Earnings Smoothing, Governance and Liquidity: International Evidence

Abstract

We examine the relation between earnings smoothing, governance and liquidity for a sample of non-U.S. firms. We divide smoothing into innate and discretionary components, and find that discretionary smoothing is increasing in incentives to smooth (greater tax-book conformity, concentrated ownership, related party transactions and weak overall governance) and decreasing in oversight (investor protection, analyst following and ADR listing). Given the potential for smoothing to affect transparency, we examine the relation between smoothing and investors' willingness to transact in the stock as reflected in liquidity. After controlling for other liquidity determinants, we find that firms with greater levels of discretionary smoothing experience lower liquidity as evidenced by greater frequency of zero returns days, lower trading volume and higher bid-ask spreads. In contrast, results for innate smoothing suggest that innate smoothing is positively correlated with liquidity. Taken together, our results suggest that investors differentiate between innate and discretionary smoothing, and discretionary smoothing reduces their willingness to transact in the stock.

Keywords: earnings smoothing, earnings management, liquidity, accounting quality, governance

JEL Classification: G15, G32, M41, M43, M47