Sources of earnings variability and their effect on earnings forecasts

Previous research shows that analysts’ forecasts of earnings do not fully incorporate information contained in reported earnings variability. This study investigates whether the inefficient forecast is because of a failure to incorporate observable information on two components of earnings variability: variability in operating performance and income smoothing. Our results show that analysts’ forecasts fully incorporate information contained in earnings variability for firms with high income smoothing and for firms with low operating variability. A smaller serial correlation of forecast errors is observed for firms with low operating variability, which suggests that analysts recognize the permanence in earnings for such firms.