Earnings Smoothness and Capital Structure

• In Event: Lending and Performance

Abstract

This paper examines the relation between earnings smoothness and firms’ capital structure. Prior research has argued that earnings smoothing improves debt capacity by reducing perceived default risk. Separately, theory also posits that earnings smoothing favors equity financing by reducing the information disadvantage of uninformed investors. In light of these distinctive and conflicting effects, it is far from clear whether earnings smoothing favors debt or equity financing at the margin. Using U.S. data from 1989 to 2011, we find a positive association between smoother earnings and leverage. Probing further, we find earnings smoothness-leverage relation holds only for the subset of firms for which earnings volatility is lower than cash flow volatility. Finally, when we decompose earnings smoothness into its non-discretionary and discretionary components, we find the positive association between earnings smoothness and leverage is due to the discretionary component. In contrast, the discretionary component of earnings smoothness negatively impacts leverage when earnings are more volatile than cash flows. Overall, our study aims to empirically sort out the conflicting views on the relation between earnings smoothing and capital structure. In general, we find earnings smoothness allows for a capital structure that tilts towards greater debt financing and this effect is not subsumed by measures of credit ratings and default risk.

Authors

• Inder K Khurana, University of Missouri–Columbia

• Dan S Dhaliwal, The University of Arizona

• Raynolde Pereira, University of Missouri–Columbia

• Rong Zhong, University of Missouri–Columbia