Environmental uncertainty and the market pricing of earnings smoothness

Environmental uncertainty induces variability in an organization's reported earnings, and accentuates the information asymmetry between its managers and outside stakeholders. Managers operating in an environment of high uncertainty, therefore, have an incentive to reduce such variability by smoothing income numbers. We investigate the stock market response to earnings smoothness for firms operating in an environment of high uncertainty. We measure income smoothing by the negative correlation of a firm's change in discretionary accruals with its change in pre-managed earnings as per Tucker and Zarowin (2006). Using future earnings response coefficient (FERC) methodology to measure the informativeness of smoothed earnings, and two measures of environmental uncertainty, this paper documents that current stock price incorporates more information about future earnings for firms operating in high uncertain environments, thus supporting the informational value view of income smoothing.