Erasmus University Rotterdam - Erasmus University Thesis Repository

Erasmus University Rotterdam
Erasmus School of Economics
Subdepartment Accounting Auditing and Control
Master Thesis (FEM11032)
Supervisor: E.A. de Knecht RA
Co-reader: Dr. sc. ind. A.H. van der Boom
Final draft submitted on September 19th, 2011 Income Smoothing Across Europe
The Informativeness Explored
Thomas van den Assem Abstract
This research studies if the use of income smoothing improves the earnings
informativeness. Tucker and Zarowin (2006) performed a similar research for
a research data sample of US listed companies. Consequently, this research
studies if the use of income smoothing by European listed companies
influences the earnings informativeness. This research shows that the use
of income smoothing does not improve the earnings informativeness. The best
predictive variable for the future earnings per share is the current
earnings per share. The use of income smoothing does not negatively
influence the earnings informativeness, but no significant evidence is
obtained that the use of income smoothing actually improves the earnings
informativeness. Consequently, this research does not contradict the
evidence presented by Tucker and Zarowin (2006), however no significant
research results were obtained to support the conclusions of Tucker and
Zarowin. Index 1. Introduction 2
1.1 Research Setting 2
1.2 Research Objectives 2
1.3 Research Question 2
1.4 Research Methodology 2
1.5 Research Limitations 2
1.6 Structure 2
2. Financial Accounting Theory and the Value of Information 2
2.1 Introduction 2
2.2 Financial Accounting research 2
2.3 The Positive Accounting Theory 2
2.4 Agency Theory 2
2.5 Efficient Market Hypothesis 2
2.6 Stakeholder Theory 2
2.7 The Purpose of Financial Accounting 2
2.8 Summary 2
3. Income Smoothing 2
3.1 Introduction 2
3.2 Earnings Management 2
3.3 Types of Earnings Management 2
3.4 Income Smoothing 2
3.5 Types of Smooth Income Streams 2
3.6 The Advantages and Disadvantages of Income Smoothing 2
3.7 Motives for Income Smoothing 2
3.8 Smoothing Elements 2
3.9 Measuring Income Smoothing 2
3.10 Summary 2
4. Informativeness 2
4.1 Introduction 2
4.2 Definition of Informativeness 2
4.3 Informativeness of Financial Data 2
4.4 Informativeness and Efficient Markets 2
4.5 Decision Usefulness and Value Relevance 2
4.6 Measuring Informativeness 2
4.7 Summary 2
5. Prior Empirical Research 2
5.1 Introduction 2
5.2 Empirical Research on Earnings Management 2
5.2.1 Earnings Management and Stock Option Plans 2
5.2.2 Income Maximization 2
5.2.3 Earnings Management and Debt Covenants 2
5.2.4 Earnings Management and Minimization of Taxes 2
5.3 Income Smoothing and Country Studies 2
5.3.1 Income Smoothing in Finland 2
5.3.2 Income Smoothing in Singapore 2
5.3.3. Income Smoothing in Japan 2
5.4 Income Smoothing and Company Characteristics 2
5.4.1 Differences in Core and Periphery Sectors 2
5.4.2 Differences in Core and Periphery Sectors Part 2 2
5.4.3 Differences in Ownership of Companies 2
5.5 Income Smoothing and the Value of the Company 2
5.5.1 Market Valuation of Income Smoothing 2
5.5.2 Market Valuation of Income Smoothing Part 2 2
5.5.3 Market Valuation of Income Smoothing Part 3 2
5.5.4 Income Smoothing, Earnings Quality and Firm Valuation 2
5.6 Income Smoothing and Expected Earnings 2
5.6.1. Smoothing in Anticipation of Future Earnings 2
5.6.2 Smoothing in Anticipation of Future Earnings Part 2 2
5.7 The Informativeness Methodology 2
5.7.1 Pricing Discretionary Accruals 2
5.7.2 Income Smoothing and Equity Value 2
5.7.3 Income Smoothing and Stock Price Informativeness 2
5.7.4 Income Smoothing and Earnings Informativeness 2
5.8 Research Hypotheses 2
5.9 Summary 2
6. Research Design 2
6.1 Introduction 2
6.2 Empirical Research Process 2
6.3 Research Theory 2
6.4 Method to Measure Income Smoothing 2
6.5 Method to Measure Informativeness 2
6.6 Primary Model 2
6.7 Additional Prescriptive Variable 2
6.8 Data Sample 2
6.9 Summary 2
7. Research Results 2
7.1 Introduction 2
7.2 Data Analysis Process 2
7.3 European Smoothers and Non-Smoothers 2
7.4 European Income Smoothing Informativeness 2
7.4.1 Correlation of Earnings per Share 2
7.4.2 Testing the Primary Model 2
7.5 Adjusting for Economic Sector 2
7.6 Summary 2
8. Conclusion 2
8.1 Introduction 2
8.2 Summary 2
8.2 Conclusion 2
8.3 Empirical Research Limitations 2
8.4 Recommendation for Future Research 2
References 2
Appendix 1: Overview of Prior Empirical Research 2
Appendix 2: Empirical Research Data 2 1. Introduction 1.1 Research Setting The process qualified as financial accounting records all financial
