyncratic Volatility

In this paper we empirically evaluate the widespread belief of managers that income smoothing results into lower stock market risk. Multivariate regressions confirm that a negative relation exists between discretionary income smoothing and idiosyncratic volatility. Further analysis indicates that smoothing is also related to analyst forecast patterns, institutional investors, share liquidity, and firm risk, all of which are independently related to volatility. Finally, we find that in cases where income smoothing appears to reduce information quality and/or otherwise lacks credibility as a signal of reduced equity risk, it is associated with higher stock return volatility, which suggests that in practice investor responses to income smoothing may be both more sophisticated and variable than previously realized