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The effect of income smoothing on the informativeness of stock price: Evidence from
the Tehran Stock Exchange
Mahdi Salehi Nazanin Bashiri Manesh
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To cite this document:
Mahdi Salehi Nazanin Bashiri Manesh, (2011),"The effect of income smoothing on the informativeness of
stock price", Asian Journal on Quality, Vol. 12 Iss 1 pp. 80 - 90
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AJQ
12,1
The effect of income smoothing on
the informativeness of stock price
Evidence from the Tehran Stock Exchange
80 Mahdi Salehi
Accounting and Management Department, Islamic Azad University,
Hidaj City, Iran, and
Nazanin Bashiri Manesh
Department of Accounting, Payam-e-Noor University, Birjand, Iran
Abstract
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Purpose The purpose of this paper is to investigate whether income smoothing does indeed
improve the informativeness of stock prices about firms future earnings and cash flows. Also an
approach to studying the effects of income smoothing is presented.
Design/methodology/approach This study uses data from 1992-2006 and runs regressions on
each of the 560 industry-year cross-sections. The data compiled from the financial statements of firms
were collected for each year available from the Tehran Stock Exchange database. Income smoothing is
defined as the management of accruals to reduce time-series variation in income, and uses a cross-
sectional version of the Jones model, modified by Kothari, Leone and Wasley. Smoothing is measured
as the variation of net income relative to the variation in CFO, or the correlation between changes in
accruals and changes in CFO. Informativeness is measured as the coefficient on future earnings (cash
flows) in a regression of current stock return against current and future earnings (cash flows and
accruals).
Findings The findings suggest that income smoothing enhances the information content of the
effect of stock price on future earnings, thus improving the ability of market participants to make
informed decisions about the allocation of capital resources.
Originality/value Although previous research on the subject of income smoothing in an emerging
market has been documented, its effect on stock prices efficiency is largely unknown. Thus, this paper
presents an approach to studying the effects of income smoothing and the knowledge that the ability to
manage earnings could improve stock prices efficiency could be useful for academics and
policymakers in this market.
Keywords Iran, Financial markets, Income, Earnings, Cash flow, Stock markets
Paper type Research paper
1. Introduction
Some academics and regulators tend to interpret the earnings management activities
as driven by managers opportunistic incentives. They believe that managing earnings
can mislead investors and therefore result in erroneous stock responses (Levitt, 1998).
Another belief is that earnings management conveys managers private information
about a firms future performance and therefore helps bridge the information gap
between managers and the capital market (Ronen and Sadan, 1981; Chaney and Lewis,
1995; Kirschenheiter and Melumad, 2002). Previous literature offers supporting
evidence for the two alternatives. This is an important question in an emerging market.
Although various research into income smoothing in an emerging market has been
documented, its effect on stock price informativeness is largely unknown. Among the
Asian Journal on Quality
Vol. 12 No. 1, 2011
international literature account, research by Zarowin (2002) and Tucker and Zarowin
pp. 80-90 (2006) have different methodologies. This paper contains a review of the effect of
r Emerald Group Publishing Limited
1598-2688
income smoothing in the Tehran Stock Exchange (TSE), with the intention to verify the
DOI 10.1108/15982681111140561 association between the degree of income smoothing and its effect on the market,
particularly in the level of risk and shareholder return. Tehran provides an interesting The effect
environment to test the effectiveness of income smoothing on the informativeness of of income
stock prices. On one hand, income smoothing would be useful when management with
sufficient future earnings growth is smoothing its earnings. This action communicates smoothing
information on the management of future earnings that are reflected on the stock prices
and increases the earnings prediction of investors. On the other hand, income
smoothing can potentially affect the users behavior. Most investors prefer to invest in 81
companies that have a fixed profit-making trend, because companies with an extra
fluctuating income are considered more risky than those with a fixed income.
In this paper, we focus on the interests of income smoothing in the capital market.
Our primary contribution is to use the approach of Zarowin (2002). Income smoothing
is defined as the management of accruals (net income CFO) to offset variation in CFO.
We measure income smoothing as the variation of net income relative to the variation
in CFO, or the correlation between changes in accruals and changes in CFO.