transactions performed by companies. One of the outputs of the process of
financial accounting is the financial statements. By the use of financial
reporting management is able to communicate the financial information and
the earnings of the company to the users of the financial statements. The
financial reporting can have many forms such as financial statements or
quarterly earning reports. The users of the financial statements or
stakeholders of the company are several parties inside or outside the
company. Without the financial reporting of the company, the stakeholders
would not be able to obtain the information. Consequently, the financial
reporting is used by the stakeholders as information that is the basis for
many economic decisions.
Because financial reporting is considered to be critical for the economic
decision process of the stakeholders, several regulatory bodies globally
regulate the financial reporting, such as the International Accounting
Standard Board (IASB) and the Financial Accounting Standard Board (FASB).
These regulatory bodies have introduced accounting standards and principles
to standardize the financial reporting. However, the current accounting
standards and principles require the judgment of management to prepare the
financial reporting. Consequently, while preparing the financial reporting
this flexibility in financial reporting enables management to make
subjective decisions. A part of these subjective decisions is the valuation
of several assets and liabilities and in addition, it provides management
with choices what to disclose and what not to disclose about these assets
and liabilities. Consequently, the management has the opportunity to manage
the financial statements of the company. By acting this way, management is
not reporting the actual financial figures and the earnings of the company.
Within financial accounting research, this practice by management is
qualified as earnings management.
For many years, the use of earnings management has been a hot topic in
financial accounting research. Earnings management has been defined as the
attempts by management either to mislead some stakeholders about the
underlying economic performance of the company or to influence contractual
outcomes that depend on reported accounting numbers by the use of judgment
in financial reporting and in structuring transactions to alter financial
reports (Healy and Wahlen, 1999).
According to Scott (2006) four main patterns exist, or the so-called
policies (Hoogendoorn, 2004) of earnings management. These are taking a
bath, income minimization, income maximization, and income smoothing.
Within the financial accounting research topic of earnings management,
researchers have always been very interested in studying income smoothing.
Bao and Bao (2004) stated that in general the study of income smoothing has
been very successful compared to the study of other forms of the use of
earnings management. This success is due to a couple of reasons. First of
all, researchers have been able to define income smoothing more precisely
than other forms of earnings management. One generally accepted definition
of income smoothing is "an attempt by managers to manipulate income numbers
so as to impart to the resulting series a desirable and smooth trend"
(Ronen and Sadan, 1981). This implies that in periods of high earnings,
management to a certain level will minimize the earnings and in periods of
low earnings bump up the earnings of the company. This results in a smooth
stream of income over the periods, which is preferred by both management
and the investors. Secondly, researchers have accomplished to make a clear
differentiation between smoothers and non-smoothers. This implies that
several tests exist that can successfully measure whether or not the
management of a company practices income smoothing. Several forms of income
smoothing exist. Management can either transfer revenue from one period to
another period by the use of accounting methods, or engage in actual
economic transactions. Income smoothing is the focus of this Master
research.
Management can have multiple motives for smoothing the income of the
company. As was stated before, both management and investors prefer
companies that report smooth streams of income. However, the use of
earnings management causes management to report manipulated financial
reporting instead of the actual financial performance of the company;
income smoothing generally is considered as garbling behavior by management
and wou