Sources of Earnings Variability and Their Effect on Earnings Forecasts

Previous research shows that analysts' forecasts of earnings do not fully incorporate information contained in reported earnings variability. This study investigates whether the inefficient forecasting is due to a failure to incorporate observable information on two components of earnings variability, namely, variability in operating performance and income smoothing. Our portfolio results show that analysts' forecasts fully incorporate information contained in earnings variability for firms with high income smoothing, and for firm with low variability in operating performance. Analysts also appear to recognize the permanence of earnings associated with firms with low variability in operating performance, and use this information to correct for past forecast errors