Do Firms Smooth Earnings Less When They Can Hedge Noise Better?

Firms’ use of accounting discretion to report a smooth earnings profile is commonly believed to be pervasive. We examine whether smoothing, at least partly, reflects managerial attempts to avert unhealthy pressures from outsiders who cannot fully disentangle the impact of transitory shocks from sustainable trends in value creation. Using variation in firms’ ability to hedge foreign currency (forex) exposure through derivatives, we find that firms are less likely to smooth earnings when they can better shield their business from extraneous forex fluctuations. Our findings inform the debate on discretion in accounting rules and illustrate how markets that facilitate efficient reallocation of risk can shape the informational properties of accounting output.