Using accounting discretion to smooth earnings is believed to be pervasive. For example, in an influential survey of CFOs, 96.9% of respondents indicate a preference for reporting smooth earnings. The underlying motives and desirability of this phenomenon, however, remain up for debate.
Under one interpretation, managers smooth earnings to mask poor decision making or rent extraction from outsiders at the expense of overall firm value. This suggests that smoothing is an inefficient outcome. Under another more positive interpretation, managers rely on earnings smoothing to deal with the earnings impact of uncontrollable, transitory shocks that can expose managers to unhealthy market pressures. The two possible motives for earnings smoothing are not mutually exclusive but have opposite implications about the desirability of discretion in accounting, making it important to assess their relative economic importance. Our recent paper aims to contribute to this broader research objective by examining if the second explanation represents a plausible driver of earnings smoothing.
When investors cannot distinguish between transitory and permanent earnings changes, managers are concerned that investors may (mis-)interpret a temporary decline in profits as a sign of declining prospects or may mistakenly consider a temporary increase in profits to be sustainable and expect future profits that managers cannot deliver. These concerns are salient because there are adverse effects for CEOs who miss earnings targets, such as declines in their firms’ stock price, lower annual cash bonuses, or worse career outcomes. Absent discretion in accounting, managers may be motivated to inefficiently distort investment and production decisions to smooth out transitory shocks to earnings. Discretion in accounting allows them to achieve the same goal, thus insulating them from external pressures and simultaneously allowing them to pursue worthy projects even if these projects impose transitory fluctuations.
To study whether managers use accounting discretion to smooth out transitory fluctuations in earnings, we measure these fluctuations with firms’ vulnerability to foreign exchange rate (forex) fluctuations for a sample of multinational companies (MNCs). Forex is an important source of fluctuations in earnings for MNCs which they can only imperfectly hedge using a combination of operational and financing hedging. For example, on average, firms in the S&P 500 generate approximately 30% of their revenue in foreign currencies. Moreover, forex can have complicated effects on reported financial statements, and recent research indicates that mandatory and voluntary disclosures are insufficient for investors to disentangle the impact of potentially unsustainable forex-induced changes from sustainable movements in earnings. Consistent with this, investors systematically misinterpret forex fluctuations when making investment decisions. Accordingly, we expect managers of firms more exposed to forex fluctuations to have stronger incentives to engage in earnings smoothing to insulate themselves from external pressures.
To identify firms’ vulnerability to forex fluctuations, we exploit the availability of liquid derivatives that managers can use to hedge forex exposure. Research shows that the majority of firms use currency derivatives to hedge most types of forex exposure. Thus, we would expect more firms to hedge when cost-effective forex derivatives become available, reducing these firms’ vulnerability to forex fluctuations. Although forex derivatives markets have existed in the US since 1972, there has been considerable variation in the availability, liquidity, and efficacy of forex derivatives during our sample period. As a result, depending upon their mix of foreign currency exposure, firms have a differential ability to insulate their profitability from forex shocks using derivatives due to differences in markets for these instruments.
Using this source of variation in firms’ vulnerability to transitory shocks, we find robust evidence of less earnings smoothing when firms have a greater ability to hedge their forex exposure using currency derivatives. We also document two additional results consistent with a benign interpretation of earnings smoothing. First, the effects are stronger for firms exposed to more currencies, namely instances when it is more difficult for investors to isolate forex-induced transitory movements from more permanent changes in earnings. Second, the effects are stronger in industries where CEO turnover is more sensitive to annual performance fluctuations. In such industries, CEOs are more concerned about job loss from a temporary misunderstanding of their long-term business prospects.
While these findings are consistent with our story, it is possible – albeit unlikely – that the availability of forex derivatives is systematically better for countries where the economic environment offers greater opportunities and motives for rent extraction. This would introduce the possibility that our findings reflect changes in rent extraction incentives (the alternative motive for earnings smoothing) rather than managerial attempts to deal with the earnings impact of transitory shocks (the motive for earnings smoothing of interest to us). For this reason, we also use the introduction of new forex derivatives on the Chicago Mercantile Exchange (CME) to further test our theory. We study firms’ earnings smoothing practices around four distinct waves of product launches on CME during 1999, 2002, 2006, and 2009 and document that the introduction of new derivative products is accompanied by reduced earnings smoothing.
Our results indicate that earnings smoothing arises, at least partially, because of managers’ desire to avoid external pressures stemming from extraneous and transitory shocks. To the extent that using accounting discretion to smooth out transitory fluctuations allows managers to avoid distorting their investment and production decisions, our evidence suggests that some discretion in accounting rules that permits earnings smoothing is desirable. Consequently, regulators should consider this benefit when evaluating whether to reduce the discretion allowed to managers by accounting standards. Our findings also speak to how markets that facilitate efficient reallocation of risk – such as forex derivative markets – can shape the properties of firms’ financial reports. When firms cannot share risk in which they have no comparative advantage with other agents in the economy, they may manipulate earnings to mask the performance consequences of that risk. Therefore, well-developed risk-sharing markets may produce the unintended consequence of influencing the properties of firms’ financial reports.
Elia Ferracuti is an Assistant Professor of Accounting at the Fuqua School of Business, Duke University.
Rahul Vashishtha is an Associate Professor of Accounting at the Fuqua School of Business, Duke University.
Shuyan Wang is a PhD Student of Accounting at the Fuqua School of Business, Duke University.
This post is adapted from their paper, “Do Firms Smooth Earnings Less When They Can Hedge Noise Better?” available on SSRN.