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Also, we use discretionary accruals estimated with the Jones model modified by
Kothari et al. (2005) as our measure of earnings management. The paper studies the
empirical evidence of the relation between income smoothing and stock price
informativeness. If income smoothing makes earnings more informative, stock price
(return) reflects more information about both future earnings and future cash flows.
Our empirical analysis is conducted on a sample of 560 firm-year observations over
the period 1992-2006. Consistent with our hypotheses, we find a significant negative
relationship between the criteria of income smoothing and the coefficient on future
earnings (cash flow). In summary, the tests find that increased smoothing is associated
with stock prices that reflect more information about future earnings and future cash
flows. The results of this study are consistent with the theoretical predictions
and empirical findings of similar research (Schipper, 1989; Subramanyam, 1996;
Zarowin, 2002; Tucker and Zarowin, 2006). The rest of this paper is organized as
follows. We discuss the relevant extant research and present our hypotheses in the
next section. In Section 3, we describe the data, the variables used, and the empirical
procedures. We present and interpret the results of the empirical analysis in Section 4.
This is followed by a summary and conclusions in Section 5.
increasing income informativeness level of future earnings and cash flows. In this
research, Collins et al.s (1994) approach was used. The results showed that the income
smoothing companies provided more information on their future profitability.
Subramanyam (1996) sampled more than 2,800 firms over the period 1973-1993 and
reported that discretionary accrual manipulations improve the ability of earnings to
reflect the firms economic value, and thus are priced by an efficient market.
H2. Firms with smoother incomes have a higher future cash flow response
coefficient.
(2002) for annual data. The second is dNI/dCFO, the variation of net income relative to
the variation in CFO, which has been used for annual data by Zarowin (2002). A greater
degree of income smoothing is evidenced by a lower relative variation in net income
and a lower (or more negative) correlation between accruals and CFO. We use annual
data, based on the assumption that management attempts to smooth year-to-year
variations in income. We use three years of NI and CFO to construct dNI/dCFO, and three
years of changes in accruals and changes in CFO to construct Corr (DACC, DCFO).
Most of the research about the signaling hypothesis examining earnings
managements role in conveying value-relevant information, uses certain
discretionary accrual models; for example, Subramanyam (1996) documents that the
market rationally attaches positive value to discretionary accruals. To estimate
discretionary accruals, we use the cross-sectional version of the Jones model, modified
by Kothari et al. (2005):
Accrualst a1=Assetst1 bDSalest cPPEt dROAt mt 1
In Model (1), the total accruals (Accruals); change in sales (DSales); and gross property,
plant, and equipment (PPE) are each deflated by the beginning-of-year total assets
(Assets). Return on assets (ROA) is added as an additional control variable because
previous research finds that the Jones model is specified for well-performing or poorly
performing firms (Dechow and Skinner, 2000; Kothari et al., 2005).
4. Empirical framework
84 The rationale for the use of accrual accounting is that it allows management to adjust
cash flows to better reflect the performance and position of the firm. In this context,
accruals are used as a signal to the market; however, the accrual component of
earnings may be a potent detractor from the reliability of earnings. If management
uses accruals to adjust cash flows to present a credible signal to the market, then
earnings should remain value-relevant and affect the FERC; however, if accruals are
used opportunistically by management, the reliability of the earnings figure is
undermined and thus should be less value-relevant. Total accruals were estimated as
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the difference between earnings and cash flows from operations. The Jones model was
used to determine the discretionary component of accruals. This involved regressing
total accruals against change in revenue and property, plant, and equipment. The
estimated regression model was used to calculate the expected level of total accruals.
The difference between the actual accruals and this expectation was deemed to be a
discretionary component of the total accruals. Zarowin (2002) uses the followed model
to deal with this issue:
Rt a b0 CFt1 b1 CFt b2 CFt1 c0 ACCt1
3
c1 ACCt c2 ACCt1 b3 Rt1 ut
In Model (3), the primary coefficient of interest is b2, the future cash flow response
coefficient, FCFRC. Since income smoothing, by definition, involves the manipulation
of accruals, it should affect the FERC through c2, the coefficient of ACCt 1, not through
b2, the coefficient of CFt 1. Thus, the coefficient of CFt 1 can be interpreted as an
informativeness measure. Given adequate controls, higher values of b2 indicate that
current returns capitalize more information about future cash flows.
