The Impact of Income Smoothing on Firm Value after the Sarbanes-Oxley Act

Sammanfattning: Purpose: To empirically investigate whether income smoothing creates or destroys value after the enactment of the Sarbanes-Oxley Act, which has tremendously changed the legal environment of income smoothing. We compare our results with pre-SOX research to conclude whether and how legislation change has affected the perception of income smoothing. Further, we make recommendations based on our research how managers should approach income smoothing. Methodology: We use three income smoothing measures (corr(PME, DA), corr (TACC, CFO), earnings volatility / cash flow volatility) to detect managers’ actions to dampen the volatility of earnings. We regress them on stock return and as control variables we use the Fama French five factor model that explains stock returns. We control for industry, the 2008 financial crisis and earnings yield as well. Empirical foundation: We collect annual data from 2004-2012 for all US nonfinancial companies from the Standard & Poor’s capital IQ data base that do not have missing observations. Our balanced panel data consists of 1.882 companies and 13.174 firm-year observations. Conclusions: Based on our results, income smoothing creates value in contrast with pre-SOX research. Our primary explanation is that SOX has changed the legal environment, in which managers are demotivated to act opportunistically. Investors regained their trust in financial reporting and do not consider managers’ actions delusive. This explanation induces managers to discontinue the application of real income smoothing and return to accrual-based income smoothing. Another possible explanation is that the effect of income smoothing is determined by market uncertainty. Under high market uncertainty accrual-based income smoothing garbles information and thus destroys firm value whereas under low market uncertainty it boosts firm value. Managers should refrain from accrual-based income smoothing if market uncertainty is high, but they ought to use accrual-based income smoothing if market uncertainty is low. At last, we note that the 2008 financial crisis does not influence the perception of income smoothing according to our results.