Economic policy uncertainty and incentive to smooth earnings

Abstract

We examine how economic policy-induced uncertainty influences managers' discretionary accounting choices to achieve a smoother earnings stream. We find that managers offset the partial risk of policy uncertainty on reported earnings by using discretionary accruals. We mainly observe that firms report more negative discretionary accruals when managers are less certain about their prospects. We further show that managers' engagement in income-decreasing earnings management is more significant when firms’ current period pre-managed earnings are higher. To complete the story, we also find that the propensity of reversal of discretionary accruals is positively associated with levels of policy uncertainty. Our results imply that managers opportunistically use discretionary accruals around an uncertain exogenous environment to smooth earnings.