Income Smoothing Bid Ask Spreads

Journal of Corporate Finance 48 (2018) 442–459
Contents lists available at ScienceDirect
Journal of Corporate Finance

journal homepage: www.elsevier.com/locate/jcorpfin
Income smoothing may result in increased perceived riskiness:

Evidence from bid-ask spreads around loss announcements
Kun Yu a,⁎, Moshe Hagigi b, Scott D. Stewart c
a
College of Management, University of Massachusetts Boston, 100 Morrissey Blvd., Boston, MA 02125, United States
b
Questrom School of Business, Boston University, 595 Commonwealth Ave., Boston, MA 02215, United States
c
S.C. Johnson Graduate School of Management, Cornell University, Sage Hall, Ithaca, NY 14853, United States
a r t i c l e i n f o a b s t r a c t
Article history: Prior studies suggest that income smoothing may be used as an earnings management tool by
Received 13 June 2017 managers, and is associated with stock price declines when companies subsequently break
Received in revised form 17 November 2017 smoothing patterns. We contend that investors' negative reaction in these situations is also
Accepted 20 November 2017
driven by their magnified concerns about firm information risk, in addition to their decreased
Available online 22 November 2017
earnings expectations. Consistent with this argument, we find that bid-ask spreads around un-
expected loss announcements are greater when preceded by higher levels of income smooth-
JEL classification: ing. Furthermore, total spreads before the loss announcements were not greater for firms that
D82
exhibited higher income smoothing but had not reported earlier losses. This suggests that in-
G14
vestors had difficulties seeing through managerial opportunistic motives before the unexpected
M41
loss announcements. Additionally, we find that institutional ownership and sell-side analyst
Keywords:
coverage appear to moderate the positive association between income smoothing and bid-
Income smoothing
ask spreads, consistent with the monitoring role institutional investors and financial analysts
Earnings volatility
Bid-ask spreads play in constraining managerial opportunism. We also detect a significant decrease in the ex-
tent of income smoothing following loss announcements. Overall, our results are consistent
with the view that income smoothing may be viewed by investors as being motivated by man-
agerial opportunism instead of as communicating the true earnings results. Further analysis
suggests that pursing a moderate amount of volatility in reported earnings may be the optimal
financial reporting policy.
© 2017 Elsevier B.V. All rights reserved.
1. Introduction
The inclination to favor income smoothing has been widely discussed in the academic and practitioner literature for many
years and has been extensively documented. Prior research has provided empirical evidence that income smoothing can improve
information quality (e.g., Tucker and Zarowin, 2006), reduce firm risk (e.g., Lev and Kunitzky, 1974; Michelson et al., 1995), and
lower the cost of capital (e.g., Francis et al., 2004; Trueman and Titman, 1988; Jung et al., 2013). It appears that a smoothed pat-
tern of earnings is highly desired by both managers and investors. Yet, several recent studies argue that income smoothing may
be used to manipulate earnings and hide bad news (e.g., Levitt, 1998; Leuz et al., 2003), reflecting managerial opportunism. Chen
et al. (2017) document a positive association between income smoothing and stock price crash risk, which supports the notion
⁎ Corresponding author.
E-mail address: kun.yu@umb.edu (K. Yu).
https://doi.org/10.1016/j.jcorpfin.2017.11.007
0929-1199/© 2017 Elsevier B.V. All rights reserved.
K. Yu et al. / Journal of Corporate Finance 48 (2018) 442–459 443
that earnings smoothing might be viewed by the market as being motivated by managerial opportunism. Along the same line, our
study aims to tackle other dimensions of this issue by investigating the effect of historical income smoothing on information risk
around earnings announcements, when reported earnings break a smoothed stream of earnings. This investigation can not only
help us understand whether investors take historical income smoothing levels into account when evaluating firm information
risk, but also shed light on whether investors accept the “managerial opportunism” view of income smoothing.
Our main analyses focus on firms with unexpected loss announcements in the current quarter. Prior literature (e.g., Degeorge
et al., 1999) suggests that firms have strong motivation to avoid reporting losses. A firm reporting an unexpected loss provides an
unambiguous signal that management is more likely to have concealed poor performance through income smoothing instead of
conveying private information to the market, and that management had been forced to release bad news in the current quarter.
We argue that both the increase in information risk (as measured by abnormal bid-ask spreads) and total information risk (as
measured by total bid-ask spreads) perceived by investors around unexpected loss announcements should be higher for firms
with higher levels of income smoothing, if investors view historical income smoothing as a manifestation of managerial opportun-
ism for firms with unexpected loss announcements.
Prior studies have also provided evidence consistent with institutional investors and financial analysts constraining managerial
opportunism as external monitors of managers (e.g., Bushee, 1998; Yu, 2008). If institutional investors and financial analysts limit
managerial opportunistic behavior, firms with higher institutional ownership or analyst following are less likely to engage in earn-
ings management through income smoothing. Therefore, we contend that the positive association between income smoothing
levels and the perceived information risk should be more pronounced for firms with lower institutional ownership or analyst fol-
lowing. Accordingly, this paper examines 1) whether historical income smoothing is associated with information risk around un-
expected loss announcements, and 2) whether institutional ownership or analyst following moderates this association.
We consider two measures of income smoothing. Our main measure of income smoothing is calculated as the correlation be-
tween the change in pre-discretionary earnings and the change in discretionary accruals (e.g., Tucker and Zarowin, 2006). This
correlation-based measure is more likely to capture discretionary income smoothing due to managerial opportunism. The alterna-
tive measure of income smoothing is based on earnings volatility (e.g., Mcinnis, 2010), and is calculated as the standard deviation
of net income scaled by total assets divided by the standard deviation of cash flows from operations scaled by total assets. This
measure can be used to separate smoothing from non-smoothing firms, and is not conditional on the choice of discretionary ac-
crual models. We find qualitatively similar results based on both measures.
Using a sample of 6243 smoothing firms with unexpected loss announcements from 1996 to 2015, we discover that both ab-
normal and total bid-ask spreads around unexpected loss announcements are positively associated with historical income
smoothing levels, even after controlling for the other determinants of bid-ask spreads, such as the magnitude of the news con-
veyed by earnings announcements, firm size, abnormal accruals, and the changes in firm fundamentals. The results are consistent
with the view that historical income smoothing is perceived as an earnings management tool by investors, leading to a higher
level of information risk around unexpected loss announcements. Furthermore, consistent with the argument that institutional in-
vestors and financial analysts act as external monitors and constrain income smoothing due to managerial opportunism, we find
that the positive association between total bid-ask spreads and income smoothing levels around unexpected loss announcements
is less manifested for firms with higher institutional ownership or analyst following.
We employ a propensity score matching (PSM) technique to further address the concern that bid-ask spreads around unex-
pected loss announcements may be driven by the changes in firm fundamentals. 1147 high smoothing firms are matched with
1147 low smoothing firms based on the changes in firm fundamentals and the other observable firm characteristics. We find
that both abnormal and total bid-ask spreads around unexpected loss announcements for high smoothing firms are larger than
those for low smoothing firms. The results confirm that the positive association between income smoothing and bid-ask spreads
around unexpected loss announcements is not driven by the changes in firm fundamentals.
Next, we examine whether investors can see through income smoothing even before unexpected loss announcements by in-
vestigating the association between bid-ask spreads before unexpected loss announcements and income smoothing levels. The re-
sults based on the full sample indicate that bid-ask spreads before unexpected loss announcements are higher for firms with
smoother earnings. However, we learn that this is not in conflict with unexpected loss announcements providing an ambiguous
signal that historical income smoothing may be driven by managerial opportunism. Specifically, when we partition the sample
based on whether firms have reported any losses during the past 20 quarters prior to current loss announcements, we find
that the positive association between pre-announcement bid-ask spreads and income smoothing levels is driven by firms that
have previously reported losses. This suggests that investors have difficulty determining whether income smoothing is due to
managerial opportunism for firms lacking previous loss announcements.
Our results are robust to using the income smoothing measure based on earnings volatility and two alternative samples of
smoothing firms that have broken previous income smoothing patterns. As an additional analysis, we compare the income
smoothing levels before and after loss periods. The results indicate a significant decrease in the extent of income smoothing
from the pre-loss to the post-loss period for smoothing firms, consistent with the view that managers' opportunistic motivation
to smooth income is reduced following loss announcements due to investors' magnified concerns about firm information risk.
Finally, we attempt to shed some light on the optimal amount of earnings volatility by examining the non-linear association
between abnormal bid-ask spreads around loss announcements unexplained by cash flow volatility and earnings volatility. Differ-
ent cutoff points for earnings volatility are entertained. Our results suggest that the non-linear association between abnormal bid-
ask spreads and earnings volatility appears to be the most pronounced when the cutoff point is the 40th percentile of earnings
volatility. In particular, when earnings volatility is below its 40th percentile, there is a negative association between abnormal
444 K. Yu et al. / Journal of Corporate Finance 48 (2018) 442–459
bid-ask spreads and earnings volatility; when earnings volatility is above this threshold, abnormal bid-ask spreads no longer vary
with earnings volatility. Taken together, the results suggest that excessive smoothing might not be the best strategy for managers,
and a moderate amount of volatility, such as of the 40th percentile of earnings volatility, in reported earnings may be optimal in
terms of minimizing the increase in information risk around potential future loss announcements.
This paper is closely related to prior studies examining the implications of breaking a string of continuous increase in earnings
(e.g., Barth et al., 1999; Myers et al., 2007; Ke, 2001). Our paper differs from these studies in the following two aspects. First, our
sample of smoothing firms is based on a broader income smoothing measure, while the current literature focuses mainly on a
special pattern of income smoothing using a sample of firms with consecutive earnings increases. Second, while the literature
has focused mainly on the impact of the string breaking on stock prices and expected future profitability, we have aimed at study-
ing the impact of breaking the smoothed earnings pattern on perceived firm risk. We thus examine the effect of income smooth-
ing on bid-ask spreads, which are more likely to reflect the perceived riskiness than the expected profitability of the firm. Our
results suggest that the decrease in stock prices following the breaking of the smoothing pattern documented in prior literature
should be at least partly driven by the increase in firm information risk.
This study strives to contribute to the literature in the following ways. First, in pointing out the potential drawbacks of exces-
sive income smoothing (e.g., Leuz et al., 2003; Bhattacharya et al., 2003; Chen et al., 2017), we document a positive association
between income smoothing and bid-ask spreads when firms break the stream of smoothed earnings. The results are consistent
with the view that income smoothing may reflect managerial opportunism and is thus associated with higher information risk
around earnings announcements breaking historical smoothing patterns. Second, we add another layer to the literature on the
monitoring roles of institutional investors and financial analysts (e.g., Shleifer and Vishny, 1986; Yu, 2008) by providing additional
evidence that institutional investors and financial analysts may have a restraining effect on the opportunistic motivations of man-
agers to smooth reported earnings. Finally, this paper complements prior studies that examine bid-ask spreads around earnings
announcements (e.g., Lee et al., 1993; Yohn, 1998). Empirical research has provided mixed evidence about changes in information
risk around earnings announcements.1 Our results suggest that investors take income smoothing levels into account when eval-
uating firm information risk and thus whether there is a change in bid-ask spreads around earnings announcements may be con-
ditional on the extent of historical income smoothing.
