Earnings smoothing: Does it exacerbate or constrain stock price crash risk?

- High degree of earnings smoothing is associated with high stock price crash risk.
- The association is more pronounced when managers likely conceal bad information.
- Cross-sectional variations exist in external monitoring and information environment.
- Negative future stock returns suggest earnings smoothing is value destructing.
- Investors should be cautious about the downside risk of earnings smoothing.

We examine the relation between earnings smoothing and stock price crash risk to evaluate the role of earnings smoothing on the downside risk of equity values. We find that, within firm, a higher degree of earnings smoothing is associated with greater crash risk; and this association, in the cross-section, is more pronounced for firms with fewer analysts following, smaller institutional holdings, and positive cumulative discretionary accruals. We also use stock returns to assess the economic significance of our results. We find that, controlling for firm fixed effects, earnings smoothing is associated with sizable negative returns in the quarter following the earnings announcement. Our findings caution investors about the downside risk of firms reporting smooth earnings, in contrast to the conventional belief that these firms are low in equity risk.