We will review the issue of whether in the companies with smoother income, the
current returns include more information about future performance. For example:
. The Pearson coefficient will be calculated for changes in the total accruals
and the cash flows of operations Corr (DACC, DCFO) between years t and t4
(all variables divided by assets at the beginning period of the year t).
. The ratio of the variation of net income relative to the variation in CFO
(dNI/dCFO) in the years of t and t3 will be calculated. In order to control the
effects of the time and industry, the calculated coefficients are ranked separately
in each of the industries between 0 and 1.
Our results use the variable, Dt, defined using the following regression model:
Since higher values of the smoothing measures mean less smoothing, a positive
(negative) b2 means that firms with less (more) smoothing have higher FERC in Model
(3) and FCFRC in Model (4), which implies that smoothing decreases (increases) stock The effect
price informativeness. The b2 negative coefficient means that the companies with of income
smoother income will have higher future earnings and future cash flow response
coefficients. Therefore, the stock prices of the companies with smoother incomes will smoothing
have more information on the future status of the company and the b positive
coefficient will have a converse meaning.
Total accruals can be decomposed into discretionary and non-discretionary 85
components. As the discretionary component of accruals provides management with
the opportunity to manipulate earnings, they are used as an indicator of earnings
management. To estimate discretionary accruals, we use the cross-sectional version of
the Jones model, modified by Kothari et al. (2005). The above model shows firms with
smoother earnings, while using discretionary accruals in measuring smoothing
earning factors shows firms with smoothed earnings. The income-smoothing
measures are the correlation between the change in discretionary accruals and the
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change in pre-discretionary income: Corr(DACC, DPDI), using the current years and
past four years observations and the ratio of the variation of net income relative to the
variation in pre-discretionary income (dNI/dPDI), using the current years and past
three years observations. In order to control the effects of the time and industry, the
calculated coefficients are ranked separately in each of the industries between 0 and 1.
Out results, as a variable, Dt, are defined using the regression model shown in Model (4).
5. Empirical results
To evaluate the effect of income smoothing on the information content of stock
prices, it is necessary, at first, to consider the returns in relation to the future earnings.
The applied model in this study is the Zarowin model (2002), which is based on the
Collins et al. (1994) model.
The results of this model are shown in Table I.
As can be seen in Table I, the coefficients of b1 and b2 are positive and meaningful
and b14b2. This means that during the study with 99 percent significance, the
information about current and future earnings is reflected in the stock price. The
information content of future earnings and cash flows is then considered.
Zarowin (2002) states that income smoothing will reduce the variances in the earnings
and can lead to more predictability of the earnings in the future years. This increases the
FERC. Hence, if the future earnings applied in the model are considered as variables,
which have been based on the information content of earnings of the previous periods,
the FERC should change, negatively, with the income smoothing criteria. In order to
study this problem, Model (3) was used. The results are shown in Table II.
In Table III, the results relate the first criteria of the smoothing earnings. As the
results in Table III show, the coefficients of Et and Et 1 are positive and the coefficient
of DtEt 1 is negative. Also, b14b2, this means that, at a significance level of
95 percent, the firms with smoother incomes will have a higher FERCs. Therefore, the
(2005), the discretionary accruals have been calculated and the regression Model (4)
and the above-mentioned criteria have been used to study this problem.
In Table V, the results relate to regression Model (4), using the first criteria for the
first hypothesis and Table VI shows the results related to this model by the second
88
6. Conclusion
This study examines the relationship between income smoothing and the information
content of stock price. Here, income smoothing was considered as the manipulation
of accruals to reduce earnings volatility and information content of stock price as
the amount of information reflected in current stock returns about future earnings
or cash flows. The results demonstrate that income smoothing affects the
informativeness of stock price about future profitability and cash flows. Ideally,
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this finding would show that income smoothing enhances the information content
of stock price about future earnings, thus improving the ability of market participants
to make informed decisions about the allocation of capital resources. The results of
this research are in line with research studies conducted by Whelan (2004);
Xue (2003); Zarowin (2002); Toker and Zaroein (2006). It is expected that income
smoothing could meet the needs of both sides (owners and agents) and have a positive
effect on the market.