This paper also has important practical implications. The results indicate that earnings smoothing may not always be an opti-
mal choice for managers, especially if the nature of the firm's business is such that reporting a loss, sometime in the future, seems
to be likely. In such a case, smoothing earnings might backfire by amplifying information risk due to the breaking of historical
income smoothing patterns. While managers with myopic view may prefer to report smoothed earnings, those with a longer
time horizon are advised to be careful of the potential consequences of such a strategy.
In the following section, we review prior literature and formalize our hypotheses. We outline the research methodology in
Section 3. The sample and descriptive statistics are described in Section 4. We present our main empirical results in Section 5
and additional analyses in Section 6. The final section summarizes the paper and provides concluding remarks.
2. Related literature and hypothesis development
2.1. Potential benefits of income smoothing
Prior studies have largely focused on how firms may benefit from income smoothing. Theoretical research generally provides
support for managers' income smoothing behavior. For example, Lambert (1984) shows that income smoothing may originate
from the moral hazard problem and reflect an optimal equilibrium behavior pursued by managers. Kirschenheiter and
Melumad (2002) show that both income smoothing and the “big bath” phenomena are part of an equilibrium strategy such
that managers prefer to take “big baths” in the cases of sufficiently bad news and conduct income smoothing otherwise. Goel
and Thakor (2003) suggest that income smoothing can mitigate liquidity traders' concerns about their information disadvantages
and thus increases stock prices.
A large number of studies also provide empirical evidence consistent with the argument that income smoothing can improve
information quality (e.g., Tucker and Zarowin, 2006), reduce firm risk (e.g., Lev and Kunitzky, 1974; Michelson et al., 1995) and
lower the cost of capital (e.g., Francis et al., 2004; Trueman and Titman, 1988; Jung et al., 2013). De Jong et al. (2014) provide
survey evidence that both managers and analysts believe smoothing earnings reduces the perceived riskiness of the firm by stake-
holders. In addition, Dichev and Tang (2009) document a negative association between earnings volatility and earnings predict-
ability. Affleck-Graves et al. (2002) find that firms with more predictable earnings exhibit lower bid-ask spreads around earnings
announcements and lower cost of capital. Taken together, these two studies suggest that firms with less earnings volatility should
have lower bid-ask spreads and lower costs of capital.
2.2. Potential drawbacks of income smoothing
Unlike the traditional view that income smoothing is beneficial to shareholders, more recent studies began to question earn-
ings smoothness as a desirable attribute. Dechow and Skinner (2000) and Dechow et al. (2010) indicate that it is difficult to
1
For example, Morse and Ushman (1983) find no significant changes in bid-ask spreads around earnings announcements, while Lee et al. (1993) and Yohn (1998)
document significant increases in bid-ask spreads around earnings announcements.
differentiate income smoothing that increases earnings persistence from opportunistic earnings management. Furthermore, Leuz
et al. (2003) view earnings smoothing as a device used by insiders to obfuscate their consumption of private control benefits;
Bhattacharya et al. (2003) argue that earning smoothing makes earnings less transparent. Consistent with these arguments,
Myers et al. (2007) offer evidence that firms use income smoothing as an earnings management tool to maintain artificially
long strings of increasing EPS. Similarly, Lang et al. (2012) and Lang and Maffett (2011) find that discretionary income smoothing
is associated with greater opacity and lower liquidity.
Several studies have also questioned the positive link between income smoothing and the cost of capital or firm value. For ex-
ample, Bao and Bao (2004) argue that lower variability of earnings does not guarantee higher firm value. They find that earnings
quality plays an important moderating role in the value relevance of smoothed earnings. Rountree et al. (2008) find that the pos-
itive association between firm value and earnings volatility is driven by the cash flow component of earnings, but not the accrual
component. Chen et al. (2017) document a positive association between income smoothing and stock price crash risk, consistent
with the view managers use income smoothing opportunistically to hide bad news. In addition, Mcinnis (2010) finds no relation
between earnings smoothness and average stock returns over the last 30 years, suggesting that income smoothing may not lead
to a lower cost of capital.
2.3. Hypotheses
This study intends to provide additional support to the notion that income smoothing may be motivated by managerial oppor-
tunism. We thus focus on firms with unexpected loss announcements in the current quarter. Prior literature suggests that man-
agers have strong motivation to avoid reporting losses (e.g., Burgstahler and Dichev, 1997; Beatty et al., 2002). Degeorge et al.
(1999) find that among the three common earnings benchmarks (avoiding losses, avoiding earnings decreases, and exceeding an-
alysts' forecasts), it is the most important for firms to avoid reporting losses. When a smoothing firm has no way but to report a
loss, it signals to the market that the firm probably concealed previous poor performance through income smoothing. In contrast,
if a firm has employed income smoothing to communicate private information and to report an earnings number that managers
believe to be persistent, it is less likely to report an unexpected loss. Therefore, unexpected loss announcements provide a setting
where income smoothing is more likely to be a manifestation of managerial opportunism.2
Bid-ask spreads have been used to measure information risk extensively in the literature (e.g., Fu et al., 2012; Callahan et al.,
1997). Following prior studies (e.g., Bushee et al., 2010; Blankespoor et al., 2014), we use abnormal (change in) bid-ask spreads to
measure the change in information risk induced by unexpected loss announcements, and total bid-ask spreads to measure the
level of information risk around unexpected loss announcements. While Verrecchia (1982) and Diamond (1985) argue that earn-
ings announcement should reduce information asymmetry by disseminating information to the market, Kim and Verrecchia
(1994) suggest that information risk should increase around earnings announcements, if investors differ in their ability to process
earnings information. Consistent with this argument, Lee et al. (1993) and Yohn (1998) document significant increases in bid-ask
spreads around earnings announcements.
When a smoothing firm reports a smoothed stream of earnings in the past, but has to report an unexpected loss in the current
period, investors are surprised by the breaking of the historical income smoothing pattern, leading to a significant increase in bid-ask
spreads around unexpected loss announcements. In particular, prior research (e.g., Hayn, 1995; Li, 2011) suggests that investors ap-
pear to have difficulty in understanding reported losses. While informed investors may understand the persistence of losses through
private information acquisition, less informed investors may not fully understand the implications of losses for future returns. There-
fore, an unexpected loss announcement is likely to induce more heterogeneous beliefs among investors and to trigger private infor-
mation search by informed investors, which in turn leads to an increase in information asymmetry around the loss announcement.
In contrast, for a smoothing firm that has reported a more volatile pattern of earnings in the past, investors are more likely to
be already aware of information asymmetry risk prior to the current loss announcement. Thus, the current loss announcement
will trigger less concern among investors and the increase in information asymmetry around the announcement would be less
manifested for a smoothing firm with more volatile earnings. The above discussion suggests that the increase in information
risk around unexpected loss announcements, as measured by abnormal bid-ask spreads, should be higher for smoothing firms
with higher levels of income smoothing. Therefore, we have the following hypothesis stated in the alternative form:
Hypothesis 1. Abnormal bid-ask spreads around unexpected loss announcements are higher for smoothing firms with smoother
income.
More importantly, unexpected loss announcements provide an unambiguous signal that smoothing firms may have concealed
bad news opportunistically in the past through income smoothing. Upon observing losses reported by a smoothing firm, investors
realize that historical earnings smoothing may have been used as an earnings management tool rather than a mechanism to con-
vey private information to the market. Ceteris paribus, the smoother the earnings, the more surprised at loss announcements and
concerned about managerial opportunism investors become. As a result, firms with smoother earnings would be perceived to
withhold more private information and to possess higher information asymmetry risk around unexpected loss announcements.
In other words, total information risk, as measured by total bid-ask spreads around unexpected loss announcements, should be
positively associated with income smoothing levels for smoothing firms. Our second hypothesis is thus formulated as follows:
2
If a loss has been anticipated, any change in bid-ask spreads or information risk will have manifested before the actual loss announcement.
Hypothesis 2. Total bid-ask spreads around unexpected loss announcements are higher for smoothing firms with smoother
income.
Prior research (Shleifer and Vishny, 1986) suggests that institutional investors and financial analysts can reduce agency cost
and information asymmetry between managers and shareholders. Empirical studies have also provided extensive evidence consis-
tent with the monitoring role of institutional investors (e.g., Healy and Palepu, 2001; Bushee, 1998, 2001; Ramalingegowda and
Yu, 2012) and financial analysts (e.g., Yu, 2008; Irani and Oesch, 2013). Institutional investors and financial analysts not only
have strong motivation to act as external monitors of managers, but also possess required expertise and resources to constrain
managerial opportunistic behaviors. Firms with higher institutional ownership or analyst following are thus less likely to engage
in earnings management through income smoothing. For a given level of income smoothing, the perceived information asymme-
try problem around unexpected loss announcements should be less severe for firms with higher institutional ownership or analyst
following. Therefore, investors would be less concerned with managerial opportunism associated with historical income smooth-
ing for firms with higher institutional ownership or analyst following, suggesting a less positive association between total bid-ask
spreads and income smoothing levels for these firms. Our third hypothesis is stated as follows:
Hypothesis 3. The positive association between total bid-ask spreads around unexpected loss announcements and income
smoothing levels is less manifested for firms with higher institutional ownership or analyst following.
3. Research methodology
3.1. Measures of income smoothing
To capture income smoothing induced by managerial opportunism, we use the income smoothing measure (ISRHO) as sug-
gested by Tucker and Zarowin (2006). Following Chen et al. (2017), we first estimate discretionary accruals using the following
modified Jones model:
ACC t =TAt−1 ¼ β1 ð1=TAt−1 Þ þ β2 ΔSALESt =TAt−1 þ β3 PPEt =TAt−1 þ β4 ROAt þ εt ð1Þ
ACCt is total accruals for quarter t, defined as the difference between earnings before extraordinary items and cash flows from
continuing operations. TAt − 1 is total assets at the end of quarter t − 1. ΔSALESt is the change in sales from quarter t − 1 to quar-
ter t. PPEt is the property, plant, and equipment at the end of quarter t. ROAt is the return on assets for quarter t, calculated as
income before extraordinary items divided by total assets. Model (1) is estimated for each 2-digit SIC industry in each quarter.
The regression residuals are the estimated discretionary accruals (ABACCt). Pre-discretionary earnings are then calculated as in-
come before extraordinary items minus discretionary accruals. ISRHO is defined as the correlation between the change in pre-dis-
cretionary earnings and the change in discretionary accruals during the past 20 quarters.3 A more negative value of ISRHO
indicates a higher level of income smoothing.
While ISRHO captures discretionary income smoothing, it is affected by the choice of discretionary accrual models. In addition,
it is not easy to differentiate smoothing from non-smoothing firms based on ISRHO. We thus consider an alternative measure of
income smoothing (ISVOL) based on the volatility of earnings (e.g., Mcinnis, 2010). More specifically, ISVOL is calculated as the
standard deviation of net income scaled by total assets divided by the standard deviation of cash flows from operations scaled
by total assets during the past 20 quarters. Similar to ISRHO, lower values of ISVOL indicate higher levels of income smoothing.
The main advantage of ISVOL is that it can be used to separate smoothing from non-smoothing firms. Following prior research
(e.g., Bao and Bao, 2004), a firm is classified as a smoothing (non-smoothing) firm if ISVOL is less (more) than one. We conduct
our main analyses based on ISRHO and use ISVOL as a robustness check.4
3.2. Empirical models
We use the following model to examine the effect of income smoothing on abnormal and total bid-ask spreads around unex-
pected loss announcements for smoothing firms.
SPRDt ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t þ β5 ROA RANK t

