This study examines whether and when real earnings smoothing influences firm-specific stock price crash risk. Using a sample of U.S. public firms for the years 1993 through 2014, we find real earnings smoothing to be positively associated with firm-specific stock price crash risk. This finding is consistent with the view that real earnings smoothing helps managers withhold bad news, keep poor-performing projects, conceal resource diversion, and engage in ineffective risk management, which increases crash risk. Further, we find a stronger relation between crash risk and real earnings smoothing when firm uncertainty is higher, product market competition is lower, and balance sheet constraint is higher. Overall, our study suggests that real earnings smoothing destroys shareholder value in that it increases stock price crash risk.

Introduction

Accounting literature has long recognized that managers use their discretion to “intentionally dampen the fluctuations of their firms’ earnings realizations” (Beidleman 1973, 653). They can do so through accrualbased earnings smoothing or real earnings smoothing.1 Real smoothing involves real economic actions that managers undertake to reduce earnings volatility. It can be achieved by changing the timing or structuring of an operating, investment, or financing transaction. For instance, managers can smooth earnings by adjusting production and investment decisions (e.g., Lambert 1984; Acharya and Lambrecht 2015). However, prior research has largely focused on accrual-based earnings smoothing, and paid little attention to real smoothing, although real smoothing is more pervasive in practice than accrual-based smoothing (Lambert 1984). In a survey of chief financial officers (CFOs) by Graham, Harvey, and Rajgopal (2005), 78 percent of survey participants admit to taking value-destroying real economic actions to achieve smoother earnings. Despite the potential for real smoothing to impair shareholder value, prior studies have provided little evidence on its value implications to shareholders. To fill the void in the literature, this study examines whether and when real earnings smoothing influences firm-specific stock price crash risk, an extreme return outcome. Real earnings smoothing could influence stock price crash risk through its impact on the flow of firmspecific information to the market as well as its impact on real decision making. Regarding the informational effect, real smoothing enables income to be overstated following negative earnings surprises, and thereby facilitates bad-news hoarding, which increases the probability of stock price crashes (Jin and Myers 2006). Also, because real smoothing can be used to manage investor expectations and limit their intervention (Acharya and Lambrecht 2015), real earnings smoothing can enable managers to keep unprofitable projects and conceal and continue resource diversion for too long, increasing the probability of stock price crashes (Bleck and Liu 2007; Kim, Li, and Zhang 2011a). In addition, real smoothing can allow managers to engage in ineffective risk management, which could increase crash risk, since real smoothing reduces investor perception about firm risk and hence the likelihood of investor intervention in risk management. Given that real smoothing can affect information flow and real activities, we expect real smoothing to be positively associated with future stock price crash risk.