Real earnings smoothing and crash risk: Evidence from Japan

Abstract

I focus on the relationship between real earnings smoothing and one-year-ahead firm-specific crash risk in Japan and investigate the effect of financial institutional ownership and the implementation of J-SOX on the above relationship. Specifically, I hypothesize that the garbling real earnings smoothing is positively associated with stock price crash risk, and the informative real earnings smoothing is negatively associated with stock price crash risk. My results show that the crash risk increases as the garbling real earnings smoothing increases due to the managerial concealment of bad news about firms’ prospects. However, there is no significant relationship between the informative real earnings smoothing and crash risk. I further find that the relation between garbling real earnings smoothing and crash risk is constrained by effective external monitoring by stable institutional investors and the implementation of J-SOX. Further evidence indicates that there is a significant and negative relationship between the garbling real earnings smoothing and asymmetric timeliness with respect to bad news. These results suggest that managers undertake the garbling component of real earnings smoothing to withhold the negative private information, resulting in the increase of downside risk of firms’ stock price. Overall, this study investigates the role of real earnings smoothing in the negative information transmission by managers in Japanese firms.