þ β6 ΔROAt þ β7 ΔCURRt þ β8 ΔLEV t þ β9 LASTGAINt þ β10 TIMELOSSt ð2Þ
þ β11 LASTLOSSt þ β12 SMOOTH t þ fixed industry and quarter effects þ ε
3
Using the past 12 quarters instead of 20 quarters to estimate the correlation does not change our results qualitatively.
4
To address the concern that seasonal changes in earnings may affect our income smoothing measure, we repeat our analyses using an income smoothing measure
adjusted for seasonality (ISRHOADJ). Specifically, following prior literature (e.g., D'Souza et al., 2010), ISRHOADJ is calculated as the correlation between the seasonal
change in pre-discretionary earnings and the seasonal change in discretionary accruals during the past 20 quarters, where the seasonal change in pre-discretionary
earnings (discretionary accruals) is defined as the change in pre-discretionary earnings (discretionary accruals) between the current quarter and the same quarter
in the prior year. The untabulated results based on this measure are qualitatively similar to those reported in Table 4.
SPRDt is either abnormal bid-ask spreads (ABSRPDt) or total bid-ask spreads (TOTSPRDt). More specifically, ABSRPDt (TOTSPRDt)
is the cumulative daily abnormal (total) bid-ask spreads from 2 days before to 2 days after unexpected loss announcements for
quarter t.5 Following the literature (e.g., Amihud and Mendelson, 1989; Roulstone, 2003), bid-ask spreads are defined as the dif-
ference between the ask price and the bid price, scaled by the average of the ask price and the bid price. Daily abnormal bid-ask
spreads are then calculated as the bid-ask spread during the event day minus the mean bid-ask spread during the estimation win-
dow beginning 50 days before the event period and ending 21 days before the event period.
Model (2) controls for the common factors identified in the literature (e.g., Yohn, 1998; Affleck-Graves et al., 2002) that may also
affect bid-ask spreads around earnings announcements.6 ABSCARt is the absolute value of cumulative abnormal returns from 2 days
before to 2 days after unexpected loss announcements for quarter t. FEt is the logarithm of the absolute value of analysts' EPS forecast
error for quarter t. Prior research (e.g., Lee et al., 1993; Affleck-Graves et al., 2002) suggests a positive association between bid-ask
spreads and information content of earnings announcements measured by ABSCARt and FEt. We thus expect positive coefficients on
ABSCARt and FEt. SIZEt is firm size, defined as the logarithm of total assets at the end of quarter t. ABACCt is abnormal accruals estimat-
ed from the modified Jones model for quarter t. ROA_RANKt is the scaled decile rank of ROAt. Specifically, ROA_RANKt is calculated by
ranking ROAt into ten deciles (0 to 9) and dividing the decile number by 9 so that ROA_RANKt takes a value ranging between 0 and 1.
To address the concern that the change in bid-ask spreads around loss announcements may be driven by the changes in firm
fundamentals, we control for the changes in firm fundamentals around loss announcements by adding three additional variables:
ΔROAt, ΔCURRt, and ΔLEVt. ΔROAt is the change in the return on assets from quarter t − 1 to quarter t. ΔCURRt is the change in the
current ratio from quarter t − 1 to quarter t, where the current ratio is calculated as current assets divided by current liabilities.
ΔLEVt is the change in financial leverage from quarter t − 1 to quarter t, where financial leverage is calculated as total liabilities
divided by total assets.
In addition, we also add LASTGAINt, TIMELOSSt, and LASTLOSSt to control for the effects of previous losses on bid-ask spreads
around current loss announcements. LASTGAINt is a dummy variable, equal to one if the firm did not report any quarterly losses
during the past 20 quarters prior to loss announcements for quarter t, and zero otherwise. TIMELOSSt is a dummy variable, equal
to one if losses were reported in any of the past four quarters prior to loss announcements for quarter t, and zero otherwise.
LASTLOSSt is the return on assets for the most recent quarter with losses if the firm reported any quarterly losses during the
past 20 quarters prior to loss announcements for quarter t, and zero otherwise. The fixed industry and quarter effects are also
added to control for unobserved characteristics that are constant within industry and quarter. The variable of interest is SMOOTHt.
SMOOTHt is either ISVOLt or ISRHOt. Hypotheses 1 and 2 suggest that both ABSPRDt and TOTSPRDt should be negatively associated
with SMOOTHt for smoothing firms.
We use the following model to test H3 pertaining to the moderating role of institutional ownership and analyst following in
the association between total bid-ask spreads and income smoothing levels for smoothing firms.
TOTSPRDt ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t þ β5 ROA RANK t

