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Earnings' Quality and Smoothing
Michael T Kirschenheiter, Purdue University
Nahum D Melumad, Columbia University
ABSTRACT. We study a model of financial reporting and show that a credible equilibrium may exist where, compared to earnings reported without discretion, better informed managers report smoother earnings by smoothing the transitory component when news is good and report earnings that accentuate the intertemporal differences when news is bad. This shows smoother earnings are higher quality. A similar strategy is optimal when investors are naïve. When the manager cannot distinguish among the components or when he knows the components in both periods, this no longer holds. Our work explains a number of empirical phenomena, including alleged differences between public forecasts, whisper forecast and reported earnings, claims that better firms smooth and report higher quality earnings and that positive earnings surprises are higher quality.
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