Also, the results show that the stock price of firms that have smoother incomes
will have higher information on the future cash flows of the firms. The investors not
only pay attention to the amount of profitability, but also consider the cash flow
of firms as one of the criteria to valuate the company that has a key role in the stock
value model.
Our empirical results suggest that the capital market and analysts recognize the
information content of income smoothing as a signal about future performance of the
firm. This paper is useful to the study of effects of other types of earnings management
on the capital market and firm value in future research.
Kirschenheiter, M. and Melumad, N. (2002), Earnings quality and smoothing, working paper,
Columbia University, New York, NY.
Kothari, S., Leone, A. and Wasley, C. (2005), Performance matched discretionary accruals,
Journal of Accounting and Economics, Vol. 39 No. 1, pp. 161-97.
Levitt, A. (1998), The numbers game, speech delivered at NYU Center for Law and Business,
New York, NY, September 28.
Livnat, J. and Zarowin, P. (1990), The incremental information content of cash flow
components, Journal of Accounting and Economics, Vol. 13 No. 1, pp. 25-46.
Marquardt, C. and Wiedman, C. (2004), The effect of earnings management on the value
relevance of accounting information, Journal of Business, Finance and Accounting, Vol. 31
Nos 3-4, pp. 297-328.
Ronen, J. and Sadan, S. (1981), Smoothing Income Numbers: Objectives, Means, and Implications,
Addison-Wesley, Reading, MA.
Schipper, K. (1989), Earnings management, Accounting Horizons, Vol. 3 No. 4, pp. 91-106.
Subramanyam, K. (1996), The pricing of discretionary accruals, Journal of Accounting and
Economics, Vol. 22 No. 1, pp. 249-81.
Tucker, W. and Zarowin, P. (2006), Does income smoothing improve earnings informativeness?,
The Accounting Review, Vol. 81 No. 1, pp. 251-70.
Xue, Y. (2003), Information content of earnings management: evidence from managing earnings
to exceed thresholds, working paper, available at: www.ssrn.com/id (accessed May 10,
2009).
Zarowin, P. (2002), Does income smoothing make stock prices more informative?, working
paper, New York University Stern School of Business, available at: www.ssrn.com/id
(accessed June 13, 2009).
Further reading
Catherine, W. (2004), The impact of earnings management on the value-relevance of earnings
and book value: a comparison of short-term and long-term discretionary accruals,
a dissertation submitted to the faculty of business in candidacy for the degree of doctor of
philosophy, pp. 105-24.
Collins, D. and Kothari, S. (1989), An analysis of the intertemporal and cross-sectional
determinants of earnings response coefficients, Journal Accounting and Economics,
Vol. 11 Nos 2-3, pp. 143-81.
Gelb, D. and Zarowin, P. (2002), Corporate disclosure policy and the informativeness of stock
prices, Review of Accounting Studies, Vol. 7 No. 1, pp. 33-52.
AJQ Healy, P. and Wahlen, J. (1999), A review of the earnings management literature and its
implications for standard setting, Accounting Horizons, Vol. 13 No. 4, pp. 365-83.
12,1
Qiang, C. and Warfield, T. (2005), Equity incentives and earning management, The Accounting
Review, Vol. 80 No. 2, pp. 441-76.
Stolowy, H. and Berton, G. (2004), Accounts manipulate: a literature review and proposed
conceptual frame work, The Review of Accounting and Finance, Vol. 3 No. 1, pp. 5-66.
90 Steveny, M. and Vanstraelen, A. (2006), Earning management within Europe: the effect of
member state audit environment audit firm quality and international capital market,
Accounting and Business Research, Vol. 36 No. 1, pp. 33-52.
international journals and he is on the editorial boards of 19 international journals. Mahdi Salehi
is the corresponding author and can be contacted at: mahdi_salehi54@yahoo.com
Nazanin Bashiri Manesh is a Lecturer at Payam-e-Noor University, Birjand Branch, Iran.
To date, she has published three papers in international journals and some papers in Persian and
in Iran.