þ β6 ΔROAt þ β7 ΔCURRt þ β8 ΔLEV t þ β9 LASTGAINt þ β10 TIMELOSSt
ð3Þ
þ β11 LASTLOSSt þ β12 SMOOTH t þ β13 INSt þ β14 INSt SMOOTHt
þ fixed industry and quarter effects þ ε
INSt is either institutional ownership (INSTt) or analyst following (AFt). INSTt is calculated as the percentage of common shares
held by institutions at the end of the calendar quarter prior to loss announcements for quarter t.7 Following prior literature (e.g.,
Huddart and Ke, 2007), AFt is defined as the natural logarithm of one plus the number of analysts following a firm prior to loss
announcements for quarter t. The other variables are as defined in model (2). The coefficient on INSt*SMOOTHt represents the ef-
fect of institutional ownership or analyst following on the association between total bid-ask spreads and income smoothing levels.
We expect a negative coefficient on SMOOTHt, but a positive coefficient on INSTt*SMOOTHt as suggested by H3.
4. The sample
We begin with all quarterly observations from the first quarter of 1996 to the last quarter of 2015 in Compustat Fundamentals
Quarterly. For each observation, non-missing quarterly earnings for 20 quarters (5 years) prior to the current quarter are required
to calculate income smoothing measures. We keep the observations with positive quarterly earnings forecasted by analysts but
losses reported in the same quarter to identify unexpected loss announcements. Bid-ask spreads and the absolute value of cumu-
lative abnormal returns around loss announcements are calculated using price information from CRSP. Analyst following, analyst
forecast, and forecast error are obtained from I/B/E/S. Institutional ownership is extracted from Thomson Reuters S34. We elimi-
nate firms in the financial industry (SIC codes 6000–6999), since additional regulation for financial firms may affect investors' per-
ception of firm risk.8 Finally, observations with missing values to calculate necessary variables are deleted. The final sample
includes 10,875 firm-quarter observations with unexpected losses from 1996 to 2015. We then partition the full sample based
5
Following Krinsky and Lee (1996) and Affleck-Graves et al. (2002), we also use abnormal adverse selection cost of bid-ask spreads to conduct our analyses. The
results are similar to those based on abnormal bid-ask spreads.
6
Following Yohn (1998), we repeat our analyses by adding trading volume and depth around loss announcements as additional control variables. Controlling for
trading volume and depth does not change our results qualitatively.
7
We also repeat our analysis using dedicated institutional ownership instead of total institutional ownership in model (4). The results using dedicated institutional
ownership are qualitatively similar to those reported in Table 6.
8
Including financial firms in our sample does not change any of our inferences.
Table 1
Descriptive statistics. This table reports the descriptive statistics of the main variables for the sample of smoothing firms vs. non-smoothing firms.
Smoothing firms (no. of obs. = 6243) Non-smoothing firms (no. of obs. = 4632)
Mean Std. Q1 Median Q3 Mean Std. Q1 Median Q3
ABSPRDt 0.003 0.042 −0.003 0.000 0.006 0.002 0.036 −0.002 0.000 0.004
TOTSPRDt 0.057 0.093 0.006 0.017 0.067 0.043 0.077 0.005 0.013 0.042
ISRHOt −0.903 0.130 −0.978 −0.945 −0.875 −0.416 0.448 −0.776 −0.527 −0.138
ISVOLt 0.547 0.236 0.356 0.540 0.739 2.581 2.470 1.285 1.739 2.801
ABSCARt 0.085 0.090 0.026 0.059 0.114 0.091 0.093 0.029 0.066 0.123
FEt −2.702 1.445 −3.912 −2.813 −1.772 −2.741 1.482 −3.912 −2.885 −1.897
SIZEt 6.715 1.795 5.428 6.607 7.898 6.703 1.871 5.461 6.606 7.944
ABACCt −0.014 0.052 −0.031 −0.009 0.010 −0.020 0.099 −0.031 −0.011 0.006
ROA_RANKt 0.667 0.288 0.444 0.778 0.889 0.627 0.304 0.444 0.667 0.889
ΔROAt −0.026 0.057 −0.032 −0.013 −0.003 −0.023 0.099 −0.032 −0.010 0.001
ΔCURRt −0.109 1.011 −0.219 −0.031 0.097 −0.109 1.663 −0.216 −0.024 0.121
ΔLEVt 0.018 0.065 −0.005 0.009 0.030 0.017 0.078 −0.006 0.007 0.029
LASTGAINt 0.167 0.373 0.000 0.000 0.000 0.020 0.139 0.000 0.000 0.000
TIMELOSSt 0.580 0.494 0.000 1.000 1.000 0.772 0.419 1.000 1.000 1.000
LASTLOSSt −0.014 0.026 −0.017 −0.006 −0.001 −0.047 0.094 −0.045 −0.014 −0.005
on ISVOL to identify the sample of smoothing (non-smoothing) firms with ISVOL less (more) than one. The smoothing (non-
smoothing) sample includes 6243 (4632) observations. The bottom 1% and top 1% regression residuals are deleted to mitigate
the effect of outliers in the regression analyses.
Table 1 provides the descriptive statistics of the main variables for the smoothing and non-smoothing samples. Consistent with
prior studies (e.g., Yohn, 1998), the means of abnormal bid-ask spreads (ABSPRD) for both samples are positive (mean = 0.003 and
0.002, respectively), indicating an increase in bid-ask spreads around the loss announcements.9 The untabulated results indicate that
the cumulative abnormal returns around unexpected loss announcements (CARt) for the smoothing firms is −2.5% (p-value b 0.00),
suggesting that the smoothing firms experienced significant decrease in stock prices around these announcements. This finding is con-
sistent with the negative implications of breaking the smoothing pattern for stock prices (e.g., Barth et al., 1999; Myers et al., 2007).
Taken together with the increase in bid-ask spreads, the results suggest that the decrease in stock prices following the breaking of
the smoothing pattern documented in prior literature should be at least partly driven by the increase in information risk. The mean
absolute value of the cumulative abnormal returns around the loss announcements (ABSCAR) is 8.5% and 9.1% for the smoothing
and non-smoothing samples, respectively, suggesting that the loss announcements conveyed significant information to the market.
In addition, for both samples, less than one fourth of the sample firms did not report any losses during the past 20 quarters
(Q3 of LASTGAIN = 0); more than one half of the sample firms reported a loss during the past four quarters prior to current
loss announcements (median of TIMELOSS = 1). Not surprisingly, the means of both ISRHO and ISVOL are smaller for the smooth-
ing sample (mean of ISRHO = −0.903; mean of ISVOL = 0.547) than the non-smoothing sample (mean of ISRHO = −0.416;
mean of ISVOL = 2.581). More importantly, while we use ISVOL to identify the sample of smoothing firms, there is a big overlap
in the smoothing firms if ISRHO is used to identify smoothers. In particular, the smoothing sample based on ISVOL is mainly com-
prised of firms with lower ISRHO (Q1 = −0.978 and Q3 = −0.875), while the non-smoothing sample generally includes firms
with larger ISRHO (Q1 = − 0.776 and Q3 = − 0.138). The results are consistent with smoothing (non-smoothing) firms
exhibiting more (less) negative correlation between the change in pre-managed earnings and the change in discretionary accruals.
Table 2 reports the industry distribution of the smoothing firms based on one-digit SIC codes. Approximately 52% of the sample
firms concentrate in the manufacturing industry with SIC codes 2000–3999. The Durable Manufacturing Industry (SIC: 3000–3999)
has the largest number of unexpected loss announcements (2153). In contrast, the Agriculture Industry (SIC b 1000) and the Public
Administration Industry (SIC N 8999) have the smallest number of unexpected loss announcements (2 and 39, respectively).
Table 3 reports the Pearson correlations of the main variables for the sample of smoothing firms. p-Values are given in the
parentheses. Both ABSRPD and TOTSPRD are negatively correlated with ISRHO (correlation = −0.01 and − 0.05, respectively)
and ISVOL (correlation = −0.02 and − 0.06, respectively). Not surprisingly, the two income smoothing measures (ISRHO and
ISVOL) are positively correlated (correlation = 0.48). In addition, both ABSPRD and TOTSPRD are positively correlated with ABSCAR
(correlation = 0.06 and 0.11, respectively) and FE (correlation = 0.04 and 0.13 respectively), but negatively correlated with SIZE
(correlation = −0.04 and −0.38 respectively). The results are consistent with the argument that bid-ask spreads around loss an-
nouncements are positively associated with the magnitudes of price movements and unexpected earnings.
5. Empirical results
5.1. Income smoothing and bid-ask spreads around unexpected loss announcements
Panel A of Table 4 reports the effects of historical income smoothing on abnormal and total bid-ask spreads around unexpect-
ed loss announcements, using ISRHO as the measure of income smoothing. Column I presents the association between abnormal
9
Untabulated results suggest that the means of ABSPRD are significant at the 0.01 level for both samples.
Table 2
Industry distribution. This table reports industry distribution for the sample of smoothing firms based on one-digit SIC codes.
Industry SIC code Frequency Percent Cumulative frequency Cumulative percent
Agriculture, forestry, and fisheries b1000 2 0.03 2 0.03

Mining and construction 1000–1999 419 6.71 421 6.74
Manufacturing 2000–2999 1084 17.36 1505 24.11
Durable manufacturers 3000–3999 2153 34.49 3658 58.59
Transportation, communications, and utilities 4000–4999 599 9.59 4257 68.19
Wholesale and retail trade 5000–5999 699 11.20 4956 79.38
Service (hotel, personal, business & etc.) 7000–7999 986 15.79 5942 95.18
Service (health, legal, educational & etc.) 8000–8999 262 4.20 6204 99.38
Public administration N8999 39 0.62 6243 100.00
bid-ask spreads and income smoothing levels. Consistent with Hypothesis 1, ABSPRD is negatively associated with SMOOTH
(coeff. = −0.007, t-stat = −2.47), indicating higher abnormal bid-ask spreads for firms with higher levels of income smoothing.
In addition, the coefficients on ΔROA, ΔCURR, and ΔLEV are not significant, suggesting that abnormal bid-ask spreads around un-
expected loss announcements are not driven by the changes in firm fundamentals.
Column II presents the association between total bid-ask spreads and income smoothing levels. Consistent with Hypothesis 2,
the coefficient on SMOOTH is negative (coeff. = −0.024, t-stat = −4.46), suggesting that total bid-ask spreads around unexpect-
ed loss announcements are higher for firms with higher levels of income smoothing. In addition, TOTSPRD is not associated with
ROA_RANK (t-stat = −1.31), but positively associated with ΔROA (coeff. = 0.054, t-stat = 3.30). Given that we have controlled
for the level of the return on assets (ROA_RANK), the positive association between TOTSPRD and ΔROA is likely due to firms with
higher ΔROA having lower lagged return on assets, leading to higher bid-ask spreads before and after unexpected loss announce-
ments. Not surprisingly, the coefficient on ΔLEV is positive (coeff. = 0.048, t-stat = 3.95), indicating higher total bid-ask spreads
for firms with larger increase in financial leverage. The significant coefficients on ΔROA and ΔLEV also confirm the importance of
controlling for the changes in firm fundamentals in the regressions.
Panel B of Table 4 examines the moderating roles of institutional ownership and analyst following in the association between
total bid-ask spreads and income smoothing levels based on model (3). Column I (II) presents the results using institutional own-
ership (analyst following) to measure INS. Similar to the results reported in Panel A, the coefficient on SMOOTH is negative in both
columns (Column I: coeff. = −0.047; t-stat = −3.96; Column II: coeff. = −0.054; t-stat = −3.69), suggesting larger total bid-
ask spreads for firms with higher levels of income smoothing. More importantly, consistent with H3, the coefficient on
INS*SMOOTH is positive in both columns (Column I: coeff. = 0.042; t-stat = 2.16; Column II: coeff. = 0.017; t-stat = 2.24),
Table 3
Correlations of the main variables. This table reports the Pearson correlations of the main variables. p-Value of each correlation is provided in parentheses.
Variable ABSPRDt (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)
TOTSPRDt (1) 0.41

(0.00)
ISRHOt (2) −0.01 −0.05
(0.30) (0.00)
ISVOLt (3) −0.02 −0.06 0.48
(0.06) (0.00) (0.00)
ABSCARt (4) 0.06 0.11 0.04 0.00
(0.00) (0.00) (0.00) (0.73)
FEt (5) 0.04 0.13 −0.02 0.01 0.12
(0.00) (0.00) (0.10) (0.55) (0.00)
SIZEt (6) −0.04 −0.38 0.01 0.01 −0.13 −0.08
(0.00) (0.00) (0.35) (0.25) (0.00) (0.00)
ABACCt (7) 0.00 −0.00 −0.03 −0.03 0.00 0.06 0.02
(0.75) (0.79) (0.03) (0.01) (0.82) (0.00) (0.20)
ROA_RANKt (8) −0.00 −0.09 −0.03 −0.06 −0.09 −0.07 0.12 0.28
(0.70) (0.00) (0.01) (0.00) (0.00) (0.00) (0.00) (0.00)
ΔROAt (9) 0.01 0.01 −0.01 0.00 −0.06 −0.02 0.03 0.31 0.56
(0.62) (0.66) (0.67) (0.87) (0.00) (0.05) (0.03) (0.00) (0.00)
ΔCURRt (10) −0.00 0.00 −0.02 −0.03 0.02 0.03 0.02 0.12 0.08 0.09
(0.70) (0.96) (0.05) (0.01) (0.14) (0.04) (0.07) (0.00) (0.00) (0.00)
ΔLEVt (11) 0.00 0.03 0.01 0.00 0.01 0.01 0.03 −0.23 −0.29 −0.38 −0.26
(0.96) (0.01) (0.49) (0.96) (0.41) (0.68) (0.01) (0.00) (0.00) (0.00) (0.00)
LASTGAINt (12) −0.02 −0.06 −0.15 −0.28 −0.05 −0.06 0.12 −0.06 −0.05 −0.11 −0.02 0.06
(0.08) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.20) (0.00)
TIMELOSSt (13) 0.02 0.08 0.11 0.21 0.05 0.08 −0.13 0.05 0.02 0.15 0.04 −0.07 −0.53
(0.20) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.07) (0.00) (0.00) (0.00) (0.00)
LASTLOSSt (14) −0.01 −0.12 −0.14 −0.23 −0.05 −0.07 0.21 0.05 0.11 −0.10 −0.01 −0.00 0.25 −0.09
(0.38) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.36) (0.91) (0.00) (0.00)
Table 4
Income smoothing and bid-ask spreads around unexpected loss announcements. Column I (II) of Panel A presents the association between income smoothing and ab-
normal (total) bid-ask spreads around unexpected loss announcements. Panel B presents the moderating roles of institutional ownership and analyst following in the
association between total bid-ask spreads and income smoothing. All the variables are as defined in Appendix A. The variables of interest are highlighted in bold. *, **,
and *** denote significance of coefficients at the 10%, 5% and 1% levels respectively, using a two-tailed test.
Panel A: the effects of income smoothing on abnormal and total bid-ask spreads
SMOOTH = ISRHO
ABSPRDt TOTSPRDt
I II
Coeff. t-Stat Coeff. t-Stat
ABSCARt 0.013 (3.08)*** 0.015 (1.79)*

