A well-known stylized fact in the literature is that managers engage in earnings smoothing: they report earnings that are sometimes higher than economic earnings and sometimes lower (see, e.g., Beidleman, 1973; Lev and Kunitzky, 1974; Ronen and Sadan, 1981, Hand, 1989; Barth, Elliott, and Finn, 1999; Goel and Thakor, 2003; Leuz, Nanda, and Wysocki, 2003; Lang, Raedy, and Wilson, 2006; and Myers, Myers, and Skinner, 2007).
Recent survey evidence provides further confirmation that managers actively smooth earnings, as evidenced by a quote from an interviewed CFO: “businesses are much more volatile than what their earnings numbers would suggest” (Graham, Harvey, and Rajgopal, 2005). However, the degree of earnings smoothing varies in the cross section of firms. This has led to research that has uncovered several factors that help explain cross-sectional variations in earnings smoothing.
While research on the determinants of earnings smoothing and how these vary in the cross section has enriched our understanding of the phenomenon, the focus has mainly been on exploring how differences in firm-specific attributes (e.g., cash flow volatility, systematic risk, etc.) can explain differences in the degree of earnings smoothing across firms. Only recently has research attention turned to how certain aspects related to attributes of decision makers in firms may also explain differences in smoothing across firms. Healy (1985) and Bergstresser and Phillipon (2006) examine the impact of executive compensation on cross-sectional differences in earnings smoothing, whereas Klein (2002) and Bowen, Rajgopal and Venkatachalam (forthcoming) focus on the characteristics of boards of directors to understand the issue.
What has not been examined thus far is the effect of the personal attributes of managers on their firms’ smoothing decisions. Bertrand and Schoar (2003) have explained how managerial attributes can affect the policies of the firms they lead, so examining the relationship between managerial attributes and corporate earnings smoothing can contribute to our understanding of the broader question of how managerial attributes and firm performance are linked. Although there are various managerial attributes one could focus on, attributes that have recently received considerable attention are those linked to managerial beliefs. To the extent that the degree of earnings smoothing reflects the manager’s beliefs about future earnings, it is natural to expect that beliefs-based managerial attributes like optimism could affect how much the manager smooths earnings.
Recent evidence indicates that managerial optimism, where optimism is defined as an upward bias in the assessment of future outcomes, does affect a wide range of corporate and individual decisions. For example, Malmendier and Tate (2005, 2008) show empirically that optimistic managers invest more aggressively and are more likely to engage in value-destroying mergers. Manove and Padilla (1999) create a model in which entrepreneurial optimism affects banks’ credit policies. Coval and Thakor (2005) develop a new theory of financial intermediation in which intermediaries arise precisely because of the opportunities created by the presence of optimistic entrepreneurs and pessimistic financiers. Puri and Robinson (2007) explain how optimism affects individual choices, and induces them to be more likely to hold undiversified portfolios as well as remarry after divorce. Recently, Graham, Harvey and Puri (2007) provide survey evidence on the importance of managerial optimism in corporate decisions. The empirically-observed relationship between optimism and a variety of real and financial decisions provides a natural backdrop for the question addressed in this paper: does managerial optimism affect earnings smoothing?
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