FEt 0.001 (2.37)** 0.005 (10.47)***
SIZEt −0.000 (−1.22) −0.012 (−27.03)***
ABACCt 0.000 (0.04) 0.007 (0.49)
ROA_RANKt −0.001 (−0.34) −0.004 (−1.31)
ΔROAt 0.006 (0.72) 0.054 (3.30)***
ΔCURRt 0.000 (0.77) 0.000 (0.68)
ΔLEVt 0.006 (0.98) 0.048 (3.95)***
LASTGAINt −0.000 (−0.33) −0.001 (−0.28)
TIMELOSSt 0.001 (0.97) 0.011 (6.43)***
LASTLOSSt −0.001 (−0.07) −0.051 (−1.75)*
SMOOTHt −0.007 (−2.47)** −0.024 (−4.46)***
Fixed quarter and industry effects Yes Yes
Adjusted R square 0.070 0.536
No. of observations 6243
Panel B: the moderating role of institutional ownership and analyst following
SMOOTH = ISRHO
Dependent var: TOTSPRDt
INS = INST INS = AF
I II
Coeff. t-Stat Coeff. t-Stat
ABSCARt 0.012 (1.54) 0.021 (2.62)***

FEt 0.005 (9.34)*** 0.004 (7.23)***
SIZEt −0.010 (−21.82)*** −0.007 (−11.90)***
ABACCt 0.011 (0.78) 0.011 (0.74)
ROA_RANKt −0.002 (−0.74) −0.006 (−2.13)**
ΔROAt 0.036 (2.26)** 0.047 (2.93)***
ΔCURRt 0.001 (0.94) 0.000 (0.28)
ΔLEVt 0.048 (4.08)*** 0.039 (3.27)***
LASTGAINt −0.001 (−0.54) 0.001 (0.52)
TIMELOSSt 0.011 (6.64)*** 0.010 (6.29)***
LASTLOSSt −0.040 (−1.42) −0.062 (−2.17)**
SMOOTHt −0.047 (−3.96)*** −0.054 (−3.69)***
INSt 0.000 (0.03) −0.004 (−0.55)
INS*SMOOTHt 0.042 (2.16)** 0.017 (2.24)**
Fixed quarter and industry effects Yes Yes
Adjusted R square 0.549 0.551
suggesting that the positive association between total bid-ask spreads and income smoothing is less pronounced for firms with a
higher level of institutional ownership or analyst following.
Taken together, the results reported in Table 4 support our hypotheses. For smoothing firms, higher levels of income smooth-
ing not only lead to a larger increase in information risk as measured by abnormal bid-ask spreads around unexpected loss an-
nouncements, but also are associated with a higher level of total information risk as measured by total bid-ask spreads around
the announcements. While investors appear to be concerned with managerial opportunism associated with historical income
smoothing, the concern is less severe for firms with higher institutional ownership or analyst following, leading to a less positive
association between total bid-ask spreads and income smoothing levels for these firms.
5.2. Propensity score matching test
We employ a propensity score matching (PSM) technique to further address the concern that bid-ask spreads around unex-
pected loss announcements may be driven by the changes in firm fundamentals. Following Fang et al. (2014), we sort the sample
of smoothing firms into terciles by ISRHO, and then employ the PSM algorithm to identify matches between the bottom and top
terciles. More specifically, we estimate the following logistic regression based on the 4162 firms in the bottom and top terciles of
ISRHO.
PSMDt ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t þ β5 ROA RANK t

þ β6 ΔROAt þ β7 ΔCURRt þ β8 ΔLEV t þ β9 LASTGAINt þ β10 TIMELOSSt ð4Þ
þ β11 LASTLOSSt þ fixed industry and quarter effects þ ε
PSMD is an indicator variable equal to one for the smoothing firms in the bottom tercile, and zero for the firms in the top
tercile. The independent variables include all the control variables in model (2). Column I of Panel A, Table 5 presents the results
from the pre-match propensity score regression. PSMD is associated with most of the independent variables except for ABACC and
ΔLEV, suggesting the importance of controlling for these variables in model (2). In addition, model (4) captures a significant
amount of variation in the choice of income smoothing levels (Pseudo R2 = 0.296). Based on the propensity score obtained
from model (4), we identify 1147 firms in the bottom tercile (high smoothing firms) that are matched with 1147 firms in the
top tercile (low smoothing firms). Column II of Panel A reports the results from the post-match diagnostic regression based on
the matched sample, where PSMD is equal to one if the firm is in the sample of high smoothing firms, and zero otherwise. The
coefficients on the independent variables are generally insignificant, except that PSMD is marginally associated with LASTGAIN
(coeff. = −0.277, p-value = 0.094), indicating that there are no observable differences in the changes in firm fundamentals be-
tween high and low smoothing firms. Thus, any differences in bid-ask spreads between high and low smoothing firms should not
be attributed to the differences in the changes in firm fundamentals.
Panel B of Table 5 shows the difference in bid-ask spreads between high and low smoothing firms. Consistent with the results
reported in Table 4, both abnormal and total bid-ask spreads around unexpected loss announcements for high smoothing firms
are larger than those for low smoothing firms at the 0.01 significance level. The results confirm that the positive association be-
tween income smoothing and bid-ask spreads around unexpected loss announcements is not driven by the changes in firm
fundamentals.
5.3. Income smoothing and bid-ask spreads before unexpected loss announcements
Our main analyses focus on the effects of income smoothing levels on bid-ask spreads around unexpected loss announce-
ments, since unexpected loss announcements may help investors detect income smoothing due to managerial opportunism. To
the extent that investors may detect income smoothing driven by managerial opportunism before unexpected loss announce-
ments, the association between bid-ask spreads around unexpected loss announcements and income smoothing levels should
Table 5
Tests based on propensity score matching. This table reports the effects of income smoothing levels on abnormal and total bid-ask spreads using the propensity score
matching technique. Column I (II) of Panel A presents the results from the pre-match propensity score regression (post-match diagnostic regression). Panel B shows the
differences in abnormal and total bid-ask spreads between high and low smoothing firms. All the variables are as defined in Appendix A.
Panel A: pre-match propensity score regression and post-match diagnostic regression
Dependent var: PSMDt
Pre-match I Post-match II
Coefficient p-Value Coefficient p-Value
ABSCARt −0.804 0.054 0.068 0.891

FEt 0.127 0.000 −0.002 0.940
SIZE −0.086 0.000 −0.002 0.935
ABACCt 0.388 0.627 0.654 0.452
ROA_RANKt 0.505 0.003 −0.101 0.621
ΔROAt 1.759 0.066 −0.169 0.889
ΔCURRt 0.082 0.026 0.020 0.637
ΔLEVt 1.051 0.128 0.373 0.653
LASTGAINt 1.420 0.000 −0.277 0.094
TIMELOSSt −0.350 0.000 −0.017 0.870
LASTLOSSt 19.957 0.000 0.382 0.856
Industry and year dummies Yes Yes
Pseudo R2 0.296 0.025
Likelihood ratio 1013.8 44.1
No. of obs. with dep. var. = 1 2081 1147
No. of obs. 4162 2294
Panel B: differences in bid-ask spreads between high and low smoothing firms
High smoothing firms I Low smoothing firms II Difference I–II p-Value
ABSPRDt 0.005 0.001 0.004 0.002

TOTSPRDt 0.061 0.046 0.015 0.000
Table 6
Income smoothing and bid-ask spreads before unexpected loss announcements. This table reports the effect of income smoothing on bid-ask spreads before unexpected
loss announcements. Column I presents the results based on the full sample of smoothing firms. Column II (III) presents the results based on the sample of smoothing
firms with (without) losses reported during the past 20 quarters prior to current loss announcements. All the variables are as defined in Appendix A. The variables of
interest are highlighted in bold. *, **, and *** denote significance of coefficients at the 10%, 5% and 1% levels respectively, using a two-tailed test.
SMOOTH = ISRHO
Dependent var: PRESPRDt
Full sample Smoothing firms with prior Smoothing firms without prior
losses losses
I II III
Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat
ABSCARt − 1 −0.002 (−1.71)* −0.002 (−1.35) −0.004 (−1.27)

FEt – 1 0.000 (4.46)*** 0.000 (4.44)*** 0.000 (0.66)
SIZEt − 1 −0.003 (−34.71)*** −0.003 (−32.91)*** −0.002 (−11.90)***
ABACCt − 1 0.009 (3.37)*** 0.011 (3.60)*** −0.010 (−1.46)
ROAt − 1 −0.032 (−5.45)*** −0.033 (−5.56)*** −0.095 (−5.62)***
CURRt − 1 −0.000 (−4.57)*** −0.000 (−4.44)*** −0.000 (−0.72)
LEVt − 1 0.008 (11.42)*** 0.009 (11.41)*** 0.003 (1.82)*
LASTGAINt −0.000 (−0.38)
TIMELOSSt 0.001 (4.02)***
LASTLOSSt 0.003 (0.52)
SMOOTHt −0.003 (−3.00)*** −0.003 (−3.17)*** 0.002 (1.06)
Fixed quarter and industry effects Yes Yes Yes
Adjusted R square 0.586 0.574 0.693
No. of observations 6154 5120 1034
be weakened. In this section, we further examine whether investors can see through income smoothing even before unexpected
loss announcements, using the following model similar to model (2).
PRESPRDt ¼ β0 þ β1 ABSCARt−1 þ β2 FEt−1 þ β3 SIZEt−1 þ β4 ABACC t−1 þ β5 ROAt−1

þ β6 CURRt−1 þ β7 LEV t−1 þ β8 LASTGAINt þ β9 TIMELOSSt ð5Þ
þ β10 LASTLOSSt þ β11 SMOOTH t þ fixed industry and quarter effects þ ε
PRESPRDt is the mean bid-ask spread during the estimation period beginning 50 days before and ending 21 days before the
event period (− 2, 2) around unexpected loss announcements for quarter t. ROAt − 1, CURRt − 1, and LEVt − 1 are the return
on assets, the current ratio, and financial leverage, respectively, measured at the end of quarter t − 1. The other variables are
as defined in model (2). Note that all the control variables, except for LASTGAIN, TIMELOSS, and LASTLOSS, are measured after earn-
ings announcements for quarter t − 1, since the relevant financial information for quarter t is not available during the estimation
period.
Column I of Table 6 reports the results based on model (5). The coefficient on SMOOTH is negative (coeff. = −0.003, t-stat =
−3.00), indicating larger bid-ask spreads before unexpected loss announcements for firms with higher income smoothing levels.
However, when we partition the sample based on whether firms have reported any losses during the past 20 quarters prior to
current loss announcements, we find that the negative association between PRESPRD and SMOOTH is driven by firms that have
reported losses prior to current loss announcements.
More specifically, consistent with the results in Column I, PRESPRD is negative associated with SMOOTH for the sample of
smoothing firms with prior losses (Column II: coeff. on SMOOTH = −0.003, t-stat = −3.17). In contrast, PRESPRD is not associ-
ated with SMOOTH for the sample of smoothing firms that have not reported losses previously (Column III: coeff. on SMOOTH =
0.002, t-stat = 1.06), suggesting that investors have difficulty determining whether income smoothing is due to managerial op-
portunism for firms without loss announcements.10 The results are also consistent with unexpected loss announcements provid-
ing an ambiguous signal that historical income smoothing may be driven by managerial opportunism.
5.4. Results based on alternative samples
As a robustness check, we examine the effects of income smoothing on bid-ask spreads using two alternative samples of firms
that break previous smoothing patterns. Sample I includes all the smoothing firms with ROA b ROAMEAN - ROASTD and
FORECAST N 0; and Sample II includes all the smoothing firms with ROA b ROAMEAN - 2*ROASTD and FORECAST N 0. ROAMEAN
(ROASTD) is the mean (standard deviation) of ROA during the past 20 quarters prior to the current quarter. FORECAST is the
mean analyst earnings forecast. For both samples, firms are expected to report profits, however, reported earnings are much
10
In addition, to entertain the possibility that institutional investors and financial analysts may see through income smoothing before loss announcements, we add
two additional variables, INS and INS*SMOOTH, in Column III of Table 6. Untabulated results indicate that the coefficients on both SMOOTH and INS*SMOOTH are
not significant, providing no evidence that institutional investor and financial analysts can detect managerial opportunism before loss announcements.
lower than historical averages, suggesting that the sample firms break previous smoothing patterns. Samples I and II include
12,594 and 4334 firm-quarter observations, respectively.
Table 7 reports the results based on these two alternative samples. The results are consistent with those reported in Table 4.
For Sample I, SMOOTH is negatively associated with ABSPRD (coeff. = −0.006; t-stat = −3.14) and TOTSPRD (coeff. = −0.020; t-
stat = −4.97). Similarly, for Sample II, SMOOTH is also negatively associated with ABSPRD (coeff. = −0.010; t-stat = −3.04) and
TOTSPRD (coeff. = −0.020; t-stat = −3.07). Overall, the results indicate that the positive association between income smoothing
and bid-ask spreads can be extended to these two alternative samples of firms that have broken previous smoothing patterns.11
5.5. Using income smoothing measure based on earnings volatility
In this section, we test the robustness of our results using the income smoothing measure based on earnings volatility. Col-
umns I and II of Table 8 report the results based on model (2), using ISVOL as the measure of income smoothing. Consistent
with the results in Table 4, ABSRPD and TOTSPRD are negatively associated with SMOOTH (column I: coeff. = −0.005, t-stat =
−2.87; column II: coeff. = −0.009, t-stat = −2.64), indicating higher abnormal and total bid-ask spreads around loss announce-
ments for firms with higher levels of income smoothing.
One may argue that the negative association between bid-ask spreads and ISVOL may be driven by the volatility of cash flows,
since ISVOL is determined by the volatility of both earnings and cash flows by construction. To separate the effect of earnings vol-
atility from that of cash flow volatility, we estimate a modified version of model (2). More specifically, we use abnormal or total
bid-ask spreads unexplained by the volatility of cash flows as the dependent variable and replace SMOOTH with the measure of
earnings volatility, EARNVOL.
SPRD EXCF t ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t þ β5 ROA RANK t

þ β6 ΔROAt þ β7 ΔCURRt þ β8 ΔLEV t þ β9 LASTGAINt
ð6Þ
þ β10 TIMELOSSt þ β11 LASTLOSSt þ β12 EARNVOLt
þ fixed industry and quarter effects þ ε
SPRD_EXCFt is either abnormal bid-ask spreads unexplained by the volatility of cash flows (ABSPRD_EXCFt) or total bid-ask spreads
unexplained by the volatility of cash flows (TOTSPRD_EXCFt). More specifically, ABSPRD_EXCFt (TOTSPRD_EXCFt) is calculated as the
residuals from the regression of ABSPRDt (TOTSPRDt) on the standard deviation of cash flows from operations scaled by total assets
during the past 20 quarters prior to quarter t. EARNVOLt is the variance of net income scaled by total assets during the past 20 quar-
ters prior to quarter t. ABSPRD_EXCFt (TOTSPRD_EXCFt) is uncorrelated with the volatility of cash flows by construction, therefore, any
association between EARNVOLt and ABSPRD_EXCFt (TOTSPRD_EXCFt) should not be attributed to cash flow volatility.
Column III (IV) of Table 8 illustrates the effect of earnings volatility on abnormal (total) bid-ask spreads unexplained by the
volatility of cash flows. The coefficient on EARNVOL is negative in both columns (Column III: coeff. = −0.343; t-stat = −4.09;
Column IV: coeff. = −1.202; t-stat = −7.10), indicating higher abnormal and total bid-ask spreads for smoothing firms with
lower earnings volatility.12 The results suggest that the negative association between bid-ask spreads and ISVOL for smoothing
firms is unlikely to be driven by the volatility of cash flows, but should be attributed to the volatility of earnings.
6. Additional analyses
6.1. Changes in income smoothing following loss announcements
In this section, we examine whether smoothing firms change the extent of income smoothing following loss announcements.
Prior literature suggests that firms take corrective actions to discipline managers and restore firm reputation following the reve-
lation of accounting fraud or earnings management. For example, Hazarika et al. (2012) find that CEO turnover is positively asso-
ciated with earnings management and that firms reduce earnings management following forced CEO turnover. Similarly, Desai et
al. (2006) document an increase in the proportion of outside directors and the ownership of blockholders, consistent with firms
improving corporate governance after accounting restatements. It would be important for smoothing firms with loss announce-
ments to restore investors' faith and recover firm reputation by constraining managers' opportunistic income smoothing, since
the market imposes significant reputational penalties, such as the increase in firm risk and the decrease in firm value, on these
firms. We thus expect a decrease in the extent of income smoothing for smoothing firms following loss announcements.
To tease out the effect of the loss period (i.e., the period from the first loss announcement to the last loss announcement) on
the extent of income smoothing, we exclude the loss period when calculating the change in income smoothing levels between
pre- and post- loss periods. More specifically, we compare the income smoothing level before the first loss announcement of a
firm to that after the last loss announcement during our sample period. Since this analysis requires at least 20 quarters available
11
We repeat our analysis using a sample of firms with unexpected gain announcements. Specifically, we identify a sample of smoothing firms with reported return on
assets more than one standard deviation above its historical mean and analyst forecast lower than reported earnings, and conduct the regression analysis based on mod-
el (2). We find no evidence that abnormal bid-ask spreads around unexpected gain announcements are associated with historical income smoothing levels (coeff. on
ISRHO = −0.001, t-stat = −0.45), suggesting that investors have little concern about firm information risk when firms report an unexpected gain breaking the pre-
vious smoothing pattern.
12
Untabulated results indicate that abnormal and total bid-ask spreads unexplained by earnings volatility are not associated with the volatility of cash flows.
Table 7
The effect of income smoothing on bid-ask spreads for alternative samples. This table presents the effects of income smoothing levels on abnormal and total bid-ask
spreads using two alternative samples. Sample I includes all the smoothing firms with ROA b ROAMEAN - ROASTD and FORECAST N 0; and Sample II includes all the
smoothing firms with ROA b ROAMEAN - 2*ROASTD and FORECAST N 0. ROAMEAN (ROASTD) is the mean (standard deviation) of ROA during the past 20 quarters prior
to the current quarter. FORECAST is the mean analyst earnings forecast. All the variables are as defined in Appendix A. The variables of interest are highlighted in bold. *,
**, and *** denote significance of coefficients at the 10%, 5% and 1% levels respectively, using a two-tailed test.
SMOOTH = ISRHO
Sample I ROA b ROAMEAN - 2*ROASTD and Sample II ROA b ROAMEAN - 2*ROASTD and
FORECAST N 0 FORECAST N 0
ABSPRDt TOTSPRDt ABSPRDt TOTSPRDt
I II III IV
Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat
ABSCARt 0.011 (4.49)*** 0.000 (0.04) 0.011 (2.61)*** −0.012 (−1.41)

FEt 0.001 (3.75)*** 0.004 (14.74)*** 0.001 (2.50)** 0.005 (9.08)***
SIZE −0.000 (−1.09) −0.009 (−36.24)*** 0.000 (1.04) −0.009 (−20.19)***
ABACCt 0.000 (0.08) 0.002 (0.20) −0.011 (−1.41) −0.005 (−0.29)
ROA_RANKt −0.002 (−2.77)*** −0.020 (−11.01)*** −0.002 (−1.00) −0.016 (−4.54)***
ΔROAt 0.001 (0.28) 0.054 (5.06)*** 0.007 (1.10) 0.036 (2.64)***
ΔCURRt 0.000 (1.29) 0.000 (0.76) 0.000 (0.35) −0.001 (−1.27)
ΔLEVt 0.008 (2.30)** 0.020 (2.94)*** 0.010 (2.05)** 0.026 (2.61)***
LASTGAINt 0.000 (0.79) 0.003 (2.18)** 0.001 (0.51) 0.004 (1.87)*
TIMELOSSt 0.000 (0.79) 0.007 (5.88)*** 0.001 (1.23) 0.011 (4.80)***
LASTLOSSt −0.031 (−1.84)* 0.002 (0.06) −0.016 (−0.51) −0.072 (−1.13)
SMOOTHt −0.006 (−3.14)*** −0.020 (−4.97)*** −0.010 (−3.04)*** −0.020 (−3.07)***
Fixed quarter and industry effects Yes Yes Yes Yes
Adjusted R square 0.053 0.580 0.083 0.573
No. of observations 12,594 4334
both before and after loss periods, only 589 (601) firms have necessary data available to calculate ISRHO (ISVOL) before and after
loss periods. The results are reported in Table 9 and indicate a significant decrease in the extent of income smoothing between
pre- and post-loss periods. In particular, ISRHO (ISVOL) increases from −0.932 (0.457) to −0.806 (0.804) and this increase is sig-
nificant at the 0.01 level, consistent with the view that smoothing firms constrain managers' opportunistic behaviors following
loss announcements by decreasing the extent of income smoothing.
6.2. The non-linear effect of earnings volatility on abnormal bid-ask spreads
In this section, we explore the association between abnormal bid-ask spreads and earnings volatility using all the firms with
loss announcements from 1996 to 2015 (34,427 firm quarter observations) to shed light on the optimal amount of earnings
Table 8
Results using the alternative measure of income smoothing. This table presents the effects of the alternative income smoothing measure (ISVOL) on bid-ask spreads
around unexpected loss announcements. Column I (II) reports the effect of earnings volatility on abnormal (total) bid-ask spreads. Column III (IV) illustrates the effect
of earnings volatility on abnormal (total) bid-ask spreads unexplained by the volatility of cash flows. All the variables are as defined in Appendix A. The variables of
interest are highlighted in bold. *, **, and *** denote significance of coefficients at the 10%, 5% and 1% levels respectively, using a two-tailed test.
SMOOTH = ISVOL
ABSPRDt TOTSPRDt ABSPRD_EXCFt TOTSPRD_EXCFt
I II III IV
Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat
ABSCARt 0.010 (2.48)** 0.014 (1.72)* 0.010 (2.47)** 0.013 (1.62)

FEt 0.001 (2.36)** 0.005 (10.38)*** 0.001 (2.02)** 0.005 (9.07)***
SIZE −0.000 (−1.07) −0.012 (−26.71)*** −0.000 (−0.37) −0.011 (−22.95)***
ABACCt 0.000 (0.03) 0.007 (0.51) 0.001 (0.16) 0.011 (0.76)
ROA_RANKt −0.001 (−0.48) −0.003 (−1.13) −0.001 (−0.35) −0.004 (−1.18)
ΔROAt 0.005 (0.65) 0.045 (2.74)*** 0.005 (0.62) 0.055 (3.31)***
ΔCURRt 0.000 (0.74) 0.001 (1.02) 0.000 (0.79) 0.001 (0.90)
ΔLEVt 0.006 (0.93) 0.047 (3.88)*** 0.006 (0.96) 0.049 (3.98)***
LASTGAINt −0.001 (−0.57) −0.002 (−0.69) 0.000 (0.09) 0.000 (0.20)
TIMELOSSt 0.001 (0.97) 0.011 (6.46)*** 0.001 (0.61) 0.009 (5.37)***
LASTLOSSt −0.007 (−0.46) −0.050 (−1.71)* −0.001 (−0.07) 0.007 (0.23)
SMOOTHt −0.005 (−2.87)*** −0.009 (−2.64)***
EARNVOLt −0.343 (−4.09)*** −1.202 (−7.10)***
Fixed quarter and industry effects Yes Yes Yes Yes
Adjusted R square 0.069 0.534 0.069 0.508
Table 9
Changes in income smoothing levels after loss announcements. This table reports the change in income smoothing levels between the pre-loss and post-loss periods.
589 (601) firms have necessary data available to calculate ISRHO (ISVOL) before and after loss periods. The variables are as defined in Appendix A.
Pre-loss period Post-loss period Change in income smoothing

levels
I II III IV V VI = IV − II VII
No. of firms Mean p-Value Mean p-Value Difference p-Value
ISRHO 589 −0.932 0.000 −0.806 0.000 0.126 0.000

ISVOL 601 0.457 0.000 0.804 0.000 0.347 0.000
volatility. Given the negative association between earning volatility and abnormal bid-ask spreads unexplained by cash flow vol-
atility reported in Table 8, we first use model (6) to examine whether this negative association can be also observed for this ex-
tended sample. The results are reported in Column I of Table 10. The coefficient on EARNVOL is not significant (t-stat = −0.06),
suggesting that the negative association between ABSRPD_EXCF and EARNVOL may be observed only for firms with lower levels of
earnings volatility. We thus employ the following piece-wise regression (e.g., Himmelberg et al. 1999) to investigate the potential
non-linear effect of earnings volatility on abnormal bid-ask spreads unexplained by the volatility of cash flows.
ABSPRD EXCF t ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t

þ β5 ROA RANK t þ β6 ΔROAt þ β7 ΔCURRt þ β8 ΔLEV t
ð7Þ
þ β9 LASTGAINt þ β10 TIMELOSSt þ β11 LASTLOSSt þ β12 m1t
þ β13 m2t þ fixed industry and quarter effects þ ε
m1t and m2t are defined as follows.

EARNVOLt if EARNVOLt bs1
m1t ¼
s1 if EARNVOLt ≥s1

0 if EARNVARt bs1
m2t ¼
EARNVOLt −s1 if EARNVARt ≥s1
Column II and III present the results based on model (7) using two alternative cutoff points: s1 = 40th or 60th percentile of
EARNVOL. When s1 equals the 40th percentile of EARNVOL, the coefficient on m1 is negative at the 0.05 level (coeff. = −1.761; t-
stat = − 2.34), indicating that abnormal bid-ask spreads around loss announcements are smaller for firms with more volatile
earnings when earnings volatility is below its 40th percentile. In contrast, the coefficient on m2 is not significant (t-stat =
Table 10
The non-linear association between abnormal bid-ask spreads and earnings volatility. This table reports the non-linear effect of earnings volatility on abnormal bid-ask
spreads around loss announcements unexplained by cash flow volatility, using all the firms with loss announcements from 1996 to 2015 (34,427 firm quarter obser-
vations). All the variables are as defined in Appendix A. The variables of interest are highlighted in bold. *, **, and *** denote significance of coefficients at the 10%, 5% and
1% levels respectively, using a two-tailed test.
Dependent var: ABSPRD_EXCFt
s1 = 40th percentile of s1 = 60th percentile of

EARNVOL EARNVOL
I II III
Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat
ABSCARt 0.005 (2.96)*** 0.005 (3.01)*** 0.005 (3.01)***

FEt 0.000 (3.41)*** 0.000 (3.49)*** 0.000 (3.46)***
SIZE −0.000 (−2.11)** −0.000 (−2.57)** −0.000 (−2.54)**
ABACCt 0.002 (0.98) 0.002 (0.96) 0.002 (0.97)
ROA_RANKt −0.002 (−3.23)*** −0.002 (−3.48)*** −0.002 (−3.49)***
ΔROAt 0.000 (0.21) 0.000 (0.24) 0.000 (0.24)
ΔCURRt 0.000 (0.79) 0.000 (0.82) 0.000 (0.82)
ΔLEVt −0.001 (−0.75) −0.001 (−0.80) −0.001 (−0.81)
LASTGAINt 0.000 (0.16) −0.000 (−0.30) −0.000 (−0.09)
TIMELOSSt −0.001 (−1.89)* −0.001 (−1.59) −0.001 (−1.65)*
LASTLOSSt 0.004 (2.94)*** 0.004 (2.78)*** 0.004 (2.66)***
EARNVOLt −0.000 (−0.06)
m1t −1.761 (−2.34)** −0.480 (−2.07)**
m2t −0.000 (−0.07) −0.000 (−0.07)
Fixed quarter and industry effects Yes Yes Yes
Adjusted R square 0.043 0.043 0.043
No. of observations 34,427
A: The coefficients on m1 with different cutoffs for s1

0
10th 20th 30th 40th 50th 60th 70th 80th 90th
-5
Coefficients
-10
-15
-20
-25
EARNVOL Percentile
B: The t-statistics of the coefficients on m1 with different cutoffs for s1

0
10th 20th 30th 40th 50th 60th 70th 80th 90th
-0.5
-1
t-stats
-1.5
-2
-2.5
EARNVOL Percentile
Fig. 1. Plot using alternative cutoff points for earnings volatility. This figure shows the effect of earnings volatility on abnormal bid-ask spreads unexplained by the
volatility of cash flows, using 9 different cutoff points for earnings volatility (i.e., s1 = 10th, 20th, … 90th percentile of EARNVOL). Panels A and B plot the coef-
ficients and the corresponding t-statistics on m1, respectively, based on model (7).
−0.07), suggesting that abnormal bid-ask spreads do not vary with earnings volatility when earnings volatility is above its 40th
percentile. When s1 equals the 60th percentile of EARNVOL, the coefficient on m1 becomes less significant (coeff. = −0.480; t-
stat = −2.07), while the coefficient on m2 remains insignificant (t-stat = −0.07). Taken together, the results suggest a non-lin-
ear association between earnings volatility and abnormal bid-ask spreads unexplained by the volatility of cash flows.
We entertain additional cutoff points using the 9 deciles of EARNVOL (i.e., s1 = 10th, 20th, … 90th percentile of EARNVOL) in
Fig. 1. Panels A and B report the coefficients and the corresponding t-statistics on m1 based on model (7), using these alternative
cutoff points. The magnitude of the coefficient on m1 decreases monotonically when s1 increases from the 10th to the 90th per-
centile of EARNVOL. More importantly, the t-statistics suggest that this nonlinear association is the most significant when s1 equals
the 40th percentile of EARNVOL. Overall, the results suggest that while investors may not favor a “too volatile” pattern of earnings,
it might not be advisable for management to present a “too smoothed” pattern of earnings, especially if losses would be reported
in the future. A moderate amount of earnings volatility, such as around the 40th percentile of EARNVOL, may be optimal in terms
of minimizing the increase in information risk around loss announcements.
7. Concluding remarks
This paper examines the influence of historical income smoothing on perceived firms' riskiness, as reflected in the bid-ask
spreads, around earnings announcements, when reported earnings break the smoothed stream of earnings. We find that bid-
ask spreads around unexpected loss announcements are significantly larger when preceded by smoother patterns of reported
earnings, consistent with the view that historical income smoothing is perceived as an earnings management tool by investors,
leading to higher information risk around unexpected loss announcements. In contrast, total bid-ask spreads before loss an-
nouncements are not associated with income smoothing levels for firms that had not reported earlier losses. This suggests that
investors have difficulty seeing through opportunistic income smoothing before loss announcements. Furthermore, the positive
relationship between total bid-ask spreads and historical income smoothing levels is less manifested for firms with higher
institutional ownership or analyst following, consistent with the monitoring role institutional investors and financial analysts play
in constraining managerial opportunism.
We also document a significant decrease in the extent of income smoothing following loss announcements, suggesting that
managers reduce opportunistic income smoothing after loss announcements due to investors' magnified concerns about firm in-
formation risk. In addition, there appears to be a non-linear association between abnormal bid-ask spreads around loss announce-
ments and earnings volatility. When earnings volatility is below (above) its 40th percentile, there is a negative (insignificant)
association between abnormal bid-ask spreads and earnings volatility. Overall, our results are consistent with the view that in-
come smoothing may be motivated by managerial opportunism and that institutional investors and financial analysts can act
to constrain earnings management through their monitoring.
This study has important implications for both academia and practitioners. While most of the academic and practitioner liter-
ature, to-date, has generally argued that investors favor smoothed patterns of earnings, our study supports the view that a too-
smoothed pattern of earnings may result unfavorably. The results suggest that it might not be advisable to present a too-
smoothed pattern of earnings. When investors are surprised by a subsequent loss, their concerns might be amplified and informa-
tion risk would increase significantly in this case. A moderate amount of volatility, such as the 40th percentile of earnings vola-
tility, in reported earnings may be optimal in terms of minimizing the increase in information risk around potential future loss
announcements.
Acknowledgements
We acknowledge the helpful suggestions made by Krish Menon, Eddie Riedl, Ana Albuquerque, the participants in the Boston
University and the American Accounting Association Annual Meeting (2016) workshops, the editors and the anonymous re-
viewers of this journal. This research did not receive any specific grant from funding agencies in the public, commercial, or
not-for-profit sectors.
Appendix A. Variable definitions
Measures of bid-ask spreads
ABSPRDt The cumulative daily abnormal bid-ask spreads from 2 days before to 2 days after unexpected loss announcements for quarter t.
TOTSPRDt The cumulative daily total bid-ask spreads from 2 days before to 2 days after unexpected loss announcements for quarter t.
PRESPRDt The mean daily bid-ask spreads during the estimation window beginning 50 days before the event period and ending 21 days before the
event period.
SPRD_EXCFt Either abnormal bid-ask spreads unexplained by the volatility of cash flows (ABSPRD_EXCFt) or total bid-ask spreads unexplained by the
volatility of cash flows (TOTSPRD_EXCFt).
ABSPRD_EXCFt The residuals from the regression of ABSPRDt on the standard deviation of cash flows from operations scaled by total assets during the past
20 quarters prior to quarter t.
TOTSPRD_EXCFt The residuals from the regression of TOTSPRDt on the standard deviation of cash flows from operations scaled by total assets during the past
20 quarters prior to quarter t.
Main variables
ISRHOt The correlation between the change in pre-discretionary earnings and the change in discretionary accruals during the past 20 quarters prior
to unexpected loss announcements for quarter t.
ISVOLt The standard deviation of net income scaled by total assets divided by the standard deviation of cash flows from operations scaled by total
assets during the past 20 quarters prior to unexpected loss announcements for quarter t.
EARNVOLt The variance of net income scaled by total assets during the past 20 quarters prior to unexpected loss announcements for quarter t.

m1t EARNVOLt if EARNVOLt bs1
m1t ¼
s1 if EARNVOLt ≥ s1

m2t 0 if EARNVOLt bs1
m2t ¼
EARNVOLt −s1 if EARNVOLt ≥s1
SMTHDUMt An indicator variable equal to one if the firm is a smoothing firm with ISVOLt less than one, and zero otherwise.
INSt Institutional ownership (INST) or analyst following (AF) at the end of the quarter prior to unexpected loss announcements for quarter t.
INSTt The percentage of common shares held by institutions at the end of the calendar quarter prior to unexpected loss announcements for
quarter t.
AFt The natural logarithm of one plus the number of analysts following a firm prior to unexpected loss announcements for quarter t.
PSMDt An indicator variable equal to one for the smoothing firms in the bottom tercile of ISRHO, and zero for firms in the top tercile of ISRHO.
Control variables
CARt The cumulative abnormal returns from 2 days before to 2 days after unexpected loss announcements for quarter t.
ABSCARt The absolute value of CARt.
FEt The logarithm of the absolute value of analysts' EPS forecast error for quarter t.
SIZEt Firm size, defined as the logarithm of total assets at the end of quarter t.
ABACCt Abnormal accruals estimated from the modified Jones model for quarter t.
ROAt The return on assets for quarter t, calculated as income before extraordinary items divided by total assets.
(continued on next page)

Appendix A. (continued)
(continued)
Measures of bid-ask spreads
ROA_RANKt The scaled decile ranks of ROAt, calculated by ranking ROAt into ten deciles (0 to 9) and then dividing the decile number by 9.
ΔROAt The change in the return on assets from quarter t − 1 to quarter t, where the return on assets is calculated as income before extraordinary
items divided by total assets.
ΔCURRt The change in the current ratio from quarter t − 1 to quarter t, where the current ratio is calculated as current assets divided by current
liabilities.
ΔLEVt The change in financial leverage from quarter t − 1 to quarter t, where financial leverage is calculated as total liabilities divided by total
assets.
ROAt − 1 The return on assets for quarter t − 1, where the return on assets is calculated as income before extraordinary items divided by total assets.
CURRt − 1 The current ratio for quarter t − 1, where the current ratio is calculated as current assets divided by current liabilities.
LEVt − 1 Financial leverage for quarter t − 1, where financial leverage is calculated as total liabilities divided by total assets.
LASTGAINt LASTGAIN is a dummy variable, equal to one if the firm did not report any quarterly losses during the past 20 quarters prior to unexpected
loss announcements for quarter t, and zero otherwise.
TIMELOSSt TIMELOSS is a dummy variable equal to one if losses were reported in any of the past four fiscal quarters prior to unexpected loss
announcements for quarter t, and zero otherwise.
LASTLOSSt LASTLOSS is the return on assets for the most recent quarter with losses if the firm reported any quarterly losses during the past 20 quarters
prior to unexpected loss announcements for quarter t, and zero otherwise.
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Income Smoothing Bid Ask Spreads

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Journal of Corporate Finance 48 (2018) 442–459

Contents lists available at ScienceDirect

Journal of Corporate Finance

Income smoothing may result in increased perceived riskiness:

2. Related literature and hypothesis development

2.1. Potential beneﬁts of income smoothing

2.2. Potential drawbacks of income smoothing

3.1. Measures of income smoothing

ACC t =TAt−1 ¼ β1 ð1=TAt−1 Þ þ β2 ΔSALESt =TAt−1 þ β3 PPEt =TAt−1 þ β4 ROAt þ εt ð1Þ

3.2. Empirical models

SPRDt ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t þ β5 ROA RANK t

TOTSPRDt ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t þ β5 ROA RANK t

Mean Std. Q1 Median Q3 Mean Std. Q1 Median Q3

Industry SIC code Frequency Percent Cumulative frequency Cumulative percent

Agriculture, forestry, and ﬁsheries b1000 2 0.03 2 0.03

TOTSPRDt (1) 0.41

Coeff. t-Stat Coeff. t-Stat

ABSCARt 0.013 (3.08)*** 0.015 (1.79)*

Panel B: the moderating role of institutional ownership and analyst following

Dependent var: TOTSPRDt

INS = INST INS = AF

Coeff. t-Stat Coeff. t-Stat

ABSCARt 0.012 (1.54) 0.021 (2.62)***

5.2. Propensity score matching test

PSMDt ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t þ β5 ROA RANK t

Panel A: pre-match propensity score regression and post-match diagnostic regression

Dependent var: PSMDt

Coefﬁcient p-Value Coefﬁcient p-Value

ABSCARt −0.804 0.054 0.068 0.891

High smoothing ﬁrms I Low smoothing ﬁrms II Difference I–II p-Value

ABSPRDt 0.005 0.001 0.004 0.002

Dependent var: PRESPRDt

Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat

ABSCARt − 1 −0.002 (−1.71)* −0.002 (−1.35) −0.004 (−1.27)

PRESPRDt ¼ β0 þ β1 ABSCARt−1 þ β2 FEt−1 þ β3 SIZEt−1 þ β4 ABACC t−1 þ β5 ROAt−1

5.4. Results based on alternative samples

5.5. Using income smoothing measure based on earnings volatility

SPRD EXCF t ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t þ β5 ROA RANK t

6.1. Changes in income smoothing following loss announcements

ABSPRDt TOTSPRDt ABSPRDt TOTSPRDt

Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat

ABSCARt 0.011 (4.49)*** 0.000 (0.04) 0.011 (2.61)*** −0.012 (−1.41)

6.2. The non-linear effect of earnings volatility on abnormal bid-ask spreads

ABSPRDt TOTSPRDt ABSPRD_EXCFt TOTSPRD_EXCFt

Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat

ABSCARt 0.010 (2.48)** 0.014 (1.72)* 0.010 (2.47)** 0.013 (1.62)

Pre-loss period Post-loss period Change in income smoothing

No. of ﬁrms Mean p-Value Mean p-Value Difference p-Value

ISRHO 589 −0.932 0.000 −0.806 0.000 0.126 0.000

ABSPRD EXCF t ¼ β0 þ β1 ABSCARt þ β2 FEt þ β3 SIZEt þ β4 ABACC t

m1t and m2t are deﬁned as follows.

Dependent var: ABSPRD_EXCFt

s1 = 40th percentile of s1 = 60th percentile of

Coeff. t-Stat Coeff. t-Stat Coeff. t-Stat

ABSCARt 0.005 (2.96)*** 0.005 (3.01)*** 0.005 (3.01)***

A: The coefficients on m1 with different cutoffs for s1

B: The t-statistics of the coefficients on m1 with different cutoffs for s1

Appendix A. Variable deﬁnitions

Measures of bid-ask spreads

(continued on next page)

Measures of bid-ask spreads

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ABSCARt 0.011 (4.49)* 0.000 (0.04) 0.011 (2.61)* −0.012 (−1.41)

ABSCARt 0.005 (2.96)* 0.005 (3.01)* 0.005 (3.01)***